JAPAN: THE VALUE OF THE YEN

• Document Type: CREST
• Collection: General CIA Records
• Document Number (FOIA) /ESDN (CREST): CIA-RDP84S00928R000300010002-8
• Release Decision: RIPPUB
• Original Classification: C
• Document Page Count: 21
• Document Creation Date: December 22, 2016
• Document Release Date: May 11, 2009
• Sequence Number: 2
• Publication Date: March 1, 1984
• Content Type: REPORT

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Directorate of Confidential
Intelligence 25X1
Japan:
The Value of the Yen
Confidential
EA 84-10043
March 1984
Copy J n 2
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Directorate of
Intelligence
Japan:
The Value of the Yen
Northeast Asia Division, OEA,
Office of East Asian Analysis. Comments and queries
are welcome and may be directed to the Chief,
This paper was prepared by
Confidential
EA 84-10043
March 1984
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Confidential
Japan:
The Value of the Yen 25X1
Key Judgments The tripling of Japan's current account surplus-the balance of trade in
Information available goods and services-in 1983 focused attention on the value of the yen.
as of 2 March 1984 Many analysts claim the yen is the prime ingredient in Japan's export
was-used in this report.
competitiveness. Others argue that the dollar is overvalued or that the
mushrooming of the surplus is a function of cyclical factors, including the
rapid economic recovery in the United States.
We believe it is helpful to review some of the arguments concerning the
yen's value and analyze, to the extent possible, their merits. This review
and analysis includes:
? A summary of the behavior of Japan's current account-considered by
the Organization for Economic Cooperation and Development to be the
primary long-term test for the appropriateness of a currency's value.
? An analysis of the yen's movements relative to other major currencies
and the extent to which these movements compensate for differing rates
of inflation among trading partners.
? A review of the factors that influence the yen's value and an analysis of
the increasingly important role of capital outflows in pushing the yen
downward.
? A discussion of the prospects for yen appreciation.
Our analysis shows that capital outflows are playing an important role in
determining the yen's value. These outflows result in part from a surplus of
savings over investment that occurs in times of recession. Ongoing efforts
at financial market liberalization have helped increase these outflows.
We believe there are signs of a reversal in the yen's weakness. In 1983 Ja-
pan's earnings from its current account surplus exceeded long-term capital
outflows, causing some yen appreciation, particularly against European
currencies. Barring a surge in commodity prices, we believe the current
account surplus will exceed long-term capital outflows again in 1984,
which should spur further yen appreciation against both European curren-
cies and the US dollar. Most analysts are predicting a 5- to 10-percent
strengthening against the dollar. Even if realized, Japanese exports will
remain unusually competitive in the United States. Given the yen's history
of volatility against the dollar, however, we believe more rapid appreciation
is quite possible. A rapid substantial appreciation would quickly reduce the
growth of Japanese exports and promote imports of manufactured goods.
Conf idential
EA 84-10043
March 1984
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Figure 1
Japan and Other Big Seven
Countries: Current Account-to-GNP
Ratios, 1970-82
Figure 2
Japan: Current Account Balance,
1973-83
-1.5 1970
Big Seven
Countries,
except Japan
-20 1973 74 75 76 77 78 79 80 81 82 83
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Japan:
The Value of the YenF---] 25X1
A Review of Current One method of judging whether a currency is undervalued is to analyze current ac-
Account Behavior count statistics;' an undervalued currency will generate chronic surpluses. The
Organization for Economic Cooperation and Development (OECD) has specified
what an acceptable current account balance is for the Big Seven countries-the
United States, the United Kingdom, West Germany, France, Italy, Japan, and
Canada. According to the OECD, these countries should share their collective
surplus or deficit in proportion to economic size, as measured by GNP:
? From 1973 through 1982, Japan ran a current account surplus equal to 0.2
percent of GNP. The other Big Seven countries ran a deficit amounting to less
than 0.1 percent of their combined GNP.
? Among Big Seven countries, Japan, West Germany, and the United Kingdom
ran surpluses for the period in question. The surplus of the United Kingdom-an
oil exporter in recent years-was the largest of the three, averaging 0.4 percent
of GNP.
