The Carry Trade Unwinds

One big result of the recent turmoil in the financial markets has been the unwinding of the carry trade.

The Carry Trade is where traders borrow in a low interest rate currency and invest the proceeds in a high interest rate currency. It can be extemely dangerous, especially if the currency you have borrowed in strengthens and ends up higher than it was at the point when you borrowed. Abu Nidal of Polly Peck fame, came a cropper in the 1980's when he borrowed in low-interest Deutchmarks and invested in high-interest Lira and got wiped out as the Deutchmark strengthened sharply against the Lira (the Lira was dropping due to inflation in Italy).

In recent years the Carry Trade has involved the Yen. In 2001 the Japanese cut interest rates to zero, which meant that people borrowing in Yen paid no interest (i.e. it was "free" money). In addition, the Bank of Japan, under pressure from the Japanese government and Japanese business, started intervening in the currency markets to hold the yen down everytime it got close to $1:Y100. The notion that you were going to be protected from a strengthening yen by the Japanese authorities made the Yen Carry Trade irresistible - free money and no currency risk. In the last year the Japanese authorities have increased interest rates to a high of 0.5% - still way too low to deter carry traders. It hasn't just been hedge funds attracted to this trade. Japanese citizens have also been borrowing in their own currency and then selling yen to buy whichever currency has high interest rates. Australia and New Zealand have been favourite destinations.

Everytime they sell the yen to invest abroad, the Yen weakens, which makes Japanese business very happy. But it creates problems for the rest of the world, which has had to cope with a wall of Japanese money seeking a home and bidding up everything in sight. Without the Carry Trade, the Yen would be much stronger as Japan runs a huge trade surplus, has non-existent inflation (which means that the currency is holding it's purchasing power), has come out of it's decade-long recession and has low unemployment.

However in the last week, there are signs that the institutional investors are unwinding the carry trade. Australia's currency slumped 8.8% against the yen, as money rushed out. The New Zealand dollar slumped 9.6% against the yen. Indeed the Yen has strengthened against all 16 major currencies in the last week including the dollar, the euro and sterling. Carry trade money has flowed into emerging markets and commodities too - therefore as the trade unwinds all these should fall as investors sell assets in order to go back into the yen and pay off their loans.

Obviously people invested in these falling stock markets will squeal, but the unwinding of the carry trade should be a good thing for the real economy. A major source of current world-wide inflation has been commodity prices rising (the tradtional souce of inflation, wage demands, has been subdued by contrast). The world will be a healthier place if the price of oil, copper, nickel and the rest fell. We are all better off with a more realistic Yen exchange rate too. Japan has enjoyed an unfair advantage exporting into Europe and the USA due to the artificially depressed Yen. Japanese companies will suffer from a rising yen though - and this is why the Nikkei slumped more than any other exchange last week.

Central bankers are starting to make noises about the yen too. According to Bloomberg,

``It's fundamentally a distortion'' to have Japan's interest rates as low as they are, Stevens [Glen Stevens, Governor of the Reserve Bank of Australia] said. ``The sooner the Japanese interest rates are able to be normal again the better from the point of view of the global-financial system.'' ......South Korea's Finance Minister Kwon Okyu said this week carry trades based on the Japanese currency threaten global markets.

It's believed that Japanese interest rates would have to rise to 2% to kill the carry trade. The big question is will the Japanese allow normalisation? In the mid 1980's they were persuaded by the Reagan administration to allow the yen to strengthen very sharply to help America sort out her trade deficit. It resulted in Japan going into a deflationary recession that lasted a decade. As a result the Japanese don't see any value in co-operating with the rest of the world - they see "co-operation" as an euphemism for getting screwed and they prefer to concentrate on their own needs and let the rest of the world get screwed instead.