5 External Sector: Summary of Staff Views

Tamim Bayoumi, Guy Meredith, and Bijan Aghevli
Published Date:
June 1998
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Bijan B. Aghevli

As all participants in this seminar are well aware, since the mid-1980s, Japan’s exports and current account surplus have been a continuous source of controversy with its trading partners, particularly the United States, Japan’s policymakers have gone to great lengths to rule out the possibility that Japan may “export its way out of a recession” by emphasizing that domestic demand should be at the forefront of economic growth and that achievements of the growth target should not lead to higher exports. But, in the short run, an acceleration of exports and a widening of the current account surplus in Japan seem inevitable given the fall in the value of the yen since mid-1995. Should Japan take strong measures to avoid such an outcome? This is an important issue that should be debated openly.

Japan’s critics have contended that its persistent current account surpluses over the longer term are evidence of explicit and implicit barriers to market access. One piece of evidence that has been cited in this regard is Japan’s relatively low ratio of imports to GDP. However, many studies, including those by Gary Saxonhouse, have argued that Japan’s import penetration ratio is consistent with that of other countries once allowance is made for its factor endowments, economic size, distance from trading partners, and other underlying determinants of trade. Other researchers have argued to the contrary, and the evidence may be inconclusive. But even granting that Japan’s import ratio may be too low, the real issue, from the perspective of the current account surplus, is whether the removal of alleged restrictions would increase imports without a concomitant rise in exports.

To the extent that removal of trade restrictions do not affect the underlying investment and savings, any reduction in the surplus would be short-lived. To be sure, trade reform will be welfare enhancing as it will increase both imports and exports, but its effect on the surplus will be ambiguous. It is, of course, difficult to persuade the public of the validity of this counterintuitive principle, as pointed out in Bhagwati’s colorful statement that “trying to explain to the public that trade reform will not lower the current account surplus is like trying to explain to a peasant that the world is round when all he can see in front him is long stretches of flat land.”

Some observers have also been skeptical of the role of traditional economic factors, and particularly relative prices, in bringing about external adjustment. In particular, they have pointed to the delayed decline in the current account surplus following the sharp appreciation of the yen in 1985—86, and its widening during 1990-93, despite a rise in the yen. Claims that Japan’s trade is not responsive to relative prices arise largely because of relatively long lags involved in volume adjustments. The presence of this strong J-curve effect makes it difficult to disentangle the impact of sharp swings in the exchange rate. For example, the J-curve effects of the appreciation of the yen contributed to the increase in the current account surplus during 1991-93. Since 1994, however, the surplus has dropped sharply as the lagged volume effects of the earlier appreciations were reinforced by the J-curve effects of the yen’s depreciation since May 1995. In fact, the level of surplus in 1996 has overshot its equilibrium value and is expected to rebound in 1997. The work in the IMF—including papers by Corker (1989), Meredith (1993), and Chadha (1996)—as well as other empirical work outside the IMF confirm that historical movements in Japan’s external trade are, in fact, well explained by conventional determinants of trade flows, including exchange rate changes, cyclical movements of domestic and external demand, and terms of trade shocks.

Nevertheless, a number of structural changes have influenced Japan’s trade in recent years. These include inroads by foreign manufacturers into the Japanese distribution system; shifts in Japanese consumer preference, partly as a result of recession, to lower-priced manufactured imports; and, as will be discussed in the next Chapter, the relocation of Japanese manufacturing facilities abroad. The net effect of these structural factors has been to reduce the surplus in the short run, but, over time, their impact is likely to dissipate, unless these factors also cause shifts in underlying savings and investment patterns.

Another objection against japan’s surplus has been based on the claim that its underlying saving rate is undesirably high. An unambiguous criterion for the national savings to be too high is that it exceed the Golden Rule rate. Miranda (1995) shows that, under plausible assumptions, Japan’s high saving rate is still well below the Golden Rule rate. Thus, “neither Japan’s flow of savings nor its stock of accumulated capital can be considered excessive from the perspective of maximizing sustainable consumption.” It should be noted that Miranda’s analysis is based on a one-country framework. In a global context, the case for the desirability of Japanese high savings is strengthened considerably, given the general shortage of savings.

It can also be argued that myriad rigidities in the Japanese economy promote excessive savings and discourage investment, thus contributing to Japan’s surplus. However, it is difficult to disentangle the impact of these rigidities on aggregate savings and investment. For example, heavy reliance on direct taxes in Japan serves as a strong disincentive to savings. This bias is expected to be reduced by the planned increase in the consumption tax, but Japan’s share of direct taxes will still be significantly higher than in all major industrial countries, except the United States. As for investment, while deregulation is likely to result in a substantial reallocation of resources, it will not necessarily raise overall investment.

