Currency Carry trade.Started with the Japanese Yen, continuing with US Dollar and can start with Chinese Yuan. The interesting observation is that it has the huge capability to effect the direction and magnitude of global capital flow. (BIS Survey on “Evidences of Carry trade”, September,2007) .
What is currency trade? Currency carry trade i.e. borrowing short term loans in low interest currency (funding) and investing in high yielding currency (target). The three conditions to ensure profitability are stable funding currency, interest rate differential and appreciating target currency. It provides liquidity in the target currency country, thus reducing the cost of capital for that country. It comes to emerging market mainly in the form of FII, providing much needed liquidity in the countries. According to Kotak Mahindra Bank, the increase in FII 15.8% in 1st quarter of 2009 can be attributed to Dollar carry trade. It provides better investment opportunities for the investors worldwide.
Sounds harmless, right?
Carry trade is a wave, until it turns into a tsunami by unwinding. Any expectation of target currency depreciation, funding currency appreciation and decrease in interest rate differential can lead to massive sell off of the target currency, crashing the stock markets. As can be seen from major stock market fall of 2007 and 2008, when the appreciation of Yen took place, even Japan’s economy was deep in recession. The recent fall in Nikkei is also being attributed to the unwinding of Yen carry trade.
The evidences of carry trade are everywhere. The continuously falling Dollar Index, the foreign holding of Japanese reaching 7 year high and China issuing dollar denominated bonds etc etc. The so called “green shoots” like” rising asset prices, rise in stocks indices.” seen as revival of world economy can be just one of the overshoots of omnipresent (well almost!!) dollar and yen carry trade.
The thing that strikes me that what if the unwinding is in offing? What if as the world economy recovers, the dollar appreciates and the interest rate rises to check inflation and widening deficits in US? What if the unwinding of dollar carry trade makes the growth of emerging markets go for a full toss? Will it push the world economy back into another recession? What is the probability of this happening?
Carry trade does carry many million $“questions “in its womb.
Related Links:
1. http://www.bloomberg.com/apps/news?pid=20601101&sid=aEx0ou2Z7ssA
2. http://www.dnaindia.com/money/report_-carry-trade-lifts-fii-stakes-for-first-time-in-7-quarters_1280334
3 comments:
Well, It seems that the dollar carry trade is already in action for the past some time.
As per the Bloomberg interview of FX Concepts hedge fund CEO, Jhon Taylor (The fund has 9 billion under management), the activity in this space was highest in the month of July, 2009.
The supporting factor is the increasing auction size of the FED for funds. This is putting pressure on the interest rates to be low for some time in future. The traders poll for the appreciation of the dollar also showed only 3 % positive results. The place where the money is getting parked is emerging markets.
Now once the global economy will be on the path of recovery, we may find some of the signs of this dollar carry trade in the emerging markets, by looking at the stock market crashes or the decrease in the asset prices where the money is getting parked right now.
Mihir
In the present scenario when we are hearing a lot of talk about "green shoots" of economic revival there is a significant situation which we need to have a closer look at. All the emerging asian and european equity markets have seen a similar fall and rise from the start of 2009.Surprising to note an interesting point that when Jan 09 turned out to be the worst month since 1916 for markets world over, down 6-10%;hedge funds outperformed the market by nearly 10%(Hennesse Hedge Fund Index). This index comprises of 3500 hedge funds with different weights given to different strategies. To add to the surprise the Arbitrage index was the leader in this growth. Thereby pointing towards some kind of carry trade activity. Thus the money is searching yield at present as US is piling on the deficits to support its economy. With such vast amounts of $/Yen floating at lowest rates there is a strong possibility that these present stock markets rallies are funded by carry trade activity.
Think outside the box to find the right solution.
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