Why weakening the yen is a terrible idea
Bank of Japan Gov. Haruhiko Kuroda recently remarked that he found it hard to see the yen weakening further on the foreign exchange markets. The yen obligingly strengthened a little. This is probably a good thing for the Japanese economy.
Although many people cling to the idea that weakening a currency is bound to help an economy's growth, the realities of the modern world mean that this is just not so. Indeed, the weakening of the yen in the past few years could be considered to have done more harm than good to Japan's economy.
A weaker yen is supposed to help Japan by lowering the cost of Japanese exports in foreign currency terms. This should then boost demand for Japanese exports. Americans, for instance, would see that the price of a Japanese sport utility vehicle has fallen in dollar terms, and rush to buy them because they are cheaper. When floating exchange rates work like this, then the effect of the currency move is passed on to the customers of Japanese exporters.
This pattern is largely what happened in the 1970s and the early 1980s. Roughly half of the yen's strength against the dollar in the latter part of the 1970s was passed on in the form of higher export prices, and about half the consequences of the weaker yen in the first half of the 1980s was passed on in the form of lower export prices. Today, however, nothing like this takes place.
Modern companies have invested a lot of time and effort in building their presence in foreign markets. They are unlikely to threaten the loyalty of their foreign customers and throw away that investment by raising overseas prices when their currency strengthens. However, they are also unlikely to lower prices when their currency weakens. The exception to this is commodity prices -- commodities trade in a global market that prices in dollars, so the effects of a currency move will be passed on.
Japanese companies have followed this new strategy of dealing with currencies throughout the recent yen weakness. From its peak, the yen has fallen by over 50% against the dollar. Japanese exporters have not cut the U.S. prices of their products. Instead, Japanese companies have used the current weaker yen as payback for the earlier period of yen strength. As a result, U.S. customers have not increased their demand for Japanese products -- the weaker yen does not show up in the dollar price, so why would they? Japanese exporters have chosen to use the weaker yen to increase their profit margins rather than their market share.
In fact, Japanese exporters to the U.S. have actually lost market share in the past few years -- Japanese exports to the U.S. have fallen as a proportion of U.S. domestic demand. This is important. If the weaker yen is not increasing demand for Japanese exports, then Japanese exporters have little incentive to increase employment of Japanese workers, or raise their pay, or boost investment in the Japanese economy.
At the same time, the stronger dollar has had an impact on commodities prices in Japan. Food prices have been affected by the weaker yen, as have electronic goods (electronic components are effectively a commodity). This has hurt the Japanese consumer. In particular, older and lower income consumers have been hurt by rising food prices, because these consumers tend to spend a higher proportion of their budget on food. Energy prices have also fallen less in Japan than in other parts of the world as a consequence of the weaker yen.
All of this means that the weaker yen has had little negative consequence for the rest of Asia. Asian exporters are not experiencing stronger price competition from Japanese exporters. In fact, Asia has arguably benefited from the weaker yen. As was noted earlier, Japanese exporters have chosen to expand profit margins rather than market share. A critical question is what happens to that additional profit? One destination for the profit has been increased investment -- but not in Japan. Japanese overseas investment has been growing relative to domestic plant and equipment investment as the yen has weakened.
So the weakening of the yen has led to higher prices for Japanese commodity imports that tend to be purchased by lower income and older consumers. The weaker yen has not led to an increase in market share for Japanese exporters, nor has it led to stronger domestic economic activity. What the weaker yen has done is raise the profits of Japanese exporters, and allow them to invest those profits overseas -- particularly in Asia. The BOJ's Kuroda is probably right to argue against any further weakening of the yen.
Paul Donovan is Global Economist at UBS Investment Bank. His recent book "The Truth About Inflation" was published by Routledge in April. More can be read at www.ubs.com/pauldonovan.