The difficulties in predicting the relationship between economic liberalization and current account balance are vividly illustrated by observing historical developments. Those of you who share my nostalgia for the 1960s would be interested to know that Japan was at the time putting pressure on the Kennedy Administration for the United States to reduce its surplus with Japan. At that time, Japan was running a large current account deficit despite rigid administrative guidelines imposed on the economy by the Ministry of International Trade and Industry. Since that time, the Japanese economy has been liberalized extensively. However, while the share of both import and export volumes in real GDP rose secularly over the next three decades, the current account balance improved gradually, moving into a sustained surplus in the early 1980s. In fact, the emergence of the surplus can be traced to the liberalization of the capital account in the early 1980s that, ironically, was undertaken partly under external pressure to open Japan to foreign investment; instead, Japanese savings flowed out in search of higher returns abroad, particularly those offered on the U.S. government debt to finance its large budget deficit. This net outflow of savings from Japan was mirrored in its large current account surplus.

Let me return briefly to the issue of “exporting out of recession.” Clearly in cases in which major trading countries are simultaneously going through recessions, it would be counterproductive to engage in beggar-my-neighbor policies such as engineering a real depreciation—or preventing a real appreciation—to get out of recession. Given the current cyclical position of the major industrialized countries in the mid-1990s, however, the staff has argued (as discussed in the session on monetary policy) that Japan should have moved more quickly to relax its monetary policy and push down the yen in order to move out of the recession earlier. A current account target in such a situation would have been counterproductive.

Other anecdotal evidence pointing to the problems associated with focusing on current account is provided by the experience of the late 1980s. Notwithstanding the emergence of the “bubble” economy, Japan’s trading partners continued to call for sustaining domestic demand at a high level, lest the surplus begin to grow. There was not, therefore, adequate recognition that the decline in the surplus reflected strong cyclical factors that could not, and should not, have been sustained. This is not to suggest by any means that external pressures were the root cause of Japan’s overheating in the late 1980s. Rather, that external pressures were being exerted in the wrong directions because of misplaced focus on the surplus.

A final objection to Japan’s surplus would be that it cannot be recycled smoothly through international capital markets, as demonstrated by periodic turbulence in the foreign exchange market. Even at its peak, however, Japan’s surplus of about $130 billion was dwarfed by the flows of funds in the international capital markets. It is true, however, that the market has been generally reacting negatively to any “news” that Japan’s surplus is likely to increase significantly. What is not clear is the extent to which this market turbulence is produced by rational assessment of economic forces, or rather the perception that any increase in the surplus will intensify trade tensions.

Against this background, the staff’s view has been that, over the long run, the current account surplus is primarily a macroeconomic phenomenon that reflects underlying savings and investment patterns. These investment and savings patterns are determined by such factors as demographic profiles, productivity growth, and fiscal policies. Thus, the size of the surplus, per se, is not of policy significance, except insofar as it reflects distortions to the underlying savings or investment. These distortions, however, should be addressed directly and on their own merit, rather than linked to the surplus. Also, while macroeconomic policies clearly affect the surplus, these policies need to focus on their legitimate targets of sustained noninflationary growth, with the current account an endogenous element.

Having said that, one must recognize that, although there may be little economic justification for being concerned about Japan’s surplus, the ongoing controversy over this issue has created an environment in which a higher surplus is likely to give rise to more market uncertainty and instability. In this context, as discussed in the paper on the yen, the staff’s medium-term projections suggest that, after a moderate increase in the short run, the current account surplus will decline gradually to near balance by early next century, as the effects of the aging population take hold. Japan, like most of us, is expected to save less as it begins to show signs of graying.

Aside from aging, however, Japan’s economy is also undergoing rapid structural change. The impact of these structural factors on the investment and savings patterns, and thus the current account, are complex and difficult to quantify. The following chapter considers one such structural change, namely the recent acceleration of Japan’s foreign direct investment and the associated phenomenon of “hollowing out” of the economy.


    ChadhaBankim“External Adjustment in Japan: Recent Developments and the Medium-Term Outlook,” in Japan—Selected Issues IMF Staff Country Report 96/114 (Washington: International Monetary Fund) pp. 15072.

    CorkerRobert1989“External Adjustment and the Strong Yen: Recent Japanese Experience,”Staff PapersInternational Monetary FundVol. 42 (June) pp. 46493.

    MeredithGuy1993“Revisiting Japan’s External Adjustment Since 1985,”IMF Working Paper 93/52 (Washington: International Monetary Fund).

    MeredithGuy1998“The Yen: Past Movements and Future Prospects,” in Structural Change in Japan: Macroeconomic Impact and Policy Challengesed. by BijanAghevliTamimBayoumi and GuyMeredith (Washington: International Monetary Fund) pp.1350.

    MirandaKenneth1995“Does Japan Save Too Much?” in Saving Behavior and the Asset Price “Bubble” in Japaned. by UlrichBaumgartner and GuyMeredithIMF Occasional Paper 124 (Washington: International Monetary Fund).

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