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The Carry Trade: Borrowing from Yoshi to Pay Ahmad and Ping

by LondonYank Wed Mar 15th, 2006 at 07:29:25 AM EST

When my mom struggled with credit card bills, she would "borrow from Peter to pay Paul" by writing a check on one card to fund payment on another.  As long as there was credit, we could live beyond our means.  

America has been borrowing from Yoshi (Japan) to pay Ahmad (oil states) and Ping (China).  The Bank of Japan's quantitative easing of the last 5 years may become a cautionary tale of unintended monetary consequences.  Within Japan growth was slow and inflation subdued, but outside Japan asset bubbles started popping up in real estate markets, bonds, equities and commodities.  The linkage between Japan's ultra-loose credit and foreign asset bubbles was the Carry Trade - borrowing in yen and swapping into other currencies for investment.

Now the Bank of Japan senses growth at home and is tightening liquidity and hinting at higher interest rates.  The last time there was a threat to the yen/dollar carry trade - in 1997-98 - we had the Asian currency crisis, the Russian debt default and the collapse of Long Term Credit Management hedge fund.  And that was a false alarm.  

From the diaries - whataboutbob

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.

We've been living on plentiful, cheap, borrowed money.

First it stops being plentiful, then it stops being cheap, and then it needs to be repaid at the worst time...

From overhang to hangover.

(comment also crossposted from the dKos diary -http://www.dailykos.com/story/2006/3/14/104326/163 - which deserves to be recommended!)

In the long run, we're all dead. John Maynard Keynes

by Jerome a Paris (etg@eurotrib.com) on Tue Mar 14th, 2006 at 11:26:13 AM EST
DailyKos seems rather subdued this week.  Everyone must be busy doing their taxes or something.

I wasn't expecting much comment on the carry trade, but I do regret that there wasn't a better reception for my YearlyKos side trips diary yesterday as I was trying to impress my Dad.

by LondonYank (LondonYank (at) aol.com) on Tue Mar 14th, 2006 at 12:37:34 PM EST
[ Parent ]
There's a rhythm to commenting I haven't quite got the hang of yet. It feels something like a herd motion. Around here comments are light early in the week and tend to ramp up in the middle of the week. They sort of follow hits/visits but only sort of.
by Colman (colman at eurotrib.com) on Tue Mar 14th, 2006 at 12:43:00 PM EST
[ Parent ]
Hey London Yank! Welcome to EuroTrib!! (or...welcome back?) Anyway, I've always like your dkos articles, so glad to see you posting here...and hope more follows. Good and informative article, written so that someone like me (as my sister once said, I didn't get the money genes) can understand it...thanks!! Of course, not the cheeriest of topics, but Jerome has warmed us all up already...

(By the way, are you back from the Middle East?)

"Once in awhile we get shown the light, in the strangest of places, if we look at it right" - Hunter/Garcia

by whataboutbob on Tue Mar 14th, 2006 at 01:12:34 PM EST
Many thanks for the warm welcome, Bob.  I've been back in London since last September, but I'm angling for more work in Dubai.  It's the happening place to be!
by LondonYank (LondonYank (at) aol.com) on Tue Mar 14th, 2006 at 02:37:59 PM EST
[ Parent ]
Kind of a tangential question, but I'm still getting my head around this global "glut of labour, shortage of capital" thing.

This BoJ lending, was it feasible only because Japan has run a surplus for so long during the boom times? Or is it just imaginary credit anyway?

by Metatone (metatone [a|t] gmail (dot) com) on Tue Mar 14th, 2006 at 04:23:28 PM EST
Central banks create money when they credit reserves to banks.  As banks only need to hold 4 percent of reserves to assets ratio, they can lend 25 times as much as they are given by the central bank.  This expansion factor explains how central bank credit blooms as a credit expansion in the economy, spurring cheap credit and "exuberance".  Japan has been very exuberant for the past five years - but only towards foreign investment.
by LondonYank (LondonYank (at) aol.com) on Tue Mar 14th, 2006 at 05:15:37 PM EST
[ Parent ]
Hm, I guess I wasn't clear.

