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Economic Insight
Currency Carry Trade: Possible Effect of Reversal?
GRAPH 1: JAPAN’S BENCHMARK INTEREST RATE (%) AND USD/JPY
7
Interest Rate
160
USDJPY
Declining Yen
•
On 10 May 2013, the Japanese yen had breached the
psychological mark of 100 yen per U.S. dollar for the
first time in four years. The yen had weakened by more
than 20% against the U.S. dollar in the last six months.
In tandem, the Nikkei 225 Index rose by 40% this year
alone, as Japanese exporters stood to further benefit
from the weakening of the yen value.
•
This new development had created some fears in the
market that persistent depreciation in the yen would
fuel another massive yen carry trade. The Bank of Japan
(BOJ) insisted that its asset purchases worth ¥60-¥70
trillion ($586-$684 billion) a year, were intended to
accelerate inflation by stimulating domestic demand.
Nonetheless, Japan’s weak growth potential coupled
with unfavourable demography, may lead the liquidity
injection in search for riskier assets with higher yields
to be leaked into the emerging markets.
•
However, a carry trade is not a free lunch. There are
ample risks and uncertainties that may turn a highly
profitable trade into a losing one, and leave the target
currencies of the trade being overwhelmed by selling
pressure. The aim of this paper is to provide insight
into how a currency carry trade works and explain the
repercussions to emerging markets, specifically
Malaysia, when the reversal of the carry trade occurs.
140
6
120
5
100
4
80
3
60
2
40
1
20
0
Mar‐81
Mar‐86
Mar‐91
0
Mar‐01
Mar‐96
GRAPH 2: US INTEREST RATE & MSIA NET PORTFOLIO INVESTMENT
US Interest Rate (left axis)
Malaysia Net Portfolio Investment (Right axis)
6
60,000
40,000
5
20,000
4
0
3
‐20,000
2
‐40,000
1
‐60,000
0
‐80,000
Mar‐07
Mar‐08
Mar‐09
Mar‐10
Mar‐11
Mar‐12
Currency Carry Trade.
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A currency carry trade basically means uncovered
interest arbitrage, where a trade is being made to profit
from the difference in interest rates in two countries,
without the use of any hedging instruments. Investors
often engage in a carry trade by borrowing in a currency
which has a very low interest rate (e.g. yen), and invest
in higher yielding assets such as foreign government
bonds and commodities in another country with the
higher interest rate.
•
Currency movement and change in interest rate are
the two biggest risks that a trader would face in currency
carry trade. For example, yen carry trade would work
well as long as the yen does not appreciate too much in
a short period of time, and interest rate in Japan stays
low. In essence, when the yen suddenly rises up in
value, the carry trade investors would have to quickly
reverse their positions and repatriate their dollars back
to yen, to pay for their loans which have now grown
bigger!
GRAPH 3: TOTAL FOREIGN HOLDING IN MALAYSIAN BONDS
RM Bill
250
224.8
200
150
112.8
100
42.2
50
0
1Q07
4Q07
3Q08
2Q09
1Q10
4Q10
3Q11
2Q12
1Q13
7 June 2013
2013/23
DISCLAIMER: This report is for information purposes only. We have based the data and information in these reports from sources we believe to be reliable. However, we do not guarantee
as to the accuracy or completeness of the information provided. Any recommendation or opinion that is provided in this document, if any, does not have regard to the investment objective
and particular needs of any specific addressee. No parts of this publication may be reproduced or redistributed in any form or any means whitout a prior written permission of the publisher.
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Say an investor borrows $1,000 worth of yen in Japan, at
an exchange rate of $1=¥80, at 0.1% interest rate. He
then invests the fund into U.S. treasury bonds that yield
1.5%. After say a year, the yen weakens and now the
exchange rate stands at $1=¥100.
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Now let us assume the trader borrows $1,000=¥80,000.
After a year, he would stand to have $1015 which equals
to ¥101,500. The interest cost on the borrowing was 0.1%
which equals to ¥80. After he pays for the amount
borrowed plus interest, the amount now totals at ¥80,080.
Hence, he stands to gain ¥21,420, a whopping 26.8%
return in just one year.
