Summary:
– The appreciation of the yen against the US dollar between 2007 and 2012 weighed on Japanese economic activity and justifies a growth policy favoring a depreciation of the yen/dollar exchange rate through expansionary monetary policy.
– Monetary policy commitments appear credible, but the yen-US dollar exchange rate must remain stable to enable a sustainable recovery in the competitiveness of Japanese exports.
– The main risk concerns the Bank of Japan’s ability to control imported inflation.
The new governor of the Bank of Japan (BoJ), Haruhiko Kuroda, took office on Wednesday, March 20, 2013, along with his two deputies. These appointments herald a change in the Central Bank’s strategy in favor of implementing a much more ambitious quantitative easing program than the previous one, which would push prices upward in order to achieve the 2% inflation target set by Prime Minister Shinzō Abe’s government.
Countering deflationary risks with a higher inflation target
Before the new executive took office on December 26, 2012, the Bank of Japan was pursuing a 1% inflation target aimed at stimulating domestic demand by easing credit conditions. Shinzō Abe had built his election campaign on a more expansionary policy mix, advocating a more aggressive fiscal policy financed by « money printing. » At the same time, the plan to have the BoJ adopt a 2% inflation target would align monetary policy objectives with those of the government and thus control the risk of falling prices.
The adoption of this new inflation target is likely to ease deflationary pressures in two ways: by lowering real interest rates in Japan and by widening the interest rate differential between the United States and Japan. This mechanism:
– increases the profitability of US dollar deposits (all other things being equal) and thus promotes a depreciation of the yen against the US dollar;
– lowers real interest rates in Japan, thereby stimulating household consumption, business investment, and domestic exports.
Policy orientations justified by the negative effects of excessive appreciation of the yen against the US dollar
The real effective exchange rate of the yen appreciated by 25% between summer 2007 and summer 2012 (50% in terms of the nominal effective exchange rate). This development had two paradoxical effects: a negative impact on exports and an accumulation of foreign exchange reserves.
Firstly, since 2007, the continuous rise of the yen has had a significant impact on national exports, which have not returned to their pre-crisis levels, with the main handicap being the overvaluation of the yen, despite numerous relocations to the rest of Asia. In February 2013, Japan’s exports fell by 2.9% year-on-year, while domestic imports rose by 11.9%. Japanese exports to China contracted by 15.8% and to Europe by 9.6% due to continued sluggish domestic demand. The price elasticity of Japanese exports to Asian countries is significantly lower than the price elasticity of exports to the rest of the world (0.3 versus 0.5). 2011 was Japan’s first year of trade deficit since 1980, while in 2012 the economy saw a record annual trade deficit of ¥6.927 trillion (approximately €59 billion). The worsening trade deficit is an indicator that the yen has appreciated too much.
Secondly, despite the appreciation of the Japanese currency, the BoJ continued to accumulate foreign exchange reserves due to an accumulation of claims on the rest of the world. This reaction fueled the rise of the yen against other currencies.
As a result, Shinzō Abe announced a $108 billion stimulus plan at the beginning of his term, equivalent to 2.2% of Japan’s GDP. At the same time, the BoJ announced new quantitative easing measures and a large-scale asset purchase program in 2014 (mainly government bonds). Since December 26, 2012, and Shinzō Abe’s arrival in government, the yen has lost 9% of its value against the US dollar (currency as of March 26, 2013) to stand at 94 yen to the US dollar, its lowest level since 2009.
Exchange rate policy must be sustainable and stable: the risk of a currency at 110 yen to the dollar
By announcing a new asset purchase program starting in January 2014, the BoJ is counting on a signaling effect, anchoring expectations of an accommodative monetary policy. Interventionist in nature, the Bank appears credible in its monetary policy announcements. Hoichi Hamada, a close associate of Shinzō Abe and professor of economics at Yale, recommends a USD/JPY parity of between 95 and 100, stating that above 110 yen to the dollar, the Japanese economy would suffer. At this level, the depreciation of the Japanese currency would significantly reduce household purchasing power due to two factors:
– Imported inflation would outweigh the positive effects of the export recovery. Although Japan expects to become more competitive with foreign products thanks to the exchange rate effect, the rise in the cost of imported products could reduce household purchasing power and thus reduce the positive contribution of domestic demand.
– Increased energy dependence. The recent closures of nuclear power plants since the Fukushima disaster have contributed to increased demand for energy imports. Before the disaster on March 11, 2011, nuclear power plants supplied 30% of Japan’s electricity. This figure fell to zero for several months after the disaster, once again highlighting the country’s difficulties in terms of energy dependence. During the same period, Japanese gas imports increased by more than 50%.
Following the depreciation of the yen against other currencies, Japan’s current account balance is only expected to see the first positive effects after a few months (J-curve phenomenon). Indeed, as economic adjustments are slower than monetary adjustments, the price effect should initially outweigh the volume effect (increase in import prices) before a more significant volume effect becomes apparent (decline in imports and increase in domestic exports). It is therefore essential that the depreciation observed since the beginning of the year be sustainable and stable.
Conclusion
Faced with the risk of deflation, the BoJ has announced that it will maintain its key interest rates between 0% and 1% and implement an asset purchase program. These two measures will help to anchor expectations of an accommodative monetary policy and could weaken the value of the yen against other currencies in the long term.
The short-term effects of this policy are visible in gains in export market share thanks to the exchange rate effect and an increase in imported inflation. In the medium to long term, Japanese exports to Europe will remain limited due to weak domestic demand in the eurozone, while exports to Asia should support the trade balance, provided that the yen-dollar exchange rate remains stable and imported inflation is kept under control.
