After peaking at over 4 percent of GDP in the mid-1980s, Japan’s external surplus declined sharply in the second half of the decade. Since 1990, however, part of this adjustment has been reversed, leading to renewed interest in the factors that underlie movements in Japan’s external balance. Traditional models explain movements in trade flows as resulting from changes in relative prices and levels of demand across countries. Some observers, in contrast, have maintained that Japan’s import performance is determined primarily by explicit and implicit barriers to market access and shifts in preferences, while export performance reflects the desire of Japanese firms to maintain foreign market shares.
This paper examines how well conventional determinants of trade flows--specifically, changes in relative prices and aggregate demand--explain the adjustment in Japan’s external balance after 1985. The results indicate that the evolution of trade flows has been consistent with conventional determinants. Adjustment was initially slow following exchange rate changes in 1985-86 because of the lagged response of import volumes to relative prices, causing the surplus to “overshoot” its underlying level. Similarly, in 1990, adjustment in the external balance was distorted by the terms of trade deterioration that resulted from a temporary weakening of the yen. A decomposition of the causes of the external adjustment indicates that relative price changes played a major role in reducing the surplus. In the absence of price changes, the surplus would have widened owing to both a high demand elasticity for Japanese exports by trading partners and rising investment income on foreign assets.
At a more fundamental level, external balances are determined by underlying patterns of savings and investment; over the medium term, changes in the savings-investment balance are manifested in the external balance via movements in relative prices. This transmission mechanism will function smoothly only as long as the response of trade flows to price changes is sufficiently large and systematic. Japan’s experience with external adjustment since 1985 suggests that these conditions are likely to be satisfied.