This is the second in a series of short comments in which the professionals at Pacific Tax Partners discuss currency exchange rates and their effects.

The Yen and Japanese Fixed Investment

Attitudes of Japanese corporations concerning the prolonged strength of the yen (“endaka,” deserves to be taken up by English as a loanword) against the dollar bear watching. What corporate Japan is thinking has a wide variety of important implications for official and corporate strategy. This deserves notice by those of us concerned with the outlook for business, industry, and the economy in Japan.

In particular, here, we discuss the outlook for fixed investment.

The challenge of how to cope with viable methods to cope with a strong yen comes at a time pundits are writing not about Japan’s “lost decade” but her “lost score of years,” and East Asia neighbors China and Korea are improving their price and non-price competitiveness, as well as at a time of domestic political instability and policy constraints imposed by the immense indebtedness of the national government. In short, Japan appears to be at a tipping point with respect to her standing in the regional and global economy (or be at a loss as to how to deal with the “Japan syndrome”).

Data replaced anecdotal information on the “endaka” issue only last August, when the Ministry of Economics, Trade, and Industry (METI) released its short study report. The prospect of “hollowing out” of domestic industry raised its fearful head. Asked what they would do in the event that the yen continued at the level of 85 to the dollar, 39% of manufacturers said they would shift some production offshore and 61% said they would increase production also offshore. The responses varied by industry, reflecting matters such as the extent that the companies had dollar-denominated business. Nevertheless, responses were resoundingly negative.

Since last July the yen has never been weaker than about 91 to the US dollar and recent levels have been in the low 80s. The in-house rate now in use is probably averaging 85, and most companies are looking at a rate in the 80-85 range for the rest of this fiscal year [Development Bank of Japan (JDB) survey, that matches our own information]. Thus, we can say at this time the plans and “guidance” (business results outlook reported to the investment community) have been adjusted to the forex market.

Short-term coping can include adjustment of currency hedging, mostly done through use of forward contracts.

Last December, the governmental JDB released its survey of about 250 companies that are among its credit recipients. The questionnaire was distributed and retrieved in October and November. Most respondents said they had not changed their investment plans, including investment in plant and equipment overseas, since the start of the fiscal year (in April). The most important reason given for making an increase in overseas investment was “increase in demand.” It is amply evident that many companies are targeting the growing demand in the emerging economies, notably the BRICs. This is one external reason for a hollowing out, or at least a shift in emphasis.

Medium- and long-term adjustment to a stronger yen is done through cost cutting, increasing the value added of products (This can involve changing product lines, for example.), and shifting production overseas (This can include using the strong yen and low domestic interest rates for overseas M&A.). Manufacturers responding to the JDB survey gave almost as much importance to that shift as to cost reduction, but more than half of the companies did not provide a specific response.

Given the “dual structure” of Japanese industry, this “cost cutting,” in many cases, means exerting pressure on vendors to lower their prices. Thus, Japan’s SME sector is at increased risk. A recent this study of sector, also by the JDB, found that of all the problems SMEs are facing, the one that grew the most in importance in the past one year was vagaries of the forex market, and the second-largest increase was that accorded to an overseas production shift by customers. This shift, of course, would be driven not only by the currency market but also the growth of emerging nation demand, as mentioned above.

All this is not to dispute advantages of the stronger yen, most notably through lower import prices of raw materials and hydrocarbons. But with domestic consumption demand as low as it is, the loss of export competitiveness, and strong growth prospects in other countries, is pointing toward a degree of realignment of production... that, in turn, presents its own problems.

For more information on customized economic reports and tailored US-Japan tax advice that cuts to the chase, contact the staff economist and experienced tax professionals at Pacific Tax Partners:

Terry Wilson

US Income Tax, IRS Tax Appeals

Terry Wilson

Terry Wilson has 25 years expertise in international financial planning and trade issues as well as US income tax and tax appeals.

He is qualified as an MBA and US CPA, Certified Financial Planner, Certified Internal Auditor, Certified Fraud Examiner, and is a Certified Computing Professional.

He is a member of the American Institute of Certified Public Accountants (AICPA), the Finance Club of Brussels at the Bourse, and the Institute of Internal Auditors.

He can be reached at [email protected].

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