There have been violent swings between the Japanese yen and its exchange rate with other currencies in the past 30 years. In the early 1980s, the yen typically traded somewhere in a band between 200 and 270 per dollar. But in September 1985, the world's major Western economies gathered in New York and decided to devalue the dollar, an agreement that became known as the Plaza Accord. The Plaza Accord set off a strengthening trend in the yen for the next decade that ended with the exchange rates reaching close to 80 yen to the dollar. That's an astonishing 184% appreciation in the yen's value.
- The Japanese yen has see-sawed in the last 35 years, particularly in the first decade after the 1985 Plaza Accord, in which a deal was made to devalue the U.S. dollar, therefore strengthening the yen.
- The Plaza Accord led to a period of exchange rate volatility that has contributed to Japan's manufacturing industry shifting from a focus on domestic production and exports to large scale overseas production.
- This shift has hit Japanese employment and consumption, even impacting companies outside manufacturing or those that are entirely domestically-based.
- The companies have enjoyed greater stability by becoming less vulnerable to the downsides of exchange rate movements, but the strength of the overall domestic economy going forward is more tumultuous.
Japan's Bubble and Economic Stagnation
While the yen's strength benefited Japanese tourists and companies conducting M&A in the United States, it was disadvantageous for Japanese exporters who wanted to sell their goods to American consumers. In fact, this sharp rise in the yen is one of the key factors leading to the building and then bursting of Japan's bubble economy in the late 1980s, a period that was followed by over two decades of economic stagnation and price deflation.
Since 1995, the Japanese yen has seen a number of violent swings. While none of them were as extensive as the first 10 years following the Plaza Accord, they have wreaked havoc on the mindset of Japanese businessmen and politicians and changed the underlying structure of the country's economy. The yen began another round of strengthening in the middle of 2007 that saw it smash through the 80 yen/dollar level in late 2011. This trend only began to reverse (and sharply so) with the election of a new government (lead by Mr. Abe) and the appointment of a new central bank governor (Mr. Kuroda), both of whom promised massive quantitative easing. So how big an impact does the exchange rate have on Japan's economy, and what changes has this volatility brought about?
Real Impacts Versus Translation Effects
To determine the effect of exchange rates on Japan's economy, it helps to use a basic example. Let's assume we have an exchange rate of 120 yen/dollar and two Japanese automobile manufacturers selling cars in the United States. Company A builds its cars in Japan, then exports them to the United States, and Company B has built a factory in the United States so that the cars it sells there are also manufactured there. Now let's further assume that it costs Company A 1.2 million yen to make a standard car in Japan (about $10,000 at the assumed exchange rate of 120 yen/dollar), and it costs Company B $10,000 to make a similar model in the United States. Then, the costs per vehicle are approximately the same. Because both cars are similar in make and quality, let's finally assume that they both sell for $15,000. That means both companies will make a $5,000 profit on a vehicle, which will become 600,000 yen when repatriated back to Japan.
Scenario Where the Exchange Rate Is Yen/Dollar
Now, let's look at a scenario where the yen strengthens to 100 yen/dollar. Because it still costs Company A 1.2 million yen to produce a car in Japan, and because the yen has strengthened, the car now costs $12,000 in dollar terms (1.2 million yen divided by 100 yen/dollar). But Company B still produces at $10,000 per car because it manufactures locally and is not impacted by the exchange rate. If the cars still sell at $15,000, Company A will now make a profit of $3,000 per car ($15,000 - $12,000), which will be worth 300,000 yen at 100 yen/dollar. But Company B will still make a profit of $5,000 per car ($15,000 - $10,000), which will be worth 500,000 yen. Both will make less money in yen terms, but the decline for Company A will be much more severe. Of course, the reverse will be true when the exchange rate trend reverses.
Scenario Where the Exchange Rate Is 100 Yen/Dollar
If the yen weakened to 140 yen/dollar, for example, Company A will make 900,000 per car, while Company B will make only 700,000 yen per car. Both will be better off in yen terms, but Company A will be more so.
