Implications Of The Rising Yen
Washington’s decision to combat the spiraling trade deficit with Japan by allowing a the dollar to plunge against the yen has failed. What are the policy alternatives, and how can U.S. firms best defend themselves against currency risk?
December 1 1993 by Robert Z. Aliber
Beginning this month, CE introduces a new department, “B-School Brain Trust,” which is roughly the successor of our longtime “Wisdom From Wharton” column. The purpose of the series is to tap insights and research of interest to CEOs in running their businesses or sorting out strategic problems. Three schools will comprise the “Brain Trust,” and they will contribute on a rotating basis. Remaining on board will be The Wharton School of The University of Pennsylvania. Entering the fray this month is the University of Chicago‘s Graduate School of Business. To plug into research offshore, we’ve also enlisted Fontainebleau, France-based INSEAD, the Institut Europeen d’Administration des Affaires. (Translation: The European Institute of Business Administration.) We encourage our readers to write to us either with suggestions on topics they’d like to see addressed, or with comments on individual articles.
In the last years of the 1980s, the “Greater Fool” theory was operating in the Japanese equity and real estate markets. Though equity prices tripled between October 1985 and December 1989, and real estate prices increased by a factor of five, investors continued to buy, anticipating that they could sell at even higher prices in the future. This grand pyramid scheme ended when the Japanese “bubble” economy burst in the early 1990s, and the prices of many securities and assets plunged to about half their peak value.
With the sharp appreciation of the Japanese yen against the U.S. dollar from 125 to nearly 100 in the first six months of 1993, one wonders whether the fools have migrated to the foreign exchange market. Perhaps. But the exchange rate also has been affected by Washington‘s decision to let the U.S. dollar fall in an effort to trim its massive trade deficit with Japan.
The approach signaled an end to Washington‘s policy of benign neglect toward the trade gap. But clearly, this strategy has been less than successful: The bilateral trade deficit this year is expected to approach $60 billion, and it remains on the rise. Thus, it’s time to talk about some policy alternatives. In addition, given the considerable exchange-rate exposure of many large U.S. corporations, it may be time for them to rethink hedging strategies and to pose a question worth tens of billions of dollars: “Is the yen bubble, too, about to burst?”
DIAGNOSING THE PROBLEM
With the bubble deflated and the Japanese economy mired in the doldrums, interest rates on Japanese yen-denominated securities are now one to two percentage points below interest rates on comparable dollar-denominated securities, so few investors would be likely to buy Japanese yen securities in search of higher yields. As a result, the most popular explanation for the appreciation of the Japanese yen is that Japan has a large, growing trade surplus. Government officials in the U.S. and Europe complain that this trade surplus is complicating their own economic recoveries; in less polite moments they apply the 1930s term “beggar-thy-neighbor” to Japanese economic policies. The story is that the Japanese trade surplus will decline as the yen appreciates, both because Japanese consumers will buy more U.S. and European goods as they become cheaper, while American and European consumers will buy fewer Toyotas and Toshibas as their selling prices are raised in these foreign markets.
But if appreciation of the Japanese yen were to lead to increases in Japanese imports and reductions in its exports, then Japan might be expected to have an enormous trade deficit, given that the exchange rate was 360 yen to the U.S. dollar at the beginning of the 1970s. During the last 20 years, the ratio of the Japanese trade surplus to its national income increased by more than three percentage points. Still, it would be risky to conclude from this association of two “factoids” that the Japanese trade surplus would have declined if the yen had depreciated.
Japan has had large trade surpluses for the last several decades, because the household savings have been larger than the domestic investment. As a result, interest rates have been low; and since the late 1970s, interest rates in Japan have some Japanese investors have been attracted to U.S. dollar securities and U.S. real assets for more than 10 years. Before they could buy these securities and assets, they first had to buy U.S. dollars in the foreign exchange market. So the U.S. dollar appreciated sharply in the first half of the 1980s-or what is the same thing, the Japanese yen depreciated. So American consumers increased their purchases of Japanese goods, while American exports to Japan were stymied. The large Japanese trade surplus developed as the mirror image of the large Japanese purchases of U.S. dollar securities and U.S. real assets.
