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J curve effect and Japan’s Balance of payment

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J-CURVE EFFECT AND JAPAN’S BALANCE OF PAYMENT

Ahmed Munawar & Rashad Mammadov

Abstract

Japan’s economy is a remarkable one which has dazzled and amazed many people

including economist over the years. Putting aside the extraordinary growth they achieved after

World War II and by being the second largest industrial economy of the world; the

fundamentals of the economy had been puzzling the economist making them confusing and

throwing away fundamental theories which had been made in many years time. And even

some economist had come to the extend to put them as exceptional case while others came up

with new explanation of why a particular theory has not worked in case of Japan.

In this paper we have glance through the Japan’s Balance of payment analyzing the

recent trends in the account. In addition we have also looked one of the puzzling stories the so

called J curve effect for Japanese Balance of Payment. We have shown that it exit even for

Japan’s economy as shown with the help of new research findings.


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Table of Contents

Abstract .............................................................................................................................. 1

Table of Contents ............................................................................................................. 2

Introduction ....................................................................................................................... 3

Statistics on Balance of Payments ................................................................................ 3

Structure of the Japan’s balance of payment .......................................................... 4

I. Analysis of Japan’s Balance of Payment ............................................................. 6

Major Developments in the Balance of Payments for 2001 ................................... 15

II. J curve and Japan’s Balance of payment........................................................ 17

New trends ....................................................................................................................... 24

BIBLIOGRAPHY ................................................................................................................. 27

Appendixes ...................................................................................................................... 28


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Introduction

In the past, Japan’s balance of payments has been characterized by a persistent and

large trade surplus, with the deficit in services (such as travel, for instance) being eclipsed by a

huge merchandise (goods) trade surplus. However, after reaching 9.5 trillion yen in 1998, the

trade surplus plunged for three straight years, dropping to 7.4 trillion yen in 2000, and again by

half to 3.2 trillion yen in 2001.

Compared to a dip in the services deficit to 5.3 trillion yen, the merchandise trade

surplus plummeted to 8.5 trillion yen in 2001 (from 16 trillion in 1998) due to sluggish export

growth amid relatively steady import growth. In particular, a flood of imports from China has

expanded Japan’s bilateral trade deficit with that country to a hefty 3.3 trillion yen.

Statistics on Balance of Payments

Balance of payments is a statistical statement designed to provide a systematic report of

all the international economic transactions based on the principles of book-keeping by double

entry.

It is compiled by the Bank of Japan, with the authority delegate by the Minister of

Finance, and with the method of calculation and the form of presentation consistent to the

Manual of the International Monetary Fund (IMF) concerning the balance of payments

statistics. Economic transactions refer to all the transactions of goods and services between

residents and non-residents of Japan as well as the increase or decrease of Japanese assets and

liabilities in foreign countries. It does not matter whether it is onerous or free of charge, nor if it

is settled by yen or a foreign currency. Statistics on Balance of Payments in Japan has been

compiled in place of Statistics on Foreign Exchange since 1966 for nearly 30 years and has

become partly inadequate to report the current international economic transactions accurately as

a result of the significant evolution of the global economic practices. Therefore, the Balance of

Payments Statistics of Japan were considerably revised in January 1996 in accordance with the

fifth edition of the Balance of Payments Manual of the International Monetary Fund. The main

items of the revised Balance of Payments Statistics are the balance of current account


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(including the account of trade of goods and services, the income account and the current

transfer account), and the capital and financial account.

Structure of the Japan’s balance of payment

1. Current Account Trade Balance This item covers both exports and imports of movable goods

with change of ownership between residents and nonresidents.

Service Account This item includes "transportation”, "travel" and "other

service”.

Income Account This item covers transactions between residents and non-

residents concerning the employee compensation and the investment income.

The employee compensation includes wages, salaries and other benefits earned

by non-residents who work in Japan and by residents who work abroad, both on

a temporary basis.

Current Transfer Account This is an offset item in the double account system

to counterbalance the transfer of real assets (goods and services) and monetary

assets without compensation, that is, an unilateral transfer of economic entity.

The current transfer is divided into the current transfer and the investment

transfer, both of which are recorded as a payment and a capital formation in the

receiving country respectively.

