There have been some violent swings between the Japanese yen and other currencies exchange rate
in the past 30 years. In the early 1980s the Yen generally 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.
This set off a trend of the yen strengthening over the next decade that
ended with the exchange rate nearly reaching 80 yen/dollar. That's an
astonishing 184% appreciation in the yen's value. While that was great
for Japanese tourists and companies wanting to conduct M&A
in the United States, it wasn't particularly good for Japanese
exporters that wanted to sell their goods to American consumers. And in
fact, this sharp strengthening of the yen is one of the key factors
often cited for leading to the building and then busting of Japan's Bubble
Economy in the late 1980s, a period that was followed by over two
decades of economic stagnation and price deflation. (To learn more,
read: The Plaza Accord: The World Intervenes In Currency Markets).
The Japanese Yen to US Dollar Exchange Rate
JPY/USD
Source: Bank of Japan
Since 1995, the Japanese Yen has seen a number of other violent swings. And while none of them were as extensive as those first ten years since the Plaza Accord, they have wreaked havoc on the mind of Japanese businessmen and politicians, leading to great changes to the underlying structure of the country's economy. Most recently in fact, 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 of an impact does the exchange rate really have on Japan's economy, and what changes has this volatility brought about? (For related reading, see: 6 Factors That Influence Exchange Rates).
Real Impacts Versus Translation Effects
Before moving on, let's take a look at a basic example. Let's assume we have an exchange rate of 120 yen/dollar and two Japanese automobile manufacturers selling cars in the US. Lets' say Company A builds its cars in Japan, then exports them to the US. And say Company B has built a factory in the US, so that the cars it sells in the US are also manufactured there. Now let's further assume that is costs Company A about 12 million yen to make a standard car in Japan (about $10,000 at the assumed exchange rate of 120 yen/dollar), and that it costs Company B $10,000 to make a similar model in the US, such that costs per vehicle are roughly 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 that vehicle, which will become 600,000 yen when repatriated back to Japan. (To learn more, see: What Forex Traders Need To Know About The Yen).
Scenario Where Exchange Is At 120 Yen/Dollar
Now let's look at a scenario where the yen strengthens to 100 yen/dollar. Because it still costs Company A 12 million yen to produce a car in Japan, and because the yen has strengthened, the car now costs $12,000 in dollar terms (12 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 Exchange Is At 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 Exchange Is At 140 Yen/Dollar
In these scenarios, we can see 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
As you can imagine, 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 build in Japan and sell abroad. Not only did this have an impact on profitability, but 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. (For more, read: Exchange Rate Risk: Economic Exposure).
As if to further compound the situation, it had also become
politically challenging to simply export products to the US where local
competition existed. The Americans watched the likes of companies like
Sony (SNE),
Panasonic and Sharp devour their television manufacturing industry and
they weren't about to let the same thing happen to other industries
viewed as strategic, like the automobile industry. Hence a period of
political tension surrounding trade emerged, where new barriers to
Japanese exports arose such as voluntary quotas on automobiles, putting
limits on how many cars the country could export to the US for sale.
So Japanese companies now had three good reasons to build factories overseas. Not only would it help lead to more stable profitability in the face of unstable exchange rates, but Japan became an expensive place to hire labor, and it was politically challenging to continue growing the export model.
A classic example of this is Toyota (TM). The slide below is from the company's FY2015 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, we can see that the vast majority of the company's revenues now come from outside Japan; some 84% in fact. But we also note that the majority of cars it builds are manufactured overseas: 64%! While the company may still be a net exporter, and while the evolution may have happened over an extended period of time, the graduation to a focus on overseas production is clear. (On a related note, see: Kaizen: An American Idea Gets A Japanese Makeover).
Source: Toyota
Furthermore, Toyota and the automobile industry are far from the only ones. Naturally, not all manufactures in Japan are large exporters. And not all exporters in Japan have been as aggressive as Toyota and the auto industry at moving production overseas. But it is a trend that has been gradually occurring over most of the last three decades (if not longer). In fact, 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.
Overseas Subsidiaries Revenue As A % Of Total
Source: METI, MoF
From this we can see that shortly after the end of the first great Japanese yen appreciation, the ratio of overseas subsidiary sales went from roughly 8% to nearly 30% by the end of 2014. In other words, more and more Japanese manufacturers are not only seeing the merit of expanding their businesses overseas, but also of making products where you sell them.
The flip side to this argument is that it has lead to a so called "hollowing out of the Japanese economy". That is as factories move abroad, fewer jobs are available domestically in Japan for Japanese workers. And with fewer jobs available for these workers, it puts downward pressure on wages and thus hurts the domestic economy. Even non-manufacturers feel the impact as consumers reign in spending, an issue so relevant that the Brookings Institution hosted a debate on the topic in February 2013.
