The Brief: Carry Trade Woes

FOR DECADES, the global go-to place for capital has been Japan, where interest rates were near zero for a long time. Investors from across the world borrowed in the country at a low cost and invested in higher yielding assets such as stocks, bonds and commodities denominated in other currencies. This, known as carry trade, created turmoil in global financial markets at the beginning of August when Bank of Japan (BoJ) raised rates from 0.10% to 0.25%. But why did a minuscule hike create a tsunami in global financial markets?

In a November 2023 research report, Deutsche Bank analysts warned that the Japanese government is engaged in a massive carry trade — funding of loans and foreign assets via low-cost borrowing in yen — that could bring unexpected risks if the central bank hikes rates. Using research by San Francisco Federal Reserve and International Monetary Fund, Deutsche’s head of currency research, George Saravelos, analysed the Japanese government’s balance sheet, covering government-run pension fund GPIF, BoJ and state-owned banks and estimated total yen carry trade debt at $20 trillion. This is more than the combined market cap of Japan ($6.2 trillion), India ($5.2 trillion), Hong Kong ($4.1 trillion) and France ($3.9 trillion).

A CMG Wealth note says there are four risks. One, as a foreign investor borrows in yen, there is a currency risk that should be hedged as dollar and yen don’t move in sync. Second, there is interest rate risk as currencies and bond prices can go up or down based on interest rate movement. Third, there is risk of assets where investors have allocated borrowed capital not doing well. Fourth, there is counterparty risk, in this case the Japanese government.

As long as yen does not appreciate significantly against dollar (or currency in play), the investor can pocket the interest rate spread. Carry trade allows investors to get free money by borrowing cheaply and investing at higher rates. However, it also carries significant risks, especially if a low interest currency like yen appreciates against a higher-yielding currency like dollar, says the note. The warning by Deutsche analysts and CMG came true when BoJ increased rates on July 31. Yen rose around 12% from 161.96 to 142 against dollar between mid-July and beginning of August.

Strengthening yen led to unwinding of carry trade and triggered a massive correction in global equity markets. In early August, the Japanese stock market faced its biggest collapse since 1987 with Nikkei 225 Index falling 12.4%. Taiwan’s Taiex fell by 8.4%, South Korea’s Kospi recorded its worst session since 2008 by falling 8.8%; and Nifty slumped 662 points or 2.68% on August 5.

WHY DID BOJ HIKE RATES?

The major decline in yen started after Covid. Between January 2021 and July 2024, it declined from 103 per dollar to 161.96 per dollar. Decrease in purchasing power of yen became a cause of concern for monetary authorities and BoJ raised policy rate for the second time in a year on July 31. The previous increase had come in March, from minus 0.1% to plus 0.1%.

Also, loss of purchasing power led citizens to demand a wage hike, and at the request of labour unions, an average increase of 5.28% was implemented, the largest in Japan in past 33 years. Adding salt to the yen injury was spike in crude oil prices. Japan imports 99% of the oil it consumes. Imported crude is priced in dollars. As yen weakens, the cost of oil imports in yen rises dramatically, putting pressure on Japan’s economy.

Higher global crude prices and weak yen prompted BoJ to shun its negative rate policy in March 2024. Despite a hike of 0.10% in the rate, yen continued its slide and made a 38-year low of 161.96 per dollar in early July 2024. A worried BoJ interfered aggressively in the currency market and put $37 billion but achieved little. This forced it to hike again on July 31, sparking a global margin call as investors who had borrowed cheap yen were forced to unwind their positions. Unwinding of carry trade had a global impact as yen exposure is global; it triggered flight of capital from risky assets to safe havens like Japanese government bonds and U.S. treasuries.

INDIA IMPACT

As per NSDL, Japanese foreign portfolio investors (FPIs) hold Indian equities worth ₹2.17 lakh crore. Some may sell due to strengthening yen. FPIs hold ₹74.59 lakh crore worth of Indian equities. Thus, market participants believe Indian stock market may not be severely impacted by unwinding yen carry trade.

However, U.S.-based FPIs are the largest holders of Indian equities. They cumulatively own Indian shares worth ₹31.5 lakh crore. The other top FPI contributors are Singapore (₹5.55 lakh crore), Luxembourg (₹5.45 lakh crore) Ireland (₹4.4 lakh crore) and Mauritius (₹3.89 lakh crore). For all these FPIs, movement of yen against major currencies, especially dollar, will play a key role. So, Indian investors too should keep an eye on Japanese and U.S. interest rates as the spread between them matters for FPIs. Higher Japanese interest rates and stronger yen could be a potential trigger for unwinding of carry trade again.