2. Capital and Financial Account The capital account consists of two main

categories: the financial account and other Capital account. In accordance with the

principles of the international account statistics, a change of appraisement values that do

not reflect actual transactions, such as those due to the variations of exchange rate and

the revised valuation of assets, are not included here.

Financial Account The investment account is divided into direct investment

account, portfolio investment account, financial derivatives and other investment

account. The direct investment includes all business transactions between


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companies, including the purchase of stocks and the loan between the mother

and affiliated companies to secure their long term interest

The portfolio investment covers international transactions of both stocks and

securities.

The financial derivatives covers transactions concerning options and warrants,

and realized profit or loss related to transactions on futures that is linked to a

specific financial instrument indicator, commodity, foreign exchanges, or FRA.

Capital Account The other capital account covers all the transactions related to

payments and receipts of capital transfers as well as acquisitions and disposals

of non-produced, non-financial assets. The capital transfer covers (1) an

ownership change for fixed properties, (2) an exemption of liabilities by the

creditor, (3) a fund movement following an acquisition and sale of fixed

properties. The acquisition and disposal of non-produced, non-financial assets

covers those of intangible, non-produced assets to be used for the production of

goods and services (patents, copyrights, trademark rights, sales rights, lease, and

salable contracts) as well as the purchase and sale of land by foreign embassies

or international organizations.

3. Gold and Foreign Exchange Reserves These reserves refer to foreign

currency assets (external assets with liquidity) held by the monetary authorities of a

country as reserves for external payment. In Japan, the statistics are published monthly

by the Ministry of Finance. Foreign currency assets are composed of gold, foreign

currencies, reserve position in IMF and special drawing rights. It should be noted that

the increase or decrease in the gold and foreign exchange reserves accounts for a major

part of the public sector in the balance of monetary movements with regard to the

balance of payments.


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I. Analysis of Japan’s Balance of Payment

Here we will be analyzing the balance of payment of Japan looking the basic trends in

the major components of the account. However main consideration will and forces will be

made on the year 2001 which we have most data and to the recent trends. Thus, basically we

will be looking into the current and the capital account, analyzing some of the main

components of the account as a detail analysis of all parts is not possible in such a project.

1. Current account analysis The most commonly used measure of the balance of payments is the current account

balance, which includes the balance of trade in goods and services, net income balance for

investment and labor income, and current transfer balance. It is defined as the difference

between a nation's exports and imports.

Following World War II, as Japan grew internationally competitive and mounted a

successful export drive, the current account balance became consistently positive around 1970.

Despite a brief period of deficits due to the two oil shocks, the current account remained large

and positive from the 1980s, to the point of exacerbating trade friction with Japan’s trading

partners.

Since the mid-1960s, to be more accurate, Japan has consistently run up a surplus,

which expanded rapidly in the 1980s. This surplus reached a new high of ¥12.39 trillion in

1994 before increases in import activity and other factors caused it to fall back to ¥6.74 trillion

in 1996. Subsequently, the stagnation of the Japanese economy resulted in a slump in import

activity, and this, combined with the strength of the U.S. dollar, sent the surplus in 1998 back

up to ¥13.99 trillion, including a ¥6.69 trillion surplus with the United States, ¥4.22 trillion

with the European Union, and ¥3.97 trillion with East and Southeast Asia

a) Trade balance

Despite the 3.2 trillion yen decline in Japan’s trade balance in 2001, the current

account surplus declined by only 2.2 trillion yen to 10.7 trillion yen mainly because another


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major component of the current account—the income surplus—grew from 6.5 trillion yen to

8.4 trillion yen. The growing size of the income surplus, which now almost rivals the trade

surplus, is indicative of major structural changes occurring in Japan’s balance of payments.

FIGURE 1

FIGURE 2

From 2000 to 2001, the value of exports declined by 5.9 percent, after showing positive

growth in 2000. The decline was mainly due to a decrease in exports of capital goods and parts

related to electronics and IT to Asia.


