Header credit goes to UBS’s Paul Donovan, the source of the piece of Japanese skepticism that follows. He takes us first to Sherlock Holmes’ “Silver Blaze”:
Gregory: “Is there any other point to which you would wish to draw my attention?”
Holmes: “To the curious incident of the dog in the night-time.”
Gregory: “The dog did nothing in the night-time.”
Holmes: “That was the curious incident.”
A strong opening gambit, as yen tales go.
Donovan’s point is that Y100 and above might not have the effect everyone hopes it will on Japanese exports, and through them, the economy. As we’ve written previously, the drivers of exports are hella complex and unique. From Donovan:
The demand for exports will not have uniform price sensitivity – some products or services will experience sharper shifts in demand to any shift in price. At a time of considerable economic upheaval, the pattern of final demand for exports is also going to be independently affected, and demand from export markets will also ebb and flow in a variable manner. Relying on export led growth in a time of below trend economic activity is always going to be more difficult than generating export growth in a time of economic expansion.
That becomes even more true in a global financial crisis. Donovan argues that one of the consequences of a more globalised, cash heavy world has been that companies are less likely to change the price of their goods and services when sold in foreign markets in response to a shift in the value of their home currency:
The strategy, generally known as “pricing to market” is based upon the idea that a German car manufacturer selling their product in the United States will respond to a change in the price of a comparable model manufactured by a US manufacturer, but they will not respond to a shift in the Euro dollar exchange rate by changing the dollar price of the model that they export to the United States. Instead, currency market movements will impact profit margin, and may be used as a trigger for cost discipline.
The strategy means more profit than volume increases. It’s been pretty visible in the UK already and the suggestion here, and elsewhere, is that Japan is going down the same route. Sterling’s deprecation in 2008/2009 was not met by a rebalancing of the economy towards exports. Donovan says that’s down to “pricing to market”.
That’s a 24 per cent fall in the value of sterling from 2007 to 2011. Import prices increased… and so did export prices. That runs counter to the more simplistic theories of foreign exchange markets:
Currency depreciation is supposed to make exports cheaper, rebalancing the trade position of the depreciating economy. Of course, what this chart is rather vividly demonstrating is that UK exporters held their overseas prices unchanged, and when those prices were translated back into sterling (as per the export price index in this chart), those prices were increased by 24% purely as a consequence of the currency moves. This price effect will be sufficient to excite an equity analyst (it does not take much to excite an equity analyst). The increase in sterling revenues, when set against presumably stable sterling costs, means an enhanced profit margin for UK exporters.
But it gets Donovan much less excited as profit does not contribute to real GDP. Of course, if those profits are actually put to use then we have a different story. Donovan points to four options (our emphasis):
If the exporter chooses to invest the increased profit that they have acquired in the domestic economy, then the act of investing will contribute to domestic GDP. Alternatively, if the exporter chooses to pay the increased profit away either in higher wages or higher dividends, then to the extent that those wages or dividends are spent by the employee or shareholder, there will be a boost to domestic GDP.
This is the critical point. In a pricing to market environment, any currency depreciation can still be positive for GDP, even if there is no volume consequence, provided the profits are spent in the domestic economy. We can not say “pricing to market means exports will not contribute to GDP” – the contribution is valid, but indirect.
The two remaining alternatives for the exporter are to invest the money overseas. This clearly does not boost the domestic economy, though it will serve as an economic boost to another economy. Failing that, the exporter could chose to hold the additional profit as an idle cash balance on their balance sheet – saving the money. This does not contribute to GDP.
In the UK, illustrative data suggests that the export sector has generally saved what it got — the UK export biased sectors increased their cash deposits by around £26.5bn between the third quarter of 2008 and the final quarter of 2012. Over the same period, the nominal value of exports of goods and services increased by just over £11bn.
(Donovan does mention the counterfactual here — if UK corporates hadn’t had this source of liquidity, job cuts might have kicked in. Balance sheet recessionary forces might also fairly be mentioned.)
Back to Japan
Citi’s Steven Englander has already pointed us to Japan’s experience earlier in the decade:
And Donovan suggests that Japan’s experience — so far this deprecation-episode — is following the UK path. There might be a lag, but so far this is what we’ve got:
The chart above shows the fall in the yen – as with the UK chart, this is a trade weighted index on an inverted scale. The dark green line is the yen price of Japanese exports, and this has risen in lock step with the depreciation of the yen. It has not quite matched the drop in the yen, but this is not perhaps that surprising. UBS estimates that around 40% of Japanese exports are invoiced in yen, and the price of these exports in yen terms should be unaffected by the value of the yen, of course.
However, the Japanese authorities rather obligingly provide an index of export prices in the currency that they are sold in. This is represented by the light green line in the chart above. What this is showing is that Japanese companies have not actually cut the foreign currency prices of their exports. Just as with the UK exporters, the Japanese have chosen to hold foreign prices constant, maintain market share, and increase the yen value and thus the yen profit associated with yen depreciation.
That kind of puts the “currency war” charge in perspective — Japanese exporters have a profit advantage from the yen’s weakness but they have chosen not to have a price competitive advantage.
Second to that, it does indeed get equity analysts excited. The Nikkei has thumped upwards to a new five-year high, gaining 3 per cent or so overnight and 40 per cent since the start of the year as people buy into the BoJ’s reflation story and selling the commodity slowdown:
Nikkei PE (trailing) has gone from about 21 to 28 since November, forward looking PE (next year’s earnings rather than last) has risen less, as earnings expectations have also risen. It’s something we’ll have to come back to.
In this piece we return to the same question: which of the four indirect impacts of this will Japanese corporations go for? Donovan suggests Japanese corporates are less likely to hoard cash — they have lots of it and liquidity desires are lower than at the height of the crisis.
They have also, as of yet, failed to really increase wages (we have put a detailed Credit Suisse note on this in the usual place) and Japanese companies do not seem to be gearing up domestic production facilities.
It all points to weak investment in the Japanese economy. Needless to say, a lack of domestic investment is a bad thing and as Donovan notes, if this trend does not change, Abenomics will be a stimulus for the rest of the world, but not for Japan.
