10/23/2013 04:08 PM


ECB Tests Set to Reveal German System Flaws

By Christopher Alessi
The European Central Bank's upcoming review of the euro zone's largest banks could expose weaknesses in the German banking sector. It may also reveal Germany's political role in limiting the scope and efficacy of the Continent's nascent banking union.

The European Central Bank is preparing to conduct a "comprehensive assessment" of the euro zone's biggest banks ahead of taking on the role of banking supervisor for the region late next year. German banks, considered some of the strongest in the fragile euro area, are expected to fare relatively well. However, a thorough -- and apolitical -- review could reveal cracks in the German financial system, while underscoring Germany's fundamental resistance to a full-fledged banking union.

Earlier this month, European Union finance ministers officially signed off on plans to create a Single Supervisory Mechanism within the ECB, which will monitor around 130 of the euro zone's largest banks. The step is the first in a larger EU plan to shift financial regulatory authority from national governments to the European level by developing a so-called banking unión.

However, the ECB, starting in November, will first assess the health and stability of the big banks through an evaluation that includes a risk assessment, an asset quality review, and a stress test targeting bank balance sheets. The review, which will be based on a capital benchmark of 8 percent, should "strengthen private sector confidence in the soundness of euro area banks and in the quality of their balance sheets," ECB President Mario Draghi said when the bank outlined its assessment criteria on Oct. 23.

Bank analysts and economists expect some banks in Italy, France, and Spain to require additional capital following the evaluation, in large part due to non-performing loans. But what about German banks?

'Too Many Banks'

"In the European context, German banks are much stronger than others, so the adjustment will probably be a lot smaller," says Marcel Fratzscher, president of the German Institute for Economic Research. However, he warns, "Commerzbank is a big question mark."

Fratzscher says it is not clear whether Commerzbank has a sustainable business model, like that of its well-capitalized competitor, Deutsche Bank. "It's not an international player, and it's not reaching a lot of private companies and households in Germany," Fratzscher explains. He suggests that the German government, which has held a 17 percent stake in Commerzbank since the global financial crisis, might ultimately need to inject more liquidity into the bank or "scale it down." Similarly, a European bank insider, who spoke on the condition of anonymity, says he could envision the government re-privatizing Commerzbank by selling to a buyer like UBS, which could lead to a "winding down" of the bank.

Part of Commerzbank's trouble stems from its large exposure to poor shipping loans. "It's taken huge losses and can't find anyone to sell its shipping portfolio to," says Megan Greene, chief economist at Maverick Intelligence. Commerzbank's exposure to non-performing shipping loans increased from 21 percent to over 25 percent between November 2012 and June 2013, according to a recent report on the planned asset quality review by Nomura Equity Research. But Commerzbank is not the only German bank facing challenges ahead of the assessment.

"I think shipping loans is a higher risk area for a number of German banks, and as in previous stress tests one of the key challenges will be the comparatively low level of Basel III core Tier 1 [capital ratios above 7 percent] as a starting point," notes Jon Peace, a Nomura analyst. Other German banks with high shipping exposures are two of the publicly-owned Landesbanken, or regional banks, including NHS Nordbank and Norddeutsche Landesbank.

Those regional banks are part of what Carsten Brzeski, chief economist at ING DiBa bank, calls Germany's "over-banked" system -- including private commercial banks, savings and cooperative banks, and the Landesbanken. "There are too many banks in Germany," Brzeski says, suggesting that the upcoming ECB tests could provide an opportunity for a consolidation of the sector.

More broadly, a functioning and effective banking union would "imply some adjustments" for German banks, says Jan Pieter Krahnen, director of the Center for Financial Studies at Frankfurt's Goethe University. "There will be adjustments -- consolidation -- for the big banks, as well as for the savings banks and the smaller regional banks," Krahnen explains.

