Abenomics is based on the premise that a weak yen is good for Japan. But so far, the results have been disappointing. The yen fell 17 per cent against the US dollar in 2013 but export volumes slipped by 1.5 per cent instead of rising and the trade deficit ballooned.
The sensitivity of Japan’s exports to exchange-rate movements has fallen over time. The recent sluggish response can be blamed on weak global demand, loss of competitiveness (particularly in electronics) or a shift to overseas production. In addition, exporters have adopted a pricing strategy that prioritises profits over growth in market share.
Faced with changing exchange rates, exporters can either keep prices unchanged in their customers’ local currencies – ‘FX terms’ – or they can maintain yen-denominated prices, allowing local prices to adjust.
Maintaining local prices means volatility in the exporters' yen-based profits but sales volumes should be stable with the firm's global market share remaining largely unchanged. However, if exporters let local prices reflect currency movements they may lose or gain market share.
With domestic labour supply and demand set to shrink over the long term, firms are reluctant to raise capacity for fear of slack when global demand falls
Japan’s exporters responded to the recent currency tumble with only marginal foreign price cuts. While the yen’s effective exchange rate plunged by an average 18.8 per cent, the export price index dropped only 1.9 per cent in local currency terms. This marked a clear break with the 1990s, when Japanese producers adjusted prices in response to a weakening yen.
This shift in pricing strategy may be tied to domestic supply side dynamics. Boosting export volumes makes sense if there is slack in manufacturing capacity because foreign sales offset weak domestic demand. But when capacity is tight, companies have less incentive to cut export prices to achieve higher overseas sales.
Japan’s domestic manufacturing capacity has been tightening for more than a year. This reflects the sharp rise in public investment associated with prime minister Shinzo Abe’s fiscal stimulus package, plus higher household consumption and housebuilding ahead of the April 2014 sales-tax hike.
But tightening production capacity also reflects increased off-shoring and domestic capital expenditure that is still 12 per cent below the pre-crisis peak. Japan’s overseas production ratio for its entire manufacturing sector increased from about 15 per cent to 20 per cent between 2008 and 2013, and more than 40 per cent of car and electronics firms’ capacity is now located abroad.
In the late 1980s and early 1990s, when export prices moved in local currencies, manufacturers adjusted production capacity to meet changes in external growth. And with China yet to join the World Trade Organization, off-shoring was a much less attractive option. Further, with Japan's working-age population growing until 1997, labour shortages were less acute.
The rise of global supply chains and concerns over Japan’s long-term growth have changed that. With domestic labour supply and demand set to shrink over the long term, firms are reluctant to raise capacity for fear of slack when global demand falls. Manufacturers have cash and access to cheap funding to boost capital expenditure, but labour shortages are an increasingly dominant supply side constraint.
If April’s tax hike slows domestic demand, it may be more attractive for manufacturers to cut export prices to generate foreign orders. The incentive could be strongest in electronics, which still has excess capacity. But in export sectors operating close to full capacity – including chemicals, metals and general machinery – it may take several months before capacity utilisation falls enough to prompt a rethink in pricing strategy.
However, long-term, rising supply-side constraints will make it increasingly difficult for Japan’s domestic manufacturers to service a simultaneous pick-up in domestic and external demand. That would spell lost opportunities for future growth.
This research was first published on 10 March 2014.