Japan has finally emerged from an extended period of economic stagnation following the collapse of the asset price bubble in the early 1990s. Factors that had weighed on activity – such as falling asset prices and declining bank lending – have been slowed or reversed, while corporate restructuring to reduce employment, capacity and debt has largely run its course. This has allowed the initial export-led upturn in 2002 to develop since early 2005 into a full-fledged expansion driven by domestic demand. The strength and duration of this upturn pushed some measures of inflation into positive territory in the first quarter of 2006 and business and household confidence have now reached their highest levels since the early 1990s. The government’s reform measures have played an important role in laying the foundation for sustained and robust growth, in particular by strengthening the banking system. The positive trends in business investment and private consumption are expected to continue, making the current expansion the longest in Japan’s post-war history, with output growing between 2 and 3% in 2006 and 2007...

Japan has overcome many of the structural problems that hindered growth during the decade following the collapse of the asset price bubble in the early 1990s, helping it to achieve a sustained expansion led by domestic demand. Although robust economic growth is projected to continue through 2007, Japan must address a number of problems to sustain the expansion over the medium term. This chapter identifies five key challenges: i) ensuring a definitive end to deflation under a new monetary policy framework; ii) achieving fiscal consolidation in the context of high public debt and rapid population ageing; iii) addressing rising income inequality and poverty while reducing government spending; iv) boosting productivity growth by upgrading the innovation system, focusing on the R&D framework, product market competition and the education system; and v) strengthening the integration of Japan in the world economy to benefit more fully from globalisation.

With the end of quantitative easing, the Bank of Japan has introduced a new monetary policy framework that includes an understanding of price stability as 0 to 2% inflation. Given remaining deflationary pressures, the Bank should be cautious in raising short-term interest rates and should increase the lower bound of the inflation zone to reduce the risk of deflation in the future. It is also important to avoid a rapid run-up in long-term interest rates in order to help sustain the economic expansion. Maintaining the soundness of the banking sector is also essential. While the major banks have achieved significant progress, the regional banks have lagged behind. Scaling back the role of public financial institutions would be beneficial for the entire banking sector. In addition, following through on the privatisation of Japan Post is essential to shift the flow of funds from the public to the private sector.

With gross debt exceeding 170% of GDP, measures to reduce Japan’s large government budget deficit have become increasingly urgent. The government’s Reform and Perspectives should be improved to sustain confidence in the consolidation process and prevent a rise in the risk premium. The medium-term target should be a primary budget surplus large enough to stabilise the public debt ratio by the early 2010s. The first priority in achieving this objective is to reduce spending, although this will become increasingly difficult in the context of rapid population ageing. The Reform and Perspectives should provide a more detailed and binding schedule of expenditure reductions, in part through further declines in public investment. As spending cuts alone are unlikely to achieve the fiscal target, additional revenues will be necessary. This should be accomplished through broadening the bases of personal and corporate income taxes, as well as some increase in the consumption tax.

Income inequality and relative poverty among the working-age population in Japan have risen to levels above the OECD average. This trend is partially explained by labour market dualism – the increasing proportion of non-regular workers, who are paid significantly less than regular workers – as well as by other factors, including the ageing of the workforce. Social spending as a share of GDP has been expanding in the context of population ageing, although it remains below the OECD average and the proportion received by low-income households is small. Consequently, the impact of social spending on inequality and poverty is weak compared to other OECD countries and inadequate to offset the deterioration in market income. The scope for increasing social spending is constrained by the fiscal situation. Instead, reversing the upward trend in inequality and poverty requires reforms to reduce labour market dualism and better target social spending on low-income households, particularly single parents.

Increasing productivity growth through innovation is a key to raising living standards. Although R&D intensity in Japan is the third highest in the OECD area, the benefits do not appear to have been commensurate with the level of investment. The innovation system, which developed during the catching-up process, is largely input-driven and focused on incremental innovation based on closed and stable corporate and employment systems. However, this approach is less appropriate in the current global environment that favours risk-taking and a more open system relying on external linkages. To improve the innovation system, a broad-based strategy is needed, including a reform of framework conditions in the product and labour markets to strengthen competition and mobility, enhance international R&D links and improve the environment for venture business. Education and public research should be upgraded through stronger competition. The effectiveness of science and technology policy should be increased by strengthening its link to economic framework policies.

Globalisation through international trade, foreign direct investment (FDI) and international movements of labour is a key force driving economic growth. However, Japan is an outlier among OECD countries, with the lowest levels of import penetration, stock of inward FDI relative to GDP and foreign workers as a share of employment, reflecting the legacy of past policies during its post-war development. Policy reforms would help Japan make greater use of goods, services, capital, technology and human resources from abroad. Given the close links among trade, investment and labour flows, it is important to pursue a comprehensive approach, including; i) reducing barriers to FDI and imports, particularly in agriculture, through multilateral trade negotiations and regional trade agreements; ii) relaxing product market regulations, notably in the service sector; iii) fully opening the M&A market to foreign firms; and iv) easing controls on the inflow of foreign workers, including those in non-technical occupations.