A Forceful Backstop

There remain a number of unsettled elements that make such a comprehensive banking union far from complete. These include the development of a Single Resolution Mechanism for addressing weak banks, the harmonization of standards for certain loan classifications and bank assets, and a deposit guarantee fund.

The resolution scheme has proven particularly controversial because it entails the creation of a central joint fund that would act as a backstop for struggling banks. In the long term, the banking industry would finance the fund, but in the short term, national governments -- potentially through the European Stability Mechanism -- might have to guarantee loans to failing banks. Germany has forcefully opposed such a move, which could theoretically force German tax payers to bailout banks in, say, Spain or Italy.

German Finance Minister Wolfgang Schäuble recently insisted that senior and junior bank creditors would have to take full losses -- so-called bail-ins -- and German law would have to be amended before Germany could agree to assist with the recapitalization of euro zone banks. But Chancellor Angela Merkel later tweaked the government's position, at least rhetorically, indicating that she could potentially support a joint resolution mechanism under certain conditions: namely, that private creditors and bondholders be liable first, and that any government assistance be approved by national parliaments. Meanwhile, Draghi said in a recently leaked letter to the European Commission that forcing losses on bondholders before a banking union is up and running could destabilize markets.

The irony of the firm German position, as former ECB executive board member Lorenzo Bini Smaghi sees it, is that the recapitalization of German banks in the wake of the financial crisis was among the largest in Europe. The Germans "have never 'bailed-in' anybody," Bini Smaghi says, "their banks have always been bailed out." He faults Germany for its insistence on a "system they have never tried at home and writing rules that put you in a straight jacket," which he suggests could create conditions that ultimately trigger a run on banks.

Without agreement on a forceful backstop, or resolution mechanism, many analysts and economists question whether the upcoming ECB assessments can actually be meaningful. "The backstop is the key thing for this test," says Krahnen. The ECB is in a tight corner. If the bank does not conduct a "serious" review of banks, it will not be able to operate effectively as a banking supervisor down the line, Krahnen says. But if it does operate a genuine comprehensive test with no resolution mechanism in place, many banks "will be in trouble soon," he explains.

Greene, of Maverick Intelligence, bets that the asset review and stress tests will ultimately be a "big fudge." "Europeans are not really sure what they'll do with the results. There's no fund for big recaps," she adds. Ultimately, she argues, Germany will get its way regarding the joint backstop.

National supervisors will continue to have a large role in the bank resolution process, which, Greene says, will make the new system more of a "banking confederation" than a banking union.

