The Impact of Exchange Rates on Japan’s Economy

There were violent oscillations between the japanese yen and its exchange rate with other currencies over the past 30 years. In the early 1980s, the yen generally traded between 200 and 270 to the dollar. But in September 1985, the world’s major Western economies met in New York and decided to devalue the dollar, an agreement known as the Place Accord.The Plaza agreement sparked a strengthening yen trend for the next decade that ended with exchange rates reaching nearly 80 yen to the dollar.That’s an astonishing 184% appreciation in the value of the yen.

Bubble and economic stagnation in Japan

While the strength of the yen has benefited Japanese tourists and businesses making Mergers & Acquisitions in the United States, it was disadvantageous for Japanese exporters who wanted to sell their wares to American consumers. In fact, this strong rise in the yen was one of the main factors that led to the formation and then the bursting of Japan’s economic bubble in the late 1980s, a period that was followed by more than two decades. of economic crisis. stagnation and price deflation.

Since 1995, the Japanese yen has experienced several violent fluctuations. Although none of them were as extensive as the first 10 years following the Plaza Accord, they wreaked havoc on the mindset of Japanese businessmen and politicians and changed the underlying structure of the country’s economy. The yen started a new wave of strengthening in mid-2007 which saw it break through the 80 yen/dollar level at the end of 2011. This trend only began to reverse (and abruptly) with the election of a new government (led by Mr. Abe) and the appointment of a new central bank Governor (Mr. Kuroda), both of whom promised quantitative easing.So what is the impact of the exchange rate on the Japanese economy and what changes has this volatility brought about?

Actual impacts versus translation effects

To determine the effect of exchange rates on the Japanese economy, it is useful to use a basic example. Suppose we have an exchange rate of 120 yen/dollar and two Japanese car manufacturers sell cars in the United States. Company A builds its cars in Japan and then exports them to the United States, and Company B has built a factory in the United States so that the cars it sells there are also manufactured there. Now suppose that it costs company A 1.2 million yen to manufacture a standard car in Japan (about $10,000 at the assumed exchange rate of 120 yen/dollar), and that it costs company B $10,000 to manufacture a similar model in the United States. Then, the costs per vehicle are essentially the same. Because the two cars are similar in build and quality, let’s finally assume that they both sell for $15,000. This means that the two companies will make a profit of $5,000 on a vehicle, which will become 600,000 yen when repatriated to Japan.

Scenario where the exchange rate is Yen/Dollar

Now, let’s look at a scenario where the yen strengthens to 100 yen/dollar. Because it still costs 1.2 million yen for company A to produce a car in Japan, and because the yen has strengthened, the car now costs 12,000 dollars (1.2 million yen divided by 100 yen/dollar). But company B still produces at $10,000 per car because it manufactures locally and is not impacted by the exchange rate. If the cars are still selling at $15,000, Company A will now make a profit of $3,000 per car ($15,000 – $12,000), which will be worth 300,000 yen at 100 yen/dollar. But Company B will still make a profit of $5,000 per car ($15,000 – $10,000), which will be worth 500,000 yen. Both will make less money in yen terms, but Company A’s decline will be much more severe. Of course, the reverse will be true when the trend in the exchange rate reverses.

Scenario where the exchange rate is 100 yen/dollar

If the yen weakens to 140 yen/dollar, for example, company A will earn 900,000 yen per car, while company B will only earn 700,000 yen per car. Both will be better off in terms of yen, but Company A will be more so.

Scenario where the exchange rate is 140 yen/dollar

These scenarios show the substantial impact of exchange rates on Company A. Because Company A has a mismatch between its produce currency and its sell currency, profits will be affected in both currencies. But company B only faces one Translation because its dollar profitability is unaffected – only when it reports profits in yen or attempts to repatriate cash to Japan will anyone notice a difference.

The hollowing out of Japan

The strong appreciation of the yen in the 10 years since the Plaza agreement and the subsequent exchange rate volatility have forced many Japanese manufacturers to reconsider their export model of building in Japan and selling to the stranger. This had an impact on profitability. Japan had quickly moved from being a low-cost producer to one where labor was relatively expensive. Even without the impact of the effects discussed above, it had simply become cheaper to produce goods overseas.

Moreover, it had also become politically difficult to export products to the United States where there was local competition. Americans witness companies such as Sony (END), Panasonic and Sharp are devouring their TV manufacturing industry, and they were reluctant to let the same happen to other strategic industries such as automotive. Thus, a period of political tension surrounding trade emerged, where new barriers to Japanese exports appeared, such as the quota on automobiles and limits on exports to the United States for sale.

Japanese companies now had two good reasons to build factories overseas. It would lead to more stable profitability in the face of an unstable exchange rate, and relieve the increase in labor costs. Toyota is a classic example.

The slide below is from Toyota’s annual results presentation for fiscal year 2019. It details the breakdown between (a) the number of cars the company produces in Japan and overseas, and (b) the amount of revenue it generates in Japan and overseas. First, the data shows that the vast majority of the company’s revenue now comes from outside of Japan. But we also note that the majority of the cars it builds are made overseas. Although the company may still be a net exporterand although the evolution may have occurred over a long period, the shift to a focus on overseas production is clear.

Source: Toyota, 2019

Not all Japanese manufacturers are big exporters, and not all Japanese exporters have been as aggressive as Toyota and the auto industry in moving production overseas. However, this has been a trend for most of the last three decades. The graph below combines data from two government agencies to illustrate this point. It looks at the revenues of foreign affiliates of Japanese manufacturers and divides them by the total revenues of those same companies for the years 1997 to 2014.

Turnover of subsidiaries abroad as % of total

The chart shows that shortly after the end of the first big appreciation of the Japanese yen, the overseas ratio subsidiary company sales rose from 8% to almost 30% at the end of 2014. In other words, more and more Japanese manufacturers saw the value of expanding their business overseas and manufacturing products where they needed them. were selling.

The problem with this model, however, was that it gutted the Japanese economy. As factories moved overseas, fewer jobs were available in Japan, which put downward pressure on wages and hurt the domestic economy. Even non-manufacturers felt the impact as consumers restricted their spending.

It’s even nuclear energy

The exchange rate plays an important role in energy security discussions because the country is devoid of natural resources such as oil. Anything the country cannot produce from renewable sources such as hydro, solar and nuclear power must be imported. Since most of these imported fossil fuels are priced in dollars (and extremely volatile themselves), the yen/dollar exchange rate can make a huge difference.

Even after the triple disaster of massive earthquake, tsunami and nuclear meltdown that occurred in March 2011, the country’s government and manufacturers were keen to get nuclear reactors back up and running. While the government’s quantitative easing program has been successful in weakening the yen since 2012, the flip side is that imports are more expensive due to this weakening. If the price of oil were to rise while the yen remains weak, it would again hurt production costs for domestic manufacturers (and households, motorists, and therefore consumption).

The essential

The strengthening of the yen against the dollar after the Plaza Accord and the ensuing exchange rate volatility encouraged a rebalancing of Japan’s manufacturing industry from an industry focused on domestic production and export to another where production moved on a large scale overseas. This has had consequences for domestic employment and consumption, and even non-manufacturers and only domestic companies are exposed. While companies themselves have become more stable because they are less exposed to the negative effects of exchange rate movements, the future stability of the national economy is less certain.