Despite all the economic problems outlined over the previous pages, Japan still remains the second largest economy in the world, behind the United States, and the yen to dollar relationship therefore affects us all, not just from a trading or investing perspective. However this is not a position it is likely to hold much longer, with many economists forecasting that China will overtake Japan in 2010.

As the second largest single economy in the world, Japan is also one of the world’s largest exporters, with manufacturing making up nearly 22% of it’s $4.5 trillion GDP with the largest sector being services which accounts for 68% of the GDP.  Japan carries a very large trade surplus from the enormous amount of its exports which in turn creates a large demand for the Japanese Yen. Japan relies on exports for the growth of its economy. The stability of its export markets directly affects the demand for the Yen. A strong Yen will reduce exports whilst a weak Yen will boost exports and the demand for the currency. As I’m sure you know, GDP is a measure of a country’s overall production and consumption of goods and services. Whilst many would argue that GDP is an over-rated economic indicator, I believe it is still important in assessing the strength or weakness of an economy, and in particular the balance of exports and imports which are so critical to Japan’s long term success and hence the strength or weakness of the yen to the dollar. GDP announcements generally conform to expectations as the numbers are announced after production figures that lead to overall GDP, have already been released, so there are rarely any surprises. So although the figures are rarely far from the economist’s expectations, the yen to dollar rate will move, simply because GDP is considered an important economic indicator. The figures are released quarterly by the Economic and Social Research Institute of Japan in the second month following the end of the quarter.

Japanese GDP Growth Figures -1995 To 2006Having said that the GDP figures rarely surprise, but those released at the end of 2007 did exactly that, and surpassed all analyst’s expectations. The chart alongside shows the GDP growth from 1995 to 2006. Japan’s economy expanded at an annualized rate of 3.5% in the final quarter of 2007, surpassing economists’ expectations of 2.3%. Yen appreciation notwithstanding, export growth proved to be an important catalyst for growth. The result validated a report recently released by the Bank of Japan that argued the economy was supported in spite of the US slowdown and rising input prices, suggesting demand from emerging markets (notably China) will continue to offer substantial stimulus. In the last decade Japan’s largest overseas market has consistently been in the US, but with the growth of China and its proximity in Asia, it is likely to buffer the Japanese export market in the event that the US enters a full recession in the next few years. Asia accounts for nearly 50 percent of Japanese exports, and Japan’s economy is also being insulated against a U.S. recession as countries that used to be on the periphery of exporters’ radar screens have developed an appetite for Japanese products and have now become significant trading partners. With exports looking healthy, many Japanese firms invested in plant and equipment in the October-December quarter, leading to a 2.9% rise in capital investment from the July-September period. Capital investment growth was underpinned by automakers, including Honda Motor Co. and Suzuki Motor Corp., who are constructing new plants.

The surprisingly strong capital investment suggests many companies, particularly large firms, expect brisk growth outside the United States. However, some analysts caution about the dangers of increased capital investment, should the impact of the sub prime debacle spread further outside the United States and soften or cool demand. Only time will tell. My own view is that Japan is through the worst, and the ‘lost decade’ is finally behind them, but the recovery is fragile, and any significant change in markets or the yen to dollar rate could stall this recovery. The key to long term success lies in the government’s interventionist policy to control the strength of the yen.