Author: Willem Thorbecke, RIETI
In March 2022, the Japanese real effective exchange rate reached its weakest level since January 1994. Matters could get worse, with analysts predicting a further 20 per cent depreciation. Given the effects of a fluctuating yen on the Japanese and other world economies, further depreciations are undesirable.
The real effective exchange rate of the yen appreciated 30 per cent between June 2007 and March 2009. In the same period, Japanese real exports fell 40 per cent, industrial production dropped 35 per cent and the Nikkei index lost more than 80 per cent of its value. The strong yen contributed to this debacle by reducing both the quantity and price of exports and by squeezing profit margins.
Japanese firms responded to the soaring yen by transferring production abroad. Many firms off-shored their production of low value-add products to foreign subsidiaries and shifted to producing only high value-add products in Japan.
The yen began depreciating in November 2012 after Shinzo Abe said that the Bank of Japan should print unlimited quantities of yen to raise inflation. Between November 2012 and March 2022, the real effective exchange rate depreciated by almost 40 per cent.
The higher value-added products that Japan exported following the endaka (strong yen) period may be more competitive abroad. This could allow Japanese exporters to keep foreign currency prices constant, instead of having to lower prices. If this is the case, depreciation would raise firms’ revenues and profit margins rather than their export volumes.
Before the yen started depreciating in 2012, evidence suggested that an exchange rate depreciation could improve trade balances. After 2012 the evidence indicated otherwise, revealing that a yen depreciation caused a much smaller increase in exports than what was initially forecast using data up to 2012.
Depreciations caused a small decrease in total imports after 2012, but several categories fell short of forecasted values. Precision instruments imports fell short of predicted figures by 34 per cent, machinery by 33 per cent, electrical machinery by 24 per cent, manufactured goods by 18 per cent and semiconductors by 16 per cent.
In contrast, crude oil imports did not decrease in the face of a weakening yen. This is because the price elasticity of demand for oil is low. Japan needs oil, and will not reduce its oil imports even as the yen depreciates. A weaker exchange rate and higher oil prices place a burden on oil-importing countries such as Japan.
Food imports tended to fall when the yen depreciated. On the other hand, pharmaceutical imports did not, but rather increased 27 per cent more than forecasted for the weak yen period.
It is also important to consider the impact of exchange rate fluctuations on profitability. One indicator of profitability is stock returns. Evidence indicates that a depreciation of the yen relative to the US dollar raised aggregate Japanese stock returns by twice as much after Shinzo Abe became prime minister. This suggests that the response of corporate Japan to the strong yen, namely transferring production abroad, was good for profitability.
The sector that benefitted most from the weaker yen is automobiles. Although depreciation did not stimulate automobile exports, automaker profits still increased after 2012. On the other hand, the biotechnology and pharmaceutical sectors were harmed by depreciations after 2012. While pharmaceutical imports remained strong, importing these products during the weak yen period reduced the profits of Japanese firms.
The yen depreciation not only benefited Japanese aggregate stock returns, but also stock returns for key trading partners such as France, Germany and South Korea. Research indicates that 60 per cent of the sectors examined in France and Germany and 27 per cent of the sectors examined in South Korea benefited when the yen depreciated against their currencies. This occurred because Japanese firms play a vital role in supplying intermediate goods to other countries, and these inputs become cheaper when the yen depreciates.
Although a weak yen has been profitable for many Japanese firms and their trading partners, a further depreciation would be harmful. It will not increase exports of goods or key services such as tourism. It would also limit any potential increase in employment at a time when Japan needs more high-quality jobs.
Further depreciation would reduce the purchasing power of firms and consumers, and hinder their ability to import key products. For pharmaceutical goods and oil, whose imports do not decline when the exchange rate weakens, depreciation would still increase their yen costs. When the dollar costs of oil and primary commodities are already high, any further increase could swell Japan’s account deficit. While the current value of the yen offers advantages, a further downward spiral would impose costs that exceed the benefits.
Willem Thorbecke is a Senior Fellow at the Research Institute of Economy, Trade and Industry, Japan.
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