Comment

“Those who cannot remember the past are condemned to
repeat it”
— George Santayana

It seems winds of optimism embraced global financial markets since March 2009 as bourses across the world marched into the first decade of the millennium with spectacular gains.

Developed markets such as the DJIA, DAX, CAC and FTSE registered gains of around 50%. As usual, emerging markets have been the cynosure of investors. Brazil and India saw an appreciation of around 100%, whereas the Russian RTSI delivered a spectacular return of 200%. Among BRIC nations, China proved to be a laggard with a return of 70%.

What drove this rally? What has suddenly changed the sentiments for risky financial assets, which made all the bourses to rally in a global fraternity and deliver spectacular returns?
Was it the hope of a recovery in the world economy, after witnessing the worst ever financial crisis since 1929, or was it the result of liquidity taps opened by world central bankers to boost economic revival through stimulus packages?

It is true that the world economy, is reviving but things are not as rosy as reflected on the bourses. One apparent reason, which emerged as a constant source of liquidity, can be traced to the low interest rate regime adopted by the US Federal Reserve. In December 2008, in order to give a fillip to its economy, the Federal Open Market Committee (FOMC) decided to keep interest rates in the target zone of 0-0.25%. Since then the FOMC is maintaining the same rates.

The objective of this policy is to provide easy money to small businesses, consumers and even to large corporations, which in turn are expected to stimulate demand in the economy.

Unfortunately these funds have altogether chosen a different path and destination under the Fed’s zero interest rate regime and started nurturing asset class bubbles, which has been now officially given a sophisticated name — currency carry trade (now dollar carry trade)

What is currency carry trade?
Currency carry trade is a strategy where the investor short-sells a currency with a relatively low interest rate and buys a different currency yielding higher interest rates. As long as trading position of an investor is open, he is required to pay interest on the currency in which he has a short position and receives interest on the currency in which he has a long position.

By adopting this strategy, the investor ends up with a free profit, which is the interest rate differential. His profits will be further enhanced if the currency in which he has a long position appreciates. This strategy holds good as long as the funding currency (currency in which money is borrowed, in this case the dollar) doesn’t appreciate and interest rates of the same remain low.Similarly, investors can also borrow money in low-yielding currency and convert the same into the high-yielding asset classes.

How deadly it can be?
Albeit the fact that the carry trade looks very simple on the face of it, it is capable of creating a tsunami in world financial markets as it happened in the past with the yen carry-trade. In the mid 1990s (1995-1998), the Bank of Japan had interest rates as low as 0.5% and ended up with a zero interest rate policy by 1999, which encouraged savvy minds in the financial markets to exploit the interest rate differential between the lower interest rate yielding currencies and higher interest rate yielding currencies. All big investors like hedge funds, pension funds, investment banks, charitable endowments and even individual investors created huge demand for yen carry trade.

Then flavour of the season became borrowing in yen and investing in US treasury bonds, which were yielding around 4-5 %.

Money also flowed into different risky assets that artificially inflated prices, thereby successfully nourishing the asset class bubble over a period of time. This may be the reason why prices of asset classes like commodities, equities and real estate went up simultaneously from the early part of 2000. Reportedly, by 2007, $1 trillion (equivalent to the current Indian GDP) worth of funds were invested in different asset classes across the globe.

The yen carry-trade successfully continued for around two decades. However, in between, severe shocks were felt in financial markets during its unwinding.For instance the yen suddenly appreciated by around 15% on October 7 and 8, 1998 in two consecutive trading sessions (implies short-covering of positions in yen). It is said that famous hedge fund LTCM, with which two Nobel laureates were associated, was heavily invested in Russian government bonds and became a victim of the yen carry trade when Russia defaulted its debt obligation.

As a consequence, LTCM lost around $4 billion before shutting shop. In 1997, the east Asian currency crisis shook the world. The Thai baht, which was pegged to dollar at 25 in July 1997, lost its value and nosedived to a level of 56 per dollar by January 1998. It is estimated that until1997, Asia attracted 50% of the total capital inflows into developing countries.

South-East Asian economies in particular maintained high interest rates to attract foreign capital.

This crisis triggered a sharp sell-off in their currencies which was followed by a ‘run on equity markets’. It is reported that currencies of ‘Asian tigers’ lost around 77% in 1997 and another 44% by mid 1998.

In February 2007, when the yen appreciated sharply, it was observed that high interest rate yielding currencies such as the Brazilian Real, Iceland Krona and New Zealand dollar depreciated significantly. All this was attributed to the unwinding of yen carry trade. It also led to a global sell-off in equity markets.

Current scenario
Right now, the greenback is playing the role of a money machine (that the yen played in the 1990s), which can pump liquidity into the global financial markets and nurture the asset class bubble by artificially inflating prices. In his testimony before the Congress (on February 24, 2010) Fed chairman Ben Bernanke reiterated that interest rates are likely to remain low for an extended period of time.

It means that money will continue to be available at cheaper rates. Emerging markets would be the favourite destination for this hot money, which has the potential to outperform other asset classes. Indian bourses alone attracted around Rs 83,424 crore of net FII inflows in 2009 against net outflows of Rs 52,987 crore in 2008.

There is no mechanism to identify how much of this money is funded by the dollar carry trade. This deadly game will come to an end when the Fed changes its mind and starts hiking rates.

As Nouriel Roubini, professor of economics at New York University, who was credited for successfully predicting the financial crisis of 2008 says, when reversal of this trade takes place the dollar will not be up by 2-3% but it will be up by 15-20% as frenetic short-covering will push the value of the greenback.
This will act as a perfect recipe for the disaster in global financial markets as investors would frantically sell different asset classes so as to repay their dollar loans. The bigger and longer the carry trade, the deeper will be the crash.

The writer is assistant vice-president — equity technical research, Darashaw & Co. Views are personal.