Why It Happened

There are two aspects to the mechanism whereby Japan's output was so much affected by the collapse of exports in late 2008 and early 2009, Japan's trade structure and its industrial structure. We will examine each of these.

3.1 Japan's Trade Structure

As noted in the previous section, over 90% of Japanese exports consist of highly income-elastic industrial supplies, capital goods, and consumer durables. Hence a collapse of the US and European markets exerted a severe negative influence on Japanese exports. Japan was not alone in this. Sommer (2009) shows that economies with a greater share of advanced manufacturing in GDP tended to experience sharper output declines than others, with Singapore and Taipei,China belonging to this group of economies. In Japan, as discussed above, both the export of consumer durables to the advanced markets (accounting for less than 15% of total exports) and the export of industrial supplies and capital goods to emerging Asia (constituting over 40% of total exports) were adversely and severely affected by the financial crisis. In particular, the export of industrial supplies and capital goods declined along with the softening of investment demand throughout the world.

Much has been said about the recent growth of intra-regional trade within Asia (see Kawai and Urata 2004; Takagi and Kozuru 2009). For example, within the member countries of the Association of Southeast Asian Nations (ASEAN), the PRC, Japan, and Korea (ASEAN+3), the share of intra-regional trade rose from around 30% during 1980-1990 to over 38% in 2006; with Hong Kong, China and Taipei,China included, the share was almost 55%. Closely related to intra-regional trade is intra-regional foreign direct investment (FDI), which has recently accounted for as much as half of the region's total FDI. Direct investment in plant and equipment has created production networks and supply chains in industries such as electronics, automobiles, and other machinery products, that cut across national borders—a flipside of the growing intra-regional trade. Japan has been the center of this increasing intra-regional trade, mainly in parts, components, and capital equipment. This explains why Japanese exports to emerging Asia expanded sharply over the last two decades (Figure 7 [ PDF 31.5KB | 1 page ]), with the share of exports to emerging Asia in total exports rising from 34% in 1990 to 54% in 2008.⁴

3.2 Japan's Industrial Structure

The industrial structure of Japan has undergone significant changes over the past twenty years. In particular it changed since around 2005 as the real effective exchange rate of the yen finally returned to a level more consistent with the long-run average (Figure 8 [ PDF 45.5KB | 1 page ]). The yen, which had begun to appreciate in real effective terms in early 1985, peaked in 1995 when the level was some 80% higher than in 1980. Then the yen began to decline as a trend until 2007, except for the brief 1999-2001 period when the value rose temporarily.⁵

During the period of the “lost decade,” the share of the non-tradable goods sector in the Japanese economy expanded, in a way consistent with the real exchange rate level that was higher than the historical average. From theoretical perspectives, a high real value of the yen increases the relative price of non-tradable goods, thus encouraging their production; resources therefore should shift away from the production of tradable goods. This relative price change, moreover, should reduce the price competitiveness of manufacturing firms that produce tradable goods, so that it also encourages them to shift their production activities abroad through FDI. Indeed, this is what we observed.

Figure 9 [ PDF 83KB | 1 page ] depicts the production of non-tradable goods relative to tradable goods from 1980 to 2007 in terms of both nominal and real outputs; the two solid lines represent the respective trend lines (for our purposes here the non-tradable goods sectors include construction, electricity, gas, water, wholesale and retail trade, banking and insurance, real estate, transportation, telecommunication, and services; the tradable goods sector includes manufacturing). The figure clearly indicates that the share of the non-tradable goods sector rose steadily over this period in terms of nominal value, although the rise in the share of non-tradable goods was not pronounced when measured in terms of real value (reflecting the relatively more rapid growth of non-tradable goods prices). An important point is that, during the period of a strong yen, i.e., 1993–2002, the production of non-tradable goods relative to tradable goods exceeded the trend, regardless of whether it is measured in nominal or real value.

What is more important to observe for our purpose is that, the share of non-tradable goods began to decline from a peak achieved in 2002. When Japan began slowly to emerge out of the prolonged recession, it relied on the export sector as an engine of growth as the yen fell in real effective terms, especially given the limited space for expansionary fiscal policy. As a result, not only did the GDP share of exports increase, but also Japan's overall openness rose from the early 2000s to 2008 when the country was hit by the global financial crisis (Table 2 [ PDF 83KB | 1 page ]). For instance, Japan's export to GDP ratio, which was 11% in 2000, rose to over 17% in 2008. Over the same period, trade openness increased from about 20% of GDP to almost 35%.

Although net exports did not show an upward trend during this period, they positively contributed to economic growth when there was a withdrawal of fiscal stimulus from 2003 to 2006 (Table 3 [ PDF 62.5KB | 1 page ]). Undoubtedly, the export-led recovery and growth was made possible by the expansion of the global economy, particularly that of the US economy that followed the post-IT bubble recession. The restructuring of the banking sector and the resolution of bank nonperforming loans also likely supported the recovery process in Japan. This export-led growth, however, became increasingly vulnerable to US economic turbulence because the export expansion was being fueled by an unsustainable increase in US personal consumption backed by the housing price bubble, a bubble that eventually burst in the summer of 2006 and led to the subsequent eruption of the global financial crisis.

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