The International Monetary Fund said today that Japan's economy is recovering from years of stagnation, but that far-reaching reforms and a "credible plan" are needed to reduce its debt mountain and sustain growth in the long run.
The IMF's assessment, in a report issued today, said the near-term outlook of the world's third-largest economy "has improved considerably".
This was thanks to monetary easing and increased government spending under the administration of Prime Minister Shinzo Abe.
It forecasts that Japan's economy will grow 2% in 2013, helped by stronger demand at home and overseas, but will expand only 1.2% in 2014 as consumers tighten their belts following an expected increase in sales tax.
The IMF's report, based on a consultation with the Abe government last month, echoes earlier comments by the World Bank's lending arm on the "Abenomics" strategy of breaking out of a long spell of debilitating deflation by flooding the economy with money.
At Abe's behest, Japan's central bank is striving to generate 2% inflation within the next two years. But the report emphasised the need for "significant adjustments" to help reduce Japan's public debt, which will amount to nearly 250% of the country's gross domestic product this year.
"The growth outlook is subject to significant risks, primarily stemming from incomplete domestic reforms and a weaker external environment," the report said.
It also said that a "credible medium-term fiscal plan should be adopted as quickly as possible as fiscal risks have risen further."
A central concern is a potential loss of confidence in Japan's ability to service its debt, given that repaying just the interest on government bonds is consuming a growing share of the country's limited tax revenues.
Japan's difficult fiscal situation is compounded by surging health and welfare costs due to the fast-expanding share of elderly in the population. Rising inflation would inevitably push interest rates on government bonds higher, adding to the burden.
Uncertainty over the resilience of the recovery has prompted debate in Tokyo over whether the government should follow through on its pledge to raise the sales tax from 5% to 8% by next April, and eventually doubling it to 10% by 2015.
Unlike some other countries facing crushing levels of public debt, such as Greece and Cyprus, Japan's financial system remains generally sound, the report said. Most public debt is held by Japanese investors and financial institutions, helping to reduce the threat of a rapid and destabilising exodus of cash.
Japan's banks have relatively low levels of debt, while a rally in share prices since late last year has burnished their financial performances.
Over the long run, Japan's economic growth will likely settle near about 1%, as government spending on reconstruction from the March 2011 tsunami disaster is wound down, taxes increase and the pool of employable workers ages and shrinks, the IMF said.
Japan needs wide-ranging structural reforms to support growth, encourage investment and improve competitiveness, it added.
The report mentioned such priorities as bringing more women into the workforce, relaxing immigration restrictions and opening markets to more trade.
Inflation, the factor Abe says will underpin growth, should increase from around 0% to 0.7% by the end of this year, the report said.
Much of that will stem from rising costs associated with a weakening in the Japanese yen, which increases costs for imported food, fuel and other commodities. Sales tax hikes will further support inflation. The IMF expects long term inflation to average 2%.
The report only indirectly referred to the issue of whether wages will increase enough to ensure Japanese consumers will spend more and not just tighten their belts to cope with rising prices and higher taxes. Consumer spending makes up about three quarters of Japan's economy.
It urged reforms to reduce the growing number of workers, about 70% of them women, hired as non-permanent staff, who are paid significantly lower wages than "regular workers" and face limited job security and inferior access to social insurance.
The report said the costs of such a labour market setup were "substantial" and recommended steps to encourage stricter legal standards but more flexibility for employment in general
