Japan must act immediately to improve its fiscal health as the risks of natural disasters mount and social security costs continue to increase, according to the International Monetary Fund.

"There is limited space today in Japan to address shocks,” warned Nada Choueiri, the IMF’s Japan mission chief in an interview in Tokyo on Thursday. "Japan needs to plan today for where to find the space to accommodate” fiscal spending needs without increasing its deficits, she added.

The IMF’s warning comes as Japan ramps up spending to address a broad spectrum of needs ranging from bolstering national defense to efforts to raise the birth rate. That’s happening just as its financing costs are inching higher as a result of the Bank of Japan’s rate hikes over the last year. Japan already has the largest public debt burden among developed nations.

In its Article IV report released Friday, the IMF said there is "a significant risk” that the nation’s deficit will widen further, given the political demands on Prime Minister Shigeru Ishiba’s minority government. It projected a slight widening of Japan’s primary deficit to 2.2% of gross domestic product in 2025, compared with 2.1% last year.

"A small deterioration, but still it’s the wrong direction,” Choueiri said. "The deficit needs to be on a downward sloping path into the medium term to ensure that the fiscal accounts remain sustainable.”

The nation’s debt servicing costs are projected to jump 25% by fiscal year 2028 from the coming year, assuming an annual economic growth rate of 3% and inflation at 2%, according to a Finance Ministry estimate last month. The IMF forecast the size of Japan’s public debt will be 232.7% of gross domestic product this year, according to the report Friday.

"The government needs to prepare today for the increase on yields, because you don’t want negative surprises four or five years down the road,” Choueiri said, while noting that the gradual pace of rate hikes mitigates immediate risks.

Meanwhile, the ruling minority government’s weakened position has emboldened opposition parties to push for more spending across multiple policy fronts. That includes ongoing parliamentary debates involving raising the ceiling on tax-free income.

"There are close negotiations going on in the Diet and we will wait to see what happens in terms of what the actual measures are,” Gita Gopinath, the IMF’s first deputy managing director, said in a news conference Friday, referring to Japan's parliament by its formal name. "But our very strong advice is that it is very important for Japan to start fiscal consolidation now.”

Ishiba’s government has passed a ¥13.9 trillion ($91.3 billion) extra budget to fund the country’s latest economic stimulus package, and the Cabinet has approved a record ¥115.5 trillion initial budget for the fiscal year starting in April.

On monetary policy, Choueiri expressed support for the BOJ’s approach to normalizing interest rates gradually, emphasizing the importance of flexibility and data dependency. The IMF continues to expect interest rates to rise gradually toward the neutral rate of around 1.5% by the end of 2027, she said.

The BOJ conducted its third rate hike since March 2024 last month, raising the policy rate to 0.5%, the highest level since 2008.

Gov. Kazuo Ueda indicated during a post-decision news conference that further increases are likely, stating that the bank is still some distance from the neutral rate.

After three decades of near-zero inflation, there are signs that Japan’s economy can converge to a new equilibrium in a sustainable manner, the IMF said in the report.

Choueiri said she is increasingly confident that Japan will achieve stable inflation in the middle term, citing recent signs of strengthening inflation expectations, consumption growth and demand-driven price pressures. "These are green shoots that maintain our confidence that we are on the right path toward sustainable 2% inflation,” she said.

Still, the mission chief warned that the BOJ should remain cautious and flexible on the size and timing of rate increases, given factors including uncertainties in the global economy. One key concern is the wave of tariff-related announcements from U.S. President Donald Trump, which could exert a drag on global trade. So far, the United States has not signaled any tariff action against Japan ahead of Ishiba’s first meeting with Trump later Friday.

"We’ll continue to observe and pay attention to these announcements,” said Choueiri. "Because Japan is highly integrated in the world economy, we need to be watchful for how any announcement will impact its economy.”