Beware the fallout from the carry trade

published 17 July 2007

Amid nerves over subprime mortgage derivatives, another threat to the financial system has been overlooked: the carry trade. This is where investors borrow in currencies with low interest rates mostly the yen and the Swiss franc and invest the money, often supplemented with leverage, in assets priced in higher-yielding currencies.

A major symptom of the global credit bubble, the carry trade has spilled over into debt, equities and real estate, says Tim Lee of Pi Economics in the FT. The New Zealand dollar (a popular carry-trade destination) is now about 20%-25% overvalued against the US dollar, while the yen is about 30% under-valued. As exchange rates ultimately converge "sharply" with fair values, losses for leveraged speculators on their currency positions could reach about $550bn, as the trade is worth around $1.5trn globally, reckons Lee. Other markets would be affected by the fallout.

Higher Japanese interest rates could be one trigger: rising corporate services costs point to higher inflation, while the authorities don't want the carry trade to inflate further. As The Daily Telegraph's Ambrose Evans-Pritchard notes, a sharp jump in the undervalued yen nearly caused a global crisis in 1998. Carry trading has been easy money, but many people will "come a cropper", says Roger Bootle of Capital Economics.