The issue is the strength of the yen

Conventional wisdom would dictate that there are two economic issues before the Group of Seven summit: unemployment and the weakness of the dollar. But only supreme optimists could hope that the summit would have any impact in unemployment in the developed world; and though the weak dollar is the markets' current preoccupation, the dollar is not particularly weak by past standards - it has been much lower against both the mark and sterling in recent years.

So what, in as far as there is any single one, is the issue? I have a suggestion. It is, or rather should be, the strength of the yen. That is the currency against which the dollar is indeed weak, but this is (mainly) a Japanese problem rather than an international one.

The G7 summit - of course - will not deal with this issue except in the superficial sense that the US will bitch about Japanese refusal to buy enough US-made goods. It is, however, precisely because the G7 is so hopeless on this issue that it is worth a closer look at the reasons for the strength of the yen, and the consequences of it. From a simple investment standpoint, calling the turn of the yen is going to be one of the big investment issues of the next 18 months.

There is an obvious explanation, a less obvious one, and an intriguing conclusion.

The obvious explanation for the strength of the yen lies in the current account surplus. There are periods where the current account seems to matter greatly to the markets and periods where their focus shifts and any current account surplus or deficit is more than offset by capital movements. But taking one year with another, persistent current account surpluses will tend to drive a currency up.

The Japanese current account has not always been in surplus, though it seems a bit like that now. It was in trade deficit, not just current account deficit, as recently as 1980, and the surpluses did not really take off until 1983. But a decade of large surpluses, thanks to efficient manufacturing exporters, has turned what looked 10 years ago like a cyclical current account surplus into a structural one.

The less obvious explanation also focuses on the current account, but looks at the import, rather than the export, side. Japan does impose cultural and bureaucratic restrictions on imports, but these stem from insecurity. While it has a large surplus on international trade in manufactured goods, exporting three times as much as it imports, it also has a large deficit in non-manufactured goods, where imports are five times larger than exports.

Japan's current account is therefore greatly affected by swings in the price of non-manufactured goods, in particular food, fuel and raw materials, for these make up 55 per cent of total imports. The world price of these in dollars happens to be particularly low at the moment (though rising), and thanks to the rise of the yen, the price to Japan is even lower.

The effect is dramatic: energy imports rose in volume terms by 30 per cent between 1985 and 1993, yet the actual energy bill in yen fell sharply. The current account surplus is at least as much the result of cheaper imports as it is of Japan's manufacturing prowess.

This less obvious explanation leads to the intriguing conclusion that the Japanese current account surplus may be more fragile than the markets perceive. It is not going to disappear overnight, but one could very easily see a set of circumstances that would cut the deficit dramatically.

The first would be a rise in commodity prices and especially the oil price - the latter surely being an odds-on bet for the second half of the 1990s as demand from China and other East Asian countries builds up. A second would be the further squeezing of manufacturing exports from Japan itself, as its corporations combat the high yen by switching production to overseas plants. A third would be any weakening of the yen, perhaps in response to one and two above. As the yen weakened the cost of imported raw materials would rise, so that at least in the short term the deficit would be cut. The weakening of the yen would therefore tend to become self-reinforcing.

To say all this is not to predict an early collapse of the yen. The message is more subtle. It is that once there is a clear turn in the yen, which may well come before the end of the year, it could move quite quickly back towards its purchasing power parity value of about Y150 to the dollar. It probably will not reach that level, but a rate of, say, Y120 is perfectly credible; certainly more credible than the Y85 rates being cited by some investment banks.

One further point. Once the authorities in Japan are convinced that large current account surpluses are not in its national self- interest, those deficits will be cut. This view is not yet established in Tokyo, but it is gaining ground.