Factors that Move Exchange Rates and Their Effects

ECONOMIC REPORT Factors that Move Exchange Rates and Their Effects There are various theories as to what factors move exchange rates, including ones that offer very complicated explanations. However, factors that move exchange rates are not actually so complicated. An exchange rate is a rate of exchange between two currencies. The rate is determined by the ratio of the total supply amounts of the two currencies. In this article, we identify factors that move exchange rates based on this idea and examine how exchange rate movements affect the real economy. Factors that Move Exchange Rates Among factors generally believed to move exchange rates are the scale of the trade and current account surplus/deficit, the interest rate and inflation rate differentials between the domestic and foreign markets and expectations for future exchange rates. However, these are only a handful of examples of such factors. As shown in Figure 1, the yen-dollar exchange rate reflects the proportional relationship between the supply of yen funds totaling one million yen provided by yen providers and the supply of dollar funds totaling 1, dollars - provided by dollar providers into the market. This relationship is represented by the equation: one million 1, dollars=1 yen/dollar. Yen providers include Japanese importers and investors who intend to sell yen to obtain dollar funds for the purchase of U.S. government bonds (U.S. Treasuries), for example. Dollar providers include Japanese exporters and investors who intend to sell dollars to obtain yen funds for the purchase of Japanese government bonds (JGBs). In some cases, dollars obtained as payment for Figure 1 The yen rate and the price of tomatoes are determined through the same mechanism -rate setting mechanism The amount of yen supplied by "yen providers" (Japanese importers and investors who sell yen to buy U.S. Treasuries) 1 million yen Foreign exchange market 1 million yen $1,=1yen/$ $1, The amount of dollars supplied by "dollar providers" (Japanese exporters and investors who sell dollars to buy JGBs) The amount of yen supplied by importers and investors who sell yen to buy U.S. Treasuries Yen rate (yen/dollar) The amount of dollars supplied by exporters and investors who sell dollars to buy JGBs Tomato-price (yen/unit) setting mechanism Tomato buyers 1 million yen Tomato market 1 million yen 1, units=1 yen/unit 1, tomatoes Tomato sellers exported goods may be provided to the market for exchange into yen, and in other 1

cases, they may be provided as funds for the purchase of JGBs (however, as the amount of JGBs purchased by foreign investors is small, the exchange of dollars into yen is mainly related to the sale of U.S. Treasuries conducted as a reverse trade following the purchase of the Treasuries). The exchange rate setting mechanism is essentially the same as the mechanism that determines the prices of goods. For example, when a tomato is priced at 1 yen, the price reflects the relationship between the supply amount of tomatoes in the market one million tomatoes - and the supply amount of funds one million yen. This is represented by the equation: one million yen 1, units=1 yen/unit. Therefore, when the yen-denominated value of imports increases due to a rise in yen-denominated import prices or growth in import volume, or when investors increase yen sales because of a rise in the U.S. Treasury yield, the yen rate (yen s value in relation to the dollar) declines (e.g. from 9 yen per dollar to 1 yen per dollar) as a result of an increase in the supply amount of yen. Inversely, when the dollar-denominated value of exports increases due to a rise in dollar-denominated export prices or growth in export volume, or when investors reduce investment in U.S. Treasuries because of a rise in the JGB yield, the yen rate rises (e.g. from 1 yen per dollar to 9 yen per dollar) as a result of an increase in the supply amount of dollars. As shown in Figure 2, the movement of the actual yen rate a (yen-dollar exchange rate) is almost in line with the movement of the estimated rate b based on the equation that calculates the yen rate based on the yen-denominated value of imports, the dollar-denominated value of exports and the U.S.-Japan interest rate differential (=the yield on the 1-year U.S. Treasury minus the yield on the 1-year JGB), and the result was statistically significant *1. The coefficient of the yen-denominated value of imports in the equation is.53. This means that a 1% rise in the yen-denominated value of Japanese imports has the effect of reducing the yen rate against the dollar by.53 yen. Meanwhile, the coefficient of the dollar-denominated value of exports is minus.6, which means that a 1% rise in the value has the effect of raising the yen rate against the dollar by.6 yen. The coefficient of the U.S.-Japan interest rate differential is 12.49, which indicates that a 1 percentage point increase in the differential has the effect of reducing the yen rate against the dollar by 12.49 yen. The above three factors do not fully explain the movement of the yen-dollar exchange rate. This is reflected by the difference between the actual rate and the estimated rate ( a-b ). The difference was greatest, at minus 1.6 yen/dollar, in the 2

