In the context of the global economic crisis, the Japanese economy has fallen into its deepest recession of the post-war era. Output is projected to contract by around 6% in 2009, reflecting a plunge in exports and tighter financial conditions. Prompt action by the authorities to stabilise financial markets, cut the policy interest rate and implement large-scale fiscal stimulus is cushioning the blow and sets the stage for a mild recovery, against the backdrop of a projected sluggish rebound in world trade. With deflation entrenched, the Bank of Japan should keep the policy interest rate close to zero. As the stimulus packages fade and fiscal consolidation begins, sustaining the expansion will depend increasingly on private domestic demand, which requires economic reforms to create new drivers of growth. Reforms in the labour market, where rising dualism has constrained wages and private consumption, and the non-manufacturing sector, where productivity gains lag far behind manufacturing, are especially important. Policy reforms in a number of other areas are needed for robust and sustainable growth.

The export-led expansion that began in 2002 ran out of steam in late 2007 in the context of slowing world trade. Output began to contract from the second quarter of 2008, even before the global financial crisis intensified in September. Although Japan was not at the epicentre of the crisis, its export-dependent economy was vulnerable to the collapse in world trade, which resulted in its most severe recession of the post-war era. Exports and industrial production each fell by around a third in volume terms between September 2008 and February 2009, leading to a rise in unemployment to unprecedented levels by mid-2009 and to a decline in wages. Financial market conditions deteriorated as credit conditions tightened and the capitalisation of the Tokyo Stock Exchange fell by half. By March 2009, the confidence of large manufacturing firms had plummeted to its lowest level since 1975, causing a major retrenchment in their investment plans. Headline inflation has turned negative and by mid-2009 prices were down around 2% year-on-year. Output is projected to drop by around 6% in 2009, following a 0.7% decline in 2008.

Despite its limited direct exposure to the global financial crisis, Japan’s exportdependent economy has fallen into its deepest recession of the post-war era. Prompt actions to stabilise financial markets, provide a large fiscal stimulus and cut interest rates are projected to lead to positive output growth in the second half of 2009. However, the pace is projected to remain sluggish at less than 1% in the context of a protracted recovery in world trade that will limit Japanese export growth. Meanwhile, fiscal consolidation will become a priority as the gross public debt is projected to reach 200% of GDP by 2010. Sustaining output growth must depend increasingly on boosting private domestic demand, requiring economic reforms, particularly in the labour market and the non-manufacturing sector. The key objectives should be to stem labour market dualism, which puts downward pressure on wages, and to pursue regulatory reform, particularly in services, to increase productivity.

Japanese banks largely avoided the direct impact from the global financial crisis thanks to their limited exposure to foreign toxic assets, the regulatory framework in Japan and the small role of securitisation. However, the sharp contraction in output and plunge in equity prices did have adverse impacts on the banking sector. The authorities responded with measures to stabilise the financial market, inject capital in depository institutions and sustain lending to small companies. These emergency measures should be phased out to limit distortions once the recovery is in place. It is essential to upgrade the regulatory framework by improving the transparency of securitised products, credit rating agencies and capital adequacy regulations. It is also important to address chronic problems, including low profitability, particularly in regional banks, and increase the efficiency of the financial sector. This requires a number of steps, including privatising public financial institutions, enhancing the efficiency of banking services and expanding the range and quality of financial products.

The top priority at present is to achieve a sustained economic recovery. However, a credible fiscal consolidation plan is important to maintain public confidence in Japan’s fiscal sustainability as the budget deficit is set to approach 10% of GDP in 2010 and gross public debt nears 200%. Although the goal of a primary budget surplus by FY 2011 is no longer feasible, the government should move promptly once a recovery is in place to implement tax increases and spending reductions, notably in public investment and government wages. While the plan of the previous government to allocate all consumption tax revenue to social security may make it politically easier to raise the consumption tax rate, it could also limit flexibility in spending. A broad-based tax reform, including improvements in direct taxes, is essential to boost revenue and support growth, which is also important to reduce the public debt ratio.

Japan’s health-care system has provided universal access to care and contributed to the outstanding health status of the Japanese. Public spending has been kept below the OECD average through high co-payment rates and reductions in medical fees. However, with continued upward pressure on expenditure, in part due to rapid population ageing, reforms are needed to limit spending increases through greater efficiency, while improving quality. It is essential to shift long-term care out of hospitals, reform the pricing mechanism away from pay-for-visit, increase the use of generic drugs, encourage healthy ageing and promote restructuring in the hospital sector. Quality should be improved by increasing the availability of effective new drugs and medical devices. In funding spending increases, it is important to limit the share borne by employees to avoid negative effects on the labour market. Japan may need to allow more mixed billing to enhance access to some advanced medical treatments.

Japan, a relatively energy-efficient country, has been active in combating climate change. Under the Kyoto Protocol, Japan is committed to reducing greenhouse gas emissions by 6% relative to 1990 over the period 2008-12. As of 2007, however, its emissions were up by 9%. Japan has relied primarily on voluntary measures, which are monitored by the government, without binding commitments or price signals on carbon. It is essential to improve the policy framework to achieve its ambitious longer-term target of a 60% to 80% emission reduction by 2050 in a cost-effective manner. Japan should shift from voluntary measures to market-based instruments, notably a mandatory and comprehensive emission trading scheme, supplemented if necessary, by carbon taxes in areas not covered by trading, which minimise abatement costs and promote innovation to reduce emissions. Trading schemes should be linked to those in other countries, while expanding Japan’s use of a wellfunctioning Clean Development Mechanism. Continued public support for R&D in emission reduction technology, particularly in basic research, is important.