A Multi-Country Evaluation of Trade Imbalances
Table of Contents
For more than 20 years except for the oil crises, Japan has been consistently running a current account surplus every year (Figure 4.1). And since 1980 from when the IMF's international financial statistics yearbook started to publish the numbers for international investment position, Japan has been always a creditor country (Figure 4.5) and nowadays the international financial assets per capita in Japan is largest in the world. Therefore, Japan definitely fits into the category of a net creditor country running a current account surplus. On the face of it, Japan looks to be in the best economic position any country can think of though, the implication regarding the current account surplus and foreign assets possessed by Japanese are rather complicated. From now on, I will examine whether the trade surplus which is huge enough to create a lot of tension with the other trading partners, is good, bad or benign for Japan by using other statistical data including international investment position and real GDP growth rate as well as trade related statistical data.
Current Account Surplus
As you can see in three figures 4.1, 4.2 and 4.3, Japan's current account surplus stems from merchandise trade surplus and income receipts from the overseas investments. If you look at only the balance on service trade, you can notice that Japan has been always running service trade deficits and net exports of merchandise goods are somewhat offset by net imports of service goods. As a result, it has become a Japan's trade pattern that it runs a huge merchandise trade surplus and at the same time a service trade deficit. This is illustrating that Japan is not necessarily exporting goods to the foreign countries all the time, but it is also importing a large amount of service goods from the other countries. And it means that the Japanese service sector does not have much competitiveness relative to the other countries. As for income receipts, which is another category of current account, Japan has been running a similar size of surplus to service trade deficit. Usually, in order for the country to record the positive income receipts, it has to own a reasonable amount of international financial assets. Those assets are owned by the Japanese in the form of foreign portfolio investment and bank deposits in foreign banks and they create income and dividends to the Japanese investors to be incorporated in the current account balance. Overall, as of 1997, its current account surplus is 121 billions of US$ and this large surplus means that Japan earned this amount of foreign currencies from the trade of goods and services and from the income receipts for the most of the part. And the flip side of this current account surplus is the capital account deficit. Therefore, almost the same amount of money Japan earned in the current account goes out of Japan as foreign direct investments, foreign portfolio investments and other type of investments every year.
Although the large current account surplus tends to be seen as a symbol of a strong economy and something any country wants to have, it can sometimes be problematic depending on the size of the surplus. Remember the following national income identity equation. Y (GDP) = Private Consumption ( C )+ Government Spending ( G )+ Domestic Investment + (Export - Import). The three former terms in the right hand side of this equation represents the domestic demand and the rest of (Export - Import) is the net export, representing the foreign demand. From this equation, you are convinced that the larger the net export is, the smaller the domestic demand has to be. Because the domestic demand shows you how much the people in that country consumed in one year, which is one of the ordinary ways of measuring the standard of living of the country, the small number of domestic demand is something to worry. If the larger the net export is, the less the population can consume and the lower the standard of living is.
Suppose that the net export in this equation is the same with current account surplus in the Japan's balance of payment, you may be able to conclude that Japanese are not enjoying high standard of living because of its huge current account surplus. But this interpretation of the current account surplus can not be true in every case. For if the country is producing much more than it can possibly consume domestically, it has to export the excess products to the foreign countries and as a result it will run the current account surplus. Obviously, this case does not mean that the country's domestic demand is weak enough to create a problem about the standard of living. Instead, it is basically saying that this country's economy is just strong to enable the country to generate more than the needs of the population. Because there is no problem with the strength of the domestic demand, this case is an example of a genuinely strong and healthy economy. Thus, it is very important to take a look at the other statistical data, not only the size of the current account surplus in assessing the fact that the country is running a large current account surplus. Therefore, in the next paragraphs, I will examine which case I put above is more closely describing the Japanese economy, by looking at the real GDP growth rate of Japan.
Real GDP Growth Rate of Japan
The real GDP measures how much the country produced in its domestic market in one year eliminating the effects of inflation on the real value of the products. Looking at Figure 4.4, you know that Japan has been recording positive real GDP growth rate since 1975, which means that Japanese economy has been continuously growing from over 20 years ago. But it does not mean that Japan has achieved a stable growth rate for that period. Average real GDP growth rate from 1971 to 1980 was 4.6 percentage point and that from 1981 to 1990 was 4.1 percentage point respectively. In the course of this 20 years, Japanese economy experienced big changes in the growth rates once in a while. Firstly in 1980, the real GDP grew much slower than earlier, mostly because of the second oil crisis and slowdown in the public investment. And secondly, in 1986 the real GDP growth rate again plunged. This time, the culprit for this plunge was the big adjustment of Yen and Dollar exchange rate in the international financial market and following depressed private investment. Through the Plaza Accord, the Yen jumped up by as much as 30 percentage point against the Dollar in a year and it hit the Japanese export and domestic business sector so much that this abrupt huge appreciation of Yen contributed to the drop in the real GDP growth rate in 1986.