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However, the value of imports grew by 3.0 percent year on year, increasing for the

second consecutive year to reach a new high. Although imports, especially from the United

States and newly industrialized economies (NIEs), decreased in value due to slack demand for

IT-related products, this decrease was more than balanced by an increase in imports mainly

from Asia, and by the rise in import prices due to the depreciation of the yen. The deficit in the

services account expanded for the first time in five years, owing to an increase in the deficit in

other services

b) Investment income

Despite fluctuations due to interest rate and exchange rate trends every year, income

from foreign assets has grown over the long term. The income surplus, which stood at only 1.6

trillion yen in 1986, grew to 8.4 trillion yen in 2001. In the future, if Japan’s foreign stock and

bond holdings continue to grow, dividend and interest income will also increase. As long as the

current account balance remains positive and net foreign assets continue to grow, the income

surplus will keep expanding as well.

The surplus in the investment income account expanded for the second consecutive

year and recorded a new high. This was partly due to an increase in:

The surplus in direct investment income caused by the recovery in the profits of

overseas subsidiaries of Japanese companies and the depreciation of the yen

The surplus in portfolio investment income resulting from the change to a surplus in

interest rate swaps and the depreciation of the yen.

The income account surplus exceeded the trade surplus for the first time and accounted

for almost 80 percent of the current account surplus.

But as foreign assets accumulate year after year, the resulting growth in income surplus

will sustain the current account surplus and strong yen, ravaging the trade surplus. Japanese

companies will lose competitiveness not only in the export market but the domestic market. As

a result, the trade surplus will gradually diminish, eventually turning to deficit.


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FIGURE 3

The phenomenon in which foreign assets accumulate to the point of altering the

structure of the current account is not peculiar to Japan, but long studied in economic theory

linking the balance of payments structure to stages of economic development. Moreover,

Japan’s population structure is also predicted to change due to rapid aging, resulting in a

declining labor force and reduction in household savings. Thus not only will Japan enter a stage

of lower international competitiveness, but the aging population will curtail productivity and

export capacity as well, causing the trade balance for goods and services to turn negative. The

graph below illustrates the possibility of a trade deficit in Japan by 2006

FIGURE 4


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c) Unilateral transfer account

The deficit in current transfers shrank for the second consecutive year. This was owing to the

decline in (1) contributions to international organizations in the official sector and (2) payments

of fines and settlement payments in other sectors.

FIGURE 5


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2. Capital account analysis Capital account basically includes the direct investments and Portfolio Investment

(Excluding Securities Lending).

a) Direct Investment

In 2001, the capital and financial account recorded a net outflow of 7.0 trillion yen.

Outward direct investment by residents recorded a large net outflow reflecting the global

industrial reorganization. For the second consecutive year, inward direct investment declined

due to no large-scale investment

FIGURE 6

b) Portfolio Investment

In 2001, outward portfolio investment by residents increased substantially resulting in

an expansion of net purchases, a net outflow of 13,225.1 billion yen in 2001 as against 11,825.8

billion yen in 2000.Investment in equities decreased as stock prices fell reflecting a slowdown

in economies worldwide. There was, by contrast, a significant increase in investment in bonds

and notes as banks actively purchased foreign bonds in anticipation of a decline in long-term


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interest rates in the United States and Europe. Life insurance companies also actively purchased

foreign bonds, hedging against exchange rate risk at the same time.

Net purchases (inflow) declined for inward portfolio investment by nonresidents to net

purchases of 5,367.3 billion yen in 2001 from 7,279.6 billion yen in 2000. Investment in

Japanese equities changed to net purchases (inflow) due to active purchases by foreign

investors in the first half of the year reflecting expectations for an economic recovery and

structural reforms under the Koizumi administration. Investment in Japanese bonds and notes

by nonresidents recorded substantially narrowed net purchases (inflow) because sales of

Japanese government bonds increased as nonresidents closed their asset swap positions in the

second half of the year.

FIGURE 7

Japan’s foreign assets consist of: (1) direct investment by Japanese companies in local

subsidiaries abroad, (2) portfolio investment in foreign stocks and bonds, (3) international

loans, and (4) foreign currency reserves. The graph below shows the composition of bond,

stock and direct investment.


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FIGURE 8

The figure below reflects the foreign (outward) direct investments of Japan by region

from 1986 to 2000.

