The yen to the U.S. dollar exchange rate has continuously remained below 80 yen since last summer while that to the euro has hovered around 100 yen. Appreciation of the yen is considered as one of the six factors worsening Japanese companies' business environment in addition to the high corporate tax rate, electricity shortage, among others, and resulting in the troubling accelerated overseas transfer of production by the manufacturing industry as well as hollowing out in Japan. Under these circumstances, there are many opinions in favor of further monetary easing policy to overcome deflation and correct the high yen rate.
Different views on the appreciation of the yen
There seems to be a gap between the opinions of industry and policymakers on the one hand and of economists on the other hand about the current yen rate and its effects on the domestic economy. For example, Keidanren stated that "the yen remains at a historically high level" and that "it is extremely difficult even for industries with international competitiveness and high market shares to respond to the current high level of the yen" (Keidanren, Seicho Senryaku [Growth Strategy] 2011). The Ministry of Economy, Trade and Industry (METI) expressed in a report of the Industrial Structure Council (June 2012) its warning that "if the current high level of the yen continues, the entire supply chain, including that of material manufacturers, will be transferred overseas, leading to 'drastic hollowing out.'"
On the other hand, many economists argue that the current yen rate is not excessively high from the point of view of the real effective exchange rate, taking into consideration the inflation rate differences and weights of trading partner countries. In fact, in terms of the real effective exchange rate, the yen rate in April 1995, when the yen was said to be "super high," and that in the early 2000s were higher than the current rate by over 30% and approximately 20%, respectively. Also, the current yen rate is equal to or slightly lower than the average rate of the past 20 years.(Note 1)
Assessment of international competitiveness of industries and companies should be made based on the real exchange rate rather than the nominal exchange rate. Also, it is more appropriate to use the effective exchange rate, which is a weighted average of exchange rates against currencies of a number of trading partner countries, rather than the bilateral rate. However, whether the current yen rate is "high" or not should be determined not only in comparison with past rates but also in relation to the equilibrium exchange rate.(Note 2) Among studies by RIETI, Sato et al. (2010) applied the methodology of Yoshikawa (1990), estimating the equilibrium rate of the yen to the dollar based on the growth rate of productivity to calculate the equilibrium rate of the Chinese renminbi (RMB) to the dollar, and concluded that the actual rate of the RMB is underestimated by over 60% vis-à-vis its equilibrium rate. Although this study does not directly assess the relationship between the RMB and the yen, it implies a possibility that the equilibrium rate of the yen is depreciating (that the actual rate of the yen is excessively high), considering the fact that China is Japan's largest trading partner with its trading constituting approximately 20% of Japan's import and export value.
Terms of trade and exchange rate
The real exchange rate is closely related to the terms of trade (export prices ÷ import prices). According to the simplest two-goods model that considers only tradable goods, the real exchange rate and the terms of trade are equal by definition (Komiya and Morikawa, 1995). In other words, the terms of trade provide a reference point for determining the deviation of the real exchange rate from the equilibrium level based on international competitiveness.(Note 3) The following chart plots the terms of trade based on import and export price indices published by the Bank of Japan and the real effective rates. The further up along the vertical axis, the higher is the yen, and vice versa.
This chart demonstrates the worsening terms of trade in recent years and indicates a possibility of continuing depreciation of the equilibrium rate of the yen. In the chart, the larger the upper deviation of the real effective rates from the terms of trade, the higher is the actual exchange rate compared to the equilibrium level. The exchange rate in 1995 significantly deviated from the terms of trade, with the appreciating yen. Yet, the deviation after the collapse of Lehman Brothers was even more significant. As a reference, the dashed line indicates the real effective rates divided by the terms of trade, and shows that the recent appreciation of the yen has been more significant than ever.(Note 4) This fact demonstrates the decline in the international competitiveness of Japanese industries and the significant appreciation of the yen in comparison to the competitiveness of the tradable goods industries, indicating the relevancy of the view of the business community and policymakers on the recent appreciation of the yen.(Note 5)
How should we respond?
The significant gap between the real effective exchange rate and the terms of trade can be attributed logically to one or a combination of the following three causes: (1) Actual exchange rate of the yen is higher than the equilibrium level due to worldwide financial instability, etc.; (2) import prices have not declined as much as the yen appreciation partly due to the increase of the prices of primary commodities; and (3) export prices are significantly declining despite the appreciation of the yen.
How, then, should we respond to such situation? The natural answer is either: (1) correct the high rate of the yen and make it closer to a level reflecting international competitiveness; or (2) narrow the deviation of the actual exchange rate by improving the terms of trade.(Note 6)
Intervention in the foreign exchange market for significant correction of the exchange rate would face international criticism and would not sustainably change the level of the exchange rate on a long or medium term basis. Monetary easing policy tends to depreciate the nominal rate of the currency, but its effectiveness to make the real exchange rate lower depends on the degree of its effects on the inflation rate and the exchange rate. At the same time, if a significant disequilibrium of the rate of the yen actually exists, drastic depreciation of the yen could occur at some point, irrespective of policies.
On the other hand, in order to improve the terms of trade, an approach from the import side could be to lower the prices of import commodities, taking advantage of the strong yen, or lower the weight of import of energy and raw materials through conservation of energy and natural resources. Another approach could be to raise the relative prices of exports by increasing the weight of export goods whose income elasticity of world demand is high. Either approach requires structural responses that relate to economic fundamentals.
