Political Stability Is the Key to the Yen’s Future

It looks as if 2012 will be a watershed year for the yen.

Since the current financial crisis emerged in Europe and America in August 2007, the yen has appreciated against virtually every other major international currency. It is up by more than 50% from its pre-crisis rate of about ¥120 to the dollar and by more than 60% from the pre-crisis rate of around ¥165 to the euro.

According to the outlook of the Organization for Economic Cooperation and Development, Japan’s government debt will reach a level equivalent to 219% of gross domestic product this year—much higher than the figures for Greece (157%) and Italy (129%), both of which are experiencing serious debt crises. Even so, people continue to buy yen. Why?

A number of reasons have been put forward. First, Japan has continued to run a current account surplus. Second, domestic investors buy up more than 90% of government bonds. And third, the consumption tax (Japan’s version of the value-added tax) is still only 5%. This means that there is plenty of room for cutting the fiscal deficit by increasing taxes.

Factors Adversely Affecting the Current Account Balance

However, the latest figures suggest that Japan ran a trade deficit in 2011 for the first time in 31 years. The March 11 earthquake and tsunami disaster resulted in plummeting exports of automobiles and other products, while the energy shortage that followed the nuclear accident in Fukushima led to a surge in imports of natural gas and other fuels for thermal power generation. These were needed to replace not just the output of the devastated Fukushima plant but of all the other reactors that shut down for regular maintenance and could not be reactivated because of post-Fukushima safety concerns. Although last year’s trade deficit may have been the result of special factors, the size of Japan’s trade surplus has been on a downward trend since 1999.

The declining trade surplus has been offset by a growing surplus in the current account balance. This has been fed by the growth in interest and dividends from international investments and profits repatriated by Japanese corporations from their overseas subsidiaries—another factor that has helped to keep the current account in the black. But the current account surplus has also been shrinking since the global financial crisis that followed the collapse of Lehman Brothers in 2008, thanks to lower interest rates and other investment yields. If factors like the European crisis cause the global economic downturn to worsen into a long-term recession, it will have a negative impact not just on exports but also on the current account surplus.

From a macroeconomic perspective, another factor in the deteriorating current account balance is the rising number of seniors drawing on their household savings to see them through retirement. Japan’s saving rate has already plunged to 3%, the lowest figure for any major economy except the United States. It is unclear how much longer the government will be able to find domestic buyers for new bond issues.

Raising the Consumption Tax?

In this context, the Democratic Party of Japan–led administration government of Prime Minister Noda Yoshihiko has decided to try to get approval for a staggered increase in the consumption tax rate: from the current rate of 5% to 8% in April 2014 and to 10% in October 2015. The opposition Liberal Democratic Party objects that this would violate the pledges made in the DPJ’s 2009 election manifesto. Many commentators expect Noda to dissolve the lower house and call another general election during the first half of this year.

At the time of the 2010 upper house election, the LDP’s campaign platform included a call for hiking the consumption tax to 10%. It is therefore within the realms of possibility that the LDP and DPJ will agree on a bill to increase the tax rate followed by a lower house election. But if the parties are unable to reach agreement and the lower house is dissolved before a tax hike becomes law, the DPJ is likely to emerge from the election with fewer seats. This would likely strengthen opposition to the idea of a tax increase within the DPJ, and seriously damage the prospects for repairing Japan’s public finances. We can also expect to see renewed opposition to the Trans-Pacific Partnership and further protests against nuclear power. These could adversely affect TPP negotiations and make it harder for the government to restart idled reactors.

People worry about the negative impact of the strong yen on exports, but exports account for only around 15% of Japan’s GDP—much less than in South Korea, where the figure is nearly 50%. And the strength of the yen also has a positive side, helping to support the economy by offsetting the rise in prices of fuel and other resources. A major drop in the yen’s value might weaken the Japanese economy by leading to increased transfers of income overseas.

Whether the DPJ stays in power or a different administration takes charge, political stability is essential. (January 23, 2012)

(Originally written in Japanese.)