It's Even About Nuclear Power
Interestingly enough, the exchange rate even factors heavily into the discussion about energy security, because the country itself is famously devoid of natural resources like oil. So anything the country cannot produce through renewable sources such as hydro, solar, and nuclear energy need to be imported. And because most of these imported fossil fuels are priced in dollars (and extremely volatile themselves), the yen/dollar exchange rate can again 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 are keen to start switching the nuclear reactors back on. While the government's quantitative easing program has been quite successful at weakening the yen since 2012, the flip side is that imports cost more as a result of that weakening. It is perhaps a fortunate coincidence at the moment that the price of oil has weakened dramatically over the past couple of years. But if this trend were to reverse while the yen remains weak, that would again hurt production costs of domestic manufacturers (and of course households and car drivers, and therefore consumption). So despite the risk of having nuclear power in an earthquake-prone country, many are keen to see the reactors back online.
The Bottom Line
Overall 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 consequences for domestic employment and consequently 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 picture for the domestic economy is still far more mixed.
The Japanese Yen to US Dollar Exchange Rate
JPY/USD
Source: Bank of Japan
Since 1995, the Japanese Yen has seen a number of other violent swings. And while none of them were as extensive as those first ten years since the Plaza Accord, they have wreaked havoc on the mind of Japanese businessmen and politicians, leading to great changes to the underlying structure of the country's economy. Most recently in fact, 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 of an impact does the exchange rate really have on Japan's economy, and what changes has this volatility brought about? (For related reading, see: 6 Factors That Influence Exchange Rates).
Real Impacts Versus Translation Effects
Before moving on, let's take a look at a basic example. Let's assume we have an exchange rate of 120 yen/dollar and two Japanese automobile manufacturers selling cars in the US. Lets' say Company A builds its cars in Japan, then exports them to the US. And say Company B has built a factory in the US, so that the cars it sells in the US are also manufactured there. Now let's further assume that is costs Company A about 12 million yen to make a standard car in Japan (about $10,000 at the assumed exchange rate of 120 yen/dollar), and that it costs Company B $10,000 to make a similar model in the US, such that costs per vehicle are roughly 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 that vehicle, which will become 600,000 yen when repatriated back to Japan. (To learn more, see: What Forex Traders Need To Know About The Yen).
Scenario Where Exchange Is At 120 Yen/Dollar
Now let's look at a scenario where the yen strengthens to 100 yen/dollar. Because it still costs Company A 12 million yen to produce a car in Japan, and because the yen has strengthened, the car now costs $12,000 in dollar terms (12 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 Exchange Is At 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 Exchange Is At 140 Yen/Dollar
In these scenarios, we can see 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
As you can imagine, 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 build in Japan and sell abroad. Not only did this have an impact on profitability, but 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. (For more, read: Exchange Rate Risk: Economic Exposure).
So Japanese companies now had three good reasons to build factories overseas. Not only would it help lead to more stable profitability in the face of unstable exchange rates, but Japan became an expensive place to hire labor, and it was politically challenging to continue growing the export model.
A classic example of this is Toyota (TM). The slide below is from the company's FY2015 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, we can see that the vast majority of the company's revenues now come from outside Japan; some 84% in fact. But we also note that the majority of cars it builds are manufactured overseas: 64%! While the company may still be a net exporter, and while the evolution may have happened over an extended period of time, the graduation to a focus on overseas production is clear. (On a related note, see: Kaizen: An American Idea Gets A Japanese Makeover).
Source: Toyota
Furthermore, Toyota and the automobile industry are far from the only ones. Naturally, not all manufactures in Japan are large exporters. And not all exporters in Japan have been as aggressive as Toyota and the auto industry at moving production overseas. But it is a trend that has been gradually occurring over most of the last three decades (if not longer). In fact, 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.
Overseas Subsidiaries Revenue As A % Of Total
Source: METI, MoF
From this we can see that shortly after the end of the first great Japanese yen appreciation, the ratio of overseas subsidiary sales went from roughly 8% to nearly 30% by the end of 2014. In other words, more and more Japanese manufacturers are not only seeing the merit of expanding their businesses overseas, but also of making products where you sell them.
The flip side to this argument is that it has lead to a so called "hollowing out of the Japanese economy". That is as factories move abroad, fewer jobs are available domestically in Japan for Japanese workers. And with fewer jobs available for these workers, it puts downward pressure on wages and thus hurts the domestic economy. Even non-manufacturers feel the impact as consumers reign in spending, an issue so relevant that the Brookings Institution hosted a debate on the topic in February 2013.
It's Even About Nuclear Power
Interestingly enough, the exchange rate even factors heavily into the discussion about energy security, because the country itself is famously devoid of natural resources like oil. So anything the country cannot produce through renewable sources such as hydro, solar, and nuclear energy need to be imported. And because most of these imported fossil fuels are priced in dollars (and extremely volatile themselves), the yen/dollar exchange rate can again 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 are keen to start switching the nuclear reactors back on. While the government's quantitative easing program has been quite successful at weakening the yen since 2012, the flip side is that imports cost more as a result of that weakening. It is perhaps a fortunate coincidence at the moment that the price of oil has weakened dramatically over the past couple of years. But if this trend were to reverse while the yen remains weak, that would again hurt production costs of domestic manufacturers (and of course households and car drivers, and therefore consumption). So despite the risk of having nuclear power in an earthquake-prone country, many are keen to see the reactors back online.
The Bottom Line
Overall 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 consequences for domestic employment and consequently 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 picture for the domestic economy is still far more mixed.
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