Carried away
By Gillian Tett and Peter Garnham
April 30 2010 03:00
Adair Turner is at it again. Having criticised numerous practices in the financial world - among them "socially useless" banks and crazed innovators - Britain's most senior regulator has a new target in his sights: currency speculators.
This month, Lord Turner solemnly told a group of economists assembled in the Great Hall of King's College, Cambridge that he was alarmed by the recent explosive growth in foreign exchange dealing. While some of this expansion helped lubricate global trade, said the chairman of the Financial Services Authority, most stemmed from speculative activities such as the "carry trade" - the practice of borrowing cheaply in one currency to invest in another.
"Foreign exchange carry trades are, as far as I can see, of zero value and potentially destabilising," he added, indicating that he would like to curb a business currently thought to have as much as $1,000bn (£655bn, €755bn) in positions outstanding in the market.
Since the world abandoned the Bretton Woods system of fixed exchange rates almost 40 years ago, most western policy-makers have assumed that vibrant, free foreign exchange markets are a good thing. But Lord Turner is not alone in questioning the value of all this activity. "The prosperity of the postwar era owned much to Bretton Woods . . . we need a new Bretton Woods," Nicolas Sarkozy, the French president, told this year's World Economic Forum in Davos. "We cannot preach free trade and tolerate monetary dumping."
Such ideas provoke horror or derision among financiers, many of whom have come to view the carry trade as a cornerstone of their strategies. Sophisticated hedge funds, for example, hop across borders with ease, using cheap yen and other currencies to buy higher-yielding assets. Even retail investors have been in on the act, with many in eastern Europe having borrowed heavily in currencies with low interest rates, such as the Swiss franc, to buy houses.
Currency speculators insist that this is needed to help rebalance the global economy. If investors were not free to trade in different currencies and use different ways of funding themselves, they ask, how would countries such as the US ever manage to fund its vast budget deficit?
The carry trade has been "one of the principal methods in which debtor nations have been able to recycle their deficits over the past 40 years", says Neil Record of Record Currency Management, a specialist adviser. "Surplus countries have historically offered their citizens lower short-term interest rates than deficit countries, and this has encouraged these citizens to seek higher returns - and therefore investment risk - elsewhere."
Some of Lord Turner's fellow policy-makers also suspect it would be hard to clamp down on the carry trade effectively - if indeed a pro-market western government wished to do so. "It is not easy to define a carry trade, or even to tell how large it is," says one senior European regulator. "This is not a very practical idea."
Nevertheless, even if his and Mr Sarkozy's comments are controversial, it could be a politically astute moment to start a new debate about the carry trade. The issue of foreign exchange speculation has not dominated the political agenda in recent years - partly because the foreign exchange markets have been relatively quiet. But after central banks loosened monetary policy to tackle the global financial crisis, some investors have used this cheap, short-term funding to make big bets on higher-yielding assets, ranging from Brazilian shares to American mortgage bonds.
"It appears to us as if bail-outs and other government and central bank stimulus policies have mainly succeeded in restoring many of the bubble elements that were in financial markets in 2006-07," says Timothy Lee of Pi Economics, a consultancy.
However, the Federal Reserve and European Central Bank are now signalling that they hope to tighten policy soon, potentially undercutting the carry trade. Publicly, central bankers say they will pursue these so-called "exit strategies" very cautiously; in practice, however, some economists fear that these actions could create new market shocks. By raising interest rates too aggressively, central banks could not only derail the global recovery, but also reduce the attractiveness of selling their currency as a funding vehicle for investing in asset markets across the globe. Thus they risk delivering a double dose of anxiety for financial markets.
As a result, the question that policy-makers are trying to assess is not merely the absolute size of the carry trade but also the degree to which any sudden reversal could hurt financial investors - if not the system as a whole. "Unfortunately, when you look at the world today, many of the imbalances that caused the last crisis are still there," says one senior western central banker. "That means there is still a real risk of more dislocation. The carry trade issue is part of that."
