The global demand for the Japanese currency has been on a steady downward trend ever since Tokyo chose in 2012 to invigorate its export-driven economy with an unending avalanche of yen liquidity.

Over the last nine years, the yen has lost 35.4% of its trade-weighted value.

Nearly one-third of that exchange rate loss occurred during the last twelve months. A bit of a shock that’s prompting the soul searching about the way forward in a country where monetary policy remains the only instrument of cyclical demand management.

Indeed, with a budget deficit of 7% of GDP and an astounding public debt of 242% of GDP, the fiscal policy has no room for tax cuts and/or rising government spending, while the structural reforms of social and economic problems still remain perpetual nonstarters.

The problem now is that the hugely expansionary monetary policy may have run its course.

Exports did not fire up domestic demand

The cheap yen has driven exports since 2012 at an average annual rate of 2.6%, but that failed to set in motion the Japanese export-driven growth model – where overseas sales stimulate business investments, which, in turn, raise employment and incomes that trickle down to reviving household spending.

None of that happened. During the last nine years, Japan’s economy grew at an average annual rate of 0.5%, which means that domestic demand (mainly private consumption and business investments) declined 2.1%.

So, what now? Well, continue to push exports?

Exports to where?

In the first 11 months of last year, China, including Hong Kong, took $180 billion, or more than one-fourth, of Japanese exports.

That dwarfs Japan’s export sales to the U.S. (18% of the total) and the EU (9.3% of the total).

But there is a much more important difference here for those Japanese export markets.

Tokyo’s political and security relations with Beijing are strained with increasingly hostile actions and clashing political and military alliances. Japan and China are at odds about contested maritime borders in the East China Sea, and Japan is party to diplomatic and military organizations (such as QUAD, consisting of U.S., Japan, India and Australia) designed to oppose China’s challenges in Asia and beyond.

How much business can Japan expect to transact with China under those circumstances?

That has been a lingering question for many years when Japan was trying to manage its Western alliances while remaining on speaking terms with China, with a constant flow of high-ranking Japanese parliamentary and business delegations going to Beijing to keep repairing politically damaged ties.

Japan merging with the trans-Atlantic community

It seems that there is not much room left for that anymore. The best indicator of that are Japan’s small and declining direct investments in China. They were almost cut in half to $6 billion last year from $11 billion in 2020.

The statement of Japan’s former Prime Minister Shinzo Abe that China was a crucially important country for Japanese economy appear to have been lost on his successors.

How much, and how fast, could the U.S. and the EU compensate for Japan’s possible business losses in China?

Japan seems to be working on that. In the first eleven months of last year, exports to the U.S. and the EU were growing at respective annual rates of 15% and 21%, and their total amount of $186 billion was slightly higher than exports to China.

Those are important results. But Japan’s strongly growing direct investment flows to the U.S. and the EU show Tokyo’s real strategic orientation.

During the first three quarters of last year, Japan placed $48.4 billion in its American greenfield projects, in addition to nearly $100 billion in the previous two years. Over the same period, Japan added $24 billion to $170 billion of direct investments in the EU.

Those numbers show Japan’s rapidly merging process with the trans-Atlantic economic and political community.

Politically, that’s where Japan belongs, and there is no doubt that its Western partners will accommodate its economic integration. Japan, however, will have to make serious efforts to open up its economy. The EU will insist on that.

The role of the yen in that new economic environment is likely to continue to shrink, because most of Japan’s trade and investment transactions will be conducted within the dollar-euro currency area. One can also expect that the changing structure of Japan’s growth model could lead to less strained demand management policies.