THE UNWINDING OF YEN CARRY TRADE
Bal Thakur
The world is awash with excess liquidity resulting due to the policy of Quantitative Easement (QE). QE is the policy of Central Banks to print unrestrained fiat currencies (money) to pump-prime the economy, fight deflationary pressures and to stimulate growth. In addition above, Central Banks also resort to Benign Interest Rate and Weak Currency Policy to make their economy competitive.
Japan for the last 18 years is in the grip of deflation and to kick-start the economy and to make its economy and exports competitive, Bank of Japan (BoJ) has resorted to three-pronged policy of (i) Quantitative Easement (ii) Zero Interest Rate Policy (ZIRP) and (iii) Weak Yen. Policies of QE, ZIRP and Weak Yen has offered Hedge Funds great opportunity to avail Credit in Japan at a Zero Cost and to utilise the proceeds in other markets and thereby making handsome returns in the process.
The availment of interest rate arbitrage, as a speculation strategy, available in two different markets is popularly known as “Carry Trade” and money raised in Japanese Currency and utilized elsewhere is known as “Yen carry Trade”.
Let us take an example of ‘Yen Carry Trade’. A trader borrows a billion Yen from a Japanese Bank at a Zero Interest rate and converts the funds into US Dollars and buys US Treasury Bonds at 5%. By entering into such an arrangement, the trader enjoys interest rate arbitrage of 5% till the time the Exchange Rate between two currencies remain the same.
However, the underlying risk in the Carry Trade is the uncertainty of the Exchange Rates. If the Yen rises vis-à-vis US Dollar, then the value of US Dollar denominated asset will fall vis-à-vis Japanese Yen and the Trader will have to book losses. However, being primarily export driven economy, Japan has not been favourably inclined for appreciation of Yen. As the traders were aware of this stated policy of BoJ, these speculative traders and Hedge Funds had a field day and have taken huge leveraged Carry Trade positions.
Moreover, QE policy of BoJ resulted in massive increase in Japanese Monetary Base from 650 Trillion Yen in 2001 to 1100 Trillion Yen in early 2006, without any commensurate and perceptible growth in Japanese Economy. This has resulted in infusion of excessive liquidity of 500 Trillion Yen, in a short span of 5 years, in the world Financial System and that too at a Zero Interest cost.
The substantial increase in liquidity at an absurdly low interest rate of zero percent enable the Hedge Funds who are pure speculators in nature, to take huge speculative positions in Trillions of Dollars in complex Derivate financial products (Bonds, Currencies, Stocks, Gold, et al). The huge Yen Carry Trade derived liquidity in Financial Markets in the last five years resulted in spiraling northward movement of price of all asset class which is the genesis and raison d’etre of the Secular Bull Run across all asset class witnessed in recent times.
However, Japan is slowing coming out of deflation and the economic growth is putting upward pressure on Japanese Interest Rates. As the overnight interest rates in Japan is hitting 0.10% ceiling limit at a regular interval, BoJ has to desperately pump in massive amount of Yen in the system to keep the interest rates in check. However, with Gross National Debt of 150% of GDP, inflationary pressures, surge in exports, and positive economic growth, BoJ cannot keep ZIRP policy for long and will have to increase the interest rates and will have to resort to tightening of monetary base and dispense with QE policy.
Increase in interest rates invariably results in strengthening of Currency. Increase in Interest Rates and Hardening of Japanese Yen will make Yen Carry Trade unviable and will result in unwinding of speculative Derivative Products. This may create massive world wide financial upheaval as speculative derivative products across all asset class will come under extreme financial strain. The tightening of the Japanese Monetary Base, increase in interest rates in Japan, hardening of Yen vis-à-vis U S Dollar will force the traders to unwind the Yen Carry Trade positions causing mayhem in the financial markets and may result in the end of secular bull run, which at present has taken in its grip the entire asset class.
Moreover, structural deficiencies in US economy is a cause of great concern for the world financial system. With fiscal deficit of more than 400 Billion Dollars and Trade Deficit of approx. 900 Billion Dollars and substantial External Debt, the macro economic parameters of US economy are not robust. Negative Savings Rate, downward pressure on housing prices and increase in interest rates has adversely impacted the US Consumer Confidence which may further retard the retail and housing activities in the US and thereby causing great financial uncertainties. US needs foreigners to lend it 40 Billion dollars every month to meet its Current Account deficit only and to attract such huge inflows will have to keep on increasing its interest rates. With interest rates hardening in Eurozone and expected increase in interest rates in Japan, US will have to increase the interest rates. Such increase in interest rates will result in higher mortgage payments and with expected bursting of US housing bubble, will leave less amount of disposable income and confidence with the US consumers. Moreover, increase in higher mortgage payments may also result in higher mortgage delinquency which may lead to credit tightening in US.
Rising Yen, rising Japanese interest rates with tightening Japanese monetary base and resultant unwinding of Yen Carry Trade, falling US consumption and mortgages, expected burst of US housing bubbles, negative US savings rate, burgeoning US trade deficit is a frightening financial proposition which may rip apart the world financial markets.
(Views are personal)
SHORT BIO-DATA
I, Bal Krishna Thakur, 37, am a Civil Engineering Graduate and have more than 14 years of experience in Credit Depts. of various Commercial Banks / Financial Institutions in India. I presently work as an Asst. Vice President (Credit) with UTI Bank Limited, a leading Commercial Bank in India. I am a Certified Associate of Indian Institute of Banking and Finance.
B K Thakur
Asst Vice President (Credit)
UTI Bank Limited
Eastern Zonal Office
5 Shakespeare Sarani
Kolkata 700 040
West Bengal
India
bkthakur1@rediffmail.com
91-9830981387 (M)