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
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
The approach signaled an end to
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
But if appreciation of the Japanese yen were to lead to increases in Japanese imports and reductions in its exports, then
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
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
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
The likelihood that a more expansive fiscal policy in
Meanwhile, a market would develop in which Japanese exporters would buy these coupons from Japanese importers. Each month or quarter, the
The more successful the measures adopted by the government of
One advantage of this coupon arrangement is that it would secure an orderly reduction in the Japanese trade surplus and the
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
These changes can be exceedingly costly for some firms-while others secure windfall profits. (The large
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
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
The supply of Greater Fools again will have been exhausted; the increase in the capital outflow from
Robert Z. Aliber is the professor of international finance at the