Obama’s Exceptional Opportunity

Jaswant Singh

23 October 2013

NEW DELHI – The United States’ era as a hyperpower has ended, leaving its policymakers to confront difficult questions about their country’s global role. Should the US continue to act with its traditional sense of embodying an exceptional destiny in and for the world, or should it retreat into isolationism?
Of course, every US president must pay lip service to the country’s “exceptionalism.” President Barack Obama did so most recently in September, when he declared that “what makes us exceptional” is that we act “with humility, but with resolve.” Despite his desire to end US entanglements in the wars in the greater Middle East, he appears determined to give life to the claims of American exceptionalism.
Evidence of this was seen recently when Obama and Iranian President Hassan Rouhani became the first leaders of their respective countries to have a conversation in more than three decades. Rouhani – a reputed moderate, whose week-long visit to New York for the United Nations General Assembly included a series of unprecedented diplomatic encounters – offered truly conciliatory rhetoric to his US counterpart. Despite catcalls from conservative US politicians and media, Obama’s reaction to Rouhani was statesmanlike.
Just as Rouhani’s trip was coming to an end, Obama initiated a phone call with him. While the conversation was brief, a senior Obama administration official reported that the two leaders had a “shared sense of urgency” over the upcoming nuclear talks, and that an agreement there “could open the door to a deeper relationship.”
Renewing the long-fractured bilateral relationship would require both parties to overcome strong domestic opposition. When Rouhani returned to Iran, conservative protesters hurled eggs and shoes at him. And in the US, instead of giving Obama time to negotiate a nuclear deal with Iran in a less charged atmosphere, hardline conservatives like Florida Senator Marco Rubio have called for the imposition of a new round of economic sanctions.
America’s experienced diplomats seem to be more supportive of the move to strengthen the bilateral relationship. Suzanne Maloney, a former State Department official, expressed cautious optimism, stating that “it is early days and it will require a lot of testing, but Mr. Rouhani has been more ambitious than I would ever have hoped.”
The journalist Steve Clemons went further, stating that “rapprochement with Iran would be the biggest positive shift in global affairs since the end of the Cold War and the normalization of relations with China.” America’s failure to take advantage of this opportunity, Clemons continued, would be its “biggest strategic error since the Iraq invasion.”
The question is how Obama, with limited room for maneuver domestically, can explore this potentially game-changing development. Given Iran’s continued progress with its nuclear program, heeding conservative demands for a return to hostility and antagonism would be a mistake. Indeed, in this case, not talking amounts to having no strategy at all – a seriously risky proposition. Even if the relationship does remain icy, lines of communication that have now been opened must remain so.
To be sure, nobody believes that many decades’ worth of mistrust and resentment can be overcome in an instant. Iranians cannot forget the US-led coup that overthrew the nationalist Mohammad Mossadegh six decades ago, and Americans remain bitter about the invasion of the US embassy in Tehran in 1979, which resulted in more than 50 American diplomats and staff being held hostage for 444 days.
But, while statesmen cannot rewrite the past, they can shape a better future. And the historic issue today is Iran’s nuclear program. As a signatory to the Nuclear Non-Proliferation Treaty, Iran has the right to develop its nuclear capacity, but only for peaceful purposes. Within this framework, there is space for the US and Iran to find common ground, if both sides adopt a realistic approach.
Obama’s other option – to launch a military attack on Iran’s nuclear facilities – is a non-starter. Such an attack has scant chance of success, particularly after America’s costly and self-defeating misadventures in Afghanistan, Iraq, and Libya.
Fortunately, although both sides have drawn “red lines,” recent events have created powerful momentum for progress. Though Iran has declared that removal of its stockpile of 20% enriched uranium from the country is its red line, Foreign Minister Mohammad Javad Zarif has expressed a desire to agree on a “road map” for resolution. Zarif also says that the nuclear crisis could be resolved within a year, with a deadline for the talks ensuring that neither “side would think the other is killing time to pursue some other goals.”
These circumstances call for the best of American exceptionalism. Iran, home to one of the world’s oldest continuous civilizations, may be willing to end decades of hostility – an outcome that would have a profound influence on the wider Middle East. The US must not allow its isolationist impulses – or its conservative hardliners – to prevent it from seizing this diplomatic opening.
Jaswant Singh is the only person to have served as India’s finance minister (1996, 2002-2004), foreign minister (1998-2004), and defense minister (2000-2001). While in office, he launched the first free-trade agreement (with Sri Lanka) in South Asia’s history, initiated India’s most daring diplomatic opening to Pakistan, revitalized relations with the US, and reoriented the Indian military, abandoning its Soviet-inspired doctrines and weaponry for close ties with the West. His most recent book is Jinnah: India – Partition – Independence.

As Developing Economies Grow, Global Value Chains Reach a Turning Point

Oct 21, 2013


In the “flying geese paradigm,” Japanese economist Kaname Akamatsu explains that companies restructure to find the cheapest labor costs by moving low-value activities to nearby less-developed countries. Today that story rings truer than ever before as global value chains (GVCs) reach a critical turning point. Simply put, GVCs take a broader look at supply chains coordinated by multinational companies, but also encompass economic analyses of the countries involved with the activities.

Last year, for the first time in history, developing economies attracted more foreign direct investment (FDI) — 52% — than developed economies, according to the latest FDI report from the United Nations Conference on Trade and Development (UNCTAD) and the World Trade Organization (WTO). The impact of this report on GVCs, say Wharton and industry experts, could be profound.