Despite the large appreciation of the yen in the late 1980s, the Japanese trade surplus declined only modestly, and then primarily because of the investment and consumption boom, which led to a rapid increase in imports. With the collapse of the bubble, the trade surplus has surged as investment spending has declined. As the yen appreciates because of purchases by the Greater Fools, investment spending by business will decline, while the increase in economic uncertainty may lead to an increase in the household saving rate.
TAMING THE DRAGON
In 1993, the U.S. will have a trade deficit of $120 billion. Japan will have a trade surplus of $140 billion-nearly 4 percent of the country’s national income. The bilateral U.S. trade deficit with Japan will be between $50 billion and $60 billion. Japan has trade surpluses with many of its neighbors such as Korea and Taiwan and Hong Kong. Many of these countries, in turn, have trade surpluses with the U.S. In effect, firms in these countries-including both U.S. and Japanese companies-import components from Japan which they assemble for export to the U.S. Altogether, perhaps as much as 80 percent of the U.S. trade deficit has as its counterpart the Japanese trade surplus.
The Clinton Administration has made the connection between increases in the U.S. trade deficit and the decline in the number of jobs in firms in the U.S. that produce tradable goods, both exports and import-competing goods. If value added in U.S. manufacturing averages $50,000 perworker, then a U.S. trade deficit of $100 billion translates into 2 million fewer jobs in U.S. manufacturing firms (which more or less corresponds to the decline in employment in U.S. manufacturing since 1980). And to the extent that the U.S. trade deficit increases, those workers who lose their jobs in U.S. manufacturing spend less on U.S. goods and services, and so the total decline in U.S. employment might be 60 percent to 80 percent larger than the decline in employment in the firms that produce tradable goods.
What are the alternatives to “talking up the yen” as a way to secure a reduction in the Japanese trade surplus? One is to encourage the government of Japan to adopt fiscal policies to stimulate the Japanese economy; the induced increase in personal incomes would encourage imports, and the induced increase in interest rates from a larger fiscal deficit would reduce the incentive for Japanese investors to acquire U.S. dollar securities. Washington continues to stress the need for such expansive policies, and there are relatively feeble responses in Tokyo: The Mandarins who dominate the Ministry of Finance are reluctant to see the debt of the Japanese government increase. Moreover, for the past 20 years Tokyo has been encouraged to open government procurement and the economy to foreign firms.
The likelihood that a more expansive fiscal policy in Tokyo and measures to “open the Japanese economy” would be successful in reducing the Japanese trade surplus in a reasonable horizon of two or three years seems little. If the government of Japan is reluctant to adopt measures to reduce its trade surplus, then the U.S.-perhaps together with the other industrial countries-might adopt a “coupon arrangement” to reduce the trade deficit with Japan. Japanese importers from the U.S. would receive “coupons” in amounts directly proportional to the value of their U.S. purchases. Japanese exporters to the U.S. would be allowed to clear their goods through the U.S. customs houses only after depositing the appropriate number of these coupons.
Meanwhile, a market would develop in which Japanese exporters would buy these coupons from Japanese importers. Each month or quarter, the U.S. government would indicate the number of coupons that each Japanese exporter would have to deposit to sell $100 of goods in the U.S. The required deposit ratio would be changed on an orderly basis to secure a reduction in the Japanese trade surplus with the U.S. The market price of the coupons would vary continuously to encourage Japanese imports from the U.S. relative to Japanese exports.
The more successful the measures adopted by the government of Japan to reduce its trade surplus, the lower the price of the coupons. Indeed, if the Japanese trade surplus were to decline rapidly, then the U.S. government could conclude that it would not be necessary for exporters to deposit any coupons for the next month or quarter.
One advantage of this coupon arrangement is that it would secure an orderly reduction in the Japanese trade surplus and the U.S. trade deficit. A second advantage is that it would encourage the government of Japan to adopt its own measures to effect an orderly reduction in its trade surplus.
Very likely, the Japanese yen will remain volatile in the foreign exchange market over the next several years in response to both the uneven pace of the economic recoveries in the U.S. and Japan, and accelerating tensions about trade issues. The Japanese yen price of the U.S. dollar might change by as much as 10 percent to 15 percent in two or three months, especially in response to the herd mentality of the Greater Fools.
