In its annual Article IV assessment, the IMF said it expects the world's second largest economy to contract by 6 percent in 2009, but revised its growth forecast up for the following year from ½ percent to 1.7 percent.

“Of course there are downside risks, particularly if export demand continues to remain weak and unemployment starts to weaken consumption further. To our mind, this emphasizes the importance of monetary policy, fiscal policy and financial sector policies remaining supportive with additional measures considered if the outlook deteriorates,” said IMF mission chief for Japan Jim Gordon.

The improved outlook is a result of adjustments in production and the authorities' strong fiscal response, which is expected to lift growth over the coming months.

Although it expects a sustained recovery to take hold next year, in line with a projected pickup across the world, the IMF warned “the outlook is exceptionally uncertain.” Risks remain, including worsening labor market conditions, tight financial markets, and global uncertainty. The report emphasized the need for policies to remain flexible if recovery fails to take hold.

“A longer or more severe recession could call for additional targeted and reversible measures next year,” said the report, which was issued after consultations with the country's authorities that ended on July 6.

Japan was not at the epicenter of the global crisis, but the subsequent collapse in global demand and financial spillovers plunged the economy into its worst recession in over half a century. The country's financial markets have since stabilized and the Japanese stock market has rebounded from earlier this year, although it remains about 40 percent below end-2007 levels.

Japanese Prime Minister Taro Aso has pledged spending measures worth around 5 percent of GDP as part of an aggressive stimulus package. The IMF praised authorities for their “well-calibrated response” and agreed with the country's decision to support growth and preserve financial stability. However, it also noted that the much-needed stimulus package represents a significant future burden for the country.

The government recently abandoned its aim of eliminating the primary budget deficit by 2011 and instead it plans to halve the gap within five years. According to the IMF, the overall fiscal deficit is projected to widen to about 11 ½ percent of GDP in 2009. The Fund says Tokyo will need to address its medium-term fiscal strategy once the recovery has taken effect.

“In addition to new targets aimed at placing the debt ratio firmly on a downward path, and careful debt management, such a strategy will likely require expenditure cuts as well as comprehensive tax reform,“ the IMF said.

On monetary and financial policies, Japan has already taken numerous steps to facilitate corporate financing and stabilize financial markets. The IMF suggested that additional credit easing measures might be needed if financial stresses resurface.

The report projected inflation to remain negative until 2011. It also noted that the Japanese yen, which has appreciated by about 20 percent in real terms since August 2008, appeared to be “in line with its longer-term equilibrium.”

The IMF's Executive Board added that exit strategies from the crisis measures and reforms to rebalance growth should be adopted once the recovery gets under way. “Once the economy recovers, attention will need to turn to implementing an exit strategy from the exceptional policy interventions necessitated by the crisis and to stepping up reforms for rebalancing growth. Determining the appropriate timing, speed, and conditions for unwinding support will be key.”

In addition, the IMF report called on the export-dependent economy to press ahead with measures to stimulate domestic demand, and recommended deregulation of the agriculture and service sectors. “By rebalancing growth toward domestic demand, such reforms will help Japan adjust to structural shifts in the global economy,” the IMF report said.#