“There is an enormous amount of change going on. The global supply chain is in flux,” notes Wharton operations and information management professor Morris A. Cohen. International supply networks have been in place for decades now, but the pace of global trade expansion has skyrocketed past the rate of the world’s GDP growth. “The recession of 2008-2009 has further increased trade with developing economies,” adds Anthony Mistri, economics expert at the World Trade Organization (WTO). “Nations may have borders, but businesses no longer do.”

How GVCs Are Changing

In 1990, developing countries had a 20% share in global trade. Today, that figure is more than 40%. Moreover, transnational companies coordinate around 80% of global trade, according to UNCTAD. This impact is particularly significant in developing economies, where value-added trade contributes to nearly one-third of a country’s GDP compared to almost one-fifth in developed nations.
The more foreign investments there are in a country, the higher the level of participation in GVCs, thereby resulting in higher domestic value added from trade. Moreover, developing economies with effective GVC participation can increase GDP per capita growth by 2% above average, says Axèle Giroud, an expert at UNCTAD who helped author the report. But that kind of change doesn’t happen overnight.
“Nations may have borders, but businesses no longer do.” –Anthony Mistri
GVCs adapt dynamically, but depending on the sector, supply chains are shifting in different ways. “You see the disintegration or fragmentation of value chains in manufacturing,” says Wharton management professor Ann Harrison. But in agriculture, you see the opposite going on. Agribusiness is becoming more and more integrated.”

“Current technological advancements have made production processes become more fragmented,” Mistri adds. “Better communications have facilitated operating at a distance, not only for raw materials or components planning, but also in services and management. Participation in GVCs can commence with the smallest of components — and don’t involve building a complete new factory — creating more opportunities to participate.”

China has jumped to third place from sixth place as the world’s biggest investor, behind the U.S. and Japan, Giroud says. Though China is still officially categorized as a developing economy, Cohen adds, it’s debatable whether the nation is “developing” or “developed.”

According to Wharton operations and information management professor Marshall L. Fisher, China “is no longer the cheapest place to produce things, and it has accelerated people’s thinking about where to go from here.” Indeed, while Chinese labor costs are growing 20% annually, wage hikes in the U.S. are inching up by 2% due to lack of jobs and the recession, Cohen notes, adding that “the labor advantage is eroding, and the tipping point” could bring jobs back to the U.S., a phenomenon called ‘re-shoring.’ General Electric recently announced that it is reopening a manufacturing plant in Kentucky, and Apple plans to start assembling Mac Pros in the U.S., the company said in June.

“Near-shoring” could potentially move jobs to Mexico from Asia. China itself is setting up suppliers in lower labor-cost markets, like Vietnam, Cambodia and Indonesia, says Cohen.

Challenges and Solutions

While experts have long accepted Asia as the go-to region for cheap labor, that reality is quickly changing. Though Africa is one of the least developed continents, it is also the region with possibly the most potential. “FDI declined significantly worldwide by 18%, whereas inflows to Africa increased by 5%. That’s a really positive sign for Africa. It may not sound high, but it’s significant when everywhere else decreases,” notes Giroud.

Even so, while developed economies retain 31% of the value added from exports, Africa retains only 14% and Asia 27%, according to the UNCTAD report. That’s partly because extractive industries contribute to a large part of Africa’s exports, yet the processing end is woefully underdeveloped.