FIGURE 9


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Investment in foreign bonds and notes by residents recorded an increase in net

purchases (outflow) because life insurance companies and banks actively purchased U.S. and

European bonds.

Investment in foreign equities by residents registered a decrease in net purchases

(outflow) reflecting a decline in stock prices worldwide. In investment in Japanese bonds and

notes by nonresidents, net purchases (inflow) narrowed substantially because investors were

reluctant to purchase government bonds given that there was hardly any room for interest rates

to decline further. Investment in Japanese equities by nonresidents saw a shift to net purchases

(inflow), reflecting active investment in the first half of the year based on expectations for an

economic recovery and structural reforms under the Koizumi administration.

Other investment shifted to a large net inflow. This was because Japanese banks

collected funds deposited with other banks overseas (inflow) as they matured given that yen

funds were abundant in the overseas financial markets, while foreign banks in Japan raised

funds from overseas (inflow) when the cost of funding yen in exchange for the U.S. dollar

became negative.

3. Gold and foreign Exchange Reserve

The last part of the Balance of payment is actually the balancing item which balances

out the difference in the current and the capital account.

For the Japan’s official reserve, it has been mostly in the negative zone. From 1995 to

1997 it has been more or less decreasing and in 1998 it was actually positive at $999 million.

However, after that point again the trends again changed unfavorable even though in the end of

2000 the negative balance was reduced. The following diagram shows the pattern of the official

reserve for the time period of 1995 to 2000.


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FIGURE 10

Major Developments in the Balance of Payments for 2001

1. A sizable decrease in the surplus in goods and services

The surplus in goods and services declined sharply, recording the second lowest level

since 1985.This sharp decline was due mainly to developments in the trade surplus, which was

reduced substantially, with a fall in export growth exceeding steady growth in imports. Exports

plunged due to cyclical factors, such as a slowdown in the U.S. economy and sluggish final

demand for IT-related products, while the growth in imports was firm due to a structural factor,

an increase in imports of goods developed and produced especially for the Japanese market

2. A record high surplus in income

The surplus in the income account expanded considerably and reached a new high,

reflecting large increases in the surplus of direct investment and portfolio investment income.

As a result, the surplus accounted for about 80 percent of the current account surplus,


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exceeding the trade surplus for the first time. Factors behind this expansion were (1) an

increase in profits of overseas subsidiaries of Japanese companies, (2) an increase in amount

outstanding of outward portfolio investment by residents, and (3) a depreciation of the yen that

pushed up income in yen-denominated credits

Outward direct investment by residents reached a net outflow of 4.7 trillion yen, the

highest level since 1990 when it marked 7.4 trillion yen. This was mainly due to active

investment in telecommunications companies and carmakers in the United States and Western

Europe. Meanwhile, inward direct investment by nonresidents decreased for the second

consecutive year to 599.3 billion yen. This was due to no large-scale investment in the

automobile industry and financial services and insurance, after substantial investment in these

industries in 1999 and 2000.

3. A sharp fall in the deficit in services after the terrorist

attacks in the United States The number of Japanese travelers going overseas by air from Japan fell sharply due to

concerns about terrorism after the terrorist attacks in the United States on September 11, 2001.

As a result, deficits in the transportation (passenger fares for air transport) and travel accounts

shrank substantially from September, causing a decline in the deficit in the services account

4. A high level of outward direct investment by residents Outward direct investment by residents reached a net outflow of 4.7 trillion yen, the

highest level since 1990 when it marked 7.4 trillion yen. This was mainly due to active

investment in telecommunications companies and carmakers in the United States and Western

Europe. Meanwhile, inward direct investment by nonresidents decreased for the second

consecutive year to 599.3 billion yen. This was due to no large-scale investment in the

automobile industry and financial services and insurance, after substantial investment in these

industries in 1999 and 2000.


