TOKYO (AP) -- Japan's efforts to end two decades of stagnation are welcome changes that could spark a recovery, but rising national debt threatens its long-term growth and financial stability, the Organization for Economic Cooperation and Development said in a report Tuesday.
Re-establishing fiscal health is Japan's "paramount policy challenge," the OECD said in the report. Japan's public debt is more than twice the size of its economy.
The OECD said efforts to restore growth by vastly easing monetary policy to achieve a 2 percent inflation target, increasing government spending and carrying out reforms to improve Japan's competitiveness were "most encouraging."
"Confidence is coming back, both in firms and in households. Japan now appears poised for economic expansion," OECD Secretary General Angel Gurria told reporters in Tokyo.
Japan's central bank has expanded its purchases of government bonds to help push interest rates lower and spur inflation. But this strategy carries risks, such as a potential jump in interest rates later on that would hurt asset values at banks with massive holdings of Japanese government bonds while pushing the country's debt burden beyond sustainable levels, the OECD report said.
Analysts warn that if the effort to break a long bout of deflation and get prices on an upward spiral succeeds, interest rates eventually will have to rise. That could lead to an onerous increase in the amount of national spending that would go to paying off Japan's debt, which amounted to 232 percent of Japan's GDP in the fiscal year that ended in March 2012.
Curbing the debt will require both higher growth and spending cuts, which could worsen poverty, the report said. Japan's poverty rate is the sixth highest in the OECD, partly due to the widespread use of informal or temporary workers by companies seeking to minimize labor costs.
Ratings company Standard & Poor's said in a separate report that Japan's plan to raise its sales tax was necessary but could threaten its recovery. It said it could downgrade Japan's sovereign debt, now at AA minus, due to "risks of the recent government initiatives and uncertainty of their success."
"So far, our assessment of economic indicators offers little clear evidence of improved economic performance in Japan," it said.
Optimism over the prospects for a recovery could be self-fulfilling by encouraging corporate investment and hiring if consumers begin to spend more, but there is also the possibility, it said, that if the gap between expectations and progress widens, "at some point the expectation bubble will burst and the positive wealth effect will end."
"It is crucial that the policies gather as much momentum as possible at an early stage, or the nation could face inflation without significant improvement in economic growth," the ratings agency said. "There will be no gain for the government or the nation, unless it takes risks."
The sales tax is due to rise by three percentage points to 8 percent on April 1, 2014, unless the government decides next fall that such an increase would cause too much damage. It would rise by an additional 2 percent, to 10 percent, by Oct. 1, 2015.
If the tax causes consumers to severely curb spending, it could have the unintended consequence in an extreme scenario of a decline in tax revenue, the report said.
Prime Minister Shinzo Abe has pledged to push ahead with fiscal consolidation. However, asked in parliament Tuesday if his administration would be certain to raise the sales tax, Abe demurred, saying the it would depend on how things look in October, when the government is due to decide on the issue.