Two Years of Abenomics: A weak yen is needed to overcome the lack of demand

Faculty Fellow, RIETI

In 2012, the Japanese yen traded at about 80 yen to the U.S. dollar. More recently, in the second term of Prime Minister Shinzo Abe's administration, the yen has slipped to about 120 yen to the dollar, representing a decline in the value of the yen of one third. Looking at the real effective exchange rate (REER) as published by the Bank for International Settlements, this shows that the yen is now at its lowest level since February 1973, when the current floating exchange rate system was adopted. (The REER measures changes in Japan's competitiveness as a result of price fluctuations relative not only to the United States but also other major trading partners.) What should we make of this historically weak yen and Abenomics, which contributed to it?

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A weak yen makes goods (and services) produced in Japan cheaper. That leads both domestic and overseas demand to shift from goods made outside of Japan to those made in Japan. That, in turn, should help to address the lack of domestic demand and increase Japan's gross domestic product (GDP). However, it takes time for this mechanism to work. Moreover, it seems that the effect of a weaker yen on domestic production is waning due to changes in Japan's trade structure, as I will discuss later. Nonetheless, there are few economists who doubt that a sufficiently weak yen will help to overcome Japan's lack of demand.

According to Cabinet Office estimates of the GDP gap, Japan presently has a demand shortage (excess supply) of 14 trillion yen, or 2.7% of GDP. As illustrated by the response of economies around the world to the global financial crisis, it is common practice to try to quickly create demand when faced with enormous excess supply. Judging from the fact that price and wage growth are currently weak in Japan, it is obviously essential to create demand for goods produced in Japan.

That Japan needs to increase its exports can also be seen from the trend in the savings-investment balance (see figure). Whereas Japan's private savings rate remains very high due to substantial savings in the corporate sector, private investment has been very sluggish, so that Japan has an extremely large private sector savings surplus. As Keynesian economics teaches, when there are very large private sector excess savings, this will result in excess supply and a decline in GDP, as is the case in Japan now, unless there is a commensurate current account surplus or general government deficit.

Figure: Japan's Savings-Investment Balance
(as a percentage of nominal GDP, four-quarter moving average)
Figure: Japan's savings-investment balance<br />(as a percentage of nominal GDP, four-quarter moving average)
Source: Prepared by BNP Paribas Japan based on Cabinet Office data.

In the wake of the global financial crisis, recession abroad and the strong yen led to a rapid reduction in Japan's current account surplus. As a result, Japan's excess private sector savings--as can be seen in the figure--at present are being absorbed by massive government deficits (the second arrow of Abenomics), propping up demand.

However, the growing mountain of government debt has made fiscal reconstruction a pressing issue that needs to be addressed without delay, meaning that Japan has no choice but to reduce the government deficit in the future. If the government's growth strategy, the third arrow of Abenomics, is successful, we can expect private excess savings to decline as a result of growing investment reflecting higher returns on investment, increased dividend payouts through corporate governance reforms, and a recovery in consumption due to rising real wages. However, it is difficult to imagine that these effects will reduce private sector excess savings substantially in the near term. This means that, for the time being, Japan has little choice but to use a weak yen to generate a large current account surplus.

Standard international macroeconomics (the savings-investment balance approach to the determination of current account balances and exchange rates) suggests that in advanced countries with active international capital movements and a floating exchange rate system such as Japan, a lack of demand for goods will lower real interest rates, which in turn will result in a depreciation of the currency and resolve the lack of demand. The exchange rate thus acts as a mechanism to adjust the supply of and demand for home goods.

Unfortunately, Japan, which has faced a consistent lack of demand for more or less the past two decades, has been able to make very little use of this mechanism. Reasons for this include the economic frictions that large Japanese trade surpluses typically engender as well as insufficient monetary easing. Another reason is that while other advanced countries adopted monetary easing during the financial global crisis, Japan, due to deflation, already was very close to the zero lower bound on nominal interest rates, so that the interest rate gap between Japan and other countries declined and the yen appreciated.

