13 February 2018
Japan’s large and persistent current account surplus means it is often considered a reliable supplier of capital to the rest of the world. Explanations for this surplus usually rest on the competitiveness of the country’s dynamic export sector. However, this narrative is no longer sufficient. Japan’s trade balance has fluctuated drastically since the financial crisis. This partly reflected the outing of its nuclear power plants following the Great Tohoku earthquake and tsunami but also a loss of competitiveness as the yen surged in the aftermath of the financial crisis. However, while Japan has frequently logged a deficit in goods and services trade in the last decade it was not enough to push its current account into persistently negative territory. This is because the country has seen a concurrent rise in its net income from overseas investments (see Chart 8). The expansion in the primary income surplus is due to an increase in both the amount of external assets and the rising share of direct investment.
Let us first examine developments in direct investment. The first thing to note is that there has been an increase in direct investment abroad over the last decade. This reflects not only stronger investment into the emerging world but also into the US, which remains the largest destination, accounting for nearly a third of total FDI. By sector, it is the manufacturing sector that dominates, reflecting Japanese manufacturers’ efforts to internationalise their value chains (see Chart 9). But the sustainability of these investments rest on their relative lucrativeness. In general, the rate of return on outward direct investments has exceeded those on portfolio investments, with noticeable divergences by sector. In Japan’s automakers, the rate of return for Asia and North American is estimated by the Bank of Japan to top 15% versus just above 1% in Europe. For electronic machinery, returns are more modest single digits but here the geographic breakdown points to a meaningfully higher return on investments in Asia and Europe. Given these healthy returns, we expect Japanese corporates to continue to funnel investment overseas despite a weaker yen and a government focus on reshoring production facilities.
Turning to portfolio investments, Japan’s long history of current account surpluses means it has accumulated a large stock of overseas assets worth close to 60% of GDP. The change in these assets has been remarkably erratic of late, peaking in October 2016 before turning negative more recently. This partly reflects the powerful influence of currency effects when compiling yen-based statistics. To understand the trend more clearly, it can be informative to look at foreign currency denominated flows. Although the data here are limited, there has been a noticeable shift in dollar denominated investment assets, with a drop off in long-term debt securities offset by equity and investment fund shares. A similar trend has also been observed in the euro and other currencies. This speaks to rising risk appetite among the Japanese investor base. It also raises questions about the durability of ‘safe haven’ bids from Japanese investors. Japanese investors have long been considered dependable buyers of developed market sovereign debt, due to its attributes as a store of value and for collateral in repurchase and derivatives markets. The latest data points to more price sensitivity in these purchases than perhaps had been bargained for.