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II. J curve and Japan’s Balance of payment

1. What is j curve? The J-curve describes the impact over time of changing currency values on a nation's

trade imbalance. The unfavorable effect of devaluation on trade balance is termed the J-Curve

phenomena. The J-Curve phenomena have been explained by many factors. Junz and

Rhomberg (1973) argued that the trade balance deteriorates first, but after the passage of time it

begins to improve. They identified at least five lags in the process between changes in

exchange rates and their ultimate effects on real trade: lags in recognition of the changed

situation, in the decision to change real variables, in delivery time, in the replacement of

inventories and materials, and in production

A change in the exchange rate has two effects on trade flows-price effect and volume

effect. The price effect implies that currency depreciation will cause imports to be more

expensive and domestic exports to be cheaper for foreign buyers at least in the short run. Since

the volume of goods imported and exported might not change drastically in the short run, the

trade balance may initially deteriorate. However, the volume of trade changes eventually in

response to the depreciation. In other words, the price effect is generally believed to dominate

the volume effect in the short run. In the long run, however, if the Marshall-Lerner condition

holds, the volume effect takes over and reverses the effect, and the trade balance improves. The

total effect when plotted over time with trade balance on the y-axis will yield the J-curve.

FIGURE 11

TTHHEE JJ -- CCUURRVVEE

TIME

Net

cha

nge

in tr

ade

bala

nce

0

Currency depreciation

Trade balance initially deteriorates

Trade balance improves


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2. Is there J curve for Japan’s economy?

a) Historical pattern

FIGURE 12

FIGURE 13


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Going with the simple chart pattern for Japan one might argue that there seems to be no

J-curve effect in the case of Japan. As can be see from about 1970 to 1995 Japan exchange rate

in terms of US $ had been more or less appreciating over the horizon. One may expect if the J

curve effect works, that the current account for the Japan’s economy to shrink as the export

become more expensive and imports more cheap in relative term. But it seems the reverse as

can be seen by the current account balance as it reaches increasing trade surplus year after year.

b) Analyst views on the subject

The same seem to be the stand point of many analysts as seen from one of paper cutting.

On12 April 1986 in the Japan’s Economic Journal it stated

“It is the thesis of this report that the so-called J-Curve does not work in the case of

Japan. That is why we call it the J-Curve Ball. The irony is that J-Curve was named in

relation to Japan. The J stands for Japan”

At the time when the appellation "J-Curve" was created in the late 1970s the yen was

rapidly appreciating. The theory was that the rapid increase in the value of the yen and the

corresponding decrease in the value of other currencies the dollar in particular, would decrease

Japan's rapidly skyrocketing trade surpluses.

Again in the same article stated that

“It did not work for Japan in the late 1970s and it is appears that it is not going to work

now. It did not work in the late 1970s due to the intervention of the Second Oil Crisis in

1979. Japan's trade surplus was promptly wiped out and the yen collapsed.”

Again the same was believed to be occurring when the yen in terms of US $ was again

appreciating in the beginning of 1986 and when the trade account was recording a surplus year

after and due to that some economist called it a myth for Japan concluding that there is no j

curve for Japan.


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This conventional wisdom on the J-curve has been called into question by Rose and

Yellen (1989), who conclude that the J-curve phenomenon does not hold for the G-7 countries.

(They are Canada, France, Germany, Italy, Japan, Great Britain, and the United States.)Using a

sample of 1960:1 to 1985:4, they find no co- integration among the variables of interest and

therefore use OLS and IV techniques to estimate the process. Rose (1990) performs the same

exercise for a sample of developing countries and again finds that the J-curve phenomenon

does not hold. Rose (1991) examines the empirical relationship between real effective

exchange rate and aggregate trade balance for five major OECD countries for the post-Bretton

Woods era. He shows some evidence of linear feedback from the exchange rate to the trade

balance in the medium and long run only for Japan.

Similarly, Bahmani-Oskooee and Alse (1994) examine the relationship between the

ratio of imports to exports (M/X) and real effective exchange rate (REER) for many countries

using the error correction method. For Japan, they find M/X to be stationary in levels, and

therefore they drop the country from further analysis. The countries for which they estimate the

J-curve, they find little evidence of a long run relationship between M/X and REER.

c) New Research Findings

However, some new research shows otherwise. One of them is the study conducted by

Backus (1993) examines the evolution of real trade balance for Japan using quarterly data from

1955:2 to 1993:2. Using vector auto regression (VAR) technique and the impulse response

function, he reports the presence of a J-curve for Japan (the variables he considers are terms of

trade and real balance of trade). He also forecasts that the trade surplus will fall from a high of

3.7 percent of GNP in 1992 to 2.6 percent in 1995.

