Japan is recovering from the 2011 earthquake and tsunami disaster but the euro crisis, its huge public debt and a Chinese slump dampens hope over 2.5 percent growth this year, the IMF said Wednesday.
In a report on annual consultations with Tokyo, the International Monetary Fund urged the government to do more to shrink its massive debt of over 125 percent of GDP under a package of structural reforms.
Japan is grappling with a debt standing at more than double gross domestic product, the highest ratio in the industrialized world, which is poised to grow as a rapidly ageing population turns to public pensions.
Reconstruction spending and strong consumer demand would push GDP growth to about 2.5 percent this year, but the trend would slow in 2013 to 1.5 percent as reconstruction projects decrease.
"Concerns about fiscal sustainability are likely dampening investment plans," Jerald Schiff, deputy director of the IMF's Asia and Pacific department, told reporters in Washington.
"Low growth makes it more difficult to exit deflation and continued deflation complicates efforts to lower the deficit," he said.
Its economy showed "remarkable resilience and adaptability" in the aftermath of last year's crippling disaster that was worsened by a nuclear meltdown, the Fund said.
Yet recovery in the short term could be hamstrung by "the possibility of a further escalation of the crisis in Europe and a sharper-than-expected slowing of the Chinese economy," it added.
Most of the nation's debt is held domestically, allowing Tokyo to escape much of the criticism that has befallen eurozone countries, including Greece.
Over the medium term, a prolonged global downturn and Tokyo's limited progress on structural reforms would expose Japan to continued "low growth and deflation, a toxic mix that would worsen public debt dynamics substantially."
The Washington-based IMF welcomed as an "important first step" Tokyo's plan to double the country's sales tax to 10 percent by 2015, a deeply unpopular move that the government said was crucial to put Japan's fiscal house in order.
The legislation has passed the lower house of parliament, though it remains unclear whether it would get a stamp of approval in the upper house before becoming law.
"But beyond that, we think that further measures will be needed both to raise revenue and curb growth in social security and other spending," Schiff said.
The report recommended Tokyo reach an overall fiscal consolidation of 10 percent of GDP over the next decade by cutting spending and increasing revenue.
To raise its potential growth, Japan should increase the participation of women and older workers in the labor force, as well as ease restrictions on immigration and east access to financing for startups and small businesses.
The report called for pension reform, boosting productivity by easing regulations in the agricultural and service sectors, and "participation in additional free trade agreements."
"While Japan is already increasingly integrating into the rest of Asia, we think that continued efforts, including through participation in free trade agreements such as the Trans-Pacific Partnership, could have significant payoff," Schiff said.