Edwin Keh, a Wharton lecturer and former chief operating officer of Walmart’s global procurement division, calls it “the curse of the abundance of natural resources. Year after year, oil and minerals were pulled out of the ground. [African countries] didn’t need to manufacture anything to make ends meet. But what happens when these resources go dry?” he asks.
“There’s the curse of the abundance of natural resources. Year after year, oil and minerals were pulled out of the ground…. But what happens when these resources go dry?” –Edwin Keh
For example, Africa is the world’s biggest producer of cashew nuts, but about “90% of the crop gets exported raw to countries like India and Vietnam and then sent to the U.S. or Europe for roasting, salting and packaging,” says Miriam Gyamfi of the African Cashew Alliance (ACA) in Ghana. “That means that Africa, the biggest producer of cashews, is missing out on the most profitable part of the cashew value chain — the processing of the nut. ACA’s mission is to [help] African cashew industries by enabling access to finance, providing technical assistance and setting up market linkages to international industries.” The organization works with companies like Kraft, Costco and Red River Foods.

In comparison, processing and manufacturing in Asia account for a significant part of export value, thereby retaining more economic benefits regionally.

These disparities mean that developing countries need to plan a more sophisticated approach to maximize their role in GVCs with “good infrastructure, education and know-how; market access; the ability to produce at internationally recognized standards; security of finances, and geopolitical stability, to only list a few,” says Mistri. “Basically, the more entrepreneurial risks a country can mitigate, the higher the chances are it can attract multinational firms.”

According to Fisher, “in the last two to three years, Africa has been more prominent on people’s radar screen as potentially the next frontier.” Adds Keh: “The attraction [of] Africa is that people who get there first make the most money. The continent of Africa is significantly underdeveloped compared to China and Latin America.”

Another challenge is political stability. “We need law, rules and regulations, and globally accepted practices for accounting,” Keh notes. “We need orderly transition of governments and an effective civil service. Joint ventures can build up an economy, but we need long-term agreements that will stay in place for 10 to 15 years.”

Peter Draper, a senior research fellow at the South African Institute of International Affairs, adds, “There have been lots of problems with governments in Sub-Saharan Africa. Governments have been open to lobbying, corruption and all of that. It’s getting better but we have a long way to go.”

Meanwhile, African entrepreneurs have come up with innovative ways to adapt to some of these obstacles, says Mistri. For instance, M-Pesa is a mobile finance system that relies on cell phone networks, not brick-and-mortar banks. Bethlehem Tilahun Alemu, founder of soleRebels, an eco-friendly footwear company based in Ethiopia, manages her shoes and sandals from raw materials to finished products within the country before she ships $6 million worth of goods worldwide annually.

 “Developing nations, as soleRebels has shown, must be willing to reinterpret how they present their assets and then find ways to re-position and re-leverage those assets globally. In doing so, they will uncover a lot of unseen potential,” says Alemu.

In Spain, this business strategy has worked for clothing brand Zara. Harrison notes that the company has kicked the global trend by designing all of its goods and manufacturing about half of them in Spain. “The reason they give is they can respond rapidly to fashion trends. It’s worked for them,” Harrison says.
“Multinationals in emerging markets are investing in other emerging markets. You see the Chinese investing in Africa, or Taiwanese or South Korean subcontractors making apparel in Indonesia.” –Ann Harrison
According to Isaac Esseku, an entrepreneur working on a venture to establish grocery retail chains in Ghana, “There is not a clear supply chain to try to engage the local produce. There are no refrigerated storage facilities so there is a lot of wastage. The transportation system with traffic and bad roads is a challenge. In the Western-style grocery chains in Africa and the developing world, it’s easier to sell imported packaged goods from Europe because they have a really long shelf life.” His plan is to expand local supply chains in concentric circles to create regional networks.

“The truth is [local supply chains] are not a priority for the government. The government should rightly focus on basic infrastructure, like roads and electricity, but [those efforts] are taking too long,” says Esseku. “Agriculture as an export commodity, like cocoa, is emphasized, but there should be an element of sustainable local agriculture to create a circulation of wealth within the system.”

The trick with GVCs “is not to rely only on the vertical chain to pull small-scale producers into productivity and prosperity,” notes Bill Vorley, a researcher at the International Institute for Environment and Development in London. He points to the success of the Kenya Tea Development Agency, which comprises 150,000 shareholders and runs a total of 63 tea processing factories. The collective has developed a partnership with Unilever, giving it a boost up the supply chain ladder.

