Global Policy Forum

By Michael MH Lim

The age of finance capitalism has eclipsed the age of productive capitalism. The amount of financial assets held worldwide and the volume of financial transactions, from currency trades to swaps to equities and bonds etc., dwarf the traditional measures of national capital. According to the McKinsey Global Institute, the ratio of financial assets to annual world output tripled from 110% in 1980 to 316% in 2005. Even more astounding is the volume of financial transactions: the notional outstanding value of interest rate swaps, currency swaps, and interest rate options reached $286 trillion (about six times the global gross product, and up 82 times from a mere $3.5 trillion in 1990). Today currency rates are determined more by speculative trading than by the underlying movement of goods and services.

Whilst the explosion of financial assets and transactions has brought benefits to mainly the big players in the markets (last year, it was reported that three hedge fund managers dabbling in the sub-prime mortgage market each took home over $1 billion in pay and bonus), with some trickle-down effects to the middle class, it has wrought tremendous risks and instability on the financial system. Today the financial markets are reeling from the risk fall-out from different types of financial instruments and derivatives, two of which are the "carry trade", and the sub-prime mortgage loans which are linked to collateralised debt obligations.

The deregulation and liberalisation of the financial system, starting from the US and foisted on other countries, the technological revolution with computerisation, and the loose monetary policies of the central banks, most notably in the US and Japan, have created huge amounts of liquidity in the world financial system. These have encouraged the introduction of all kinds of new financial instruments, and created even more interdependence between financial markets. Money borrowed in one currency can easily be transferred or invested in any currency or instrument at an instant and in billions. (The size of the foreign currency markets is so huge that currency traders invent their own language; for them $1 represents $1 million, and 1 yard denotes $1 billion.)

The "Carry Trade"

Imagine you can borrow money using your credit card at zero interest and then invest that money in fixed deposit and earn interest. When the credit card's zero-rate period matures, you pay back the loan or, better still, roll it over on to a new card! That was known as "stoozing" and was very popular among Americans at one time until the credit card issuers started charging a balance transfer fee.

Bankers and financial speculators do the same thing when they borrow money in one currency with low or zero interest rate (as was the case with the yen a few years back), then invest the funds in another currency or instrument with higher yields, and earn a spread (i.e. the difference in the yields). Except this practice has a more respectable-sounding name: it is known as the "carry trade" in financial circles; and it is more risky because it carries with it currency risks. Any profit made from the interest rate differential can easily be wiped out if the yen appreciates significantly. This risk is further amplified if the transaction is leveraged, as is mostly the case.

In the simplest case, speculators and investors borrow yen at 0.5% and invest in US treasuries at 5%, earning a spread of 4.5%. In theory, this is not supposed to happen as the difference in interest rate between the two currencies is equal to the difference between the spot and forward rates of the two currencies. In other words, the interest rate differential is theoretically offset by the appreciation of the yen over the dollar over the same period. Perversely, however, borrowing the yen puts downward pressure on the yen value. Furthermore, a confluence of factors in Japan, including a high savings rate and the government's policy to reflate the economy out of recession and deflation through cheap exports, result in an undervalued yen and a low interest rate environment. The yen has traditionally been undervalued, and the relative stability of the interest rate spread between the yen and other currencies has allowed investors to enjoy the ride from the carry trade for a long time. Japanese yen is reputed to be the most undervalued currency, even more than the renminbi. It is estimated that the yen is 40% undervalued against the euro.

To enhance their yield, investors could invest in bonds, equities, real estate, sub-prime mortgage loans or any other instruments. In short, the carry trade has become a major source of low-cost funds for the world, with money flowing into everything from Wall Street stocks, to main-street home mortgages, to emerging-market stocks and bonds. The yen carry trade amplifies the already serious distortions in the global economy. Japanese excess liquidity is supporting asset inflation and bubbles across the world.