? The United States ran a negligible deficit from 1973 through 1982, but France
and Canada ran relatively large deficits.
The current account data, which show that Japan ran a small surplus relative to
GNP during the decade, imply the yen has been chronically but not substantially
undervalued. The long-term figures, however, conceal the mushrooming of the
surplus that usually occurs during periods of world economic recovery:
? Japan ran a $21 billion surplus in 1983 and will have a $20-30 billion surplus
this year, according to most economic analysts.
? In 1977 and 1978, when the OECD recovery was well under way, Japan ran sur-
pluses of $11 billion and $17 billion, respectively.
The periodic swelling of the surplus implies that the yen depreciation that followed
each of the oil shocks was excessive.
' Analysts caution, however, that current account data are becoming increasingly unreliable.
Apparently because of errors in measuring service receipts, reported global current account deficits
exceed surpluses by $100 billion, up from less than $20 billion a few years ago.
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Figure 3
Japan: Price-Adjusted, Trade-
Weighted Movements of the Yen,
1970-83a
a Quarterly data.
b An index below 100 indicates the yen is undervalued
relative to the base period.
Figure 4
Japan: Price-Adjusted Movement of
the Yen Against the Dollar, 1970-83
1970
75
a A negative index indicates the yen is undervalued
-30
relative to the dollar compared with the 10-year
baseline.
-40
Figure 5
Japan: Price-Adjusted Movement of
the Yen Against the Deutsche Mark,
1970-83
a A negative index indicates the yen is undervalued -15
relative to the deutsche mark compared with the 10-year
baseline.
-20 1970
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How the Yen Current account statistics show the yen is undervalued, but give no idea how
Has Adjusted for much. To quantify the extent of a currency's undervaluation, most analysts rely on
Inflation Differentials trade-weighted, price-adjusted exchange rate indexes. These indexes show the
extent to which a country's currency movements offset inflation differentials with
trading partners:
? For example, if a country has an inflation rate that is 3 percentage points per
year above the average for its trading partners, its currency would have to
depreciate by 3 percent per year to maintain its competitive position. If the
currency declined by more than 3 percent and the index fell below 100, that
country would have gained competitive advantage.
Morgan Guaranty Trust Company compiles the most widely circulated set of these
indicators in the United States. The index uses spot exchange rates and is based on
wholesale price inflation for nonfood manufactured goods for the currencies of 15
countries:
? According to Morgan's calculations using a base period of 1980-82, the yen was
undervalued at the end of 1983 by about 3 percent compared with the currencies
of other industrialized countries.
Measurements of the yen's value using this technique vary with the base period se-
lected, however. When Morgan uses a base period of 1973, the yen is shown as un-
dervalued by more than 10 percent. In addition to the problem of reaching a
consensus about a time period when currency alignment is about right, there are
also difficulties in deciding which inflation rate series should be used. For these
reasons, trade-weighted, price-adjusted measures of yen undervaluation are
debatable.
We believe, nonetheless, these indexes are useful in providing estimates of bilateral
currency movements. The trend of the yen in bilateral terms is striking:
? Against the major European currencies such as the deutsche mark, the yen has
been relatively stable over the last decade and appreciated significantly in 1983.
? Against the dollar, on the other hand, our own calculations show the trade-
weighted, price-adjusted index for the yen has plunged by nearly 30 percent
since 1980 and is currently about 20 percent below its 10-year average rate
against the dollar, despite mild appreciation last year.