Certainly, recent history suggests that carry trades can produce unpleasant surprises. Take the yen. In the 1990s, following the collapse of the Japanese property bubble, the Bank of Japan slashed interest rates to a level well below the rest of the developed world. By the middle of that decade, the gap between medium-term US and Japanese rates was 4 percentage points.
That prompted both western hedge funds and Japanese domestic investors to borrow heavily in yen to place bets in higher-yielding currencies ranging from the Italian lira to the New Zealand dollar. As a result, the value of the yen fell and the price of those other assets soared, since investors were essentially selling the Japanese currency to buy other assets.
In 1997, however, those trading strategies started to unravel when the Asian financial crisis tipped markets into a panic. Then, after Russia defaulted the following year, hedge funds such as Long Term Capital Management were suddenly forced to cut their positions. As investors unwound their carry trades, currencies gyrated wildly, with the yen appreciating in value by 15 per cent over just two days in October 1998 - causing huge losses for investors. For LTCM it brought implosion.
After that bruising experience, many currency speculators were happy to sit on the sidelines for a while. But by the middle of the last decade, the carry trade returned with a vengeance. The low level of Japanese rates prompted investors again to borrow in yen in order to purchase high-yielding assets such as New Zealand bonds. And, once more, the value of those currencies and assets soared. (Indeed, by 2006, the New Zealand government was so alarmed by the appreciation of its currency that it begged Japanese investors to stop buying kiwi bonds.) Meanwhile, investors in Europe and the US also borrowed heavily in currencies such as the Swiss franc or the euro to buy eastern European assets or to invest in countries such as Iceland.
Yet in 2007 - as in 1997 - many of these carry trades were dramatically unwound, when the onset of the subprime crisis forced banks and hedge funds to cut their positions. The yen strengthened; currencies such as the Icelandic krona, New Zealand dollar and Brazilian real fell. Disastrously, this sudden carry trade unwinding prompted investors to flee from assets in countries such as Iceland, where it triggered a full-blown crisis.
These days, to the relief of many policy-makers, there is no sign that the yen carry trade is about to re-appear. Mr Lee of Pi Economics estimates that the bulk of the yen carry trade that built up between 2004 and 2007, and peaked at $1,000bn, has been unwound. That is partly because the cost of borrowing yen has moved into line with other currencies: last summer, the three-month rate for borrowing yen in the London interbank market rose above similar dollar costs, for the first time for several decades. This made the dollar a more attractive currency than the yen in which to fund carry trades.
But that does not mean that the carry trade is in decline, just that investors have switched from funding deals in yen to selling other currencies to finance their investments. Indeed, by late last year the International Monetary Fund was observing that "there are indications that the US dollar is now serving as the funding currency for carry trades". Mr Lee thinks many of the investors he tracks have switched out of yen carry trades into the dollar in the past couple of years. He calculates that there are some $500bn-$750bn of dollar-based carry trades in the global financial system, plus $250bn-odd funded in other currencies.
Others have even bigger estimates. "To me the big risk this year is the dollar carry trade," Zhu Min, deputy governor of the People's Bank of China, said recently, adding that there was now a real risk of a violent unwinding. "It is a massive issue. Estimates are that the dollar carry trade is $1,500bn - which is much bigger than Japan's carry trade was."
In the foreign exchange markets, however, some analysts argue that there are already signs that investors are preparing themselves for the prospect of higher US interest rates - and may even be unwinding some of their carry trade positions in the dollar as a result.
With the dollar having already appreciated this year, Mansoor Mohi-uddin, managing director of foreign exchange strategy at UBS, thinks the US unit is moving from being a "funding" - or "safe haven" - currency to become one that investors use if they want to chase higher returns as a result of economic growth. "The dollar [is] starting to behave as a growth currency," he says, noting that "the Federal Reserve is likely to be the first of the major central banks to raise interest rates this year".