Players in the carry trade include individual Japanese who would rather invest in foreign bonds than in Japanese bank deposits; Japanese pension funds, insurance funds, and banks which do the same; and, of course, international hedge funds, banks and other speculators. Nobody knows for sure how big the market for the carry trade is. Estimates run from $350 billion, according to Japanese banks, to over $1 trillion (based on futures and options contracts in the Chicago Mercantile Exchange). That is 10 times the size of Malaysia's GDP.

Just imagine what will happen when this carry trade dries up. Like a tsunami, the drying of the carry trade will hit the financial markets, causing a massive liquidity crunch and a fall in worldwide financial asset prices.

History of the Carry Trade

The first wave of carry trade started in the late 1980s when financial speculators borrowed in yen and invested in European securities. This first phase ended in 1993 after the Japanese bubble collapsed, Japanese investors retreated home and the yen appreciated. The second round of carry trade began in the summer of 1995 and ended in late 1998 after Russia defaulted, the Long-Term Capital Management hedge fund collapsed, and the Japanese government planned to recapitalise the distressed banking sector. The yen rose 15% against the dollar in a week.

The recent wave of the yen carry trade is built on the Japanese government's policy of keeping its interest rate and currency low in order to export its way out of recession and deflation. It has continued until last week (10-17 August) when the yen jumped 10% caused by the default in sub-prime mortgages and the knock-on effects on equity markets worldwide.

Effects of the Carry Trade

Because many of the speculators used the funds to invest in overseas equities on a leveraged basis, when stock prices decline, they are forced to liquidate their equity positions to meet margin calls. This in turn causes the equity markets to tumble further. When the speculators and investors divest their foreign equities and securities and convert their dollars into yen, that sends the yen spiralling upwards. Hence, the investors are dealt a double whammy: not only have they lost on their equity investments, they now also lose from the yen currency appreciation.

Because of the scale of carry trades and the negative effect on liquidity, the consequences on world-wide financial instability are enormous. The problem with todayí¢â‚¬â„¢s financial system is that much of the trading is carried out by big-time players like international banks and hedge funds which have contrived highly complicated transactions that are opaque and where the risks are not well understood, let alone regulated. Many of the risks of these instruments have been packaged and repackaged, sold and resold to all types of investors, so that it is now difficult to figure out where the risks are located, and how to regulate and control them. While the risks have been diversified through packaging and parceling out, they have not been eliminated.

A corollary of this diversification is that we do not know where the risks reside. This is best illustrated in the current crisis of sub-prime mortgages. This problem surfaced recently with the collapse of two funds managed by Bear Stearns; this was followed by the suspension of three of BNP Paribasí¢â‚¬â„¢ sub-prime mortgage funds. These prominent players probably just represent the tip of the iceberg. The Bangkok Post has revealed that even Thai banks, and no doubt many domestic banks in other emerging markets, looking for high-yielding assets, have speculated in these sub-prime mortgages. The 24 August CNBC news reported that the combined sub-prime mortgage holdings of the major banks in China were $11 billion. Where is the next revelation? The big question, therefore, is: where is the proverbial Waldo? Who will be the next to emerge naked? As Warren Buffett put it vividly, we do not know who is naked until the tide starts to recede.

When will the carry trade end? In a prescient article in the International Herald Tribune of 22 February 2007, the author wrote that while the 0.5% rate rise by the Bank of Japan would not halt the yen outflow, the carry trade could dry up from other external shocks. Sure enough, six months later, the chickens have come home to roost. The crisis of not only the sub-prime mortgages, but the whole housing bubble created in the super-low interest rate environment of the 1990s, have created ripple effects throughout the world financial markets. Falling stock, bond and real estate prices have caused speculators and investors to liquidate their financial holdings to buy and repay their yen borrowing, sending the yen higher and amplifying their losses.

Whilst this latest episode of the yen carry trade is not yet over, it is unlikely it will be the last until the structural conditions in Japan and the US make it unprofitable for investors and speculators to play the game. Meanwhile, the tidal waves created by finance capital are sweeping the ordinary guys on the street helplessly about like pebbles on the shore.