[R-G] Beware the Unwinding of the Yen Carry Trade

[Yoshie Furuhashi]

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Beware the unwinding of the yen carry trade
By David Pilling
Published: October 29 2008 20:15 | Last updated: October 29 2008 20:15

We are used to the concept that when a butterfly flaps its wings in
Brazil all manner of unspeakable things happen in New Jersey and
Tunbridge Wells. But many have struggled to understand the link
between Mrs Watanabe's mood swings and the price level of exotic
currencies, distant equity markets and sundry commodities. What, in
short, does a Japanese housewife have to do with the price of tea in
China?

Mrs Watanabe is crude shorthand for Japan's $15,000bn pool of savings,
the deepest in the world and worth more than the annual economic
output of the US. These vast resources are somewhat apocryphally
marshalled by Japanese women, who have traditionally held a firm grip
on family finances.

In fact, Mrs Watanabe is very crude shorthand indeed: she is just as
likely to be Mr Watanabe, the manager of a Japanese life assurance
company portfolio, or Mr Smith, an American hedge fund manager,
borrowing in yen to buy South African rand, US mortgage-backed
securities or tea futures. Whoever, she is, she borrowed cheaply in
yen, courtesy of Japan's rock-bottom interest rates – which have been
stuck between zero and 0.5 per cent since 1999 – and put the money in
higher-yielding assets abroad.

The important thing to know about Mrs Watanabe is that, temporarily at
least, she has all but stopped flapping her wings. In the past days,
as spectacular moves in global currencies reveal, the carry trade has
been violently unwound. With last week's panic retreat from risk
assets of almost every description came a dramatic rise in the yen,
partially reversed in the past two days on rumours of a Japanese
interest rate cut. Even so, the yen was trading on Wednesday at about
Y97 to the dollar, the other "safe haven" currency, against a
remarkably steady Y110-Y120 in recent years.

The yen carry trade has not been the only cheap source of liquidity in
recent years. But Ashraf Laidi, chief currency strategist at CMC
Markets, reckons it has been the biggest. He quotes figures suggesting
that Japanese households alone, discounting savings mediated through
life assurers and other institutions, have mobilised $500bn in
outbound funds. That leaves aside speculators, who have borrowed
unknowable amounts of yen to invest abroad, often on highly leveraged
terms.

Just as state bank bail-outs risk moral hazard, more recklessness and
the need for future bail-outs, so the unwinding of the carry trade
carries with it the danger of the next great bubble. In Japan, the
central bank appears to have reacted to a rising yen and sinking stock
market by contemplating the uncontemplatable: a rate cut. Even the
rumour of such has provoked a mini equity rally and a weakening of the
currency.

This is poison for the BoJ. It hated having to keep rates low, fearing
that cheap money can cause bubbles in real estate, in capital
investment and in the carry trade. Its sightings of inflationary
danger everywhere provoked mirth among outside experts. But few are
laughing now.

The BoJ might feel vindicated. Even so, it may have to do the opposite
of what it wants by cutting rates to avoid the danger of sharp
economic contraction. The risks are compounded by the renewed danger
of deflation, a ghoulish presence for a decade that, thanks to sliding
commodity prices, could come back to haunt Japan.

If Japan really is about to reverse course towards zero interest
rates, it will once again become the source of almost free money for
anyone with an appetite to invest. Worse even than that, says Mr
Laidi, is the potential for an even more dangerous dollar carry trade.
The Federal Reserve has been desperately cutting rates, and lopped
another half point off again on Wednesday. The nearer US interest
rates approach zero, the greater the incentive to move dollars into
higher-yielding assets elsewhere.

These gyrations do nothing to solve the underlying problem, which is
that Asia has an excess of savers and the US and Europe an excess of
spenders. Unless that is solved, the world seems condemned to repeat
the swings of recent years, as capital is arbitraged between countries
where money is cheap to those where it is expensive.

Until recently, one of Mrs Watanabe's favourite wheezes was to take
her Japanese yen and put them in Australian dollars, earning her a
roughly six-point interest rate gain. This week, she – and those who
travel with her – will not have missed the fact that Iceland just
raised its interest rate to 18 per cent. That is a 17.5 point
differential with Japan, and counting. Krona, anyone?

david.pilling at ft.com

More columns at www.ft.com/pilling