The Japanese yen has been depreciating fast and significantly against the dollar. It had had been hovering around 115 yen to the dollar from around October of last year until mid-March of this year. It has since weakened, at one point approaching 139 yen to the dollar, and is hovering around 133 yen as of August 2022. The rapid depreciation of the yen and its volatile fluctuations to the current extent have been at levels unseen for a long while.
Traditionally, it had been argued that a weak yen is good and that a strong yen is bad for the Japanese economy, because a weak yen lowers the prices of Japanese products in the global market and increases sales and profits for exporting companies.
However, this time, people argue that a weak yen is not necessarily good for the Japanese economy. In fact, it is bad for the economy, because Japanese firms, especially the large multinational firms, produce products (e.g., parts and unfinished products) in production bases overseas such as China and other East Asian countries and export the products to Japan. A weak yen raises the prices of these products from overseas, which in turn hurts the companies' profits. Furthermore, it has been argued that a weak yen exacerbates inflation because it raises the prices of imported goods. In particular, Japan relies on imports for most of its food and energy from overseas, so a weak yen causes higher inflation, which in turn lowers corporate and individual consumption and worsens the economy as a whole.
Is a weak yen good or bad for the economy?
The short answer is, they are both correct. The effects of currency fluctuations are not so black and white. The impact varies from industry to industry or from company to company, and depends on whether we are talking about the effects on consumers, workers, or investors, and so on. In short, it is not easy to determine which market rate is better for the economy.
However, when it comes to the discussion of the impacts of exchange rate movements, there is one thing that is somehow not often mentioned in the media. That is what is known as the “balance sheet effect” (formally known as the "valuation effect") of exchange rate fluctuations. The question of how exchange rate fluctuations affect the assets and liabilities owned by the Japanese economy as a whole, i.e., the overall balance sheet of the Japanese economy, is not often discussed.
The balance sheet of an economy is a tabulation of the “external assets” and “external liabilities” of the citizens belonging to that economy. For example, if a Japanese citizen holds a government bond issued by the U.S. government, she can make a claim to the U.S. government that she wants it to be converted to cash. The U.S. government, in return, has an obligation to provide cash to the bond holder when such a request is made. In this case, Japan owns an external asset that is listed on the asset side of Japan’s balance sheet, whereas the U.S. owes an external liability that is listed on the liability side of the U.S. balance sheet.
Japan's balance sheet includes all the foreign assets and liabilities that Japanese people own, including Facebook shares owned by Japanese people (assets), bonds issued by Toyota to raise money (liabilities), Australian dollars owned by Japanese people (assets), loans to Honda from American banks (liabilities), Japanese government bonds owned by the Chinese government (liabilities), shares of foreign companies owned by Softbank (assets), etc.
Japan holds more external assets than external liabilities. Since 1991, its net external assets (i.e., external assets minus external liabilities) have been in surplus, and represent the largest amount of external assets owned in the world. In other words, for the last 31 years, as "the world's largest creditor nation,” Japan has lent more to foreign countries than it has borrowed from them. As of 2021, the amount of the external surplus is about 75% of Japan's GDP, or about 411 trillion yen. In contrast, the U.S. has the world's largest net foreign debt, which means that it is the world's biggest debtor country. Its debt amounts to approximately 70-80% of U.S. GDP, or $17-20 trillion.
Japan holds most of its external assets in foreign currencies (other than the yen). On the liabilities side, some are denominated in foreign currencies such as the U.S. dollar and the euro, but the amount is relatively small.
What would happen if a country with a balance sheet like Japan experienced a depreciation of its own currency?
This issue is easy to understand from the perspective of a typical Japanese investor in FX – Mrs. Watanabe, as she is often referred to in the foreign media. A weaker yen means a stronger foreign currency, especially the dollar. This means that if Mrs. Watanabe has a lot of assets denominated in the dollar and if the dollar becomes stronger (the yen becomes weaker), the amount of assets she holds when converted into yen will increase. Furthermore, assuming that she has little or no liability denominated in foreign currencies, a weaker yen would mean that Mrs. Watanabe would be successful in her FX investments.
If we consider this for Japan as a whole, a weaker yen would mean that individual investors like Mrs. Watanabe and financial institutions such as banks and insurance companies that make large foreign investments would gain a lot from a weaker yen.
Figure 1 shows the rate of change in net external assets (orange bars) and the rate of change in the yen's exchange rate against the dollar (blue line). From the figure, we observe that net external assets often increase in years when the value of the yen declines. (Note: Net external assets change due to current account balances, changes in asset prices, and changes due to exchange rate fluctuations. Hence, exchange rate fluctuations alone do not necessarily cause changes in net external assets. The correlation function between the rate of change in net external assets and the rate of change in the yen against the dollar in Figure 1 is about 34%.)
Exchange rate fluctuations affect our lives in another way
In Japan, contributions collected for national and employee pensions are invested in Japanese bonds (e.g., government bonds) and stocks, and in foreign bonds (e.g., U.S. government bonds) and stocks. An organization called the General Pension Investment Fund (GPIF) manages pension funds.
For a long time until recently, investments in foreign bonds or stocks did not account for a large portion of GPIF’s portfolio because investing in foreign assets was viewed as highly risky. However, thanks to Dr. Takatoshi Ito of Columbia University and others, the Japanese government decided to increase the portion of investments in foreign assets with the hope that the overall return on pension investments would increase even if the pension investment became riskier. In FY2001, the pension fund portfolio consisted of 68% domestic bonds, 18% domestic stocks, 3% foreign bonds, and 10% foreign stocks. In FY2021, the share of each of the four categories in the portfolio was 25%.
Thanks to this change in GPIF’s portfolio management, the impacts of exchange rate fluctuations on pension investment returns have become greater. In other words, the weaker yen is having a greater positive impact on pension fund investment returns. In fact, not only have the investment returns of financial investments increased due to the weaker yen, but the investment incomes of pension funds have also increased, and Japan's external assets have also increased.
Some people argue that Japan is experiencing a “bad yen depreciation,” or that a weak yen at the current level is the worst thing that could ever happen to the Japanese economy. Some others even claim that the era of 1,000 yen per dollar is coming, etc. However, none of these people take into account the positive valuation effect of yen depreciation on Japan's external wealth at all. Interestingly, for some reason, the media rarely covers this issue as well, most likely because it is considered too complicated.
At the very least, we should try not to be too provoked by an argument like a strong yen, or a weak yen, will doom the Japanese economy to an apocalypse. It is important to grasp potential risks and benefits of exchange rate movements. For that, the balance sheet or valuation effect of exchange rate fluctuations should be one of the issues to be discussed.