No. 7 — February 23, 1996


Weekly Review

--- by Douglas Ostrom

Japan's economy finally is on the mend. That message, already explicitly stated by the Economic Planning Agency in an early February pronouncement that a recovery is underway (see JEI Report No. 6B, February 16, 1996), received further support from the Bank of Japan's release of 1995 current account statistics. The 14.5 percent drop in the huge current account surplus last year, coming on the heels of a decline in 1994, pushed the broad measure of Japan's foreign commerce to the lowest level since 1991 (see Table 1). The inferences about the health of Japan's overall economic activity are in the details of the trade measures. For example, the large discrepancy between the 22.8 percent jump in 1995 imports and the 11.2 rise in exports suggests the likelihood that broad economic changes were underway. The strength of the yen through much of the year, which reduced the competitiveness of exports and increased that of imports, played a role. However, purchases from abroad probably would not have achieved the growth they did in the absence of improved economic conditions. As if to underscore the role of the nascent recovery, the surge in imports relative to that of exports was particularly pronounced in the fourth quarter, when signs of an economic upturn were multiplying. Rising aggregate demand lifts the demand for all goods and services, including foreign-supplied ones.

Another current account-related bellwether, net foreign purchases of Japanese equities, also moved sharply higher in 1995, with the biggest jump occurring late in the year. Overseas investors pumped a record $50.7 billion into Japanese equities last year (see Table 2); about $10.4 billion of that came in December alone. The increased level of foreign interest in Japanese shares was attributable in part to surging equities markets in the United States, which made the Tokyo Stock Exchange — where prices are little more than half what they were six years ago — appear relatively attractive. However, foreign investors would have not taken the plunge had they not had confidence that the Japanese economy and, by extension, the stock market would recover. Given their relatively marginal role in the Japanese stock market, foreign investors have an easier time than their domestic counterparts in moving in and out of equities as perceptions of economic prospects warrant. In fact, the huge sell-off of Japanese equities in the early 1990s was preceded at the end of the 1980s by foreign investors heading for the exits in massive numbers.

More generally, a drop in Japan's current account surplus is exactly what one would expect from an economy on the path to recovery. As prospects for economic growth have improved, business investment has shown signs of life, with accompanying demands on domestic capital markets. In addition, countercyclical spending, the latest dose of which was announced last September, continues to compete for available savings, which have remained relatively constant. Long-term interest rates accordingly have crept upward. At the end of December, for example, the Nikkei bond index carried an average rate of 3.4 percent, up from 3.2 percent at the end of June. The index rose another 0.1 percentage point this past January. One result has been a diminished enthusiasm for foreign bonds, on which interest rates tended to drift downward during the same period. Another consequence is that net outbound capital flows are smaller, other factors equal. Outflows, in turn, are arithmetically equal to the current account surplus, which, as noted above, declined noticeably in 1995.

In short, improving economic conditions in Japan are beginning not only to increase the demand for goods relative to supply, implying more imports relative to exports, but to boost the demand for capital, thereby curtailing the still-large capital outflow. Both effects, as mentioned, tend to narrow the current account surplus. However, they carry opposite implications for the yen. Higher imports resulting from economic growth, other factors equal, tend to increase the supply of Japanese currency on foreign exchange markets, reducing its value. Lower outbound capital flows raise the demand for yen relative to the supply, pushing up its value. Depending on circumstances, one effect or the other may dominate. In addition, causation runs both directions. High imports or low outbound capital flows not only are a factor in future currency flows but also are the consequence of past changes in the yen's value.

Such factors are clearly too ambiguous in their impact to be of much everyday use to those trying to profit from shifting exchange rates. Over the medium to long term, however, the shifting balance of domestic investment relative to savings and the impact of economic growth on levels of trade assume greater importance. If, as is likely, increases in private capital spending loom large relative to other factors in the Japanese economy over the next year, the odds increase that the yen will appreciate. That development, in turn, would mean that Japan's current account surplus could decline further.

The views expressed in this report are those of the author
and do not necessarily represent those of the Japan Economic Institute

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