The International Monetary Fund hailed Japanese Prime Minister Shinzo Abe's reform efforts, dubbed 'Abenomics', and urged the authorities to fully implement the 'three arrows' of his plan to revive growth and exit deflation.
Releasing the regular annual assessment of the economy, the Washington-based lender also warned of risks if the government fails to rein in the mounting debt. Nonetheless, IMF said that there were encouraging signs that the short-term outlook is improving.
The first arrow of the Abenomics, unprecedented monetary easing by the Bank of Japan, was launched in April. The central bank action has contributed to a pickup in demand and growth accelerated sharply in early 2013, the IMF pointed out.
The report, nonetheless, stressed on the need to adopt the second and third arrows of Abenomics—by developing credible medium-term fiscal and growth plans—to secure a sustained recovery and to bring down public debt.
IMF economists expect growth to reach 2 percent in 2013 and inflation to gradually increase to 0.7 percent by the end of the year. However, the IMF warned that Japan faced significant risks both from international and domestic factors.
On the external side, a slowdown in emerging markets, especially in China, or a protracted period of slower growth in Europe could result in lower demand for Japanese exports, lowering growth below the IMF's projection, the IMF said.
According to the report, the most significant domestic risk is the lack of credible fiscal consolidation and structural reform plans. It warned that without concrete measures, the new macroeconomic framework lacks credibility and may fail to raise growth and inflation expectations.
As a consequence, the monetary policy will become overburdened and the rest of the world could be negatively affected through a weaker yen, it noted.
IMF said in a worst case scenario, given Japan's high public debt, the lack of a convincing debt reduction strategy could result in a shift in market perceptions and a self-fulfilling sell-off of government bonds.
The adoption of concrete fiscal and structural reform measures by the government would strongly mitigate these risks, the lender said. To bring the public debt-to-GDP ratio on a downward path, Japan needs a fiscal consolidation of 11 percent over the next decade.
"Implementing the planned increase of the consumption tax rate from 5 to 10 percent by 2015 is a necessary first step in this direction, but substantial additional consolidation measures to take effect after 2015 will also be necessary," the report said.
IMF economists have also suggested measures that include a further increase of the consumption tax rate to at least 15 percent, broadening the personal income tax base to raise revenue and improve incentives to work, and containing pension and health spending.
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