The Carry Trade involves borrowing in one currency and swapping to other currencies to invest elsewhere.  The most popular carry trade is yen to dollar, as you can borrow yen at near zero rates and make a risk-free 4.5 percent on US Treasuries.  As long as the yen remains depressed against the dollar, which it has been with rising US interest rates and a faster growing US economy, then you can buy the yen you need to repay your loan later for less and pocket the profits.

The carry trade finance wheeze falls apart if rising interest rates in yen mean that you pay more interest on your loans, and an improving yen/dollar exchange rate risks your dollars buying you less yen when the time comes to repay the capital sum of the loan.  In those circumstances, a yen borrower speculating in dollars or any other underperforming asset could lose a lot of money very quickly.  

William Pesek, Jr., a Bloomberg columnist, provides a useful analysis of the likely consequences of unwinding the yen/dollar carry trade.  Two quotes struck me:

``All liquidity starts in Japan, the world's largest creditor country,'' said Jesper Koll, chief economist for Japan at Merrill Lynch & Co. ``When rates go up here, rates go up everywhere.''

And this description of how a collapse in asset values could be precipitated:

It would start slowly with speculators suddenly closing positions that are becoming more expensive: dumping Treasuries, gold, Shanghai real estate, shares in Google Inc. or whatever else they used yen borrowings to bet on. The chain reaction would accelerate once the mainstream media jumped on the story.

We know that the carry trade and hedge funds are behind much of the speculative froth on markets the past five years, but we don't know just how much.  There are no measures of the carry trade, and no transparency of hedge fund investment or leverage.  Estimates put the yen/dollar carry trade at well over $1 trillion, but no one knows what the number becomes once leverage is added to the speculative equation.

We also don't know what happens when the carry trade unravels as it never has before.  Floating exchange rates have only been around since 1974, globalised investment markets only go going in the late 1980s, and hedge funds on their current scale only blossomed since the late 1990s.

Evidence of the unwinding of the yen/dollar carry trade is beginning to show through.  Most worrying for the USA is that its huge deficits may not be easily financed without the yen financed carry trade.  

From Forexnews.com:

The 38% drop in December net foreign flows was largely due to the 66% decline in net purchases of Treasuries, which was caused by a 76% decline in non-official institutions' purchases (usually hedge funds) of US treasuries. The role of private institutions is especially essential considering that they accounted for 69% of the foreign purchases of Treasuries. The over-concentration of private flows into US assets raises the question of sustainability regarding the US financing of the US trade gap.

From Bloomberg:

``Central bankers across the world are pre-occupied by the removal of excess liquidity,'' said Sandra Petcov, an economist at Lehman Brothers in London. ``The world economy is growing rapidly and after a sustained period of very high liquidity provision, the stimulus is now being removed.''

The BOJ said on March 9 it will cut the cash provided to lenders to about 6 trillion yen ($50.7 billion) from as much as 35 trillion yen over the next few months, ending a five-year policy of flooding the economy with money to fight deflation.

 

Any time liquidity is withdrawn from markets, bad things are likely to follow.

Ben Bernanke has blamed those thrifty foreigners for causing a "savings glut" that financed American profligacy.  He may find that their return to responsibile lending is much more dangerous as they tighten global liquidity, force unwinding of the hundreds of billions of dollars worth of investments financed with the carry trade, and deprive the US economy of the oxygen of easy credit that has sustained its modest growth for the past five years.