Demystifying Carry Trade Matrix: Economic Times, 16th May 2007

Demystifying carry trade matrix

The emergence of carry trade has made Japan the centre of the fi-nancial markets. The low interest rates are responsible for this sce-nario as has been warned by the IMF in its latest ‘Global Financial Stability Report’. Carry trade is a simple process where one borrows in countries that have low interest rates and converts the local currency into another currency and invests or lends the same in a higher yielding instrument in the converted currency. The gain made could be substantial, and the system works on the premise that exchange rates remain stable. Japan has traditionally been a country with low interest rates, with borrowing rates of not more than 50 bps. One can borrow at 0.5% and then convert it into dollar or rupee and invest the same in a Fed bond or lend the same in India. The net return could be say 4.5% in the US or as high as over 10% in India in case a bank chooses to be the player. The table gives an illustration of the net gains to be made by bor-rowing in three currencies i.e. yen, dollar and euro, and investing in different countries. The cross-country net returns assumes that one borrows in yen at 0.5% and then invests the same in the 10-year risk free government bond in the other country. Three features emerge from the table. Firstly, borrowing in yen or euro is better than borrowing in the dollar. Secondly, the developing countries provide greater opportunities for carry trade as their interest rates are higher. Lastly, carry trade within developing countries does not make much sense. However, for carry trade to be successful, exchange rates need to be stable. In particular, the country from where one borrows to indulge in carry trade should not appreciate. For example, let us take the case of where one borrows in the yen and converts the same to a dollar. Let us assume the rate of one dollar is 120 yen. If the yen appreciates to say 110 yen to a dollar, then when the loan has to be repaid, the borrower has to bring in around 1.1 dollars. Now just think of billions of yen getting translated into various currencies on account of low in-terest rates in Japan. Any appreciation in the yen, can create tremen-dous financial instability as borrowers will have to move out that much more currency for conversion purposes. This leads to two pertinent questions. The first is whether this is potentially destabilising. The answer is yes, because the future of the dollar is quite bleak to begin with. A current account deficit of over 6% of GDP is not sustainable and the dollar is going to keep weaken-ing for adjustment. The burden of adjustment would bend heavily on Japan and Euro zone with China refusing to take part in this adjust-ment. The raising of rates by the Fed has not helped to lower con-sumption to any significant extent so far. While Japan would ideally resist appreciation as it impedes its exports growth, beyond a point it may be difficult to resist further appreciation. And given that most currencies including the rupee are tied to the dollar, the same chain would hold.