April-June period of 211, immediately after the Great East Japan Earthquake. Except for this period, the difference was less than 5 yen/dollar. 14 13 12 11 1 9 8 7 6 5 Yen/dollar Figure 2 Actual and estimated yen rates 2 3 4 5 6 7 8 9 1 11 12 13 Coefficient of the yen rate (multiple regression equation), "t" value, and coefficient of determination, etc. Coefficient "t" value Value of yen-denominated imports (25=1).53 12.2 Value of dollar-denominated exports (25=1).6 12.8 U.S.-Japan interest rate gap (%, 1-yr US Treasuries-1-yr JGBs) 12.49 15. Fixed value 83.19 18.4 Coefficient of determination=.964 Observation period: Jan-Mar 22 to Apr-Jun 213 Source: Bank of Japan, Cabinet Office, FRB Actual-estimate difference a-b, right axis Yen rate (yen/dollar) a Estimated rate b Izanami economic boom Global recession D.W.=1.4 Great East Japan Earthquake 7 6 5 4 3 2 1-1 -2 (Year) *1 The t value in the lower table in Figure 2 is an indicator of the closeness of the relationship between individual indicators (explanatory variable) and the exchange rate (explained variable). When the t value is above 1, the higher the value is, the closer the relationship is. The coefficient of determination is an indicator of the closeness of the relationship between the exchange rate and the various indicators as a whole. The nearer the co-efficient is to 1, the closer the relationship is. Usually, a coefficient higher than.8 indicates a strong positive correlation, while a coefficient of between.6 and.8 indicates a positive correlation. A coefficient of between.4 and.6 indicates a weak positive correlation and a coefficient of to.4 indicates a near-total lack of correlation. Cause of the Yen s Recent Weakness Figure 3 shows what factors affected the movement of the yen-dollar exchange rate and the extent of their effects over the period between 22 and 213 based on the abovementioned equation. According to this figure, for most of the period, the movement of the yen-dollar exchange rate was affected by the effects of net imports/exports, which represent the yen-denominated value of imports minus the dollar-denominated value of exports, as well as by the U.S.-Japan interest rate 3

differential. As for the effects of net imports/exports, a rise in the yen-denominated value of imports has the effect of reducing the yen rate, while a rise in the dollar-denominated value of exports has the effect of raising it. 14 13 12 11 1 9 8 7 6 Yen/dollar Figure 3 Factors moving the yen rate 2 3 4 5 6 7 8 9 1 11 12 13 Note: Effect of net exports/import=effect of yen-denominated imports- effect of dollar-denominated exports Source: Bank of Japan, Cabinet Office, FRB Yen rate (yen/dollar) Effect of net imports/exports (right axis) Effect of U.S.-Japan interest rate gap appreciation depreciation 5-18. -25.7-43.3 +2.7 +21.4 +21.7 4 3 2 1-1 -2-3 (Year) For the period of around four years between the April-June quarter of 27 and the October-December quarter of 211, the yen appreciated 43.3 yen/dollar; net imports/exports and the U.S. Japan interest rate differential had the effect of raising the yen rate by 18. yen/dollar and 25.7 yen/dollar, respectively. For the period between the October-December quarter of 211 and the April-June quarter of 213, the yen depreciated by 21.4 yen/dollar; net imports/exports had the effect of reducing the yen rate 21.7 yen/dollar, much larger than the reduction effect of 2.7 yen/dollar for the U.S.-Japan interest rate differential. However, the effect of the interest rate differential has recently become non-negligible. Figure 4 shows the indexes of four items that constitute the exchange rate-moving effect of net imports/exports: yen-denominated import prices, import volume, dollar-denominated export prices and export volume. For each index, the figure in the October-December quarter of 211, when the yen rate reached its peak, is used as the base of 1. In the yen-appreciation phase lasting through the October-December quarter of 211, export volume changed drastically. A rebound in export volume after the slump caused by the global recession led to the yen s appreciation. However, what 4

