Yen Carry Trade

Reference

Currently, global markets are witnessing a decline. One of the main reasons for this decline is the closure of Yen Carry Trade. Other factors include the possibility of economic recession in the US economy and increase in geopolitical tensions due to increasing turmoil in West Asia.

What is Carry Trade

• Often global investors borrow money from a country where interest rates are low and invest that money (after currency exchange) in a country where interest rates are very high. This is called carry trade.
• Such a situation arises due to the central banks of different countries setting interest rates to suit their specific economic conditions.

Impact of Japan’s Yen Carry Trade

• Japan’s central bank (Bank of Japan) kept interest rates at 0% between 2011 and 2016 and lowered it to below zero (-0.10%) in 2016.
  • The idea behind low interest rates is to stimulate economic activity.
• As the third largest economy, Japan’s cheap monetary policy has global implications.
• Such low interest rates encourage investors to borrow cheaply in yen and invest in other countries (such as Brazil, Mexico, India and even the US) to get better returns. This is called the yen carry trade.
• The Bank of Japan’s long-term low interest rates led to billions of dollars of ‘yen’ carry trade that encouraged investment in many countries around the world.
  • Even when central banks around the world raised interest rates sharply after the Russia-Ukraine conflict, the Bank kept its rates unchanged.

Interest Rate Changes by Japanese Central Bank

• Between March and July this year, the Central Bank of Japan raised interest rates by 35 basis points, taking the interest rate from -0.1% to 0.25%.
  • Though this is not a big increase from the Indian perspective (where interest rates are above 6.5%), it was like a monetary earthquake in Japan’s context.
  • There was also speculation that the Japanese Central Bank might raise interest rates further in the future.
  • This adversely affected investors who had borrowed in Yen and invested in Brazilian Real or Mexican Peso or Indian Rupee.

Impact

• The yen has strengthened against the dollar and most other emerging market currencies due to the rise in interest rates in Japan.
  • The yen exchange rate has strengthened against the dollar, real, rupee, peso, etc. in the past week.
• Assets held in these currencies were worth relatively less when converted back to yen.
• The narrowing of the return gap and the possibility of further increase in this direction fuelled the decline and prompted investors to sell assets that were bought using the cheaper yen.