With the United States exiting from quantitative easing (QE) on the back of a strong economic recovery and Japan registering a trade deficit, Japan at present faces the opportunity to benefit from an adjustment of the exchange rate without the impediments that existed previously. We should not miss this opportunity.

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But why is it that Japan's exports have not increased despite the weaker yen since late 2012? Reasons that can be pointed out include the following: (1) growth in newly emerging economies such as China as well as in Europe has slowed down; (2) offshore production, especially in the automobile industry, has increased rapidly; (3) the price elasticity of demand for Japanese goods has declined as exports of commodity items have been gradually replaced by exports of system products and high-quality goods; (4) with automobiles and other branded goods, local prices do not fall unless there is a model change; and (5) productivity growth has been slow, especially among small and medium enterprises (SMEs), so that their international competitiveness has declined.

That being said, trade statistics for October 2014 indicate that exports are showing signs of recovery due to the weaker yen, including lower local sales prices and an increase in export volumes. The effects of the weak yen can also be seen in the trade in services, with Japan's travel balance, for example, turning into a surplus.

Since domestic demand can be expected to decline due to Japan's shrinking population, it may be difficult for Japanese multinational enterprises (MNEs) such as Toyota Motor Corporation to relocate overseas production back to Japan on a large scale. However, as MNEs take an increasingly global approach to locating different corporate functions--such as production, research and development (R&D), and headquarters--in different parts of the world, a weak yen would provide them with a stronger incentive to bring such functions to Japan. Moreover, the weak yen will likely help expand production in the materials and components industries and among exporting SMEs which have kept their production bases in Japan.

The weaker yen also has side effects such as lowering real wages due to higher import prices and increasing production costs for firms using imported intermediate goods. However, to overcome the insufficient demand for goods, a weaker yen is indispensable. What we should lament, though, is the offshoring of production and disappointing productivity growth over the past two decades, which have led to a situation where Japan cannot increase exports unless it accepts a historically weak yen.

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Achieving inflation of about 2% is crucial to restore the effectiveness of monetary policy free from the zero interest rate constraint. The economic recovery and exit from QE in the United States mentioned earlier make it possible for the Bank of Japan (BOJ) to further weaken the yen through additional QE, and in this sense the effectiveness of monetary policy in Japan has been temporarily restored. However, Japan should step up its attempt to break away from deflation, since there is no guarantee that the U.S. economic recovery will continue.

We should abandon the illusion--sparked in a recent press conference by Prime Minister Abe--that Japan faces a rosy economic future once deflation has been overcome.

Even if Japan manages to expand demand temporarily and overcome deflation, there is no guarantee that demand will remain strong. Once deflation has been overcome, it will be possible to achieve negative real interest rates (nominal interest rates minus inflation) by continuing with the zero interest-rate policy and the government will be able to carry out policies promoting capital investment; however, negative real interest rates could also lead to wasteful capital investment and asset speculation and therefore carry the risk of generating bubbles and non-performing assets. In order to maintain demand, successful implementation of the growth strategy is necessary to promote private investment by improving the return on investment and to stimulate consumption by raising household real incomes.

Japan must also urgently restore confidence in its public finances. As Professor Paul Krugman of Princeton University has pointed out, as long as the BOJ is buying large amounts of Japanese government bonds (JGBs) in a deflationary environment, "Japan selling" due to a decline in confidence in Japan's public finances will only lead to a weaker yen and mild imported inflation, in fact helping Japan to overcome deflation. However, once deflation is overcome, if confidence in Japan's public finances deteriorates and "Japan selling" takes hold, the BOJ will have no choice but to raise interest rates to keep rising inflation due to a falling yen in check. This will in turn increase the risk of sharp hikes in JGB interest rates. If the BOJ hesitates to carry out monetary tightening under these circumstances, there is a danger of a vicious cycle of a falling yen and rising inflation.

This means that the government and the BOJ should look ahead to the post-deflationary period, make a roadmap for fiscal consolidation and an exit from QE, and prepare crisis response scenarios to react to "Japan selling," high inflation, and steep interest rate hikes on JGBs.

>> Original text in Japanese

* Translated by RIETI.

December 11, 2014 Nihon Keizai Shimbun

February 17, 2015