Asia's Yen Problem.

If later this year the yen-dollar rate reaches 140, watch for all hell to break loose.

Asian economies are being buffeted this year by deepening slump in global demand for information technology. With crude oil prices proving to be relatively sticky, the more than two-year-old deterioration in terms of trade for Asia does not look like it will abate anytime soon. Bad as these developments may be, things could get worse were the yen to enter into a trend decline. The economic downturn in Asia then could prove to be much more severe.

Last year was marked by one of the narrowest ranges for the Japanese yen in over a decade. Through most of 2000, the yen hugged a tight range between 100 and 110, and provided a stable neighborhood for currencies and exporters in the rest of Asia. However, since November 2000 the Japanese yen has weakened to its lowest level since the middle of 1999. The anemic Japanese recovery, its moribund political landscape, its unsustainable fiscal position amid a rapidly aging population, present the perfect recipe for a trend decline in the yen over the medium term. After range trading close to Yen 125/US$1 through most of this year, the chances of a sharp slide towards Yen140/US$1 into the turn of the year are high.

The damage from a weak lien. A weakening in Japanese growth prospects will be telegraphed by a trend weakening of the yen, and the pressures on Asia will first arise from that front. There are three major avenues through which a weak yen will hurt the rest of Asia.

* Competitive pressure on rival exports that compete directly with Japan, particularly in Korea, Taiwan, and Singapore. Erode export-pricing power in the rest of Asia, and undermine the terms of trade.

* Slow the pace of production outsourced from Japanese MNCs and/or domestic producers located outside of Japan.

* Weaken recycling of Japanese capital and increase pressures to repatriate financial savings back to support restructuring activities in Japan.

Competitive pressures on rival exporters. Unlike the U.S. economy that is a net importer from Asia, Japan is a net exporter to the rest of Asia barring Indonesia and Malaysia. Hence, growth in Japan does not directly feed into final demand for Asia, and conversely weakness in Japan should not directly undermine final demand in Asia except for the two countries aforementioned. However, at the margin, reliance on external demand versus domestic demand to fuel GDP growth in Japan means that the net exports balance of the rest of Asia, which together absorbs close to 40 percent of Japanese exports, gets undermined.

A weak yen/Japan hurts exports from the other parts of Asia through several other channels. Over the 90's several Asian economies have moved increasingly into a position of direct competition with Japanese merchandise exporters, and a weakening yen adds to competitive pressure on exports from rival producers in Asia who compete with Japanese companies in the global market place. None more than Korea, where shipbuilders, steel producers, automakers, petrochemicals producers, semiconductors and consumer electronics manufacturers go head to head with Japanese products. To a lesser degree than Korea, Taiwan and Singapore also overlap with Japanese exports.

A weakening of the Japanese yen could start off a chain of competitive devaluations in Asia led by the Korean won. This then gets transmitted forward to the rest of the region through the Singapore dollar and the New Taiwan dollar. Often currency weakening alone will not be enough to absorb the pressures from a depreciating Japanese yen, and export prices have also to be reduced to safeguard exports. Arguably, the lower income countries of Indonesia, Philippines, and Thailand have the lowest export overlap with Japanese exporters and thus face the least threat from this front, though Indonesia would suffer from its position as a supplier of raw materials and crude oil to Japan in the face of a weak yen. The comparative insulation enjoyed by the currencies in Southeast Asian would all end if China were to respond to slowing exports by adjusting the value of the Renminbi lower. A weakening of the yen and the renminbi would compress Asian exporters from the higher and lower end of the value added chain of exports, leaving little choice but for a cycle of competitive devaluations.

Competitive devaluations would narrow scope for monetary easing. A sequence of competitive devaluations would do little to boost aggregate exports from Asia. At best it would help maintain the status quo on external demand, while damaging Asia's ability to ease monetary policy and stimulate domestic demand. Depending on the magnitude of the currency volatility that is sparked by competitive pressures, some countries may even be called on to tighten monetary policy into an economic slowdown. Lack of flexibility on monetary policy at a time of intensifying deflationary pressures and while restructuring of Asian financial sectors are still incomplete could tilt a cyclical downturn into a regional slump.

Outsourcing of Japanese production. The sustained appreciation of the Japanese yen since the middle of 1999 has propelled Japanese companies to outsource production, particularly in memory DRAMS and electronics components from Taiwanese and Singaporean companies. It would have also increased the output from Japanese factories for consumer electronics previously established in several Southeast Asian economies from Malaysia to Thailand. With the strong yen phase easing, the urgency to source output from production bases outside of Japan also gets diluted.

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Over the past decade the relocation of manufacturing out of Japan has taken several distinct phases. The first phase to the beginning of the 1990's saw Japanese direct investment flow into Malaysia, Thailand, and Indonesia to set up factories to produce consumer electronics, auto parts and chemicals. The second phase in the latter half of the 1990's saw the direction of FDI shift more into China and an increase of outsourcing of production to local component manufacturers located in Taiwan, Singapore and Korea. Though this is a trend development that will continue over the medium term; the momentum could wax and wane according to the trajectory of the yen. The latest phase could lead to a pause in the outsourcing momentum of 1999 and 2000, hurting most Asian producers until the current cycle of yen weakening is overhauled.

Financial flows from Japan. Apart from the trade links and direct investment, Asia is tied to Japan as a recipient of financial savings from the world's largest net creditor nation. Japanese banks have followed FDI and outsourcing flows into the rest of Asia, and have been a significant channel for directing foreign savings into Asia. Data from the BIS reveal that loans from Japanese banks have been a significant part of savings into Asia, most notably into Southeast Asia. These bank loans have already been cut back significantly since the Asian crisis, some 30 percent contraction since December 1998, and renewed yen weakness could dim the prospects of any revival here. Proportionately, Indonesia, Thailand, Malaysia are the most reliant on Japanese capital and would stand the most to lose if restructuring demands back home led to a repatriation or reduction of lending by Japanese banks.

Reliance on Japanese bank lending. Singapore and Hong Kong, as regional financial centers, get a substantial amount of Japanese savings to re-channel and direct them into the countries and banks in the neighborhood. A pull back in lending by the banks will directly impact the volumes of interbank activity in these financial centers as was seen at the height of the Asian financial crisis in 1998.

The links on private financial flows is multiplied by the flow of government related concessionary funding to these countries, often in the proportion as the distribution of private financial flows. The most to Indonesia, followed by Thailand, Malaysia and lesser amounts to China, Korea, and Taiwan. However, government related funding should be relatively insulated from weakening of economic growth in Japan. The major impact here will be an easing of debt servicing pressures on yen-denominated loans with the weakening of the yen. The main beneficiaries of this are expected to be Indonesia, Thailand, and Malaysia.

A firm and stable yen is critical for Asia this year. Headed into global demand weakening, a firm and stable yen is critical to the economic prospects in the rest of Asia this year. A significant weakening of the yen could spark chain devaluations of currencies across Asia, cutting room for monetary stimulus, and putting considerable strain on semi-functional financial sectors in the region. Increased currency and asset market volatility in an environment where credit spreads are already at record highs could reinforce the ongoing flight to safety. A weak yen will slow the outsourcing of production out of Japan into the rest of Asia, and further erode the recycling of Japanese capital. A trend weakness in the yen this year could extend a temporary cyclical downturn in non-Japan Asia into a more prolonged slump. It is critical that Asian economies get a reprieve from the yen this year when they will be at their most vulnerable.

Paul Alapat is Regional Economist at Nomura International (HK) Limited.