I appreciate the general mechanics, but the question is what are the fundamental limits on a central bank? Why can the Fed (for example) not choose to replace the dwindling liquidity itself?

I understand that the BoJ had internal reasons for having a low interest rate (no growth in Japan) but if you assess that this liquidity is keeping the US going, why is it not in the interest of Bernanke to pump in liquidity.

by Metatone (metatone [a|t] gmail (dot) com) on Tue Mar 14th, 2006 at 05:58:39 PM EST
[ Parent ]
Does not that depend on general trust in your currency? If I have understood previous diaries and blogentries on this subject the Fed has also pumped in liquidity for quite some time now.

As long as it is bought by someone in exchange for goods it is all fine, and most of the dollars has ended up in the Chinese central banks vaults (though, of course, it is all numbers so there is no real vault with tons of dollar bills). As the Fed has stopped publicising the amount of liquidity they pump (the M3), it is not unreasonable to assume that the Fed is rather worried about the amount they have already pumped. A serious disturbance, as the BoJ raising their interest and disrupting the carry trade, could probably not be met by even more Fed liquidity without seriously undermining the credability of the dollar. In fact the BoJ raising interests could be the strain that breaks the camels (dollars) back, with everyone rushing to sell their dollars.

If this answer made any sense, most of the credit belongs to Jerome, Colman, Bernhard (at moonofalabama) and Billmon. All my international economics comes from blogs, I will soon finish my Bachelor of bloggish economics :)

All misconceptions are probably mine though.

Sweden's finest (and perhaps only) collaborative, leftist e-newspaper Synapze.se

by A swedish kind of death on Wed Mar 15th, 2006 at 08:35:11 AM EST
[ Parent ]
On another tangential point, over on dKos you talk a bit in a comment about Hedge Funds and quote an LTE that talks about LTCM. Was that your LTE, or just a view you appreciate?

I was going to comment right there, but I realised that since I look at dKos very infrequently it'd be better to put it here.

It struck an interesting chord with me, because as you may be aware some of those proprietary algorithms were developed by people with connections to MIT. I was an undergrad there at the boom time of LTCM and there were a number of leaks of the algorithms around campus. Now, unfortunately, none of those leaks could be confirmed in a deep manner. Even more unfortunately, everybody and his dog on campus who had seen them said they contained some fundamentally flawed assumptions, notably about the possible range of certain conditions.

The thing is, whilst times were good, they did make money and I'll happily bet there is at least one major hedge fund using the old LTCM algorithms if not unmodified, then certainly still vulnerable to the same boundary effects.

Hm, not a cheery thought.

by Metatone (metatone [a|t] gmail (dot) com) on Tue Mar 14th, 2006 at 04:35:25 PM EST
It was my LTE.  I get on very well with the FT.  It's my morning paper.  :-)

I can well believe that the algorithms doing the rounds were flawed in their assumptions, as that is what brought LTCM so close to collapse.  They discounted the "flight to quality" phenomenon during the 1987 Asian currency crisis, so got caught heavily betting the wrong way.  

I find it reassuring that even Nobel Laureates and former deputy governors of the Federal Reserve and Big Swinging Dicks from Wall Street can get it terribly wrong sometimes.  If the world were entirely predictable to the right formula, it would take the fun out of markets.  

by LondonYank (LondonYank (at) aol.com) on Tue Mar 14th, 2006 at 05:20:15 PM EST
[ Parent ]
Well, it is nice that people get things wrong, but not always when they think (as in LTCM and I fear, quite a few current hedge funds) they cannot get it wrong. The shock can be bad for the system...
by Metatone (metatone [a|t] gmail (dot) com) on Tue Mar 14th, 2006 at 05:59:41 PM EST
[ Parent ]
... I never "get", even with a moderate amount of math in my head. But a subject worthy to be taught in. As whataboutbob, I extend my welcomes and hope for further enlightments in these subjects. I still have stocks and only this year they're higher before the 2000 collapse. This kind of talk is scarying the newbie.


by Nomad (Bjinse) on Tue Mar 14th, 2006 at 04:56:15 PM EST

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