The global economy has been experiencing very substantial moves in exchange rates. The likely effects of these changes in the relative value of national currencies on the respective economies are an important consideration for investment strategies. In this and several forthcoming commentaries we will examine to what extent the “J-curve theory” of the effects of currency depreciation on trade balances is applicable to the increasingly globalized economies of the 21^st century. In this note we consider the experience to date of Japan under “Abenomics,” where since October 2012 the yen has depreciated some 30 percent on a multilateral real exchange-rate basis and 50 percent versus the US dollar.

From the time of Alfred Marshall (1842-1924) and Abba Lerner (1903-82), economists and policymakers have believed that a real devaluation of a nation’s currency will lead to an improvement in that nation’s trade balance. The expected trajectory of the trade balance following the currency depreciation looks more or less like the letter J and is hence called the “J-curve theory.” At first the devaluation is likely to lead to a temporary decrease in the trade balance. Import and export prices are in many cases fixed in advance in contracts. However, importers who have not fully hedged their trades will experience an increase in the cost of their imports in their domestic currency, and thus the country’s trade balance will worsen. After a period of time contracts will be renegotiated and traders will adjust quantities demanded, reducing the demand for the more-expensive imports and increasing foreign demand for the less-expensive exports. The trade balance then improves, rising above its level prior to the depreciation.

The designers of Japan’s current economic policy, often called “Abenomics” after Prime Minister Shinzo Abe, clearly placed importance on the J-curve, expecting that substantial devaluation of the yen due to a massive program of quantitative easing by the central bank, the Bank of Japan, would lead to a strengthening of Japan’s trade balance, which would in turn deliver a much-needed stimulus to the economy. Indeed, that was probably expected to be the main effect of the quantitative easing, as interest rates were already extremely low.

The experience to date has likely disappointed Japan’s policymakers. The trade balance in 2013 was -10,685.0 trillion yen and was even worse for the year 2014, at -12,572.2 trillion yen. There was an improvement in the fourth quarter of last year, when exports in December advanced at an annual rate of 6 percent. This could be the start of the upturn in the J-curve as the delayed effects from the weaker yen may finally be feeding through. It has been over two years since the yen started to depreciate.

There appear to be several reasons for this delayed effect. Analysis by Barclays shows that Japanese exporters have been very slow to adjust prices in their foreign currency contracts, despite the very much weaker yen. This has seriously limited the response of export quantities to the yen depreciation. Japanese exporters have not sought to increase their global market share in this situation, perhaps because of reluctance to invest in capacity expansion. They have chosen instead to gain the increased profits from their current volume of exports. Another factor is that the percentage of export contracts settled in yen is only about 35 percent. And of course, the depreciation has occurred over an extended period, not at one time as the theoretical model assumes.

Another reason for the weak response of export demand until very recently may be the fact that Japan’s exports (capital goods and industrial materials) are mainly to companies. While price changes will have an effect, the main determinant of the demand for these products is the current and expected pace of economic activity for these foreign companies. While Japan’s most important customer, the United States, which accounts for 19 percent of exports, is experiencing a quickening economic recovery, China, which accounts for 18 percent, has an economy that has been decelerating; and the economy of the third-most-important customer, the European Union (10 percent of exports), having barely grown last year, is just beginning to pick up its pace. (These export shares are for 2013.)

In addition, it is important to bear in mind that over 68 percent of Japan’s economy consists of services and agriculture. Industry accounts for just 32 percent. While some services such as tourism can be considered tradable goods, there are limits to the ability of exports to lift the Japanese economy.

On the import side the yen depreciation increases costs. While that will decrease the demand for various imports, the most important factor is that the weaker yen has come at a time when Japan has become increasingly dependent on energy imports, following the shift from nuclear to thermal power. This shift has substantially worsened Japan’s trade deficit. The dramatic fall in oil prices is working in the other direction to improve the trade deficit, but oil is only third in importance for Japan’s energy imports, after LNG and coal.

For the future, with growth in the US and now Europe strengthening, China probably not slowing much more, and Japan bringing its nuclear capacity back on line, Japan’s trade balance does look likely to improve, at least during the next two years. But Japan’s economic policymakers cannot rely on the trade balance alone to bring Japan’s economy to a stronger and more sustainable rate of growth. Meaningful structural reforms, promised but still unrealized as the “third arrow” of Abenomics, will be essential.

The ideas and opinions expressed in this blog are those of the author, and they should not be perceived as investment advice or as any other kind of advice.

The preceding is an abridged commentary by Cumberland Advisors and has been reposted with permission. Cumberland Advisors commentaries are available at http://www.cumber.com/commentary_archive.aspx.

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