Another example, adds Harrison, is Olam International, which works with farmers in Africa to sell food ingredients worldwide. The organization started by exporting raw cashew nuts from Nigeria to India in 1989. Since then, it has moved its headquarters from London to Singapore and operates more than 16 platforms in 65 countries.

“The competitive advantage of China and Hong Kong is they have a developed supply chain. They start with raw materials and end with manufactured final products,” says Keh. Their expertise is leading to a rise of “South-South” investments, notes Harrison. “Multinationals in emerging markets are investing in other emerging markets. You see the Chinese investing in Africa, or Taiwanese and South Korean subcontractors making apparel in Indonesia. They can go into emerging markets very successfully.”

Solutions for a New World Order

As GVCs reach more complex levels worldwide, transnational companies and developing countries need to find ways to mutually benefit. “We need to think more dynamically … to synthesize trade and investment policies. We can build domestic capacity to support global firms so they give attention to social and environmental factors,” says Giroud.

“Developing regional strategies by integrating investment trade, joint capacity-building and cross-border industrialization” is one the first steps for emerging economies, suggests Giroud. Another recommendation, says Draper, is “establishing special economic zones that promote manufactured exports and allow duty-free imports. Any type of policy tried successfully elsewhere could work.”
At the end of the day, Keh adds, “global supply chains are all about total supply chain, upstream and downstream, from raw materials to final assembly. The developing world is disappearing. We’re a global society with big capacity for growth.”

Markets Insight

October 23, 2013 6:01 am

Look to ‘Helicopter’ Ben for clues to Yellen’s Fed

Janet Yellen is haunted by history of dovish monetary sentiment
What can we expect from a Federal Reserve helmed by newly nominated chair Janet Yellen? Unlikely as it may sound, we can draw insight from a decade-old misinterpreted remark.
In November 2002, as the US economy was emerging from recession, Federal Reserve Governor Ben Bernanke delivered his now infamous “Helicopter” speech – during which he recalled Milton Friedman’s jocular depiction of dropping money from helicopters as a last-ditch means to fight deflation.

The witty but obscure reference to Friedman’s 1969 paper “The Optimum Quantity of Money” was largely misinterpreted, both on Main Street and Wall Street. Derided as “Helicopter Ben”, Mr Bernanke saw his commitment to price stability drawn into question as he was viewed as championing easy money. Nevertheless, it appeared that his comments serendipitously contributed to ending the deflation scare. Interest rates stabilised and the market’s concerns over price deflation were successfully allayed.

Inflation fighter

The helicopter speech continued to haunt Mr Bernanke, even upon his confirmation as chairman of the Federal Reserve. With his commitment to price stability in doubt, the chairman found it hard to take pre-emptive and decisive action in the subprime crisis he encountered soon after taking office. It was imperative to him that he reaffirm his mantle as an inflation fighter, even though maintaining a restrictive monetary policy before the housing collapse would prove only to further exacerbate the crisis.

Ultimately, the chairman relented. He dramatically reversed course and flooded the financial system with unprecedented levels of monetary liquidity.

Future historians will ultimately judge whether the chairman’s actions in the early days of the crisis – marked by a reluctance to reduce rates – are responsible for the depth of the collapse.

More pressing, however, is the similar series of questions that looms large for Ms Yellen. Like Mr Bernanke, she is haunted by a history of dovish monetary sentiment; her reputation for favouring easy money is virtually ubiquitous. But this characterisation may be unfair.

Her long and established career at the Fed renders her one of the most seasoned and highly informed central bankers in the world. Ms Yellen has an impeccable resume, and is arguably one of the best qualified candidates in recent history for the Fed chairman position.

She has previously served as chair of the president’s Council of Economic Advisors, was an FOMC governor for two years, and president of the San Francisco Fed for five-and-a-half years. Over the past three years, she has served as vice-chairman of the Fed, and is known for her cautious and methodical leadership style. She is well regarded for having excellent communications skills and is a leading advocate of Fed transparency.

