Japan Struggles to Maintain Growth

A rapidly appreciating yen, combined with falling domestic prices, may prove to be the one-two punch that K.O.s any chance for Japan’s recovery to continue into the new year. This possibility was highlighted on Friday when the yen rose to a 14-year high against the dollar, even as the latest Consumer Price Index numbers verified that Japan’s domestic prices fell for the eighth straight month.

The threat of a surging yen, and the dampening effect this could have on Japan’s critical exports, was not lost on Deputy Prime Minister Naoto Kan who earlier today said, “During the cabinet meeting there was talk that the recent strong yen will put downward pressure on the economy. I will take necessary steps to prevent the economy from hitting a second bottom.”

For many observers however, what we are witnessing in Japan today is actually a repeat of history, and it was twenty years ago that Japan entered into what many still refer to as the “lost decade”. This difficult period in Japan’s economic history could provide some valuable lessons for decision makers in Japan today as authorities work to avoid falling back into recession.

Japan and the Lost Decade

During the 1980s, Japan entered into a period of rapid growth due largely to increased demand for its goods. It was around this time that the phrase “Made in Japan” shed its negative connotations derived from Japan’s early attempts to mass-produce consumer goods, becoming instead a statement synonymous with leading-edge technology and overall high quality. One unintended side-effect of this tremendous growth however, was a growing wave of speculation that led to an unprecedented appreciation in many assets including land values in a country where land was already at a premium.

By 1989, the Japanese government realized that asset valuations were entirely out of control and were on the verge of becoming an unsustainable bubble. Interest rates were quickly raised in a bid to cool down the economy, and while this did accomplish the goal of deflating the asset bubble, the sudden devaluation led to a banking crisis as many financial institutions found themselves holding loans and assets now worth a fraction of their original book price. Direct government intervention was required to prop up the now infamous “zombie banks”, throwing the entire banking system into turmoil.

To counter the sudden deflation, the Bank of Japan quickly reversed its interest rate policy and implemented a series of interest rate reductions. In short order, the benchmark lending rate was down to less than one percent where it has remained – more or less – ever since. Even today, Japan’s rate remains “zero bound” at 0.1 percent, and despite doing everything possible from an interest rate standpoint, prices in Japan continue to fall and the threat of deflation remains a prime concern for the government.

How Falling Prices Leads to Deflation

Everyone loves a sale; however, when falling prices become a long-tem trend within an economy, the path leads inevitably to deflation. This is because lower prices for consumer goods reduce corporate profits which – over time – forces companies to limit salary increases or even reduce the workforce. Obviously, this means consumers have less money to spend and the reduction in spending only compounds the deflation problem, and it is this deflation trap that now threatens to ensnare the Japanese economy.

Appreciating Yen Hurts Exports

In addition to potential deflation woes, Japan is also facing an exchange rate crisis that threatens to further weaken the competitiveness of its exports. Because the US is the largest market – and because other markets also tend to pay in US dollars – any appreciation of the yen against the US dollar makes Japan’s products more expensive than similar goods from other exporting countries such as China and Korea. In recent years, these two countries in particular have muscled in on the automotive and electronics industries that until recently, have been most closely associated with Japan.

The recent experiences of Toyota Motors exemplifies the dilemma facing many of Japan’s largest companies that rely on export sales to maintain their profits. Toyota has long had a stellar reputation for building quality products and even replaced General Motors as the largest manufacturer of automobiles in the world in 2007.

The global financial crisis soon took the shine off Toyota’s impressive accomplishment however, and despite continuing to lead in overall sales, the storied car-builder recorded its first operational loss in its 70-year history in 2008. Much of this loss was due to lower demand for new cars during the recession, but part of the loss can also be traced to a stronger yen.

For 2009, Toyota lowered its outlook for the dollar / yen exchange rate to 90 yen to the US dollar. Based on this assumption, Toyota said its operating loss for the fiscal year will be 350 billion yen (US$4.03 billion); however, each time the rate drops one point per dollar, Toyota’s operating profit falls an additional 348.5 million yen (UD$4.02 million). At today’s rate of roughly 86 yen to the dollar, Toyota clearly needs to adjust its original profit estimate downward to take into account the widening gap between the yen and the dollar.

Outlook for Yen

On Friday, Japan’s currency rose to a 14-year high against the greenback, briefly touching 84.41 yen to the dollar before falling back to the mid-86 range. However, analysts project that by the end of the first quarter of 2010, the yen could strengthen to 83 yen to the dollar, putting even more downward pressure on Japan’s exports.

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