If this process of adjustment does not proceed smoothly - as people such as Mr Zhu fear - it could spark a great deal more political debate. In any event, the French will next year chair the Group of 20 leading industrialised and developing nations and Mr Sarkozy's remarks show he is determined to open discussions about a new monetary system.
Yet the French have broached similar ideas before without any impact, while even men such as Lord Turner know that calling for a rethink of the carry trade is too radical for most policy-makers. "There are a range of ideas that need to be taken out of the 'index of forbidden thoughts'," he recently declared.
But if the last two years have shown anything, it is that when a crisis strikes, ideas that used to seem unthinkable can suddenly enter the mainstream. Right now, all might seem relatively quiet on the foreign exchange front. But investors and politicians alike could do well to watch the carry trade as closely as they can, even - or especially - if no one knows how large it might be.
Authorities are uneasy at shifts
What exactly have western investors been doing with all their cheap dollars or euros in the past year? It is a question that has prompted endless debate among policymakers and analysts.
Some of the funding has undoubtedly been recycled inside domestic markets. Many analysts believe, for example, that the recent rally in US and European shares has been fuelled by cheap finance. And in the US, it seems, some institutions have been self-consciously playing a form of dollar-dollar carry trade.
Meredith Whitney, a banking analyst, says American regional banks have recently been buying prime US mortgage bonds on a large scale. Since these instruments pay a slightly higher return than the bank's cost of dollar funding, they produce an easy source of earnings. "This is a big carry trade," says Ms Whitney, who fears the pattern could produce losses for the banks when funding costs rise.
A cross-border focus for carry trade activity appears to be developing in emerging market countries such as Brazil, India and South Africa. In the past few months, there has been a flood of short-term investment into these places, pushing up the value of assets and the national currencies.
The currency appreciation has triggered growing unease. In South Africa, for example, Renosi Mokate, the Reserve Bank deputy governor, recently warned that carry trades had fuelled a rise in the value of the rand - and warned that this could be a "big challenge" for emerging markets this year. In Brazil, an alarmed government recently imposed mild capital controls.
Just this week, Duvvuri Subbarao, governor of the Reserve Bank of India, said he was so concerned about "sharp and volatile exchange rate movements" - meaning an appreciation of the rupee - that the government was considering imposing capital controls.
"Recent experience has underscored the issue of large and often volatile capital flows influencing exchange rate movements against the grain of economic fundamentals and current account balances," he said.
In the world's largest financial market, a web of bilateral trades makes it hard to count the
The carry trade has been a popular trading strategy in the foreign exchange markets for decades. It is based around one of the most reliable phenomena in the currency market: the "forward rate bias".
Buying high-yielding "target" currencies with low-yielding "funding" currencies should not in theory be profitable, as purchasing power parity theory suggests the low-yielding ones should appreciate to compensate for lower returns.
But in practice, the FRB ensures that higher-yielding currencies can outperform lower-yielding currencies over time as investors, buoyed by increasing optimism, leverage their positions by continuing to sell low-yielding target currencies.
At its simplest, investors fund the purchase of higher-yielding assets by borrowing in a low-yielding currency, such as the dollar or the yen. A carry trade need not just involve two currencies. But its success requires two elements: a funding currency with a low yield, and stability in asset markets. The strategy works well when the low-yielding funding currency is depreciating or stable, but any sharp upward movement in the funding currency or downward move in asset prices can quickly wipe out any yield advantage.
Carry trade strategies are therefore vulnerable to any shock to the financial system, as witnessed by the surge in the yen after the Russian financial crisis in 1998 and in the aftermath of the collapse of Lehman Brothers in 2008.
Measuring the carry trade is an inexact science. A tangled web of bilateral transactions in foreign exchange, the world's largest financial market, is notoriously difficult to track.
One popular measure is provided by the Commodity Futures Trading Commission, which publishes weekly data on positioning on the Chicago Mercantile Exchange. But while these figures are often used as a proxy for speculative activity from hedge funds, they provide only a limited insight into the activity of the currency market as a whole and are not regarded as effective for tracking the activity of longer-term investors such as asset managers.
