The subprime debacle has exposed many dicey deals in recent weeks. One of the most worrisome is the yen carry trade, a perfectly legal, highly profitable and hugely popular trick that involves borrowing cheap yen at low Japanese interest rates, and using them to invest in countries with higher interest rates and more valuable currencies. When it worked, it was like shooting greenbacks in a barrel. Some investors have gambled as much as 10 times their own worth on what looked like a sure thing. But now that these deals are unraveling, they show just how interconnected and vulnerable to contagion modern financial markets have become.
Yen carry traders are mainly institutions, hedge funds and other big-time players, but in recent years Japanese retail investors have also gotten in on the game. Some of the most popular yen carry trades have involved the purchase of New Zealand dollars or Australian bonds, emerging-market debt and various U.S. dollar-denominated investments. While there’s no clear tally of the trade, estimates of its total size go as high as $1 trillion.
For some time now, central bankers have worried about the destructive potential of the carry trade—the more investors sell yen, the weaker it gets, and while that may be good news for Japanese exporters, it also distorts the global economy by increasing liquidity and encouraging bubbles.
Now, worried about growing currency volatility in unsettled markets, yen investors have begun unwinding their trades. In the past four weeks, the yen has risen 6 percent against the U.S. dollar, and over 20 percent against the New Zealand dollar. While it’s unclear how much of this is due to the unwinding of the carry trade, the result is a snowball effect. As the yen rises, more investors have to pull back their positions faster. “I’d call it an inevitable correction,” says Mark Cutis, chief investment officer at Shinsei Bank in Tokyo. “It’s difficult to estimate, [but] the next round of unwinding will likely be more violent.”
Already, there have been sharp drops in the Australian dollar, the Korean won and the South African rand, to name a few. Experts say that the effects could ricochet back to Japanese stocks. “The Nikkei hinges on the strength of Japanese exports,” which will be undercut by a rising yen, says Julian Jessop, chief international economist for Capital Economics in London. If the yen rises, Japanese automakers and electronics companies probably won’t sell as many wares abroad (particularly to credit-crunched Americans, who are finally reining in their profligate spending).
But the more important result would be the effect on worldwide liquidity. In global markets, buyers are already hard to find, and the retreat of carry traders will make them harder to find. While most of the unwinding so far has likely been done by hedge funds, which move fast, individuals could follow suit. Already, numerous housewives and salarymen dabbling in the foreign exchange market have lost money as the yen appreciated sharply. The impact of hundreds of thousands more Japanese retail investors’ unwinding their investments—considered part of the carry trade—is hard to predict. Could it wreak havoc with U.S. interest rates? Could it further depress emerging markets and undermine Asia as a growth engine? Nobody knows, and that uncertainty could prompt worried investors to stampede, producing the crash scenarios they fear.
