Priorities for the Japanese Economy in 2014 (December 2013)

The Future of the Trade Balance

Visiting Fellow, RIETI

Looking ahead at the Japanese economy in 2014, there are undoubtedly two factors that could have negative impacts on the economy: the expected reaction after the scheduled consumption tax increase and overseas financial and economic conditions. Strong consumption has contributed to the current optimism. Meanwhile, the Japanese business cycle in recent years has been influenced by overseas economic developments to a greater degree than before. Furthermore, it is thought that the stabilization of international financial and capital markets was behind the yen's recent depreciation. However, I pay the greatest attention not only to short-term demand conditions but also to developments in the trade balance as an indicator suggesting the direction the Japanese economy should take in the medium to long term.

Despite the fact that the yen has weakened considerably during the period from late 2012 through 2013, Japan has continued to run a trade deficit, showing a different tendency from past economic recoveries led by foreign demand. To predict short-term economic developments, it is important to see if an increase in foreign demand would help increase the level of production. However, rather than looking from a cyclical perspective, I am more interested in, if the trade deficit continues in 2014, whether that would suggest a structural change in the Japanese economy.

The aging population and the trade balance

Looking at Japan's external balance in the past, as a result of its continued trade surplus, the country has become the largest creditor nation in the world (this is why the yen appreciates when uncertainty increases in international financial markets as mentioned above). As a consequence, in addition to the trade surplus, the income balance (and, as a corollary, the current account balance) has continued to be in surplus. With the aging of the population expected to advance, in order to prepare for declining production in the future, it is desirable to keep consumption smaller than production, in other words, to save money and accumulate financial assets. Thus, Japan's trade surplus in the past could be considered to have played the role of self-insurance in preparation for the aging of the population.

Will these trends continue in the future? Elderly people generally depend more on financial income than on labor income. For this reason, where the aging of the population has advanced, even if production declines, consumption does not fall to the extent of the decline in production, backed by income from accumulated financial assets. Looking from the perspective of the balance of international payments, this situation means that the trade balance is in deficit and the income balance is in surplus. Over the medium to long term, Japan's current account will continue to be in surplus for some time to come. However, according to economic theory (due to the transversality condition), the trade deficit will be offset by the income surplus, and the economy will head toward a stationary state, where its current account balance will become zero and the foreign asset balance will become steady. From the perspective of domestic demographic trends and according to economic theory, Japan will see a prolonged trade deficit sometime in the future against the backdrop of the largest net foreign assets.

Furthermore, from a global perspective, it is becoming difficult for Japan to continue a trade surplus. Given that the sum of the balance of payments over the world should be zero, Japan's trade surplus means a trade deficit for the rest of the world. Japan is the largest creditor, while the United States is the largest debtor. Japan's foreign assets are almost equivalent to U.S. foreign liabilities. Due to such characteristics as the U.S. dollar being a key currency and U.S. government debts as safe assets, funds have continued to flow into the United States from not only emerging Asian economies but also oil-producing countries in the Middle East, especially from the 2000s, accelerating the growth of U.S. foreign debt. This situation, which is called global imbalances, has attracted lots of attention for its consequences not only in academia but also in the policy arena. Furthermore, some point out that the latest financial crisis was due mainly to interest rates remaining at a low level against the backdrop of the inflows of funds into the United States. In light of these points, the global imbalances are expected to be corrected in the future. U.S. efforts toward fiscal restructuring are also headed in this direction.

Will an economy led by domestic demand, which has been pursued since being proposed by the so-called Maekawa Report published in the mid-1980s, finally take root in Japan? It has been thought that Japan's external balance would change someday, and it would become a country with a trade deficit and an income surplus. Is Japan at such a turning point now? Or will Japan resume an export-led economic recovery? Answers to these questions may become obvious in 2014.

Exchange rates and the terms of trade

Even if the trade balance is in deficit, if the country maintains a current account surplus, the national income will increase. In an economy where the working age population is decreasing, in addition to per capita gross domestic product (GDP), per capita consumption (national income) is an important economic indicator. For this reason, some consider that there is no need to care about the trade balance itself. However, if the trade balance tends to be in deficit, a significant change in economic policy design will be required. When the aging of the population is expected, it is necessary to maintain a trade surplus and increase savings. For these purposes, it is desirable that exchange rates against foreign currencies move toward depreciation. On the other hand, when the aging of the population has advanced, exchange rates should tend toward appreciation. Thus, by improving the terms of trade, social welfare may be higher in a society where more consumption is possible at the same production level than otherwise.

Needless to say, it would be necessary to continue to have medium- to long-term perspectives, such as advancing manufacturing technology by maintaining the level of production, and it would be difficult to provide a clear answer to such discussions as what level of exchange rates is eventually desirable (in addition to the terms of trade mentioned above and a vision for the future, including whether manufacturers should continue to be the engine of the Japanese economy or be replaced by the service sector, it depends also on the currency composition of foreign assets and liabilities and overseas conditions.) However, it is necessary to pay attention to the possibility that a weak yen is no more than a panacea to the cyclical problems of the Japanese economy (that is to say, social welfare cannot be improved in an economic cycle.)

Japan's trade deficit so far has been explained in many cases by special or temporary factors, such as dependence on expensive energy imports and global economic conditions that are not necessarily strong. Certainly, these were major factors behind the trade deficit. However, there have been a number of instances that had initially been explained by special or temporary factors, but it has been found, in retrospect, that they had indicated signs of structural changes. I will pay close attention to developments in the trade balance in 2014 in looking ahead at the future of Japan and the policies that should be taken.

December 27, 2013

January 24, 2014

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