Scenario Where the Exchange Rate is 140 Yen/Dollar
These scenarios show the substantial impact exchange rates have on Company A. Because Company A has a mismatch between its currency at production and its currency at sale, profits will be affected in both currencies. But Company B only faces a translation effect because its profitability in dollar terms is unaffected - only when it reports earnings in yen or tries to repatriate cash to Japan will anyone notice a difference.
The Hollowing Out of Japan
The sharp appreciation of the yen during the 10 years after the Plaza Accord, and the exchange rate volatility that followed forced many Japanese manufacturers to reconsider their export model of building in Japan and selling abroad. This had an impact on profitability. Japan had rapidly gone from a position as a low-cost producer to one where labor was relatively expensive. Even without the impact of the effects discussed above, it had simply become cheaper to produce goods overseas.
In addition, it had also become politically challenging to export products to the United States where there was local competition. Americans witnesses companies such as Sony (SNE), Panasonic, and Sharp devour their television manufacturing industry, and they were reluctant to let the same thing happen to other strategic industries such as automobiles. Hence, a period of political tension surrounding trade emerged, where new barriers to Japanese exports arose, such as voluntary quotas on automobiles and limits on exports to the United States for sale.
Japanese companies now had two good reasons to build factories overseas. It would it lead to more stable profitability in the face of an unstable exchange rate, and relieve the increasing cost of labor. Toyota is a classic example.
The slide below is from Toyota's FY2019 annual results presentation. It details the split between (a) how many cars the company produces in Japan and overseas, and (b) how much revenue it generates in Japan and overseas. First, the data show that the vast majority of the company's revenues now come from outside of Japan. But we also note that the majority of cars it builds are manufactured overseas. While the company may still be a net exporter, and while the evolution may have happened over an extended period, the graduation to a focus on overseas production is clear.
Source: Toyota, 2019
Not all manufacturers in Japan are large exporters, and not all exporters in Japan have been as aggressive as Toyota and the auto industry in moving production overseas. However, it has been a trend for most of the last three decades. The chart below combines data from two government agencies to illustrate this point. It looks at the revenues from overseas subsidiaries of Japanese manufacturers and divides it by total revenues of those same companies for the years 1997 to 2014.
Overseas Subsidiaries Revenue As A % Of Total
Source: METI, MoF
The graph shows that shortly after the end of the first great Japanese yen appreciation, the ratio of overseas subsidiary sales went from 8% to nearly 30% by the end of 2014. In other words, more and more Japanese manufacturers were seeing the merit of expanding their businesses overseas and making products where they sold them.
The problem with this model, however, was that it hollowed out the Japanese economy. As factories moved abroad, fewer jobs were available domestically in Japan, which placed downward pressure on wages and damaged the domestic economy. Even non-manufacturers felt the impact as consumers reined in spending.
It's Even About Nuclear Power
The exchange rate factors heavily into discussions on energy security because the country is devoid of natural resources such as oil. Anything that the country cannot produce through renewable sources such as hydro, solar, and nuclear energy must be imported. Because most of these imported fossil fuels are priced in dollars (and extremely volatile themselves), the yen/dollar exchange rate can make a huge difference.
Even after the triple disaster of the massive earthquake, tsunami and nuclear meltdown that occurred in March 2011, the country's government and manufacturers were keen to have the nuclear reactors back in operation. While the government's quantitative easing program has been successful at weakening the yen since 2012, the flip side is that imports cost more as a result of that weakening. If the price of oil were to rise while the yen remains weak, that would again hurt the production costs of domestic manufacturers (and households, car drivers, and therefore, consumption).
The Bottom Line
The strengthening of the yen against the dollar after the Plaza Accord and the exchange rate volatility that followed has encouraged a rebalancing of Japan's manufacturing industry from one focused on domestic production and export to one where production has shifted overseas on a large scale. This has had consequences for domestic employment and consumption, and even non-manufacturers and solely domestic companies are exposed. While the companies themselves have become more stable because they are less exposed to the negative effects of exchange rate movements, the future stability of the domestic economy is less certain.