The head of Japan's central bank said the country lacks a sense of urgency to tackle the reforms needed to improve government finances that are in "very bad shape."
Japan needs to raise its growth potential and improve its fiscal health, Bank of Japan Gov. Masaaki Shirakawa said Monday at the Foreign Correspondents' Club of Japan.
He called on the government to cut expenditure and boost revenue because inflation alone cannot solve budget problems. While higher prices could mean more tax revenue, it could also lead to higher costs for social security and public works. Japan is currently experiencing persistently falling prices known as deflation, but prices are expected to start rising again in the next fiscal year starting April.
"The country cannot continue to run deficits forever," Shirakawa said. "Therefore, society needs a credible commitment to fiscal reform."
His comments come less than two weeks after Standard & Poor's cut Japan's credit rating for the first time in almost nine years. The move reminded the world of the country's ballooning debt, now twice the size of gross domestic product, and highlighted questions about Prime Minister Naoto Kan's ability to stem fiscal deterioration.
Kan has proposed a record 92.4 trillion yen ($1.1 trillion) budget for the next fiscal year starting April 1. He came under fire for his initial response to the S&P downgrade, which suggested that he did not understand what the move meant.
Shirakawa declined to comment on Kan's words. But he blamed the country's general complacency on the fact that right now, Japan overall stands on relatively sound financial footing.
Japanese companies are still profitable, and long-term interest rates are not rising, he said. The yen, a key international currency, has not depreciated, and the country has not seen any capital flight.
Recent signs suggest Japan is emerging from a temporary "pause" and performing at par with other advanced economies, Shirakawa said.
The country, however, faces looming issues that weigh on its future, such as a rapidly aging population, lackluster productivity and growing public debt. Japanese society, he said, is "losing a healthy sense of optimism."
"Just as excessive optimism can generate an asset bubble, excessive pessimism can depress the economy," Shirakawa said. "What is necessary is a strong will for reform and overcoming excessive pessimism."
The Bank of Japan deserves more recognition for its own efforts to support Japan's economy, he said.
Under a "comprehensive monetary easing" policy, the central bank in October lowered its key interest rate to virtually zero percent and pledges to maintain the level until prices start rising again. It also unveiled a temporary 5 trillion yen ($61 billion) fund to buy financial assets such as government securities, commercial paper and corporate bonds to help lift the economy and reverse deflation.
Shirakawa said the central bank could expand the operation if the economy "deviates materially" from its projections.
The central bank expects Japan's economy to return to growth that is moderately in tandem with an expanding global economy. It expects real GDP to expand 3.3 percent this fiscal year through March.
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