The concept of the ‘carry trade’ is key to understanding what is going on in the financial markets and the global economy as a whole – now perhaps more than ever. With the phrase being bandied about so much, it’s hardly surprising that some readers have requested ‘clarifications’ – so here goes.
In essence, the carry trade is extremely simple, indeed it’s a variant on the basic commercial dictum of ‘buy low, sell high’. However, because the carry trade is conducted in financial markets using financial instruments, such as currencies and interest rates, rather than in the goods markets using widgets, it has an aura of sophistication and complication. Let’s consider a few examples:
a) The classic yen carry: The rate of interest on the Japanese yen has been very low – almost zero – for a very long time. Conversely, before the crash,many currencies paid interest of 3, 4 and 5% on deposits. It therefore made sense to borrow in Japanese yen, paying a very low rate of interest on the loan, convert the yen into, say, euro or sterling or Australian dollars, and receive a rate of interest on the deposit that was several times higher than the cost of the loan. The risk, of course, is that the exchange rate goes against you and your gains on the interest-rate arbitrage are more than exceeded by your losses on the exchange rate moves. But because this trade has been available for many years, it has been very profitable over time.
b) The double-whammy carry: suppose a country has a weak currency AND low interest rates. This is not a normal combination, because usually currency weakness will force the central bank to raise interest rates. But in a country that doesn’t much care about currency weakness, such as the US, it could happen, even in ‘normal times’. In today’s environment, when interest rates in most advanced economies are at or near record lows, it is commonplace. People borrow in a low-interest currency, say dollars, and convert as before to a currency with higher rates. But this process of selling the low-interest currency would, if done on a large-enough scale, help push that currency’s value down. The borrower would thus be able to garner BOTH the interest rate differential between the dollar and the currency he invested in, AND the exchange rate differential as the dollar’s value declined. Last year, the dollar was the carry-trade currency of choice (along with the yen, of course). Now the euro is supplanting it.
c) The central-bank supported carry: Not all carry trades need involve a different currency. If short-term interest rates are low and long-term interest rates are much higher, then it pays to borrow short and lend long. In fact, that is the staple business of commercial banks, paying low interest on deposits and charging much more on loans. But currently, as in previous major financial crises (the South American collapse of 1982, the S&L crisis of 1989, etc.), central banks have deliberately forced short-term rates to very low levels and are intent on holding them there. They are also prepared to lend huge amounts to financial institutions, especially banks. This money can be taken and invested in medium and long-term Treasury bonds, with the interest rate differential generating massive profits for them. That, in fact, is how bankrupt banks and collapsed banking systems are ‘recapitalised’, under the aegis of paternal central banks. It is happening today on the largest-scale ever. Since you asked – yes, there is a cost. Taxpayers are subsidising this process, and it costs a fortune.
Note that all these are very simple examples. What has been happening over the last year, since the financial crisis bottomed, is that people have been borrowing in low-interest currencies (which includes most everything) and investing not merely in higher-interest currencies or securities, but in much higher-risk assets, including shares, commodities and real-estate.
This process has run amok in China, where the government poured vast amounts of money into the banking system and directed it to lend as much and as fast as it could. The result has been a doubling of housing prices in many cities (and more in select areas), as well as huge speculation in commodities (e.g. copper) and other ‘hard assets’. The reason why this is phenomenally dangerous is because the investments are exposed to high risks – market risk (the price of copper could slump), liquidity risk (try selling your house when everybody else wants to sell theirs), credit risk (the company invested in goes bust), etc. The biggest risk of all, in China, is actually political risk – that the same bureaucrats who decided to open the spigots wide then decide to shut them.
That is beginning to happen, which is one major reason why there is so much nervousness in the markets. But this week the Chinese are busy celebrating their new year – the year of the tiger. Hopefully, they will figure out how to get off the tiger they have been riding without being eaten. If not, the carry traders will learn that the only free lunch on the menu is them.