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Carry trades back in focus

T.B. Kapali

CARRY trades are back in focus, both in the international and domestic financial markets.

The 10 per cent rise in dollar/yen since the start of the year, for instance, is being attributed majorly to carry trades in the currency pair _ borrowing short in yen at the Japanese currency's rock bottom interest rates and investing in higher yielding dollar assets in the expectation that the interest rate pick-up would more than match the currency risk inherent in the strategy.

As is clear, crucial to the sustenance of such a carry-trading strategy is the persistence of low interest rates in the currency in which borrowings are made. In the yen's case, this is more or less guaranteed. More critical is the issue of currency risk _ the risk of the dollar falling against the yen and thereby wiping out its (dollar's) favourable interest differentials. Of course, in dollar/yen, the magnitude of the carry trading activity seems to have imparted its own upward momentum to the dollar, thereby inducing further carry-trading activity.

An additional and important incentive (related to the issue of currency risk) for carry-trading activity in dollar/yen is that the Japanese authorities (the MoF and the Bank of Japan) seem to be quite intent on preserving the gains the dollar has made on the yen so far in the year.

All the necessary conditions for carry-trading then seem to be in place in dollar/yen.

A somewhat analogous strategy was in place in the Indian bond markets till recently. Borrowing money in the overnight money market at around 8 per cent, banks built long positions in gilts, hoping to reap trading profits inherent in the already investor- favourable bond market sentiment. The funding side was quite well taken care off, the banks assumed, given that overnight rates were in a narrow 8/9 per cent band for quite some time and there was a persistent tone of softness in the overnight markets.

More significantly, quite like the encouragement which the dollar/yen carry-traders have been obtaining from the BoJ, bond traders in the Indian market were also being encouraged by the keenness with which the Reserve Bank of India, for quite some time, was working towards maintaining softness and stability in the rupee interest rate markets.

That effort from the RBI _ to maintain a soft tone to rupee interest rates _ was basically a compulsion for the central bank arising from its role as public debt manager.

Therefore, in both the above cases, we find central banks themselves creating the environment and opportunities for high risk strategies such as carry-trading.

And, in both cases, one sees the central banks operating under some compulsions. In the case of the BoJ, the exchange rate priorities of the Japanese MoF take precedence over the central bank's other responsibilities. And as has been noted above, in the case of the RBI, its responsibilities as public debt manager are onerous.

The issue though is whether such central bank-inspired high-risk trading strategies can create systemic instability. It is clear from the dollar/yen experience of August 1998 and the current experience with Indian bonds that such leveraged trading in the currency and bond markets do contain the potential for inflicting systemic damage.