17 October 2007

Carry Trade

Kasia Burzynska explains how to print money on your own. Kids, don't do it at home...

Printing money is not that difficult. Global traders have been doing it over the past few years thanks to the magical machine called carry trade. It all comes to the strategy in which an investor borrows a low-yielding currency and uses the funds to buy a higher-yielding one. Yen carry trade is the best example.

When the Japanese economy faced the crisis in the 1990s, the Bank of Japan decided to maintain for a very long time zero interest rates policy. Till today the rates are kept very low – at the moment it is 0.5 percent. On the other hand, the benchmark rate in Euroland is currently 4 percent, in the United States 4.75 percent and in New Zealand as much as 8.25 percent.

The traders have been eagerly taking advantage of this yield gap. They could borrow 10 000 yen from a Japanese bank, convert the funds into New Zealand’s kiwi and re-loan it out. The spread of 7.75 percent (i.e. 8.25 percent - 0.5 percent) makes up profit. And it can be even bigger when we take leverage, that is popular method of increasing profit by using borrowed money, into consideration. Common leverage factor of 10:1 boosts profit to 77.5 percent.

But carry would not be that interesting without risk. And carry trade can be a risky business. First of all the interest rates can change. The investors got used to very low interest rates in Japan and take it for granted. But after nearly 6 years of zero interest rates policy, Japan’s central bank raised rates to 0.25 percent in July 2006, then to 0.5 percent in February 2007. As the economic situation in Japan seems to be gradually improving, the Bank of Japan is likely to continue the hikes (Chavez-Dreyfuss, 2007) and the narrowing of the interest rate gap makes carry trade less attractive. Secondly the cross-currency carry trade involves the risk of moves in the exchange rate. If the lower-interest rate currency rapidly rises, the cost of debt relative to assets increases and at the same time the value of assets relative to borrowing decreases. That is why any strengthening of the yen worries traders. They can lose a lot in no time without a warning.

The investors must mind the risk from other sides too. Very often the money from borrowing the yen is invested in places like emerging markets, which are more unpredictable and riskier. When the economic slowdown comes, the risky assets will lose in value, which will lead to the situation in which traders will want to receive their money back to repay the debts in yen. This may make the yen rise and even more traders will have to go back to the yen, deepening the trend.

What is even more interesting, no one really knows how much capital in carry trade is involved. Its total size is estimated to as high as $ 1 trillion (Lenzner, 2007). But theoretically it should not even exist or at least not for long. The carry trade is against economic theory that says the high-yield currency compensates investors for the risk of depreciation. Similarly the low-yield currency should have the tendency to appreciate. Nevertheless, yen remains weak. The very actions of traders can be a good explanation of why it happens. They sell yen and buy other currencies. The more investors enter into carry trade the more they strengthen the tendency for the yen to fall and other currencies like the kiwi or won to rise.

Carry trade has been used by the Japanese households to get higher returns by shifting the money from their bank accounts to relatively secure but higher–interest-rate assets like New Zealand, American or Australian bonds. International investors, like hedge funds, have found carry trade applicable also for more speculative, leveraged trades.

All these flows of cheap money cannot stay without impact on global economy. The Economist’s Big Mac index from July 2007 suggests that the yen is undervalued against the dollar by 33 percent. The weak yen favours the Japanese exporters. And the high-yielding currencies are getting stronger. As O'Brien and McIntyre (2007) report Australia's dollar has gained 18 percent versus the yen in the past 12 months and the New Zealand dollar strengthened 12 percent. The same tendency is seen in the value of the won – it has been rising against the dollar and meanwhile the yen has dropped against the dollar as well as the won. That is why South Korean Finance Minister Kwon Okyu says the low value of the yen is “deepening global imbalances” and sees carry trade as “a potential threat to the international financial markets”. Carry trade hurts a lot of exporters in South Korea or New Zealand too, first of all worsening the competitiveness of small and medium-sized businesses.

Latest report from UN Conference on Trade and Development (2007) draws attention to the danger of unwinding of carry trade. It can be a threat especially for developing countries. “The web of different funding and lending currencies of otherwise unrelated economies causes the countries involved to become interdependent and subject to reversals of perceptions and to contagion effects”. Unexpected changes in exchange rates can trigger “a large unwinding of investments and this can spill over to emerging market economies”.

Carry trade is a major source of financial liquidity in global markets. It causes asset prices to rise worldwide. Unwinding of carry trade and thus drying up of this source can create market volatility. When the traders suddenly begin to sell the assets in order to raise cash to pay back their short-yen currency positions, the yen will jump accelerating further selling. And so the declines will deepen, which can lead to global crisis.

For the time being, yen carry trade still exists and still works. But it becomes even riskier. Former Federal Reserve Chairman Alan Greenspan said: “at some point it's got to turn”.

Author: Kasia Burzynska


Adam, S., Batchelor V. (2007), “APEC Says Flexible Currencies Will Reduce Imbalances”. Bloomberg.com.

Arnold, W. (2007), “Yen carry trade falling from favor”. International Herald Tribune.

“Carry on living dangerously” (2007). The Economist.
“Carry on speculating” (2007). The Economist.

Chavez-Dreyfuss, G. (2007), “Japan inflation shock could fuel carry unwind”. Reuters.

Chen, S.-C. J. (2007), “A Yen For Currency Trading”. Forbes.com.

Chen, S.-C. J. (2007), “Yen Carry Trade Unraveling Faster”. Forbes.com.

Da Costa, P. N., Kadoya T. (2007), “Greenspan says carry trade has limited room to run”. Reuters.

Lenzner, B. (2007), “A Meltdown From The Yen-Carry Trade?”. Forbes.com.

O’Brian, E., McIntyre E. (2007), “Australian and N.Z. Dollars Gain on Demand for Nations' Bonds”. Bloomberg.com.

Pesek, Jr. W. (2006), “Japan's Boom May Explode Yen-Carry Trade”. Bloomberg.com.

Smith, P., Pilling D. (2007), “Japan faces carry trade scrutiny”. Financial Times.

“What keeps bankers awake at night?” (2007). The Economist.

Young, A. (2007), “Eye on the Carry Trade”. Business Week.


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