A Stronger Yuan Will Do Japan No Good

Senior Fellow, RIETI

In recent years, China's remarkable economic growth has made it into the main culprit behind global deflation, and calls for a stronger yuan are mounting from other countries such as Japan. However, when we consider the fact that the economic relationship between China and Japan is more complementary than competitive, the overall impact of an appreciation of the yuan on the Japanese economy is likely to be a negative one.

Is Japan's Deflation "Made in China"?

Of the many countries calling for a stronger yuan, Japan is especially vocal. The Japanese government's line of thinking regarding the xyuan issue can be seen in the opinion column titled "Time for a Switch to Global Reflation" jointly released in the Dec. 12, 2002, issue of The Financial Times by Haruhiko Kuroda, then vice minister for international affairs at the Ministry of Finance, and Masahiro Kawai, his deputy. In the column, they argue that the entry of Asia's newly emerging markets, such as China, into the global trade system is exerting strong deflationary pressure on industrialized countries, and that in order to resolve the deflation issue on a global scale, China's cooperation in further monetary easing and the appreciation of the yuan is necessary in addition to policy harmonization among Japan, the United States and Europe.

However, it is hard to believe that the China factor is greatly contributing to deflation in Japan. In 2002, Japan's imports from China accounted for a scant 1.5% of gross domestic product, and when the fact that the two countries compete very little on the trade front is taken into consideration, the effects of China-induced deflation on Japanese prices both directly and indirectly (through international competition) is limited. Furthermore, China's inflation rate (or, more precisely, its deflation rate) is at a level similar to that of Japan, and if China is to be branded as being the reason for deflation in Japan, then the opposite should also hold true.

For the sake of argument, even if deflation in China is accelerating deflation in Japan, is it really such a problem? To solve this question, we need to differentiate between whether the decline in the prices of Chinese goods is "good deflation" that leads to an expansion of production for Japan, or "bad deflation" that brings about a fall in output.

Needless to say, the Japanese media tend to focus on the "bad deflation" scenario. In other words, if the export prices of Chinese products fall, it is assumed that Chinese goods will take the place of Japanese goods, not only at home, but also in third country markets. This is deflation in the sense of its effect on prices, and it will also have a negative impact on Japan's output.

However, there is also a side to "Made in China" deflation that is "good deflation." In the case where a Japanese company imports various parts and intermediate goods from China, reduced prices of Chinese products signifies a drop in production costs, and as a result prices fall, but it is still of benefit to output.

The conclusion as to which of the effects - bad deflation or good deflation - is greater will differ depending on whether the economic relationship between Japan and China is viewed as being competitive or complementary. If the relationship is seen as competitive, the effect on the demand side will be greater, and there will be a larger negative impact. However, if the bilateral relationship is complementary, the positive impact on output will be greater because there will be a big effect on the supply side. When we look at the actual export structures of Japan and China, we see that the former focuses on high value-added high-tech products, while the latter concentrates on low value-added, low-tech goods. In other words, only a small part of their economic activities actually compete with each other, and because they are in a complementary relationship, the supply factors outweigh the demand factors, and for the producer, deflation in China is "good deflation" that brings about an increase in output.

Moreover, while the above analysis is based on the viewpoint of Japanese companies, for the Japanese consumer there is no need to differentiate between whether deflation is good or bad. For the public as a whole, just as in the case of a fall in oil prices, the decline in the import prices of Chinese goods means an improvement in Japan's terms of trade, and therefore an increase in real income.

Belief That a Strong Yuan Will Boost the Japanese Economy is Mere Illusion

By contrast, an appreciation of the yuan will likely have a negative impact on the Japanese economy through the "income effect," brought about by a deceleration of the Chinese economy, and the "price effect," caused by a surge in the prices of Chinese goods in international markets.

First, let us consider the income effect. If the yuan strengthens, the competitiveness of Chinese products in international markets will decline, and the Chinese economy, which is fueled by exports, will probably slow down. Yet, because processing makes up a great proportion of China's trade, Japan's exports to China will decelerate as a result. For Japan, whose export dependency on China is rising, this will be a big blow to such industries as the machinery industry.

Secondly, let us look at the price effect. The rise in the prices of China's exports will simultaneously apply upward pressure on both the input and output prices of Japanese industries, but the extent to which they will be affected depends on which has the greater impact on each individual industry. Generally speaking, in industries that compete with China on the output front, the greatest influence will be on output prices, and both profit and production will increase. In other words, the industries that would benefit from a stronger yuan would be limited to those labor-intensive industries in which Japan no longer has a comparative advantage. In contrast, for industries that are in a complementary relationship with China on the input front, the increase in input prices would be greater than that of output prices, meaning a decline in both profit and output. From the viewpoint of individual Japanese firms, companies whose products compete with those from China in both domestic and international markets will see their competitiveness increase with a stronger yuan, but companies that procure intermediate goods from China will be adversely affected through an increase in production costs.

When we consider the impact of a "stronger yuan," focusing on the price effect on Japanese industry as a whole, if a majority of industries were in a competitive relationship with China, output would increase (the demand curve would shift to the right). However, in reality, there are more industries that are in a complementary relationship with China, and so the effect of decreasing output is greater (because the supply curve shifts more sharply to the left). When the aforementioned negative income effect (the shift to the left of the demand curve) is also taken into account, on the whole, a stronger yuan would have a greater negative impact on Japanese industry than positive. Meanwhile, for the Japanese consumer, the rise in prices of Chinese goods signifies a decline in real income.

Diagram: Effects of a Stronger Yuan on the Japanese Economy

Thus, both the diagnosis that China is the reason for deflation in Japan and the prescription that the situation can be corrected through a stronger yuan are wrong. As long as the real reason behind deflation in Japan remains the delay in structural reforms and the accompanying domestic economic slump, it is clear that unless such problems are solved, there can be no real economic recovery in Japan no matter how strong the yuan becomes.

July 29, 2003

July 29, 2003