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Figure 6
Japan: The Yen's Value and the
Basic Balance, 1973-83
Table 1
Japanese Balance of Payments
270
0
260
-5
250
-10
240
-15
220
210 1973 74
18.1
31.6
137.7
145.4
119.6
113.8
Services and transfers
-11.2
-10.6
Long-term capital balance
-15.0
-17.8
Outflows
-27.4
-32.5
Direct investment
-4.5
-3.6
Loans
-7.9
-8.4
Trade credits
-3.2
-2.7
Securities investment
-9.7
-16.0
Other
-2.1
-1.8
\ / I
-25
75 76 77 78 79 80
81 82
83 -30
12.4
14.7
Direct investment
0.4
0.4
Securities investment
7.6
8.5
External bonds
4.3
5.7
Other
0.1
0.1
Basic balance
-8.1
3.2
Nonmonetary short-term capital balance
-1.6
0.2
Errors and omissions
4.7
1.8
Overall balance
-5.0
5.2
Commercial banks short-term
net position
0
-3.6
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What Drives the It is impossible to capture and accurately quantify all the variables that affect the
Yen Up and Down? yen's value, but we believe it is possible to identify key variables. In our view,
changes in Japan's basic balance-the current account surplus plus net long-term
capital flows-provide the best explanation for the yen's movements since it began
to float against other currencies in 1973. The connection between the yen and the
basic balance is understandable since the latter encompasses all the transactions
involving international demand for and supply of the yen except for short-term
capital flows and errors and omissions. Short-term flows generally have a neutral
effect on exchange rates because they usually are offset by forward exchange
contracts to eliminate risk:
? Annual changes in the basic balance and the yen-dollar exchange rate appear
connected. The 40-percent appreciation of the yen in 1977 and 1978 accompa-
nied rare basic balance surpluses.
? From 1980 through 1982, the basic balance also appears to have influenced
quarterly movements of trade-weighted, price-adjusted yen rate series.
The yen's depreciation in 1982 can thus be viewed as the result of a basic balance
deficit caused by net long-term capital outflows exceeding a small current account
surplus. As the current account mushroomed in 1983, it overwhelmed capital
outflows. The yen appreciated somewhat as a result.
OECD attempts to quantify the relative importance of the two major components
of the basic balance-the current account and interest-sensitive capital move-
ments-in relation to the yen's value have been only partially successful:
? According to OECD studies, interest rate differentials between the dollar and
yen assets were marginally more important than cumulative current account
balances of the two countries in fostering yen-dollar movements between 1973
and 1981. These factors, together with differences in inflation rates and
adjustment for "dollar unease" during the second half of 1978, accounted for 83
percent of the observed movements.
? The relative importance of interest rates diminished when the OECD extended
the study to cover the period through the first quarter of 1983. Moreover, the
new equation only explained 66 percent of the yen's movements.
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Figure 7
Japan: Savings by Sector, 1973-81
5
a Household sector includes unincorporated enterprises. I I I I I I I
Figure 8
Japan: Capacity Utilization and
Corporate Investment, 1973-81
Figure 9
Japan-US: Short-Term Interest-Rate
Differentials, 1973-83a
a Quarterly data. Negative numbers indicate US interest
rates exceed Japanese interest rates.
b Real interest rates are nominal rates adjusted by a
Total
Corporate
Government
Corporate Investment
Percent of GNP
Capacity Utilization
Index: 1975=100
Real interest-
rate differentialb
Nominal
interest rate
differential
deflator, which is used as a proxy for inflationary
expectations.
-25 1973 74 75 76 77 78 79 80 81 82 83
110
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Why Have Capital Japan has chalked up deficits on long-term capital in nine of the last 10 years. A
Outflows Accelerated? combination of factors, including an excess of domestic savings over investment,
has caused these persistent deficits.
The imbalance between savings and investment is a chronic problem that also has
a cyclical element. When domestic factors push the economy into a recession,
outflows usually increase because investment drops off more sharply than savings:
? Japan has a high personal savings rate due to a variety of institutional and
cultural factors, including a social security program that is less generous than
those in other major countries, low income taxes, and limited mortgage
financing. The aging of the Japanese population is expected to reduce the savings
rate over the long run, but only very gradually.
? Investment, on the other hand, is cyclical. Corporate investment, which accounts
for over half of total Japanese investment, generally increases when business
conditions improve and capacity utilization rates rise.
Fiscal policies both in Japan and the United States have exacerbated these
underlying trends during the 1980s:
? Fears about the government's future refinancing needs caused Tokyo to formally
abandon stimulative fiscal policies in 1980. To offset the contractionary effect on
domestic demand, monetary policy was eased somewhat, putting downward
pressure on interest rates.
? At about the same time, the United States began to loosen fiscal and tighten
monetary policies, which pushed up real interest rates.
? A gap between real interest rates in the two countries developed early in 1981,
encouraging capital to flow from Japan to the United States. Deregulation of
financial markets and changing inflationary expectations in the United States
also helped create interest rate differentials that persisted through most of 1983.
