IMF warns Japan of spillovers from rising foreign market volatility

By Leika Kihara

TOKYO (Reuters) - Japan should be on alert for any spillover effects from rising foreign market volatility that could affect liquidity conditions for its financial institutions, the International Monetary Fund said on Friday.

The IMF also said the country needed to be vigilant about monitoring any fallout from the Bank of Japan's interest rate rises, such as an increase in the government's debt-servicing costs and a possible jump in corporate bankruptcies.

"As interest rates rise, the cost of servicing the large public debt is expected to double by 2030, putting a premium on a robust debt management strategy," the IMF said in a statement released after its consultation with Japanese policymakers.

"In the face of rising gross financing needs and a shrinking BOJ balance sheet, government bond issuance will need to rely on additional demand from foreign investors and domestic institutions," it said.

The yen has made sizable swings against the dollar, driven largely by shifts in the Japan-U.S. interest rate differentials, but also amplified by the build-up and unwinding of yen carry traders, the IMF said.

Rises in foreign market volatility could affect domestic liquidity conditions, potentially triggering spill-over effects, the IMF said.

"To mitigate these risks, the central bank should closely monitor liquidity conditions and funding rates in money markets, while paying particular attention to the uneven distribution of liquidity among banks," it said.

The IMF welcomed Japan's "continued commitment to a flexible exchange rate regime," saying that should continue to help the country absorb external shocks and support its monetary policy's focus on price stability.

The BOJ ended a decade-long, radical stimulus programme last year and raised short-term interest rates to 0.5% from 0.25% in January, reflecting its growing conviction that Japan is on track to sustainably achieve its 2% inflation target.

After three decades of near-zero inflation, there are signs Japan's economy can sustainably converge to a "new equilibrium" with inflation exceeding the BOJ's 2% target for more than two years and a tight job market pushing up wages, the IMF said.

The IMF called for a gradual increase in the BOJ's policy rate, saying Japan's ultra-low interest rates may have allowed low-productivity firms to survive longer than they otherwise would have and delayed necessary economic restructuring.

But it warned that faster-than-expected interest rate increases coupled with rising bankruptcies among smaller firms could destabilise the banking sector.

"While gradually rising interest rates have helped bank profitability, faster-than-expected increases in interest rates or sudden changes in global financial conditions could amplify financial market volatility," the IMF said.

A faster-than-expected monetary tightening could also disrupt the Japanese government bond (JGB) market, amplifying interest rate risks for banks with larger exposures, it said.

(Reporting by Leika Kihara; Editing by Jamie Freed)