Revitalizing the Japanese Economy: Is a Weaker Yen the Answer?

Citi GPS Opinion Article

22 March 2013 – Over the past few months, as Prime Minister Abe has amassed political support for more aggressive economic policies, financial markets have responded enthusiastically to prospective monetary easing by the Bank of Japan (BoJ). The yen has fallen sharply, and Japanese equities have powered upward.
Much has been written on whether the BoJ under Governor Kuroda will actually make good on these expectations. But setting this debate aside, we turn now to a related question: If the BoJ actually does pull out all the stops and shifts its policies to a much more stimulative path, how far would this go toward revitalizing Japan’s economy? How powerful would a marked re-orientation of Japanese monetary policy ultimately be?

With interest rates in Japan already at exceptionally low levels, the most powerful effects of intensified BoJ easing would likely be felt through a weakening of the yen. Of course, reflating the Japanese economy would also bolster the country’s equity market, as seen in recent months; but evidence suggests that the associated wealth effects are relatively muted in Japan.

How much would a sizable deprecation of the yen raise Japanese GDP? In a recent report with my colleague Robert Sockin (See Empirical & Thematic Perspectives on Citi Velocity), we estimate the relationship that links Japan’s international trade to moves in the real exchange rate. We find that a sustained 20 percent depreciation of the currency — similar to that which has been recorded since early October — lifts Japanese real net exports by roughly 1½ percent of GDP over the course of several years. Given the slack in Japan’s economy (i.e. the economy has much unused productive capacity), most of this increase would likely pass-through into a higher level of GDP as well.

But this discussion requires two caveats. First, yen depreciation would provide only a temporary boost to real GDP growth — just through the several years that real net exports are rising to their new higher level. Thereafter, growth would likely return to its previous anemic pace. Second, a depreciation of the currency also has important effects on the prices of exports and imports — and there are winners and losers. On the one hand, a decline in the yen gives Japanese exporters scope to increase their yen prices abroad, while maintaining — or even reducing — their prices in foreign currencies. On the other hand, the depreciation pushes up the price of imports, especially of imported commodities, which reduces the purchasing power of domestic households and firms.

The upshot is that a substantially weaker yen seems likely to provide some boost to the trade surplus and, hence, to the level of real GDP. Exporters’ profits should rise, but import prices will also be higher. On net, these effects would no doubt be welcomed by the Japanese leadership, but they hardly represent the broad transformation of Japan’s economic performance that Prime Minister Abe seems to contemplate.

With this observation in hand, we now turn to a second question: How far would a weaker yen actually go in defeating Japan’s current deflationary environment? Over the past fifteen years, actual inflation has typically bounced between zero and −1 percent, but long-term inflation expectations have been very stable and somewhat higher, at around 1 percent. Observers seem to have believed that, given enough time, the BoJ would spring the economy loose from deflation.

Looking more systematically at these data, we find that the sensitivity of Japanese inflation to moves in the yen is quite limited. In recent years, a sizable 20 percent weakening of the currency — similar to that since October — has tended to increase core inflation the following year by just ¼ percentage point and headline inflation by ¾ percentage point. And these effects are only temporary; inflation would fall back to its baseline pace the following year unless the currency continued to decline.

Whether aggressive easing by the BoJ would be more successful in pushing up inflation than these statistical relationships suggest is very much an open issue. One possibility is that a well-crafted communications strategy, coupled with significant balance sheet expansion and yen depreciation, might convince the public that higher inflation was in train and, thus, raise inflation expectations. If “ Abenomics ” is to be successful, this “expectations channel” will need to be skillfully managed.

This then raises a final question: If Japanese leaders ultimately are successful in stamping out deflation (through whatever means), how would Japanese growth be affected? Our sense is that deflation distorts the supply-side of the economy by blunting the incentives for investment. Specifically, firms may hesitate to invest in capital goods today when the output that is produced is likely to fall in price tomorrow. Deflation also distorts the demand-side of the economy, providing incentives to delay spending, because goods will be cheaper in the future. Alternatively, deflation means that real interest rates (which are constrained by the zero lower bound) tend to be higher than they would otherwise be — and should be — given the economy’s overall performance.

But quantitatively, how much does deflation actually weigh on economic growth? We examine this question using data for 32 countries beginning as early as 1961 . The various countries suffered annual price declines in a total of 65 instances. Most of the deflationary episodes that we observe were relatively mild, however, with two-thirds at less than 1½ percent.

Our headline result is that deflation of ½ percent a year — such as that which Japan has recorded during its deflationary episodes — has been associated with annual growth that is roughly ⅓ percentage point weaker than if prices had been stable.

In other words, if the Japanese authorities are successful in defeating deflation, we believe that the resulting growth dividend would be on the order of ⅓ percentage point a year. This would be helpful in reinvigorating the Japanese economy, but it is only a partial solution to Japan’s economic ills. In this respect, we have appreciation for the arguments that previous BoJ Governor Shirakawa has made over the years: the deep drivers of Japan’s weak performance are actually more structural in nature. A comprehensive strategy to jumpstart the Japanese economy would also address inefficiencies and lack of competitiveness in the country’s services and non-traded goods sectors. The challenges imposed by aging demographics, which are an even thornier issue, are likely to require either strong incentives to raise labor force participation among women and older workers or — as an admittedly more controversial proposal — taking action to liberalize immigration.