Export Performance under Depreciation
Negative contribution of net exports
GDP numbers for the 2014Q1 was revealed in May 15. As Fig.1 shows, the seasonally adjusted real rate of growth over the previous quarter was 1.5 percent (5.9 percent in annualized terms). In addition to the high growth rate, due to the forward shift of demand in anticipation of the rise in consumption tax rate in April, what attracted the attention of economists was the fact that net exports made a negative contribution to real GDP growth rate.
Since the current recovery started in November 2012 (the official date of trough of the most recent business cycle was announced in May 30), net exports have made a negative contribution in three out of five quarters (and the three happens to be the most recent three). It attracted attention because it is in stark contrast with the recent performance of the Japanese economy whose main feature was export-driven growth. It also attracted attention because it seemed as though the depreciation of the yen that had taken place since late 2012 had no positive impact at all.
Net contribution of net exports was, in part, a result of the increase in LNG and other fuel imports that have become necessary since the shutdown of nuclear power plants. However, it was also a result of the poor performance of exports, particularly in export volume of goods as witnessed by the customs data.
Why didn’t exports respond to the depreciation of the exchange rate? This is the topic which is going to be picked up in this month’s column.
Stable foreign-currency denominated export prices
The expectation that export volume should increase when exchange depreciates is based on the assumption that foreign-currency denominated export prices would be reduced in such circumstances, attracting more customers to buy the commodities. But the fact of the matter is that foreign-currency denominated prices have not declined during the depreciation period.
Refer to Fig.2 to check this fact, It shows the changes in the nominal effective exchange rate index and export price index as surveyed by the Bank of Japan. According to the figure, even though nominal effective exchange rate had depreciated by 17.7 percent in FY2013, contract-price based export prices fell only by 2.1 percent during the period. Since only 35.6 percent of the export contracts in FY2013 were in Japanese yen according to the Ministry of Finance, the changes in the contract-price based export prices can roughly be seen as reflecting the changes of foreign-currency denominated export prices. Thus, it can be interpreted as an evidence of foreign-currency denominated export prices showing only a limited response to the depreciation. In contrast, it is in the changes of yen-price based export prices that the impact of the depreciation is observed clearly. Yen-price based export prices rose by 10.3 percent in the period.
Low pass-through rate of exchange rate fluctuations
Such a phenomenon is known as the low pass-through rate of exchange rate fluctuations. Pass-through rate, which is the ratio of the exchange-rate fluctuation that shows up in foreign-currency denominated export prices, can be high if firms consider maintaining domestic-currency denominated export prices to be important, and low if they do not. The case where foreign-currency denominated export prices are shielded from exchange rate fluctuation is also known as the “pricing to the market” behavior. Japan has been known as having low pass-through rate since the 1980s. Recent estimate shows that it could be as low as 10 percent in the recent years (cf. Cabinet Office study of 2009).
Low pass-through rate applies not only to depreciations but also to appreciations. As a matter of fact, it was also witnessed during the extended period of appreciation that preceded the recent depreciation. One of the obvious options firms can take when facing an appreciation of the exchange rate is to raise the foreign-currency denominated export prices. However, if the firms do not have a competitive edge over others, they would be risking a fall in market share and decline in export volumes. That is exactly what the Japanese firms tried to avoid; they chose to keep the foreign-currency denominated export prices constant and maintain the market share. Of course, in return, they had to endure fall in yen-denominated export prices. During the period of appreciation that took place between FY2007 and FY2011, export prices on foreign-currency denominated terms rose only by 4.2 percent, while those on yen denominated terms fell by 20.8 percent. The decline in export values, therefore, came from fall in yen prices rather than decline in export volumes during the period.
Benefits of depreciation enjoyed through price-effects
What is taking place during the recent depreciation period is exactly the reverse of what has taken place during the preceding appreciation period. Since firms did not raise foreign-currency denominated export prices during appreciation, they wouldn’t dare reducing the prices or they could be accused of engaging in dumping in the market. They chose instead to maintain foreign-currency denominated export prices constant and enjoy the benefits of the depreciation through rise in the yen denominated export prices. That is why export volume did not match the expectation that was based on the assumption that foreign-currency denominated prices would decline.
Low price elasticity of export volumes
From a different point of view, keeping foreign-currency prices constant is an optimal behavior of the firms if they are to maximize export values. Recent estimates of price elasticity of export volumes shows that they are currently below one. For example, an estimate in the Annual Report on the Japanese Economy and Public Finance for FY2013 shows that it is only 0.79 even in the long-term. If this is true, it implies that, when faced with 1 percent depreciation, it is not wiser to cut foreign-currency denominated prices by 1 percent only to gain 0.79 percent rise in export volumes, resulting in (0.79-1.00=) 0.21 percent decline in foreign-currency terms or (0.79-0.00=) 0.79 percent increase in yen-terms. It would be wiser for them to maintain the foreign-currency denominated export prices constant (and suffer 0 percent fall in export volumes) and to enjoy increase in export values in yen-terms by 1 percent, if they are to maximize export values.
Impact of shifts of production sites abroad
By passing, it may be worth mentioning that low price elasticity of export volume could be a result of firms’ recent shift of production sites abroad. Foreign direct investment to shift production site abroad could substitute for direct exports of domestic production. However, the new production site abroad could induce exports of capital and intermediate goods of domestic production. To some degree, the former could be offset by the latter. In addition, such exports could take place between the parent firm and its subsidiary. It is in effect a within-firm transaction which would not be subject to a strong influence coming from exchange rate fluctuations. A low price elasticity of export volumes could have showed up as a result.
Foreign direct investment is often considered to be a factor reducing the impact of exchange rate fluctuations. However, it is because it would result in a smaller export volume. It is important to acknowledge that the responsiveness of exchange rate fluctuation could also be mitigated by the fall in price elasticity of export volumes, as discussed above.
The question posed at the outset was “Why didn’t exports respond to the depreciation of the exchange rate?”
The answer to the question, as above discussion suggests, is that exports are responding to the depreciation. It is just that they are responding in a way consistent with the current constraints: The benefits of depreciation are enjoyed through increase in export prices in yen-terms, rather than increase in export volumes which many seem to expect under depreciations.