By Leika Kihara
WASHINGTON (Reuters) - Japan should increase fiscal spending, instead of putting off a scheduled sales tax hike or expanding monetary stimulus, if risks to the economy materialize, a senior International Monetary Fund official said on Thursday.
Odd Per Brekk, deputy director of the IMF's Asia and Pacific department, said Japan is likely to avert a recession despite slowing global demand that is hurting exports.
The hit to growth from a scheduled sales tax hike in October will also be limited thanks to government measures to mitigate the pain, such as tax breaks and education benefits, he said.
Raising the sales tax rate is considered important for Japan to rein in its huge public debt, which is twice the size of its economy, and pay for the rising cost of financing welfare for a rapidly ageing population.
"Fiscal policy should be the first line of defense" if overseas headwinds threaten to derail Japan's economic recovery, Brekk told Reuters on Thursday.
"Japan shouldn't defer on the consumption tax increase but if downside risks materialize, think about spending involving infrastructure and social transfers," said Brekk, who is the IMF's mission chief of Japan.
Prime Minister Shinzo Abe has pledged to proceed with a twice-delayed increase in the sales tax to 10 percent from 8 percent. Some analysts speculate that Abe could delay the tax hike again if the economy worsens further, as he faces an upper house election in the summer.
The Bank of Japan could also face pressure to expand stimulus if the economy slumps, though many in the bank are wary of easing further given its dwindling policy ammunition.
Brekk said while the BOJ needs to maintain its ultra-easy policy, there was less room to ramp up monetary stimulus than increase fiscal spending.
"If you ask where the policy space is, fiscal policy should be the first line of defense," he said.
The BOJ should stick to its 2 percent inflation target and enhance its communication with markets, such as by clarifying the timing for maintaining ultra-low interest rates.
Under a forward guidance adopted in July last year, the BOJ pledges to keep rates very low for an "extended period."
"The BOJ may consider further clarifying the link between interest rates and inflation," which could help heighten inflation expectations, he said.
The BOJ is in a bind. Subdued inflation is forcing it to maintain its ultra-easy policy longer even as years of near-zero rates inflict pain on financial institutions by crushing their already thin margins.
Brekk said monetary policy alone cannot fix structural problems haunting Japan's regional banks, such as an ageing population that is shrinking corporate fund demand.
Changes in competition rules and mergers among the regional banks could be among options to fix the problem, he added.
"Big picture, the financial system in Japan is quite sound. Banks are well capitalized," he said.
"There are pockets of vulnerabilities around insurance firms and regional banks. But these problems are way more fundamental. The problems they're facing are more fundamental and structural issues, and therefore not really issues for monetary policy."