By Gillian Tett and Peter Garnham
April 30 2010 03:00
Adair Turner is at it again. Having criticised numerous practices in the financial world - among them "socially useless" banks and crazed innovators - Britain's most senior regulator has a new target in his sights: currency speculators.
This month, Lord Turner solemnly told a group of economists assembled in the Great Hall of King's College, Cambridge that he was alarmed by the recent explosive growth in foreign exchange dealing. While some of this expansion helped lubricate global trade, said the chairman of the Financial Services Authority, most stemmed from speculative activities such as the "carry trade" - the practice of borrowing cheaply in one currency to invest in another.
"Foreign exchange carry trades are, as far as I can see, of zero value and potentially destabilising," he added, indicating that he would like to curb a business currently thought to have as much as $1,000bn (£655bn, €755bn) in positions outstanding in the market.
Since the world abandoned the Bretton Woods system of fixed exchange rates almost 40 years ago, most western policy-makers have assumed that vibrant, free foreign exchange markets are a good thing. But Lord Turner is not alone in questioning the value of all this activity. "The prosperity of the postwar era owned much to Bretton Woods . . . we need a new Bretton Woods," Nicolas Sarkozy, the French president, told this year's World Economic Forum in Davos. "We cannot preach free trade and tolerate monetary dumping."
Such ideas provoke horror or derision among financiers, many of whom have come to view the carry trade as a cornerstone of their strategies. Sophisticated hedge funds, for example, hop across borders with ease, using cheap yen and other currencies to buy higher-yielding assets. Even retail investors have been in on the act, with many in eastern Europe having borrowed heavily in currencies with low interest rates, such as the Swiss franc, to buy houses.
Currency speculators insist that this is needed to help rebalance the global economy. If investors were not free to trade in different currencies and use different ways of funding themselves, they ask, how would countries such as the US ever manage to fund its vast budget deficit?
The carry trade has been "one of the principal methods in which debtor nations have been able to recycle their deficits over the past 40 years", says Neil Record of Record Currency Management, a specialist adviser. "Surplus countries have historically offered their citizens lower short-term interest rates than deficit countries, and this has encouraged these citizens to seek higher returns - and therefore investment risk - elsewhere."
Some of Lord Turner's fellow policy-makers also suspect it would be hard to clamp down on the carry trade effectively - if indeed a pro-market western government wished to do so. "It is not easy to define a carry trade, or even to tell how large it is," says one senior European regulator. "This is not a very practical idea."
Nevertheless, even if his and Mr Sarkozy's comments are controversial, it could be a politically astute moment to start a new debate about the carry trade. The issue of foreign exchange speculation has not dominated the political agenda in recent years - partly because the foreign exchange markets have been relatively quiet. But after central banks loosened monetary policy to tackle the global financial crisis, some investors have used this cheap, short-term funding to make big bets on higher-yielding assets, ranging from Brazilian shares to American mortgage bonds.
"It appears to us as if bail-outs and other government and central bank stimulus policies have mainly succeeded in restoring many of the bubble elements that were in financial markets in 2006-07," says Timothy Lee of Pi Economics, a consultancy.
However, the Federal Reserve and European Central Bank are now signalling that they hope to tighten policy soon, potentially undercutting the carry trade. Publicly, central bankers say they will pursue these so-called "exit strategies" very cautiously; in practice, however, some economists fear that these actions could create new market shocks. By raising interest rates too aggressively, central banks could not only derail the global recovery, but also reduce the attractiveness of selling their currency as a funding vehicle for investing in asset markets across the globe. Thus they risk delivering a double dose of anxiety for financial markets.
As a result, the question that policy-makers are trying to assess is not merely the absolute size of the carry trade but also the degree to which any sudden reversal could hurt financial investors - if not the system as a whole. "Unfortunately, when you look at the world today, many of the imbalances that caused the last crisis are still there," says one senior western central banker. "That means there is still a real risk of more dislocation. The carry trade issue is part of that."
