The Japanese Economy

Book by David Flath

Review & Article by GlobalMacroForex

This undergraduate textbook does an excellent job of conveying what makes Japan’s economy unique before the bubble burst as well as teaching basic economic terms and principles.  However, this textbook is 12 years old and deals little with post-bubble Japan.  So to help you understand what is going on now with the yen, I’m going to show you how to continue to apply these basic economic concepts to Japan’s current situation using concepts from the book.

Post-bubble Japan is a distinctive economy with:

·      Low-interest rates (financial repression)

·      high current account (trade surplus)

·      low incoming, but high outgoing foreign direct investment (FDI)

·      declining savings rate

·      the high number of wholesalers and retail stores

Let’s go over each of these things…

High Current Account (Trade Surplus)

A trade balance consists of the current account and the financial account.  The current account deals with goods and services.  The financial account deals with investments and capital transfers. 

Current account = exports – imports

So an economy that exports more than they import (like Japan) is said to have a trade surplus.  And in particular, Japan relies on exports more than most advanced economies.  After the bursting of the Japanese stock and real estate bubble, the economy has been going through severe deflation.  To continue to earn profits, Japanese companies and households have been relying on overseas sales, outgoing FDI, and carry trading.  Although the Asian growth model, of export lead growth, has always been an important factor to Japan even before the bursting of the bubble.  Here’s the current account as a percentage of GNP going back to 1885.

In more modern times the Current Account / Trade Surplus has been very pronounced.

A trade surplus usually turns into to a stronger currency, because it means more foreigners want to buy your goods/services that you want to buy theirs.  A stronger currency would normally make your exports more expensive to foreigners and therefore less competitively priced thus bringing the trade balance back to normal without any necessary government interference.

However, the Bank of Japan (Japan’s central bank) very frequently interferes with this market mechanism by printing money to depreciate the currency thus artificially increasing the current account.  Whether this produced positive result is up to debate.  This textbook points out, once a currency is depreciated, it takes a full 2 years for currency changes to change exports. 

Also once the currency is depreciated; it doesn’t increase the current account right away.  In fact, it initially makes the current account even worse.  This is because the country’s imports are immediately more expensive with a depreciated currency, so the results of which are realized right away as people’s buying habits may not change right away.  On the other hand, it takes time to reach new potential export customers with the cheaper currency.  This sudden drop in the current account and then the gradual rise is referred to by economists as ‘The J-Curve’.

The above chart is a theoretical drawing from the textbook.  Below is Japan’s most recent actual current account to GDP and currency value,

The cheaper yen lead to the initial current account to go down, as the J-curve predicts. Although the decline in the yen starting in 2013 was much more gradual than a J-Curve drawing, so the current account theoretically can go down gradually as well.  However, this yen depreciation lifted the current account by 2014-5 again in line with the J-Curve.  This (among other factors) then lead to increases in the JPY/USD in 2016.

Declining Savings Rate

The Japanese initially had a very high savings rate after World War 2.  This savings rate would fluctuate between 20 to 30% while America stayed in the range of 5 to 10%.  These savings helped finance the country’s industrial export-driven growth model.  However starting in 1985 the savings rate started to decline even though in the late 80s equity shares and land prices continued to climb.  This means those asset prices rose based on credit and/or foreigners buying.

This textbook goes over some of the potential theories that might explain the high savings rate of the post-war boom, including a youthful demographic profile of workers and the ubiquity of Japanese extended families to live together.  According to David Ricardo’s economic theory, individuals save for their children.   So one potential reason for the high savings rate is the devastations of World War 2 reduced the wealth of Japanese families significantly below their target levels.

Another potential reason is that a substantial portion of wage income in Japan is paid in the form of bonuses.  Therefore when one receives a lump sump of unknown payouts, it’s more likely that it will be saved since the next lump sum payment is variable.  Therefore any changes in consumption patterns would have to be temporary. 

Now in modern times, the Bank of Japan has reduced interest rates so drastically that they are actually negative.  The intention of the central bank is to reduce savings even further.  If households believe the recessionary post-bubble deflation is done, they will spend and consume.  If however, they think deflation will continue, then they will continue to save.  This textbook is written from a Keynesian perspective.  Keynesian economists tend to think inflation and consumption are good.  Austrian economists think savings and technology-induced deflation is the key to a successful economy.

Since the bursting of the bubble in 1992, Japanese households keep a much higher proportion of their savings in cash than Americans.  So their overall savings rate is declining as their percentage of savings in cash is increasing.

As this poll presented by the Bank of Japan, but originally researched at Osaka University, presents how Japanese households are less willing to hold risky assets.