was conspicuous in the subsequent yen-depreciation phase was a fall in dollar-denominated export prices. This largely reflected continuing drops in electrical machinery, which is Japan s main export item. Figure 5 shows a comparison between Japanese and U.S. interest rates as represented by the yields on the 1-year JGB and U.S. Treasuries. U.S. interest rates were initially higher but later fell substantially, and this worked to push up the yen. However, in the latter half of the yen-depreciation phase that began in the October-December quarter of 211, a rise in U.S. interest rates has become a major factor behind the yen s depreciation. If the U.S. economy continues to recover and U.S. interest rates rise, the yen may depreciate further. Figure 4 Import/export prices and import/export volume Figure 5 U.S.-Japan interest rate gap 11 15 1 95 9 85 8 75 7 9 1 11 12 13 (Year) Source: Bank of Japan, Cabinet Office Yen-denominated import prices Import volume Dollar-denominated export prices Export volume Oct-Dec 211=1 appreciation depreciation 4 3 2 1 U.S.-Japan interest rate gap a-b U.S. Treasury yield a JGB yield b % appreciation depreciation 9 1 11 12 13 (Year) Source: Bank of Japan, FRB Short-term Economic Effects of Exchange Rate Movements It is generally believed that a strong yen has negative effects on the Japanese economy while a weak yen has positive effects. However, we must distinguish between short-term and long-term economic effects. As for short-term economic effects, the exchange rate movement affects the economy much less than is generally believed *2. As shown in Figure 6, net exports, or nominal exports minus nominal imports, account for a relatively small proportion of nominal GDP. The largest proportion of net exports recorded over the past 1 years was 2.% in 24. As the yen appreciated by 6.7% in that year, the exchange rate movement had the effect of pushing down nominal GDP by.13 (2.% x 6.7%). However, nominal GDP grew 1.% compared with the previous year, indicating that the yen s appreciation made a negative contribution of only around 1%. 5

Nonetheless, the belief that a strong yen has negative economic effects and a weak yen has positive effects prevails, presumably because a change in the yen rate appears to have a larger impact on exports than on imports. Most of the items that constitute the dollar-denominated export price index are finished goods, which means that the degree of change in their prices is relatively small; over the past 1 years, export prices rose 39.2% at maximum. Over the same period, the yen appreciated much more steeply, by 71.2% Figure 6 Effect of yen rate changes on nominal GDP at maximum. Consequently, when the yen-appreciation phase began, yen-denominated export prices started to fall almost simultaneously, imposing a heavy burden on export-dependent companies. Therefore, as shown in Figure 7, the movement of the yen rate, indicated by the red arrow, was almost in the same direction as the movement of yen-denominated export prices, indicated by the blue arrow. Figure 7 Yen- and dollar-denominated Figure 8 Yen- and dollar-denominated export prices and the yen rate import prices and the yen rate 2 1-1 -2 % Ratio of net exports to nominal GDP Effect of yen rate changes on nominal GDP (contribution) Nominal GDP (right axis) 24 :2. 24: 1. 24: -.13-6 2 4 6 8 1 12 (Year) Source: Cabinet Office, Bank of Japan 6 4 2-2 -4 16 15 14 13 12 11 1 9 8 appreciation Yen-denominated export prices (25=1) Yen rate (yen/dollar) Dollar-denominated export prices (25=1) depreciation appreciation 7 2 4 6 8 1 12 depreciation (Year) 16 15 14 13 12 11 1 9 8 Yen-denominated import prices (25=1) Yen rate (yen/dollar) Dollar-denominated import prices (25=1) appreciation depreciation appreciation depreciation 7 2 4 6 8 1 12 (Year) Source: Cabinet Office, Bank of Japan Source: Cabinet Office, Bank of Japan Meanwhile, items that constitute the dollar-based import price index are mainly commodity goods with volatile prices and crude oil, the price of which is controlled 6