The last period in which Japan had unusually small growth rate was from 1992 to 1994. In fact, from 1990 the real GDP growth rate was falling down sharply till 1993. Needless to say, it owed much to the burst of the asset bubble in 1990. The suddenly depressed asset prices hit the private consumption and private investment so much that after 1990, it took several years for the Japanese economy to show the recovery by 1996. However, in 1996 the real GDP grew at a higher rate relative to the previous years and Japan looked to be recovering, thanks to the huge increase in the domestic investments though, in the past 6 years from 1991 to 1997, the real GDP growth rate averaged 1.7 percentage point which is substantially smaller than growth rates in the 1970s and 1980s. The reason for this poor growth is attributable to the weakened private consumption and domestic investments caused by fiscal tightening in 1997.
When it comes to the assessment of the current account surplus, it is important to take into account the other data regarding to the economic growth over the years in order to see if the economy as itself is also growing in line with the large size of its current account surplus. If the large current account surplus is based on a country's strong economy, reflected by a strong domestic demand, that surplus does not pose any problem. But conversely, if the domestic demand is weak and a current account surplus is too large, its trade imbalance can be seen as a bad sign for the country. Therefore, no matter how much the country is earning foreign currencies from the other countries by export, it does not necessarily show what's exactly going on in the domestic market of the country. In the case of Japan after 1990, the large current account surplus has not corresponded to the GDP growth rate. So, we can not say that the reason for the huge surplus was coming from the excessive supply of the goods over the strong population's demand for them in the domestic market because the real GDP growth rate was slowing. Thus, we can find that during that period, a weak domestic demand has been the source of the huge Japanese current account surplus. In other words, a strong trade figures represents rather weak state of the Japanese economy.
Net International Investment Position
From 1980 when the international investment position started to be recorded in IMF's international financial statistics yearbook, Japan has been keeping a creditor position (Figure 4.5). Including debt and equity, the net international investment position amounts to 19.4 percentage point of GDP as of 1996. This large amount of foreign assets held by the Japanese has some undesirable problems as well as desirable ones. As one of the desirable signs, Japan can count on this huge financial wealth accumulated in foreign countries at a time when Japan's current account surplus turns into deficit in the future. In that case, Japan can pay for the excess import over export which may be caused by future retirees, by cashing in its foreign assets.
Secondly, especially at a time when domestic interest rates are extremely low like now, the Japanese can benefit from the higher interest rates offered abroad and enjoy the higher returns than what they can get in the domestic market.
As the people have started to live longer than ever and the birthrates are keeping falling down, currently young generation desperately needs to prepare for their retirement well because public and corporate pension schemes are likely to fail to give them sufficient benefits after they retire. However, the huge amount of investment in foreign countries contains several negative implications as well. One of them is that those investments are very much exposed to foreign exchange movements. Although Yen's appreciation may well contribute to driving people to hold foreign assets because every foreign goods starts to look cheaper than ever, if the appreciation proceeded too much and the currency in which the Japanese investment is denominated depreciated substantially, the value of the assets, after converted to Yen, would get shrunk and even go below the initial investment unless you hedge and capital gains are big enough to offset the exchange losses.
In fact, from 1985 when the Yen- US dollar exchange rate was adjusted in the Plaza Accord, Yen significantly appreciated especially to the US dollar (Appendix 1). Because considerable amount of the Japanese Yen invested in the foreign financial assets was denominated in the US dollar, this excessive appreciation clearly reduced the value of the Japanese foreign assets to a great extent.
Secondly, the foreign assets contain risks of price drops caused by the foreign financial market turmoil. If you don't diversify your investment portfolio into different kinds of assets and different currencies, you may incur financial losses from the foreign countries' financial problems. The same caution applies to the foreign direct investment as well. In this context, the huge investment assets abroad can make Japan's financial asset position fragile under some circumstances, exposing it to a lot of foreign factors which Japan can not manage on its own. In the end, increasing international investment, especially foreign direct investments abroad has the risks of hollowing the Japanese industries. Because investment is one of the main sources of future prosperity for the country, if many companies keep getting out of Japan through FDI, Japan may end up with fewer private investment in its domestic market and it will lead to less potential for the future economic growth based on that investment.
Investment Rate toward GDP after 1973
Compared to other countries, Japan has been investing a larger share of GDP which is around 30.8 percentage point of GDP on average from 1973 to 1997 (Figure 4.6). The domestic investment represents one of the potentials to enable the country to grow in the long run because investment can create more production capacity, improvement of the production facility and innovation in the domestic market which are all crucial factors for the future economic growth. Therefore, falling investment ratio against GDP means that the country might risk keeping expanding its economy in the long run. However, destination of the investments is as important as the volume of the investments. In the case of Japan, it is sometimes doubtful that all of the domestic investments have been used for the productive purposes in the history. Because of the quick effect of the investment on the GDP growth, as long as the GDP kept rising along with the investment, Japan failed to pay much attention to the real return from that huge investment until the burst of the asset bubble occurred.