Nevertheless, the spectre of easy money advocacy with which she is associated could potentially complicate her life as the chair of the Fed.

Will she face the same challenges as Mr Bernanke? Will her dovish legacy cause her to act in ways inconsistent with promoting economic recovery? Will she exit QE too soon or too quickly – causing rates to rise and potentially damaging the housing market – in an effort to establish inflation-fighting credibility?
Hard course to steer
Or will Ms Yellen embrace earlier comments which suggest the Fed might tolerate higher levels of inflation than the central bank’s stated 2 per cent ceiling – assuming such price pressures were deemed to be transient? Either way, it will be hard for the chairman to steer a middle course in trying to fulfil its dual mandate.

I take Ms Yellen at her word. I believe in the long run she will use monetary policy, including inflation, as a tool to reduce unemployment. She may, in the short run, feel a need to establish her anti-inflation credentials – resulting in an earlier exit of QE than expected. If that path were to result in dramatic increases in interest rates, similar to the aftermath of Mr Bernanke’s June press conference when he raised the notion of tapering, I believe she would quickly reverse course.
The ultimate normalisation of post-crisis monetary policy will be tricky. Policy makers will find it difficult to pace the reduction in monetary accommodation to assure both price stability and full employment. Given the significant possibility for a policy error, the odds favour betting on lower unemployment and higher inflation in a Yellen Fed.

Scott Minerd is global chief investment officer at Guggenheim Partners

October 23, 2013, 1:24 AM ET

IMF Warns Japan About Using Monetary Policy as Crutch

By Mitsuru Obe

Since Japanese Prime Minister Shinzo Abe took office last December, both the yen and yields on sovereign debt have gone down, largely due to the government and the Bank of Japan's heavy involvement in the economy’s monetary framework.

But with the BOJ now purchasing Japanese government bonds at a faster pace than Japan’s government can issue debt, economists at the International Monetary Fund warn that Mr. Abe’s plans to revive the economy through monetary policy could hit a wall unless more fundamental reform measures take their place.

“Without ambitious growth and fiscal reforms in train, the BOJ could face difficulties in mainintaining stable long-term rates,” a working paper released by the global financial watchdog showed. “Monetary policy alone cannot counter a potentially rising fiscal risk premium under current policies.”

While public spending along with private consumption have been key factors in recent strong readings of gross domestic product, underlying economic data that reflect what fundamentally drives the nation’s economy paint a different picture. Neither industrial production nor machinery orders have logged significant gains in recent years, while the country has racked up 15 straight months of merchandise trade deficits.

The IMF has long called for radical, market-driven reforms as a way to kick-start Japan’s long-dormant economy. Deregulating the agricultural sector, encouraging foreign investment, increasing labor mobility and relaxing immigration rules are among the recommendations the IMF made in its annual consultation with Japan this year.

Mr. Abe has pledged to undertake bold reforms, calling them “the third arrow” of his “Abenomics” policy after “the first arrow” of monetary easing and “the second arrow” of fiscal stimulus. But the announced programs so far have been seen as a far cry from the proposals that the IMF and the business community have suggested.

The IMF paper warned that incomplete implementation of structural reforms in Japan could lead to slower growth, requiring further fiscal stimulus to close the output gap and boost inflation in the near term, leading to a further deterioration in Japan’s fiscal conditions, already the worst among developed countries.

Under the scenario of incomplete policy implementation, Japan’s government debt is projected to increase to around 310% of its GDP by 2030, from around 240% now.

By contrast, successful implementation of the reforms would spur economic growth, reduce the need for fiscal outlays, and keep the debt level at around 250% of GDP over the medium term.

“Successful implementation of Abenomics … will be essential to keep long-term interest rates low and stable at levels broadly similar to nominal GDP growth rates,” it said.
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