The International Monetary Fund warned Japan on Thursday it must urgently restructure banks and companies or risk smothering a fragile recovery from its worst recession in the past decade.
Considerable risks lay ahead, IMF directors said in a report issued after annual consultations with Tokyo.
"They were concerned that the recovery is likely to prove short-lived unless Japan's deep-seated structural problems in the bank and corporate sector are urgently and comprehensively addressed," the IMF chiefs said.
"They urged that complacency must be avoided at all costs as this would only serve to prolong Japan's decade of stagnation as well as heighten the vulnerabilities from the bank, corporate and fiscal sectors."
Even after an economic growth spurt of 1.4 percent in the three months to March from the previous quarter, Japan's output was expected to shrink 0.5 percent on a year-average basis this year, IMF staff forecast.
Sharp increases in private consumption and state investment were likely to taper off because of the uncertain job market and a government withdrawal from economic stimulus packages, they said.
IMF directors endorsed a four-pillar strategy of addressing bank weaknesses, speeding up company restructuring, laying out a plan to shore up government coffers over the medium term and using monetary policy to end deflation.
Most IMF directors urged Japan to act quickly on banks, warning that time was running out before the government lifts a full guarantee on ordinary bank deposits in April next year.
They warned of the threat that a loss of confidence in weaker banks could spread across the industry.
Japan must ease rules governing private job placement, liberalize employment protection laws and boost government funding of retraining programs, the IMF said.
Rules limiting the size of housing developments and requiring large stores to get local government approval should be reviewed, it said.
"As the implementation of vigorous bank and corporate restructuring is likely to intensify headwinds against the fragile recovery, most directors considered that a key role for fiscal policy is to achieve a broadly neutral stance in the near term," the report said.
Government spending could be more balanced, with less expenditure on public works and more expenditure on social safety nets, it said.
IMF directors also urged Japan to fight deflation.
"While directors welcomed the efforts by the Bank of Japan to expand base money over the past year, they concurred with the view that these steps are unlikely to eliminate deflation soon," the report said.
But the IMF bosses were divided over how the Bank of Japan should conduct policy.
"Many urged further quantitative easing, particularly in light of concerns about the likely adverse impact of the recent appreciation of the yen on deflation and external competitiveness," the report said.
"On the other hand, a number of directors expressed skepticism over the effectiveness of further quantitative easing."
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