Here our main focus is on to the study done made Anju Gupta-Kapoor and Uma

Ramakrishnan of Georgetown University which was published in the International Economic

Journal, on 4th November 1999 under the topic ‘Is there a J-curve? A new estimation for Japan’

In the paper, they used an error correction model (ECM) to determine whether quarterly data on

Japanese exports and imports exhibit a J-curve during the flexible exchange rate regime, from


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1975:1 to 1996:4. The impulse response function from the model is used to examine the J-curve

phenomenon.

The model

The J-curve is a nominal phenomenon. The nominal merchandise trade balance, BN, is

the difference between the value of merchandise exports (X) and imports (M).Following

Bahmani-Oskooee and Alse (1994), we define the trade balance as the ratio of M to X. As

explained in their study, this ratio is not sensitive to the units of measurement. X and M are

functions of domestic income, foreign income and exchange rate. The reduced form equation

for J-curve estimation in log-linear form is thus:

ln(M/X) = a + b ln(YN) + c ln(Y *N) + d ln(NEER) + v

Where, YN and Y* N are nominal domestic and foreign incomes, NEER is the nominal

effective exchange rate, and v is the error term. NEER is defined as the weighted average of the

indexed bilateral exchange rates: NEER = Πi [(ei/e)* 100/ (ei/e) 1990:2] wi: where i refer to the

domestic country’s (i.e., Japan) main trading partners (namely, US, Canada, Germany, France,

UK, Italy, and Korea), and wi are their respective trade weights. ei is the number of units of each

trading partner’s currency per dollar, and e is the number of units of domestic currency (yen)

per unit of foreign currency (US dollar). (ei / e) has been indexed to 1990:2. Based on the

above equation, an appreciation is given by a rise in NEER. However, since we use the ratio of

imports to exports to define trade balance, a currency appreciation should lead to a decline in

M/X in the domestic country in the short-run (due to price effect), and to an increase in M/X in

the long-run (due to volume effect).

In most of the studies done so far on the J-curve, attention is paid only to the direct

effect and not to the feedback effect. The effect of a depreciation of the exchange rate on the

balance of trade, given by the partial derivative shows the direct effect of the depreciation.

However, feedback effects arise from a one-time change in exchange rate which will have an

impact not only on the balance of trade, but also on the future exchange rate, which will in turn

affect the balance of trade and so on.


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Further, there are additional feedback effects from other endogenous variables, such as

domestic income and foreign income. These feedback effects (which could be linear or non-

linear), represented by the total derivative and have to be captured to analyze the dynamics of

the J-curve. In this study a vector auto regression and the impulse response function have been

used to take these feedback effects of the exchange rate fluctuations into account.

Results

Johansen’s likelihood ratio co-integration test was performed to analyze the co-

integrating relationship among the variables. The results are reported in Table 1. There are 2

co-integrating equations at the 5% level of significance. Note that, generally, for every I(0)

variable in the model, the co-integration rank increases accordingly (Hansen and Juselius,

1995:1). In the model, foreign income is I(0), and therefore it got two co-integrating vectors.

FIGURE 14

The co- integrating relation, given by the β matrix, can often be interpreted as a long-

run relationship among the variables in levels. The β matrix indicates that when the yen

appreciates by 1 percent, the long run increase in the ratio of M/X is 4.1 percent. However, this

long-run relationship between M/X and exchange rate is not unique since there are two co


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integrating equations. Therefore, the interpretation of the co integrating equations is no longer

straight forward.

It was considered the response of the ratio of M to X to an impulse (innovation) in

exchange rate. The impulse response function indicates that the nominal data used for the

analysis follow the J-curve pattern. The period of the short-run deterioration in M/X follows the

conventional wisdom that it will last for about one year. Figure 1 plots the responses of M/X to

a one-time appreciation of yen.

