The Long-term Yen/Dollar Exchange Rate and Its Adjustment Effect on Japan's Trade Balance

Joji Iguchi

Summary

From January 1993， the yen surged as a results of Japan's large trade surpluses and the encouragement of the Clinton administration. In retrospect， the debate on whether the strong yen would reduce Japan's trede surplus has been settled in the affirmative. Had the yen not appreciated， the current surplus to GDP ratio would have returned to the record levels prior to the 1985 Plaza Accord.
While economists had predicted a decline in the trade surplus from the yen's surge， the speed and scale of decline greatly exceeded most expectations. The surplus plunged mainly because imports rose sharply-particularly reverse imports， due to the higher overseas production ratio. This mechanism ( stronger yen-higher overseas production ratio-higher reverse imports ) combined with the strong yen's usual effects to reduce the trade surplus more than predicted.
From a long-term viewpoints， the exchange rate is an endogenous variable affected by ecomomic fundamentals such as differences in inflation rates， global disequilibrium， and domestic and foreign interest rate spreads. Two separate trends can be distinguished along the time axis: a long-term equilibrium rate， and medium-term fluctuations.
The equilibrium rate coincides with a "macro balance rate" obtained from external ( current balance) and domestic (full employment) macroecomomic equilibrium. Since calculations of the equilibrium rate are sensitive to structural changes in import and export coefficients， debate over future equilibrium rates must be premised on a fixed trade structure.
Reflecting internationalcapital movements， the medium-term exchange rate fluctuates around the equilibrium rate rather than coinciding with it. However， due to instability in international capital markets from the growth in global debt and credit， and to the G7's de facto introduction of moderate terget zones， deviations of the medium-term rate from the equilibrium rate are shrinking. Thus exchange rate predictions need to consider the equilibrium rate more carefully.
If the present trade structure persists， the equilibrium exchange rate is likely to move toward a stronger yen. However， present trends in the trade structure， such as the rising overseas productin ratio， will abate the yen's appreciation. Over the long term， the direction of the exchange rate and equilibrium rate will be greatly affected by changes in the trade structure.