Certainly, recent history suggests that carry trades can produce unpleasant surprises. Take the yen. In the 1990s, following the collapse of the Japanese property bubble, the Bank of Japan slashed interest rates to a level well below the rest of the developed world. By the middle of that decade, the gap between medium-term US and Japanese rates was 4 percentage points.
That prompted both western hedge funds and Japanese domestic investors to borrow heavily in yen to place bets in higher-yielding currencies ranging from the Italian lira to the New Zealand dollar. As a result, the value of the yen fell and the price of those other assets soared, since investors were essentially selling the Japanese currency to buy other assets.
In 1997, however, those trading strategies started to unravel when the Asian financial crisis tipped markets into a panic. Then, after Russia defaulted the following year, hedge funds such as Long Term Capital Management were suddenly forced to cut their positions. As investors unwound their carry trades, currencies gyrated wildly, with the yen appreciating in value by 15 per cent over just two days in October 1998 - causing huge losses for investors. For LTCM it brought implosion.
After that bruising experience, many currency speculators were happy to sit on the sidelines for a while. But by the middle of the last decade, the carry trade returned with a vengeance. The low level of Japanese rates prompted investors again to borrow in yen in order to purchase high-yielding assets such as New Zealand bonds. And, once more, the value of those currencies and assets soared. (Indeed, by 2006, the New Zealand government was so alarmed by the appreciation of its currency that it begged Japanese investors to stop buying kiwi bonds.) Meanwhile, investors in Europe and the US also borrowed heavily in currencies such as the Swiss franc or the euro to buy eastern European assets or to invest in countries such as Iceland.
Yet in 2007 - as in 1997 - many of these carry trades were dramatically unwound, when the onset of the subprime crisis forced banks and hedge funds to cut their positions. The yen strengthened; currencies such as the Icelandic krona, New Zealand dollar and Brazilian real fell. Disastrously, this sudden carry trade unwinding prompted investors to flee from assets in countries such as Iceland, where it triggered a full-blown crisis.
These days, to the relief of many policy-makers, there is no sign that the yen carry trade is about to re-appear. Mr Lee of Pi Economics estimates that the bulk of the yen carry trade that built up between 2004 and 2007, and peaked at $1,000bn, has been unwound. That is partly because the cost of borrowing yen has moved into line with other currencies: last summer, the three-month rate for borrowing yen in the London interbank market rose above similar dollar costs, for the first time for several decades. This made the dollar a more attractive currency than the yen in which to fund carry trades.
But that does not mean that the carry trade is in decline, just that investors have switched from funding deals in yen to selling other currencies to finance their investments. Indeed, by late last year the International Monetary Fund was observing that "there are indications that the US dollar is now serving as the funding currency for carry trades". Mr Lee thinks many of the investors he tracks have switched out of yen carry trades into the dollar in the past couple of years. He calculates that there are some $500bn-$750bn of dollar-based carry trades in the global financial system, plus $250bn-odd funded in other currencies.
Others have even bigger estimates. "To me the big risk this year is the dollar carry trade," Zhu Min, deputy governor of the People's Bank of China, said recently, adding that there was now a real risk of a violent unwinding. "It is a massive issue. Estimates are that the dollar carry trade is $1,500bn - which is much bigger than Japan's carry trade was."
In the foreign exchange markets, however, some analysts argue that there are already signs that investors are preparing themselves for the prospect of higher US interest rates - and may even be unwinding some of their carry trade positions in the dollar as a result.
With the dollar having already appreciated this year, Mansoor Mohi-uddin, managing director of foreign exchange strategy at UBS, thinks the US unit is moving from being a "funding" - or "safe haven" - currency to become one that investors use if they want to chase higher returns as a result of economic growth. "The dollar [is] starting to behave as a growth currency," he says, noting that "the Federal Reserve is likely to be the first of the major central banks to raise interest rates this year".