Figure 15 indicates that the initial deterioration in the ratio M/X is 1.1 percent for a one

standard deviation shock in exchange rate of about 4.6 percent. The percentage change in the

ratio M/X that is obtained through the impulse response function is converted to M/X values by

normalizing the first period response to 100. Thus, the ratio of M/X deteriorates to around 99 in

the first quarter, and declines to a maximum of 97.8 by the fourth quarter which is equivalent to

a 2.2 percent fall from the initial level. The short-run price effect lasts for four quarters, beyond

which the volume effect sets in. By the sixth quarter, the initial deterioration in M/X caused by

the price effect has been fully recovered, and the ratio M/X continues to rise at a decreasing

rate. The dotted lines are the 95% confidence intervals. They show that the short-run

deterioration is somewhat significant and the long-run rise is highly significant. The long-run

improvement in the trade balance is due to the volume effect (as explained earlier). This

analysis is consistent with Meade’s (1988) “textbook J-curve” description.

FIGURE 15


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The results of the analysis imply that the J-curve phenomenon holds for Japan. In fact,

the results generally follow the pattern predicted by theory. The presence of co-integration

implies that there is a long-run equilibrium relationship between M/X and the exchange rate.

As for the J-curve itself, several reasons may be responsible for the lag in volume adjustment in

response to a change in exchange rate. Firstly, finding alternative supply sources are costly for

the buyers of goods. Therefore, the volume will not adjust unless the impact of the change in

price outweighs the adjustment costs. Secondly, there may be lags in finding new investment

opportunities to take advantage of the exchange rate. Thirdly, contractual obligations force

trade to occur at the volumes set prior to the depreciation. It is difficult to test some of these

reasons — they serve more as plausible explanations rather than testable hypothesis.

New trends

Japan experienced a big current account surplus decline between 1986 and 1990 going

down from 4.4% in 1986 to 1.1% in 1990.And again in 1996 (see Table 1), that country's

customs-clearance trade surplus was at its lowest level since 1983 at ¥6.7 trillion. In 1996 alone

it dropped 32.4 percent, continuing a contraction that started in 1992

Beginning in the spring of 1995, the yen steadily lost ground against the dollar. That

pointed to an increase in the surplus sooner or later since eventually a weak yen will lift Japan's

exports and reduce its imports, other factors equal. The familiar shorthand reasons are that

exporters find it easier to make money in foreign markets and the higher prices of imports scare

away would-be buyers. This effect takes months, if not years, to materialize under the most

favorable of circumstances.

For a variety of reasons the impact on trade of a weakening yen was particularly slow in

arriving in 1995 and 1996. The quarterly yen-calculated surplus continued to contract over

these two years because exporters and importers still were responding to the strong yen that had

been the norm from late 1994 through the early spring of 1995. In addition, the infamous J-

curve kicked in during this time.


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In the current situation, where the yen has depreciated almost nonstop against the dollar

since mid-1995, the effect is to boost the reported value of trade denominated in dollars.

Exports, which are denominated in both yen and dollars, eventually rose modestly in yen terms

in response to the weakening currency, with any given price in dollars translating into more

yen. Imports, which are only about half as likely to be quoted in yen as in dollars, tend to scale

up or down in synch with the Japanese currency's strength or weakness. In short, the falling

value of the yen implied for at least several months a rise in Japan's trade surplus. Moreover,

the yen kept losing ground until the early spring of this year, suggesting that short-run shocks

continued to push the imbalance down, other factors equal.

In time, the J-curve turns up with a vengeance, and the freight train, first seen as only a

speck in the distance, arrives in full fury. That is one explanation of what happened in the

April-June period. The short-term impact of currency changes on the values of a given volume

of exports and imports — the cause of perverse movements in the trade imbalance — finally

lost out in the second quarter to the long-run effects of a weakening yen, which trigger drops in

import volume and jumps in export volume. The spring trade results had been foreshadowed to

some extent in the first quarter, when exports jumped 7.7 percent in volume over January-

March 1996 level while imports managed only a 2.9 percent gain. Absent further currency

changes, the long-run effects of the yen's weakness over the last year or two will continue to

dictate a bigger gap between exports and imports for some time to come

These changes in the Japanese trade structure as above are attributable to the increase of

the Japanese manufacturers' overseas production. Basically the overseas production substitutes

the export. At the early stage, however, the export from Japan of capital equipment and parts

will increase and make the trade surplus even larger. But the trade surplus will gradually

decrease as the local procurement of capital items increases. The trade surplus will decrease

further when the "reverse import" starts

In above, it has been explained the J-curve" effect of the overseas production, which is


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typically observed in the auto production by the Japanese manufacturers in the U.S. As to the

Japanese manufacturers' production in Asia, however, "J-curve" effect is occurring continually

as the direct investment in Asia by the Japanese manufacturers continues to increase, and it is

considered that the Japanese trade surplus with Asia has not started to decline yet.