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If his bet is wrong, and the yen instead strengthened to
$1=¥75, his $1015 would only be worth ¥76,125,
rendering a loss to his investment. A small movement in
interest rate or currency exchange may magnify the losses
or gains as the currency carry trade is often leveraged at
a very high level.
•
Meanwhile in Japan, Shinzo Abe, the new Prime Minister
had just unleashed his plan to revive the economy with a
three-pronged approach, focusing on easy monetary policy,
more aggressive fiscal expansion and restructuring of the
economy. Therefore, it is highly unlikely that he would
prematurely risk bringing the recovery to a halt.
•
In the United States, the Federal Reserve announced that it
would continue with easy monetary policy until the
unemployment rate falls below 6.5% and inflation rate does
not exceed 2.5%. Nonetheless, the unemployment rate stood
at 7.5% in April and following that trend, it might reach the
target as soon as the middle of 2014. Nonetheless, at this
juncture, we do not expect any rate hikes in the next one
year.
Conclusion
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The G-7 in their meeting in May, reaffirmed their commitment
to not use economic policies to seek weaker currencies, and
so far have not concluded that Japan had broken the pact
yet. Yen had breached the psychological benchmark of
$1=¥100 on May 10 this year, after dropping more than 20%
in the last 6 months against the U.S. dollar.
•
It has since been revolving around 100, and whilst the
Japanese currency has the potential to drop further, at this
juncture, we postulate that the maximum that it would fall
in the next six months is to $1=¥110. Any further weakening
may resuscitate tension amongst the G-7 leaders, regarding
the issue of unfair devaluation of yen.
•
The yen carry trade has the potential to be rekindled, with
ultra low interest rate and depreciating currency. Nonetheless,
massive volatility in yen value, resulting from its position asFIGU
a safe haven currency favoured in the times of turmoil, may
strengthen the yen quickly and wipe out the profits made
from the carry trade.
•
And while the reversal of the carry trade was not the main
cause of 1997/1998 Asian crisis, the outflow of funds, exiting
the troubled countries, would clearly exacerbate the fragile
situation, if it were to happen again. Despite Malaysia having
a strong and stable banking system, the sudden reversal of
hot money would severely impact our equity market, and
thus affect the sentiment in the economy.
Carry trade now?
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The interest rate in many of the advanced economies is
at very low levels compared to the interest rate in
emerging economies. Focusing on Malaysia, we can see
that the influx of foreign funds have started to flood the
Malaysian bond market, quite significantly since early
2009. (Refer to graph 3)
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With the yen going on a long stretch of weakening,
supported by Abenomics, yen carry trade will go back in
trend. The Bank of Japan, under the new governor,
Haruhiko Kuroda, pledged to double bond holdings up to
1.3% of Japan’s GDP, compared to the rounds of bond
buying in the U.S. which amounts to 0.6% of U.S. GDP.
•
The yen has the potential to depreciate further, reaching
possibly $1=¥110 by 2014. As carry trade becomes more
active, more traders will borrow in yen and simultaneously
sell the yen as well in exchange for other higher yielding
currencies. Hence, putting a cycle of downward pressure
towards the Japanese yen.
•
Besides, Japanese local investors would be forced to look
outside Japan for better asset returns. As of 15 May 2013,
Japan’s local investors have become net buyers of foreign
bonds for the third straight week, after three straight years
of being net sellers. Mass selling of yen by local and
foreign investors would further support the weakening of
yen.
•
The rally in asset prices in the emerging markets,
specifically Malaysia, would continue for the foreseeable
future until the Federal Reserve, the Bank of Japan or the
European Central Bank (ECB) starts to hike the benchmark
interest rate. As the Eurozone is still battling with meagre
economic growth and rising unemployment rate, the
possibility of the ECB to significantly hike interest rates in
the next two years is very low.
Sources
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Exploring the yen carry trade: investor’s choice of target currencies,
Thiti Tosborvorn, Stanford University.
Carry Trade and Currency Crashes, Markus K. Brunnermeier, Stefan
Nagel, Lasse H. Pedersen, Stern Business School, New York University.
What Can the Data Tell Us about Carry Trades in Japanese Yen?,
Joseph E. Gagnon and Alain P. Chaboud, Board of Governors of the
Federal Reserve System.
The 1997-1998 Financial Crisis in Malaysia: Causes, Response and
Result. Zubair Hassan, Islamic International University of Malaysia.