? These differences in policy have also occurred to a lesser extent between the
United States and Europe, offering a partial explanation for the relatively close
tracking of the yen and major European countries.
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Figure 10
Japan: Capital Flows, 1974-83
80
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The Effect of Financial Relaxation of foreign exchange controls in Japan has contributed to the growth in
Liberalization on capital outflows in recent years as investors have altered the currency mix of their
Capital Flows existing asset portfolios:
? The foreign exchange law implemented in December 1980 removed the 3-
million-yen ($13,000) ceiling on foreign asset holdings by individual Japanese
investors.
? Life insurance companies, permitted by the Ministry of Finance to hold up to 10
percent of their assets in foreign securities, bought $3 billion of these instruments
in fiscal year 1982.
? In October 1983 the Finance Ministry eased restrictions on yen offshore lending
by Japanese banks.
Long-term capital inflows, like outflows, have increased sixfold since 1977, when
Japan began to liberalize capital transactions in earnest. They, nonetheless, remain
only half as large as outflows in dollar terms. Western analysts blame this
relatively low level on residual legal restrictions on inflows, interest rate ceilings,
the limited choice of instruments available, and the shallowness of asset markets in
Japan. We believe these criticisms are only partially justified:
? Legal barriers prevent foreign companies-along with domestic ones-from
buying up Japanese companies without permission of the firm's board of
directors. Foreign investment in 11 designated companies also has been circum-
scribed, but the Diet is considering legislation to remove these restrictions.
? Interest rates on time deposits in commercial banks are regulated under
authority of a 1947 law. On the other hand, interest rates in short-term money
markets and in the secondary market for long-term bonds are freely determined.
? Monetary authorities in Tokyo have thus far refused to permit treasury bill or
corporate paper sales in Japan, limiting investors' options.
? The limited size of corporate bond markets in Japan makes them unattractive to
large investors, who, if they needed to liquidate their portfolios quickly, would
risk driving down the price of the assets they were selling. On the other hand, the
equity market in Japan as of 30 November 1983 is large by international
standards as indicated in the following tabulation:
1,595
475
210
125
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Figure 11
Japan: Excess Savings and Current
Account Balances, 1973-83
Figure 12
Japan: Price-Adjusted, Trade-
Weighted Movements of the Yen and
Export Prices, 1973-82
a Relative export prices for Japan (1980= 100)
This index represents the ratio of Japanese export
prices to a weighted geometric average of 13 other
industrial countries.
b Trade-weighted, price-adjusted yen (1980-82=100)
-3.01973 75
Current account
balance
Japanese savings
minus
Japanese
investment
90 1973
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The Current Account Although growth in capital outflows from Japan led to yen weakness early in the
Part of the 1980s, the tripling of the current account surplus last year triggered yen
Basic Balance appreciation. We believe cyclical factors-both globally and within Japan-are
largely responsible for the surge in the current account surplus:
? The yen-denominated unit value index for imports declined 10 percent in 1983,
because, given the limited economic recovery worldwide, industrial raw material
markets remained soft.
? The volume of Japanese imports also fell, reflecting drawdowns in accumulated
inventory that built up during the recession in Japan that ended early in 1983.
? The robust economic recovery in the United States coupled with yen-dollar
misalignment boosted Japanese exports to their largest market 18 percent last
year. This more than offset reduced sales to developing nations and permitted a
6-percent increase in total exports.
The growth in protectionism in countries Japan trades with also added to the
surplus, by permitting Japan to boost the relative price of its goods independently
of changes in the exchange rate. The Economist has characterized this phenome-
non as one of "larger surplus but stable market share."
11 Confidential
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Figure 13
Japan: The Yen's Volatility Against
the Dollar, 1973-83
1 1
320 1973
Table 2
Liberalization Measures and Capital Flows a
Repeal of designated company system, which has limited foreign +
investment in 11 Japanese companies
Relaxation of guidelines on Japanese corporate issues of Euro-yen +
bonds
Removal of requirement that forward purchases of yen in Tokyo be
accompanied by an underlying trade transaction
a A plus sign indicates the new or proposed measure is likely to
stimulate capital inflows. An equal sign indicates the measure's
effect on the capital flows is indeterminate.