Therefore the rapid current account decrease can not be explained by the effect of the

overseas production alone. What are the other causes? One of the factors is the price hike in the

import due to the yen depreciation. Most of the Japanese import contract is in dollar terms.

Therefore the weaker the yen becomes against the dollar, the higher the import value goes up in

yen terms. The export value also goes up, but the yen terms portion of the export being more

than that of the import, the export value increase due to the yen depreciation is less than the

import. This causes the trade surplus to drop

If the yen-dollar exchange rates stay around the current level, however, the Japanese

exporters will raise the export price at the next contract as their price has become more

competitive in dollar terms, and the Japanese importers will request the price reduction or they

will decrease the import volume for the items which can be substituted by domestic products.

(Tsunao Nakamura., 2002)


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BIBLIOGRAPHY

Fry, Maxwell J. (1993), Foreign Direct Investment in Southeast Asia, Institute of

Southeast Asian Studies.

Japan External Trade Organization (JETRO) 1989, White Paper on International Trade

Japan

Kim, June-Dong and Kang, In-Soo (1997), “Outward FDI and Exports: The Case of

Ministry of International Trade & Industry (MITI) Japan, White Paper on International

Trade Japan 1994, Mcgraw-Hill Book Co.

Ministry of International Trade and Industry, International Trade White Papers of

Japan 1994-1995, The Japan Institute of International Affairs, 105-114.

Nester, William R. (1990), Japan s Growing Power over East Asia and the World

Economy: Ends and Means, The Macmillan Press Ltd.

Pantelidis, P., Kyrkilis, D., and Papazoglou, C. (1998), - Japan European Union Bilatera

Trade: An Empirical Investigation”, Hitotsubashi Journal of Economics 39, 37-48.

Phaup, E. Dwight (1981), “The Demand for Imports: Estimates of Bilateral Trade

Flows”, Journal of Macroeconomics 3, 97-113.

Rose, Andrew K. (1991).“The Role of Exchange Rates In a Popular Model of

International Trade Journal of International Economics.30, 301-316.

Rose, Andrew K, and Yellen , Janet L. (1989), “Is There a J curve?, Journal of

Monetary Economics 24(1), 53-68.

Soon, Lee Ying (1990). Foreign Direct Investment in ASEAN, Malaysian Economic

Association c/o Faculty of Economics & Administration, University of Malaya.

Statistical Bureau, Management and Coordination Agency, Government of Japan,


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Appendixes

Table 1

Table 2


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Table 3


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Table 4

Table 5

CAPITAL & FINANCIAL ACCOUNT

Year Current transfers

Total Financial account

Changes in reserve assets

Errors and omissions

1995 -725 -6,275 -6,061 -5,424 1,3131996 -978 -3,347 -2,993 -3,942 1321997 -1,071 -14,835 -14,347 -766 4,1651998 -1,146 -17,339 -15,408 999 5561999 -1,387 -5,396 -3,487 -8,796 2,0182000 -1,060 -9,124 -8,130 -5,261 1,809

GOLD AND FOREIGN EXCHANGE RESERVES (1980--2001) (In millions of U.S. dollars) End of year Gold and foreign exchange reserves

Gold Foreign currency

IMF reserve position 1)

Special drawing rights of the IMF

1980 25,232 1,081 21,567 846 1,7381985 26,510 931 21,916 1,547 2,1161990 77,053 1,206 69,488 3,317 3,0421995 182,820 1,260 172,444 6,409 2,7071999 288,080 1,164 277,708 6,552 2,656

2000 2) 361,638 6,737 347,212 5,253 2,4362001 401,959 6,803 387,727 5,051 2,378

1) Through 1999, Reserve and trenched position. 2) Beginning 2000, Reflect marked to market values. Source: International Bureau, Ministry of Finance.

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