During the bubble era, companies were scrambling to invest much money only to increase the already large production capacity and to increase the values of the property and securities which ended up with well above the fundamental values afterwards. Therefore, we need to be careful that the mere incident of large amount of domestic investment relative to GDP can not guarantee you anything about the economic growth that the country can enjoy in the long run, unless those investment are made in the right places.
Private Consumption ( C ) and Government Spending ( G ) per Capita
Looking at Figure 4.7 gives us how steadily the real C + G per capita in Japan has been growing for over 20 years since 1973. Despite several times of economic stagnation during the period, that the real C + G has been continuously increasing means that the people's standard of living looks to never fail to improve year on year. But here, I want to mention the importance of the role which the private consumption is playing in GDP because especially nowadays amid the worst recession since the war, the Japanese private consumption does not grow as much as before and its recovery is a key to get the economy back on the self-sustaining growth path from now. From the Figure 4.8, the real growth rate of private consumption has been kept at a lower pace than the previous period after the burst of the asset bubble. In fact, Figure 4.8 gives you a different picture of the Japanese economy from Figure 4.7. This difference comes from the mighty effect of the government spending, in particular, public investment on Japan's GDP. Appendix 2 shows you the real growth rate of government spending which is composed of government consumption and government investment. As you can notice, during several years from 1990 after the asset bubble ended when the private consumption started to dwindle, the government injected considerable amount of money in the domestic market in an attempt to boost the economy. This enabled the real C + G per capita to grow at a stable pace over the period. Because in Japan, the government spending sometimes works only in ad-hoc way and its effects do not last for a long period, it might be better to break down C + G into C and G respectively in order to grasp the real standard of living for the Japan's population.
The first and foremost reason for this long lower real growth rate of private consumption is that the current recession was triggered from the very domestic factor which is failure to tackle with the fallout from the burst of the asset bubble by strong determination, not from the foreign factors such as oil crises and the rapid appreciation of Yen Japan had experienced in the history. That is, it has much to do with the Japanese economic structure as itself and unless the problems incorporated in the structure are solved, the economy does not recover and then, the private consumption can not increase, either. The examples of the problems regarding the Japanese economic structure are reluctance of the Japanese government to take necessary drastic measures to pull the country out of this recession, many regulations hampering innovation and bureaucratic system still wielding a strong influence in the markets and so on. Illustrated by the fact that despite a string of stimulus packages launched by the Japanese government, the private consumption does not seem to recover easily, Japan clearly needs to implement other measures to revive its economy not only from the demand side, but also from the supply side.
In 1997, Japan had real growth rates which were lower than those in 1996 in all domestic demand categories such as private consumption, private investment and government spending and in GDP.(1) As for private investment and government investment, the real growth rates were even negative. Therefore, in the short term, it is clear that Japan is facing a lot of difficulties to stimulate the domestic demand. If we regard the domestic demand as a yardstick of standard of living in the country, no matter how big the figure of the Japanese current account surplus is, it does not mean that Japan is enjoying a high level of standard of living at that period. But in the long term, the currently large current account surplus can be expected to play a big role. For, as I mentioned earlier, Japan is going to face a critical change of demography relatively soon, caused by lowering birthrates and longevity, therefore, high level of domestic saving represented by a huge current account surplus is very necessary for Japan to keep a standard of living at a reasonable level when the current workforce starts to retire. Since retirees tend to spend more than the workforce does, it may become real that Japan finally runs trade deficits. If this happens, Japanese may need to break up their savings they have been accumulating from the trade and rely on them to avoid lowering their standard of living. Therefore, the fact that Japan has been running a large mount of current account surplus right now can work very positively for the Japanese population in the long term.
Summing up the favorable and unfavorable effects of the Japanese huge current account surplus, I would say that the surplus can be a positive and negative indicator for the Japanese economy, depending on the domestic economic situation in the short term. If the domestic demand, composed of private consumption and government spending and private investment, and real GDP growth rate are strong enough, the large current account surplus is nothing to worry, although there are several problems depending on which country you are looking at because for Japan, the real return for the domestic investment is not so high. But if the country is suffering from recession or ailing economy which is the case for Japan at this moment, the surplus is indicative of the low level of standard of living and therefore, the large size of current account surplus can be a problem. On the other hand, in the long term, the Japanese long running current account surplus is a good thing, considering forthcoming serious demographic change.
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©1999 The Elliott School of International Affairs, The George Washington University, ALL RIGHTS RESERVED Last Updated on 10/9/99