As this chart from the Economist magazine on Sep 27, 2014, shows, a similar situation exists with Japanese corporations.

This is because many Japanese households think deflation will continue, they, therefore, want to keep cash that will go up in value instead of assets like equities which will decline.  Also, bonds likely would depreciate if the economy experienced any future inflation from the central bank’s aggressive easing since yields would rise to compensate for inflation. 

This chart I made from 10/5/2017, shows Japan has one of the flattest yield curves of the developed nations.

As interest rates are already at or approaching negative territory, if there’s further deflation, then cash is the best investment.  These awful investing prospects for Japanese households have given rise to the Yen as a carry trade funding currency.

A carry trade is borrowing in one currency (yen in this case) and investing it in a higher-yielding currency.  This is profitable as long as the yen does not appreciate against the other currency.  For many years after the bubble, the yen depreciated in terms of foreign currencies but appreciated against local consumer and capital goods prices.  In other words, the foreign exchange market dumped the yen as the country experienced severe internal deflation.

This consistent depreciation of the yen against foreign currencies combined with low prospects for investment at home, lead Japan to pursue a more export-oriented strategy and a large amount of Foreign Direct Investment.

Low incoming Foreign Direct Investment

The difference between buying foreign equity shares and foreign direct investment (FDI) can sometimes be difficult to discern.  According to this textbook, the defining factor is a controlling interest.  If the investor controls more than 20% of the outstanding equity of the company, then it would be considered FDI.  The main thing is that FDI is a less liquid investment.  It’s the difference between actually running a business as opposed to equity shares which can be quickly traded for fast capital gains.

FDI is really just another version of the carry trade but an illiquid one. It is only profitable when the yen is falling in value in the forex market, even if Japanese consumer prices are falling from deflation.  Japan is unique in that it has a high outgoing FDI, but a low incoming one.  This chart shows FDI by country in 1993, right as the bubble was bursting.

As we can see, Japan invests more abroad than foreigners invest in Japan.  This creates a high incentive for corporations to pressure the Bank of Japan to keep the yen down so the FDI continues to be profitable.

This textbook lays out two reasons for Japan’s low incoming FDI.  The first is government regulations/restrictions/tariffs and the second is the distinctive uniqueness of Japan’s culture.  Now this book doesn’t say it, but I interpret a large part of this cultural difference to be the difficulty of the Japanese language for foreigners, as well as the difficulty of the Japanese in learning English.  Also, Japan had a high savings rate so didn’t require external capital.  On top of all that, the “cultural uniqueness” has a large part to do with Japan’s isolated history giving the country a strong sense of internal ethnic pride and xenophobia, which encourages incoming FDI.

High number of wholesalers and retail stores

A wholesaler sells products in larger quantities to other retailers.  Japan has a much higher percentage of wholesalers than other industrial nations.  This textbook points out that from 1985 to 1986, the percentage of wholesale revenues that are to other wholesalers was 41.9% in Japan compared with 24.8% for the United States.  On average, Japan went through 1.8 wholesale steps while America was 1.4.  However, despite an increase in the number of wholesalers, the total price markup of wholesale chains in Japan is less.  For that same year, the final chain markup was 24% of the manufacturer’s price in Japan against 35% in the United States.

This textbook proposes that the reason for this increase in a number of retailers is an increase in a number of retail stores.  Because Japan is an archipelago and has a language and culture that isn’t deductive to living in foreign countries, the land is scarce and highly valued in Japan.  Having high-value land makes it difficult to have large retail stores.  Also, households don’t have the room to store large amounts of merchandise and many people don’t have a car so prefer stores to be in very close proximity to their home.  (Another reason people might not have cars is that Japan has no oil.)  With many different types of specialty stores in Japan (that stock less merchandise and take up less space) it makes sense to have more wholesalers to distribute this across the retail network.

Another reason for more wholesalers is government interference in the free market.  The Department store act of 1937, which was later revamped in 1978, banned all new stores with floor space above 500 square meters.

Other Topics

The Japanese Economy by David Flath covers many other topics including:

·      The Postal system acting as a savings institution

·      Lifetime employment for males

·      Rising female participation in the labor force

·      Previously banks were focused on narrow lines of business but that changed with the Big Bang 2001 which legalized them to form banking conglomerates

o  City banks, regional banks, trust banks, long-term credit banks

·      Comparative advantage of trade

o  Japan in the 1950s after the war was labor abundant but capital scarce

o  Created friction with the United States who accused it of “dumping” goods

·      Toyota’s production management innovation through subcontracting

  However I’m going to write about these issues in another article because I’m covering so many different books that are all about Japan, it quickly will get repetitive.  I’ll see you next time.