These changes can be exceedingly costly for some firms-while others secure windfall profits. (The large U.S. money center banks have reported exceptional profits from their foreign exchange trading activity; presumably their foreign counterparts also have earned large trading profits.) One petroleum company in Japan has incurred foreign exchange losses of more than $1 billion, because it developed a long position in the U.S. dollar at the time the Japanese yen appreciated. And Toyota, Nissan, Honda, and the other auto firms have reported sharp decreases in profits, either because of losses on their export sales or smaller profits on these sales; the inference is that they failed to hedge the anticipated U.S. dollar sales receipts.
The essential step for virtually every firm involved in U.S.-Japanese trade is to develop an estimate of its foreign exchange exposure, and to determine the sensitivity of anticipated profits on its exports and other international transactions to changes in the exchange rate. (Many firms spend a great deal of time and effort estimating the foreign exchange exposure of their balance sheets; they devote relatively little attention to estimating the foreign exchange exposure of their income statements.) In effect, the firm should estimate the foreign exchange sales receipts for the next three or four years on the assumption that the firm’s market share remains unchanged. The present value of these sales receipts can then be calculated. For many firms, this number will be large-in some cases staggeringly large.
The least risky alternative for the firm is to hedge this estimate of future sales receipts by the use of foreign exchange contracts or futures contracts or swaps. Not to hedge the exposure is to “bet the firm” that the current exchange rate will remain unchanged for the next two to three years-which seems unlikely.
One of the standard objections to the recommendations that foreign exchange hedges be purchased in amounts equal to the sales of the next few years is that the future sales aren’t known with any precision. However, most firms have incurred large investment expenditures and made substantial commitment to their employees and suppliers on the basis of estimates of future sales, even though these sales aren’t known with precision; all that is involved is estimating the export component of these sales. And for many firms, exports may be 30 percent or 40 percent of total sales. The firm might acquire hedges equal to 80 percent or 85 percent of anticipated sales or a number that corresponds to the lower boundary of anticipated sales.
A second objection is that hedging the foreign exchange exposure is not a cost-less activity. This conclusion is based on the insurance analogy; while hedges can be considered insurance, there is no participant in the foreign exchange market that corresponds to the insurance company. Instead, the counterpart to the purchases of foreign exchange hedges by U.S. firms is the purchase of similar hedges by Japanese firms. Most firms grossly overestimate the cost of hedging their foreign exchange exposure; the effective comparison is between today’s forward exchange rate and the estimate of the spot exchange rate on the date the forward exchange contract matures, for an extended series of transactions. Since over long periods the forward exchange rates tend to be more or less approximate estimates of the values of the spot exchange rates on the dates the forward exchange contracts mature, the cost of hedging tends to approximate zero.
OUTLOOK FOR THE YEN
The Greater Fool approach to forecasting the foreign exchange value of the Japanese yen suggests the currency is likely to continue to increase, because the price has increased so sharply in recent months-and the Japanese trade surplus has been increasing. The straight line approach to forecasting changes in economic variables should be suspect, since the oil price, which had been $2.75 in 1970 and $12 in 1975 and $36 in 1980, failed to increase to $60 or $80 in 1990. Indeed, the 1990 price declined to $20. Economics abhors straight-line forecasts. As the economic situation in Japan worsens, cash-rich life insurance companies are again likely to find the 6-plus percent yields on U.S. dollar securities attractive compared with the 4 percent yields on Japanese yen securities. Some of the investors who have profited after buying Japanese yen in the early months of this year are likely to become sellers of yen. And some foreign equity investors who purchased Japanese yen equities at the beginning of 1993 also may become sellers of yen.
The supply of Greater Fools again will have been exhausted; the increase in the capital outflow from Tokyo will lead to a depreciation of the yen. And the likelihood is high that the trade surplus will increase, further intensifying frictions between Washington and Tokyo.
Robert Z. Aliber is the professor of international finance at the University of Chicago‘s Graduate School of Business. He has written about exchange rates, and international financial and banking relationships and policy problems, including “The Multinational Paradigm” (1993). Prior to joining the Chicago faculty in 1965, he was senior economic adviser, Agency for International Development, Department of State (1964-65), and staff economist, Committee for Economic Development (1961-64).