Abenomics, Yen Depreciation, Trade Deficit and Export Competitiveness

International Macroeconomics (FY2011-FY2015)
Research on Exchange Rate Pass-Through

The advent of Abenomics in December 2012 brought a significant change to the U.S. dollar/Japanese yen exchange rate. The yen remained at a record high level, trading below 80 per dollar, up until mid-November 2012. However, amid growing expectations for Abenomics, the yen weakened rapidly to the 90 level in the latter half of January 2013 and slightly below 100 in early April 2013. The exchange rate has remained stable since at around 100 yen per dollar as of March 2014.

There was a strong expectation that the rapid depreciation of the yen since the end of 2012 would improve Japan's trade balance. A weaker yen increases import prices and causes the trade deficit to rise in the short run. Over time, however, it was expected that Japan's trade balance would improve in line with the J-curve effect as the weaker yen translates into lower and hence more competitive export prices of Japanese products, which in turn would lead to a rise in the volume of exports. In reality, Japan's trade balance has worsened rather than improved. This indicates that the exchange rate is not the true cause of trade deficits, giving rise to the concern that Japanese products may be losing their competitive appeal in the global market.

In response to such observation, this paper makes the following three arguments. First, a sharp appreciation of the yen following the collapse of Lehman Brothers prompted many Japanese companies to enhance the cross-border division of labor by expanding their production networks in other Asian countries. The result is a structure where much of the export-boosting effect of a weaker yen is negated because an increase in Japan's export of industrial products is accompanied inevitably by an increase in the import of parts and components produced by Japanese overseas subsidiaries. Indeed, our empirical analysis of the J-curve effect found that exchange rate fluctuations in the 2000s had a weaker impact on the trade balance than in the mid-1980s through 1990s.

Second, the Bank of Japan (BOJ)'s export price index measured in contract (or invoicing) currency shows that Japanese export prices have been stable since 2000, indicating that Japanese exporters have been maintaining their export prices in overseas markets regardless of exchange rate fluctuations, a phenomenon referred to as "pricing to market (PTM)." However, a more rigorous analysis, in which we examined changes in the exchange rate pass-through rate for Japanese exports by using a time-varying parameter model, found that Japanese companies raised their pass-through rates in the post-Lehman period when the yen appreciated sharply. Despite facing fierce price competition in overseas markets, many companies found it inevitable to raise export prices as the yen strengthened to a record high. Meanwhile, those that were not confident of maintaining competitiveness with higher prices shifted more production to overseas locations. And then, in response to the latest development, i.e., the significant weakening of the yen since the end of 2012, Japanese companies lowered their pass-through rates to the level prior to the Lehman collapse and have stabilized their export prices denominated in the contract currency. This means that the yen's depreciation under Abenomics has not led to a decline in the local currency prices of Japanese products in their export destinations. From the viewpoint of the choice of invoicing currency, the greater the volume of yen-denominated exports, the greater is the likelihood for a weaker yen to lead to lower prices denominated in local currencies in importing countries. However, as the proportion of yen-denominated exports to total exports from Japan has been on a decline in recent years, Japan's export structure may have turned into one where the yen's depreciation no longer leads to an improvement in the trade balance.

Lastly, trends in industry-specific real effective exchange rates show that the yen's depreciation since the end of 2012 has improved Japanese manufacturing companies' export price competitiveness significantly. The below figure is a comparison of the trends in the real effective exchange rates of the Japanese yen and the Korean won for the electric machinery and transport equipment industries. From this, we can confirm that the rapid depreciation of the yen since the onset of Abenomics has enabled Japanese companies to narrow the gap with their South Korean rivals significantly in terms of export price competitiveness. This is also supported by the fact that Japanese transport equipment manufacturers reported strong earnings results for the half-year period through September 2013, achieving robust growth in sales.

What specific policy implications can we draw from those observations? First, an increase in the import of mineral fuels due to the shutdown of nuclear power plants following the Great East Japan Earthquake will continue to be a major factor contributing to Japan's trade deficit, and a weaker yen will translate into a greater yen value of imports. If a weaker yen fails to deliver its conventionally expected export-increasing effect--i.e., the positive section of the J-curve--under this situation, Japan's trade deficit may become chronic. In order to prevent this from happening, it is imperative for Japan to reexamine its long-term energy policy to explore more affordable energy sources and promote the development of new energy sources.

Second, in order to offset a decrease in exports resulting from manufacturing offshoring by increasing income surplus, it is necessary to maintain the flows of overseas earnings repatriated to Japan. A rise in the share of overseas sales has been prompting the offshoring of research and development (R&D) activities, a function that has been typically retained at the headquarters in Japan. Against this backdrop, Japanese companies are becoming inclined to keeping more of their earnings overseas, giving rise to the concern that Japan's income surplus may turn into a downward trend. In order to prevent such a turn of events, the government needs to implement measures designed to encourage companies to undertake R&D activities in Japan and remove tax impediments to the repatriation of overseas earnings, namely, by expanding the scope of application of tax exemption for foreign income.

As aforementioned, our analysis found that Japanese export prices have been stable when measured in contract currency, and the implication of this finding is that Japanese exporting companies have strived to keep their prices unchanged, even at the cost of lower margins, each time they were challenged by a sharp appreciation of the yen. Those companies having their export prices set in Japanese yen would not be directly impacted by foreign exchange fluctuations. However, in order to be able to increase the proportion of yen-denominated exports, a company must be highly competitive in export markets. Meanwhile, those having their export prices set in foreign currencies would be hit directly by a sharp appreciation of the yen. When foreign exchange losses become unbearable, they would move their manufacturing bases to overseas locations and cease to export affected products from Japan.

Our estimation using the time-varying parameter model shows that the pass-through rate of exchange rate changes into Japanese export prices increased amid a historic appreciation of the yen in the period following the Lehman collapse. This suggests that many Japanese companies must have raised their export prices in response to a higher yen. At the same time, however, those unable to do so were left with no choice but to shift to overseas production. In fact, some electric machinery products and telecommunications equipment such as mobile devices, which suffered a significant decline in their export competitiveness in the post-Lehman high-yen period, are now being produced entirely overseas. It may be the case that as a result of this prolonged high-yen trend, which drove manufacturing offshoring to what appears to be an excessive extent, Japanese manufacturers are now focusing on areas of core competitive advantage. Indeed, those capable of producing highly competitive products are the ones that have been able to enjoy huge foreign exchange gains brought by the rapid yen depreciation under Abenomics. And it may be said that the yen depreciation policy has been effective, at least to some extent, in stemming the excessive exodus of Japanese manufacturing. Going forward, it is hoped that the government will put its growth strategy, the third arrow of Abenomics, into concrete action as quickly as possible so as to foster export competitiveness across a broader spectrum of industrial sectors.