The Carry Trade and Global Imbalances

A fine post on Seeking Alpha, “What Good is the Carry Trade?” by Tim Iacono, takes a stab at the impact of the alleged unwinding of the carry trade (we have though it played a fairly big role in the upheaval of the last week plus, but no one can tell for certain) and the role of cheap credit.

Many have defended what economists describe as “global imbalances,” the massive flows of capital from China, Japan, and other high-savings nations into the US and other countries with chronic trade deficits (any country’s fund flows have to be offsetting, so a country with a trade deficit must run a capital account surplus, that is, must import capital, i.e., sell domestic assets to foreigners to pay the trade deficit).

The other way to characterize this pattern is to see the trade deficit as the result of America’s chronically low savings rate. America must import capital to fund needed investment and government deficits because domestic savings aren’t large enough to fund them. That leads to capital imports, which produces a trade deficit.

Martin Feldstein
, Harvard economics professor and president of the National Bureau of Economic Research, describes the situation in a Foreign Affairs article, “The Return of Savings“:

The savings rate of American households has been declining for more than a decade and recently turned negative. This decrease has dramatically reduced total national savings despite a rise in corporate saving. In 2003 and 2004, the combined net savings of households, businesses, and government were only about one percent of gross national income — the lowest level in at least 50 years.

This sharp decline in saving has had important implications for the United States and for the global economy. It has reduced productivity-enhancing net business investment in the United States to less than four percent of GDP and made the United States increasingly dependent on capital from the rest of the world to finance that investment. At the same time, the decreased national savings rate — and the increase in consumer spending that it implies — has induced a rise in U.S. imports. Those imports have contributed to the growth of output and employment in many countries around the world.

The downward trend in U.S. household saving will likely soon be reversed. In the long term, a substantial rise in household saving will have a positive effect on the U.S. economy. But the initial effects will pose problems for the United States and its trading partners. If these effects are not managed well, the result could be declines in output and employment and a corresponding rise in U.S. protectionism.

Feldstein is, in essence, saying that he doesn’t regard the current situation as sustainable. But it has persisted so long that many have become complacent about it, a complacency that parallels the widespread complacency about risk that evaporated last week.

Iacono make a more immediate point: that despite attempts to defend it, the carry trade creates financial instability and fails to channel capital to good uses. Remember, in Japan’s bubble years, the country’s excess liquidity went to overpaying for foreign assets and to dubious domestic projects, like theme parks in the boonies. In this iteration. other people are doing the buying on behalf of the Japanese, but their choices don’t look all that much better.

From Iacono:

Much of the blame for last week’s shellacking of financial markets around the world has been attributed to the “unwinding” of the Yen “carry trade”. That is, when hedge funds and other financial institutions closed out investment positions funded by money borrowed at low rates of interest from Japan….

Spurred by a recession warning from Alan Greenspan and the plunge in the Shanghai Composite index last Tuesday, carry trade profits were promptly taken, resulting in the sale of stocks, commodities, currencies, probably a few paintings, and who knows what else.

The after-hours plunge of over $20 in the price of gold on the New York Access market last Tuesday is being attributed, at least in part, to the sale of more than six tonnes of gold bullion by the streetTRACKS Gold ETF (GLD), a trading vehicle that has apparently become quite popular with hedge funds and other speculators.

The price of the metal had fallen only a dollar or two when the COMEX closed at 1:30 PM, but as of 4:15 PM, the gold ETF had lightened its load by a couple hundred thousand ounces. Clearly, there were few buyers for the supply being liquidated.

Similarly, high-yielding currencies in countries such as New Zealand and South Africa plunged as foreign currency positions, funded by the carry trade, were liquidated.

For the rest of the week, the rout was on for equity markets around the world, margin calls were made, and forced selling ensued.

The highly leveraged bets of hedge funds using cheap money denominated in the lowest yielding currencies once again wreaked havoc with financial markets.

When Rates Were Low in the U.S.
Not more than a few years ago, in the aftermath of the bursting of the U.S. stock market bubble when the short-term interest rate was only one percent, the U.S. Dollar was the preferred funding source for the carry trade.

There was great trepidation in mid-2004 when former Fed Chairman Alan Greenspan, a staunch backer of hedge funds over the years, began his “baby step” interest rate normalization campaign that eventually saw short-term rates climb 425 basis points.

Though many expected some sort of disaster, there were few problems. However, interest rates rising at a snail’s pace over a two year period emboldened borrowers around the world and at the top of the list of confident punters were buyers of real estate in the U.S.

Many of these loans are now going bad.

If not for the carry trade would interest rates in the U.S. have been raised at a faster pace avoiding some of the most egregious practices of the last two years in the U.S. housing market?

No one will ever know, but all of this prompts the question, “What Good is the Carry Trade?”

In comments on Tuesday in Greenwich, Connecticut, Assistant Treasury Secretary Anthony Ryan noted that, “few groups are more adept at identifying opportunities and moving capital around the world than those managing hedge funds.”

But do they have to do it with money borrowed from countries with weak economies?

This distorts the entire exchange rate picture and only benefits hedge fund managers and their investors. There is no discernible improvement in the “allocation of capital” – it’s just “asset shuffling”.

More Bubbles
It seems that all the carry trade really accomplishes is a further “bubbleization” of the world economy. Some hedge funds will reap huge profits and others will fail disastrously. Some rich investors will get a little richer and some will lose out. Some pension funds will have huge surpluses and some will have to resort to plan “B” to fund retirements.

Meanwhile, emerging economies struggle to survive the torrent of carry trade money and markets become more volatile.

There is an enduring idea that if the “the market” sets the price of currencies, equities, commodities, and other assets, then this is somehow better. The market knows best. But if “the market” is dominated by hedge funds with easy access to cheap money, this can be more destabilizing than beneficial…

Speculators have always played an important role in financial markets, but why must they be provided with such easy access to cheap money?

Print Friendly, PDF & Email