Japanese crisis can revive yen carry trade

Earthquake and tsunami in Japan, political unrest in the Middle East, sovereign debt crisis in the eurozone and trade deficit in China. Indian investors apart from their own domestic issues of inflation and corruption scams are hit by these global events and do not know where to look for direction.

The markets, however, treat each event as a profit opportunity and will either go long or short on different asset classes of commodities, equities, currencies and bonds.

Investors should look at what will benefit them and what will not from these global events and the take positions accordingly.
The earthquake and tsunami in Japan are natural disasters of very large proportions. The Japanese government and the central bank will look to calm their citizens as well as pledge to rebuild destroyed infrastructure.

This would mean flooding the market with liquidity, keeping borrowing costs at all-time lows and spending heavily on infrastructure. Low rates, weak economic growth and a heavily indebted government calls for a weaker yen, and if liquidity is high, the yen can again become a funding currency. If the world does start borrowing in yen and investing in carry assets, it is good for markets like India which traditionally sees a positive impact of these flows due to its higher interest rates and higher growth rates.

The political unrest in West Asia is clearly negative for an oil importing nation like India. High oil prices on supply worries lead to rising fuel costs as well as rising subsidy bill, which leads to rising inflation as well as weakening the government finances. If the unrest continues and oil prices remain high, India will see investor sentiments turning weaker while the reverse is true if the unrest stops and oil prices stabilise.

Sovereign debt crisis in the eurozone impacts India both ways. On the negative side, risk aversion by global investors due to debt default worries leads to pullout of funds from risk assets including emerging market equities. On the positive side, global investors looking to diversify their bond holdings into less indebted nations can lead to inflows into India.

The Friday accord of European leaders on supporting debt-ridden countries like Greece, Portugal, Ireland and Spain will calm jittery markets. The accord is positive for India as there will be less risk aversion selling.

The sudden trade deficit numbers reported by China is a potential cause of high volatility in financial markets. China reported a trade deficit of $7.3 billion for February against consensus estimates of $4.9 billion. The February trade deficit compares against a trade surplus of $6.5 billion for January 2011. The trade deficit for January and February 2011 was $800 million against a surplus of $22 billion seen last year.

The reason for trade deficits in China causing volatility in financial markets is that there has been high speculation in the markets for a stronger yuan. The yuan has appreciated 4% since March 2010 on the back of calls for China to revalue upwards its currency.

High speculation on yuan revaluation has taken up other emerging market currencies as well including the Indian rupee, which has appreciated by 5% from lows seen in 2010. Trade deficits run by China will allow the country to fend off calls for yuan revaluation. The markets that are long emerging currencies based on China’s expected revaluation of the yuan will sell off on the back of dim prospects for revaluation. The rupee will also face its share of weakness on the back of speculative unwinding.   

Net to net, there are positives from global events and negatives from global events. Investors will have to wait for events such as Middle East unrest to calm down and China to manage its economy to bring about a soft landing before it can turn bullish.