Those of you watching recent events in the financial markets might have seen the terms ‘carry trade’, ‘Yen carry trade’ and ‘YCT’ crop up a few times. This is often explained in the press as the process of borrowing money in a low-interest currency and investing it in high-interest one. Which is true, but there’s rather more to it than that and we have to step back a few years to find the full explanation.
About 20 years ago Japan went through a period of property price inflation, a speculative bubble of investment driven by people who assumed that property prices only went up, particularly on a crowded island where there was little scope to build new homes (sound familiar?). Inevitably, as always happens when prices exceed underlying fundamentals for a length of time, the Japanese property market crashed, hard. I’ve read figures quoting a 40-45% drop since the early 1990s, much of that happening in the first few years.
As is the standard reaction to such an event, the Bank of Japan dropped their interest rates. And dropped them. And dropped them again. Doing so was intended to encourage people to borrow money to stimulate economic growth. But the Japanese had had their fingers burned once through borrowing and, perhaps partly for cultural reasons, were extremely reticent to do so again. The Bank of Japan, to use a popular phrase, was ‘pushing on a string’ in trying to encourage Japanese people to borrow.
However, with laws around the world being relaxed to allow more free movement of capital between countries and currencies, the Yen had quite a few takers outside of Japan. Foreign investment bankers and fund managers saw opportunities in borrowing large quantities of Yen at low interest rates and ploughing them into countries where the currency yield was much greater. For example, even today you can borrow Yen at 0.5% interest per year and invest it in the UK at 5.75% interest. And that’s without using your borrowed Yen to invest in riskier, potentially higher-return foreign investments such as shares, commodities and, dare I say it, property.
The Yen wasn’t the only currency to be used in a carry trade. Any currency pair was fair game where a lower yield could be borrowed and then lent for a higher yield. These included the Swiss Franc against the Euro or the Pound, the Euro against the Turkish Lira and many others. The greater the difference in yield, the greater the interest earned, but the greater the perceived risk.
At some point, of course, the loans would have to be repaid in Yen. But the great thing about the carry trade was that the more people who got involved, the weaker the Yen became against other currencies. So when you eventually repaid your loan in Yen, you could do so at a cheaper exchange rate than you had borrowed it. Fantastic! You borrow money to earn interest on that money, then pay back less in real terms than you had borrowed in the first place.
Soon even individual investors were getting in on the carry trade, through online currency trading accounts. Apparently it has been particularly popular amongst Japanese housewives. But, as is usually the case when someone tells you that an investment can only go up in value, this situation couldn’t last forever.
It’s important to bear in mind that most of this borrowing was leveraged, which means that any movements in exchange rates were multiplied. For example, with a leveraged account at 100-to-1, you might use £10,000 to borrow £1,000,000-worth of Yen. So you get the interest on £1,000,000 even though you’ve only invested £10,000. However, a 1% negative move in the exchange rate would wipe out your entire £10,000 stake and you’d have to repay your loan. This is known as a margin call, another phrase you might have heard recently, perhaps in a sentence such as “Hedge fund forced to liquidate assets at a loss due to margin calls”, though the hedge funds were dealing with stakes of hundreds of millions or even billions of dollars.
Anyway, the only danger, as these investors saw it, was that the Japanese economy could suddenly get stronger, resulting in the Bank of Japan pushing up interest rates to counter inflation and the value of the Yen rising against other currencies. But Japan has been hovering around the low growth / zero growth / negative growth point for years and the Bank has been pretty good at signalling its intentions well in advance, arguably helped by political will to keep the Yen artificially cheap to assist its export industry.
Of course, there are two sides to any currency trade. You may borrow in Yen, but in doing so you are also investing in US dollars, or Pounds Sterling, or Icelandic Krona, or Turkish Lira, or whatever other high-yielding (i.e. high interest) currency you may choose. The Yen doesn’t have to get stronger on its own for you to be in trouble: the other currency could get weaker, making the Yen stronger by comparison. But in the Western countries with their good old stable economies, that didn’t seem likely.
In the end, in summer 2007, what happened was much, much bigger than most people had anticipated and not directly related to the value of the Yen, at least not initially. Some of the borrowed money ended up in rather complex investment instruments based on residential mortgages. Many of those were in the USA. Some of the people who took out mortgages turned out to be… well, less than 100% likely to be able to afford them. Suddenly a lot of investment banks and funds were losing money.
Margin calls were hit. Loans had to be repaid, some of them in Yen. Which meant that the Yen suddenly gained in price against other currencies. Which in turn made it more expensive for other banks and funds to repay their loans in Yen. Which led to more margin calls, more fast liquidations and so on, in a vicious cycle, a disorderly unwinding of the carry trade.
Sentiment changed. People began liquidating their Yen positions even if they were nowhere near a margin call, because they believed that the Yen would continue to appreciate and that they might end up losing their initial stake (after all, it’s better to quit now than run the risk of greater losses in the near future). This became a self-fulfilling prophecy, and *all* the carry trades suffered, some by more than ten percent in the space of a few weeks (equating to a 1,000-fold movement at a leverage of 100-to-1, remember).
The carry trade isn’t dead yet. Interest rates in the various currencies are pretty much the same as they were before all the unwinding started and some investors are still involved. But the fear of risk is so great that few large funds and banks are willing to play it, even if they have the funds to do so, at least until they know how the next few months will play out.
(c) Alex Cruickshank 2007
The author of this article started playing the carry trade via an online currency trading account earlier this year and lost a good chunk of his capital when it unwound. He consoles himself with the thought that even though he lost a lot, he didn’t do quite as badly as some of the major investment banks and funds.
