Factor Decomposition of Japan's Trade Balance

Hit by the global financial crisis and a great earthquake followed by a tsunami, Japan's trade balance has turned to deficit, ending its 26 years of trade surplus. However, it is puzzling that its trade balance has remained long in deficit even during the sharp depreciation of the yen beginning at the end of 2012. We construct several alternative indices for price and quantity, decomposed at the country and industry level, for Japanese exports and imports between 1988 and 2014. Income elasticity, price elasticity, and pass-through elasticity are estimated at the country and industry disaggregated levels. The estimated results support that Japanese trade experienced a structural change both in income and exchange rate pass-through elasticity. After the crisis, exports became more unresponsive to exchange rate fluctuations, whereas import prices rose more proportionately with the depreciation of the yen and income elasticity of imports rose sharply. The difference in income elasticity between Japan and the rest of world is reminiscent of the Houthakker-Magee effect and suggests that the trade balance of Japan is likely to deteriorate. The decomposition of Japanese trade reveals that almost every element shifted, resulting in the deterioration of the external balance.