Strong Yen May Force Japanese Auto Makers to Rethink Export Strategies

For Japanese auto makers, the strong yen is a burden, not a blessing, which could force changes in their global footprint.

In the last three years, Japan’s currency has jumped in value from ¥119:$1 to ¥86:$1, and foreign exchange losses have soared.

Today, every yen gain in strength has a negative impact on the domestic auto makers’ operating profits, estimated at about ¥30 billion ($348 million) for Toyota Motor Corp., ¥12 billion ($136 million) for Honda Motor Co. Ltd. and ¥11 billion ($127 million) for Nissan Motor Co. Ltd.

“The yen has rarely been so strong, and I have never heard Japanese auto makers groaning so loudly about their foreign-exchange losses,” says Chris Richter, a senior analyst with CLSA Asia-Pacific Markets in Tokyo.

So far, the pinch is bearable.

“The strong yen has hurt sales in North America, where Hyundai (Motor Co. Ltd.) has benefitted from the weak Korean won and gained market share, and in Europe, as well,” says Kota Yuzawa, an industry expert with Goldman Sachs Japan. “But for the current fiscal year, we are not changing our forecasts, based on ¥95:$1.”

GSJ foresees a breakeven scenario for Toyota, operating profits of ¥241 billion ($2.8 billion) for Honda and ¥180 billion ($2.09 billion) for Nissan. But Yuzawa cautions forecasts for the next fiscal year may be changed.

The U.S. dollar currently is at its lowest level in yen terms since dropping to ¥79.70:$1 in April 1995. Whether the dollar will continue to weaken is by no means clear, nor are there are any quick or easy fixes available for anything as unpredictable as currency fluctuations.

“Some auto makers are already taking baby steps, such as sourcing more from outside Japan and trying to reduce the volume of Japanese-made components shipped to their overseas assembly plants. But this is not something they can undo overnight,” Richter says.

There are changes as well in the Japanese auto makers’ sales mix of locally produced vehicles vs. imports in North America, their biggest export destination.

“A year ago, Honda was importing 25% of its North American sales volume, whereas imports are now about 17%,” Richter says. “In the same period, the import share of Toyota sales there dropped from around 45% to 35%.”

However, an accelerated production shift overseas from Japan has yet to happen.

Every yen gain in strength has negative impact on domestic auto makers’ operating profits.

Says Yuzawa: “If the same model is made in different countries, production can easily be shifted. But most models are produced on dedicated lines, and production cannot easily be moved abroad. Nor can such moves be made overnight. It would take two or three years.”

Notably, the 48.5% plunge in automotive exports from Japan in first-half fiscal 2009 (April-September) is not blamed on the strong yen but rather on the collapse in sales and inventory buildup in major overseas markets.

But for more than 30 years, the Japanese auto makers have exported half or more of all vehicles they build in Japan – 6.7 million units out of 11.5 million in 2008, and the most obvious way to reduce foreign-currency risks would be to move more production overseas.

However, with 5.5 million Japanese employed in auto manufacturing and related industries, or 8% of the country’s workforce, the economic and political consequences would be formidable.

Overseas production, 11.6 million units in 2008, already exceeds that in Japan. And there is no consensus yet about when or even whether substantially more domestic production could be moved out.

To shift or not to shift, that is the question. And opinions vary.

“Japanese auto makers have enjoyed a free pass for many years, able to keep their domestic auto production high with large exports even though domestic demand has been continuously sagging,” Richter says. “Now the day of reckoning has come.

“They need to start sending overseas the Japanese production formerly exported and, over a period of time, they will end up exporting relatively few cars.”

Adds Mitsuru Kurokawa, senior market analyst-Japan with IHS Global Insight: “If the strong yen trend continues, Japan’s car makers may have to bring forward their planned overseas production starts.”

This more painless option fits with Yuzawa’s analysis. “Globally, we are looking at almost 5% annual growth in global automotive demand through 2020,” he says. “More Japanese plants will be built overseas as demand recovers.

“Over time, Japan’s automotive production base has to contract (as domestic demand shrinks). But this does not mean domestic plants will have to be shut down soon.”

Emerging markets such as China, India, Brazil and Russia, where most global automotive growth is expected to take place in the future, likely will be served by local production, possibly involving some imported components yet still posing minimal foreign currency exposure.

Yuzawa doubts there would be significant cost savings in shifting production abroad, noting equipment in many Japanese assembly plants has been fully depreciated. Plus, Japan ranks 12th globally in labor costs, which are less than 10% of total costs.

Maintaining massive auto exports from Japan would mean retaining substantial foreign exchange risks. But just how big a bite would be taken from the auto makers’ operating profits depends on how widely and wildly exchange rates swing and how deeply exposed the car companies are in major markets.

In Europe, for example, Honda and Nissan already have reached 80% local content, reducing their currency sensitivity.

Yet a new, improved operational footprint may be what Japanese auto makers will need.

“Japan is becoming less attractive as a place to manufacture and, conversely, North America is becoming more attractive,” says Michael Wynn-Williams, author of “Surfing the Tide” and a former senior auto analyst with IHS Global Insight.

“It is still the richest vehicle market in the world and the keystone for any car manufacturer’s strategy for profitability and reduced foreign-exchange risk.”

Says Yuzawa: “Japanese auto makers have been cost-cutting for the past 12 months and, at ¥85:$1, they make a profit. (But) if the yen gets stronger, managers will have to seriously consider shifting more production offshore.”

Kurokawa points out most Japanese auto makers have been very careful about transferring their manufacturing offshore due to the important role domestic factories play as mother plants in their business framework.

“But our macro-economy team forecasts the yen continuing strong for the next five or six years,” he says. “And if the negative effect becomes more serious, domestic car makers may be forced to transfer more production overseas.”

Richter agrees the strong yen has become a strategic concern. “Nobody is really confident about what direction the yen will ultimately go. If it weakens to ¥100:$1, auto makers can relax. But if it goes to ¥70:$1? There’s no way they could make money exporting cars from Japan at that exchange rate. It would put them at extreme risk.

“Things have not reached the point yet of sacrificing domestic production in favor of overseas production, but it’s a road Japanese auto makers are going to have to take,” he adds. “They cannot continue as successful auto makers with their current operational footprint and yen/dollar exchange rate.”

Says Wynn-Williams: “It’s generally believed that ¥85:$1 is the breakeven point for Japanese exporters, and it’s likely the ¥80:$1 level could be tested in first-half 2010. This would undermine all the domestic survival strategies of Japanese vehicle manufacturers.”

What’s more, the fallout from foreign exchange fluctuations extends beyond the auto industry.

“Economic recovery in the next few years largely depends on export recovery,” Kurokawa says. “If the yen continues to strengthen, the Japanese economy will be damaged more seriously.”

In past years, the Japanese government has intervened in currency markets to weaken the yen and keep exports more competitive and conceivably may do so again. But a new political party has taken charge in Tokyo after a half century reign by the Liberal Democrats, and its leaders have different priorities that may not include export support.

There is speculation the new government may feel obliged to intervene if the yen becomes too strong. Or not. Given the present sorry state of Japan’s economy, government intervention might not succeed.

Reliable crystal balls are in short supply in Tokyo, but changes of one kind or another are considered likely.