If this process of adjustment does not proceed smoothly - as people such as Mr Zhu fear - it could spark a great deal more political debate. In any event, the French will next year chair the Group of 20 leading industrialised and developing nations and Mr Sarkozy's remarks show he is determined to open discussions about a new monetary system.
Yet the French have broached similar ideas before without any impact, while even men such as Lord Turner know that calling for a rethink of the carry trade is too radical for most policy-makers. "There are a range of ideas that need to be taken out of the 'index of forbidden thoughts'," he recently declared.
But if the last two years have shown anything, it is that when a crisis strikes, ideas that used to seem unthinkable can suddenly enter the mainstream. Right now, all might seem relatively quiet on the foreign exchange front. But investors and politicians alike could do well to watch the carry trade as closely as they can, even - or especially - if no one knows how large it might be.
Authorities are uneasy at shifts
What exactly have western investors been doing with all their cheap dollars or euros in the past year? It is a question that has prompted endless debate among policymakers and analysts.
Some of the funding has undoubtedly been recycled inside domestic markets. Many analysts believe, for example, that the recent rally in US and European shares has been fuelled by cheap finance. And in the US, it seems, some institutions have been self-consciously playing a form of dollar-dollar carry trade.
Meredith Whitney, a banking analyst, says American regional banks have recently been buying prime US mortgage bonds on a large scale. Since these instruments pay a slightly higher return than the bank's cost of dollar funding, they produce an easy source of earnings. "This is a big carry trade," says Ms Whitney, who fears the pattern could produce losses for the banks when funding costs rise.
A cross-border focus for carry trade activity appears to be developing in emerging market countries such as Brazil, India and South Africa. In the past few months, there has been a flood of short-term investment into these places, pushing up the value of assets and the national currencies.
The currency appreciation has triggered growing unease. In South Africa, for example, Renosi Mokate, the Reserve Bank deputy governor, recently warned that carry trades had fuelled a rise in the value of the rand - and warned that this could be a "big challenge" for emerging markets this year. In Brazil, an alarmed government recently imposed mild capital controls.
Just this week, Duvvuri Subbarao, governor of the Reserve Bank of India, said he was so concerned about "sharp and volatile exchange rate movements" - meaning an appreciation of the rupee - that the government was considering imposing capital controls.
"Recent experience has underscored the issue of large and often volatile capital flows influencing exchange rate movements against the grain of economic fundamentals and current account balances," he said.
In the world's largest financial market, a web of bilateral trades makes it hard to count the
The carry trade has been a popular trading strategy in the foreign exchange markets for decades. It is based around one of the most reliable phenomena in the currency market: the "forward rate bias".
Buying high-yielding "target" currencies with low-yielding "funding" currencies should not in theory be profitable, as purchasing power parity theory suggests the low-yielding ones should appreciate to compensate for lower returns.
But in practice, the FRB ensures that higher-yielding currencies can outperform lower-yielding currencies over time as investors, buoyed by increasing optimism, leverage their positions by continuing to sell low-yielding target currencies.
At its simplest, investors fund the purchase of higher-yielding assets by borrowing in a low-yielding currency, such as the dollar or the yen. A carry trade need not just involve two currencies. But its success requires two elements: a funding currency with a low yield, and stability in asset markets. The strategy works well when the low-yielding funding currency is depreciating or stable, but any sharp upward movement in the funding currency or downward move in asset prices can quickly wipe out any yield advantage.
Carry trade strategies are therefore vulnerable to any shock to the financial system, as witnessed by the surge in the yen after the Russian financial crisis in 1998 and in the aftermath of the collapse of Lehman Brothers in 2008.
Measuring the carry trade is an inexact science. A tangled web of bilateral transactions in foreign exchange, the world's largest financial market, is notoriously difficult to track.
One popular measure is provided by the Commodity Futures Trading Commission, which publishes weekly data on positioning on the Chicago Mercantile Exchange. But while these figures are often used as a proxy for speculative activity from hedge funds, they provide only a limited insight into the activity of the currency market as a whole and are not regarded as effective for tracking the activity of longer-term investors such as asset managers.