by OPEC, so dollar-denominated import prices and the yen rate sometimes move in different directions. Moreover, over the past 1 years, export prices rose by 11.1% at maximum, much higher than the maximum rise of 71.2% in the yen rate. Therefore, as shown in Figure 8, the movement of the yen rate, indicated by the red arrow, was in the same direction as the movement of yen-denominated import prices, indicated by the blue arrow, only for some of the 1-year period. Long-term Effects of Exchange Rate Movements As for long-term economic effects of exchange rate movements, a weak yen has the effect of increasing export volume and reducing import volume, while a strong yen has the effect of reducing export volume and increasing import volume. This is confirmed by the presence of correlation between year-on-year changes in the yen rate and in the ratio of export volume to import volume (export-import ratio *3 ). As shown in Figure 9, the export-import ratio starts to rise four months after the yen begins to depreciate, and it starts to decline four months after the yen begins to appreciate. Figure 9 Yen rate and the ratio of export volume to import volume (=export volume import volume) 3 2 1-1 -2-3 -4 Yen rate (yen/dollar) Ratio of export volume to import volume (export-import ratio) of four quarters later Year-on-year change, % 8 85 9 95 5 1 (Year) Correlation coefficient Correlation coefficient Export-import ratio (current).17 Export-import ratio (3 quarters later).461 Export-import ratio (1 quarter later).272 Export-import ratio (4 quarters later).482 Export-import ratio (2 quarters later).358 Export-import ratio (5 quarters later).47 Source: Cabinet Office, Bank of Japan The correlation reflects the fact that a weak yen creates room for reduction of dollar-denominated export prices by improving export profitability, leading to an increase in export volume after a certain time lag. Importing companies reduce import volume as a weak yen erodes profitability. This is the so-called J-curve effect *4. Since the latter half of last year, the yen rate has depreciated by around 2% compared with the previous year. As a result, it is expected that export volume will 7

increase and import volume will decrease, leading to growth in real GDP. However, it must be kept in mind that if exporting companies reduce their dollar-denominated export prices at the expense of profitability, it would mean a deterioration of the terms of trade as represented by the ratio of the export price index to the import price index, making it all the more difficult to overcome deflation *5. The Japanese economy faces a choice of whether to place emphasis on increasing export volume or to put priority on improving profitability. *2 That the short-term effects of the exchange rate movement are neutral can be presumed from the calculation formula of the terms of trade. The terms of trade is calculated by dividing the export price index by the import price index. As the exchange rate movement affects both the denominator and numerator, its effects on the terms of trade are neutral. *3 The ratio of the value of yen-denominated imports to the value of dollar-denominated exports is the product of the ratio of import prices to export prices (=yen denominated import prices dollar-denominated export prices) by the ratio of import volume to export volume (=import volume export volume). In most cases, the ratio of import prices to export prices changes more than the ratio of import volume to export volume. That is why the purchasing power parity theory places emphasis on the difference between price changes in the domestic and overseas markets. For further information in this respect, please refer to Chapter 7 Mechanism of Exchange Rate Movements of Deta ga kataru keizai hendo no mekanizumu: makuro keizaigaku saikochiku no kokoromi (Mechanism of Changes in Economic Conditions as Shown by Data: Restructuring of Macroeconomics) by this author (Taga Shuppan, 211; available only in Japanese). *4 However, the correlation coefficient of the J-curve effect, at.482, is not very high, indicating that the probability of the effect arising is low. Moreover, similar effects are not observed in countries like Germany and the United Kingdom where priority is placed on profitability improvement rather than on volume growth. *5 As to how the deterioration in the terms of trade has caused deflation, refer to FINANCIAL FORUM 213, SPRING NO.1 (ECONOMIC REPORT: Reality and Cause of Deflation in Japan). Haruhiko Murayama General Manager, Tokyo Economic Research Division Kyoto Research Institute, Inc. FINANCIAL FORUM 213.AUTUMN 12 The purpose of this report is to provide information, not to solicit the buying or selling of investment products. Information included in this report comes from sources regarded as reliable by the Kyoto Research Institute, Inc. However, the Kyoto Research Institute, Inc. makes no guarantees as to the accuracy and completeness of the information. Customers themselves are responsible for making final investment decisions. 8