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Prospects for The consensus of market analysts is that the current account surplus will be large
Yen Appreciation enough in 1984 to keep the basic balance in surplus and to engender yen
appreciation of 5 to 10 percent against the dollar.
Underlying these predictions are three key assumptions about Japanese economic
policies, namely that monetary policy will remain cautious, that new financial
liberalization measures will tend to foster capital inflows rather than outflows, and
that the divergence between Tokyo's and Washington's fiscal policies will stabilize
or narrow. We believe there is a good chance that all three conditions will be met:
? In keeping with its policy last year, the Bank of Japan is likely to make further
easing of Japanese monetary policy contingent on a loosening of US monetary
policy. The central bank delayed a cut in the discount rate several times last year
because it feared such a move would accelerate capital outflows.
? On the fiscal policy side, differences between the United States and Japan may
narrow. Nakasone's second cabinet, appointed in December 1983, includes
Toshio Komoto as head of the Economic Planning Agency. Komoto, more
charismatic and powerful than his predecessor, is pushing for fiscal stimulus in
the form of investment tax credits.
? The capital market liberalization measures already announced for 1984 look like
they will have a positive or indeterminant impact on capital inflows.
History shows, however, that another year of relative stability in yen-dollar rates
would be extremely unusual. The yen is extremely volatile and subject to
speculative runs that could alter the yen's value more rapidly than is now expected.
We believe changes-or anticipated changes-in US economic policies could
spark very rapid yen appreciation.
On the other hand, with raw materials and fuels constituting three-fourths of
Japanese imports, sharp rises in commodity prices could cause renewed yen
depreciation. If commodity prices accelerate in response to unexpectedly strong
global economic recovery or if oil prices soar because of an escalation of tensions in
the Middle East, the projected large and growing current account surplus for
Japan could easily evaporate. The other downside risk for the yen involves an
increase in the pace at which Japanese investors are diversifying the currency
denomination of their portfolios.
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Figure 14
Japan: The Yen and Export
Market Share, 1973-82
a A yen index below 100 indicates the yen is
undervalued against other major currencies relative to
1980-82 baseline.
Figure 15
Japan: Trade Balance With the
United States and Western Europe,
1973-83
Yen Indexa
Index: 1980-82=100
Market Share of OECD Exports
Percent
90 U 10
70 1973 75 80
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How the Yen's If the yen appreciates as most analysts expect, the price of Japanese goods relative
Value Affects to the cost of other countries' goods should increase. Such declines in competitive-
Trade Balances ness have taken their toll on export volume relatively swiftly in the past:
? Work done by the OECD in 1980 indicates that price changes associated with
currency appreciation reduce the volume of manufactured exports more rapidly
in Japan than in other industrialized countries. According to the OECD study, a
10-percent increase in relative prices cuts Japanese export volume by 6.4 percent
and US exports by 4.5 percent during the first year.
? The Japanese experience in 1977-78 conforms to the swift reaction pattern
identified by the OECD. A 40-percent appreciation of the yen against the dollar
in 1977 and 1978 abruptly ended a two-year export drive, and Japan's share of
total OECD exports shrank.
The time lags involved in the adjustment of trade volumes to exchange rates
temporarily cause perverse movements in the trade balance, even when the lags are
relatively short, as in Japan:
? Yen appreciation boosts the dollar value of an unchanged volume of exports.
This ensures that the trade surplus will widen until volume adjustment occurs.
As far as sales to Western Europe are concerned, it appears that the adjustment of
trade to last year's yen appreciation has begun:
? Japanese exports to Europe in January 1984 were off 5 percent from levels a
year ago.
? Japanese manufacturers of construction machinery and precision instruments
are running into stiff European competition in third-country markets in the
Middle East and Southeast Asia.
In the United States, however, Japanese goods are still quite competitive. The
yen's stengthening against the dollar in 1983 offset only about one-sixth of the real
depreciation that had taken place in the preceding two years. Until this misalign-
ment is corrected, Japan will continue to run massive trade surpluses with the
United States, although as economic recovery takes hold in Japan the size of the
surplus may decline somewhat.
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