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To save the world financial system, Japan must die

Section: Daily Dispatches

Carry Trade Threatens
Deflationary Global Collapse

By Tim Lee
Financial Times, London
Tuesday, June 26, 2007

Concerns that the credit cycle may be turning down are growing. But so far the impact on stock markets has been fairly limited.

Investors take comfort in three misguided beliefs. They believe that equities are not expensive and that there is no sign of any diminution in the flood of global "liquidity." Further, they believe that if the worst happens, the US Federal Reserve will come to the rescue.

Such beliefs represent a failure to understand the unique nature of this global credit bubble and the consequences of its inevitable collapse. The financial markets have become closely intertwined in ways that we have never seen before.

Some of these links are obvious, such as private equity's arbitrage between the credit bubble and the equity markets. Others, such as the role of the global currency carry trade -- the financing of leveraged positions in higher-yielding assets from low-interest rate currencies such as the yen and the Swiss franc -- are less well understood.

A symptom of the bubble is that high-interest rate currencies have been soaring to multi-year or multi-decade highs against the yen. The New Zealand dollar, for instance, is approaching 21-year highs against the yen even though over those 21 years the price level in New Zealand has doubled while in Japan it has risen by only 12 per cent.

A simple purchasing power parity exercise suggests that the New Zealand dollar is 20-25 per cent overvalued against the US dollar, while the Turkish lira is about 65 per cent overvalued. The yen meanwhile is roughly 30 per cent undervalued.

Huge currency misalignments are leading to enormous current account imbalances. The Turkish and New Zealand current account deficits, for instance, are likely to be well into double-digits as a percentage of GDP by 2009, while Japan is likely heading for a record surplus of 6 to 8 per cent of GDP over the same time frame. The Swiss current account surplus is already about 17 per cent of GDP.

Ultimately there must be a sharp convergence of exchange rates with fair values, inflicting heavy losses on carry trades. The size of the global carry trade is at least $1,500 billion, and losses from a convergence of currencies with fair values could total about $550 billion, with most of these losses accruing to leveraged speculators.

Given the close linkages between markets, we can be confident that the unprecedented deviations of currencies from fair value resulting from the carry trade are reflected in credit, equities, and real estate markets.

For the US, this is confirmed in the ratio of personal sector net worth to GDP. Prior to 1995, this ratio tended to fluctuate at about an average of 3.4. Now, despite the paucity of savings in the US economy, the ratio stands at 4.1. A return to the long-run average would imply a fall in US personal net worth of approximately $10,000 billion. With similar trends mirrored across much of the world, total global losses from the coming financial meltdown could easily reach $25,000 billion to $30,000 billion.

Central banks are likely to attempt to ratify current inflated asset values by inflating prices and incomes to avoid a deflationary economic collapse. Unfortunately, sharp reductions in interest rates in the US, UK, and the euro area will lead to a rapid unwinding of the global carry trade, perversely threatening to worsen problems in the credit markets.

The solution would have to involve massive unsterilised intervention by the Japanese authorities, which would have the effect of inflating Japanese prices to a level consistent with the current yen exchange rate, thereby alleviating huge upward pressure on the yen as the carry trade unwinds.

Combined with a similar inflation in the US, this "solution" would require roughly a doubling of the Japanese price level, destroying the real value of Japanese savings.

If the losses are to manifest purely in real terms -- via inflation -- then they must occur mostly where the savings have been, which is certainly not in the US.

If the Japanese authorities balk at the prospect of such a huge inflation, then global deflationary collapse will be inevitable once the credit bubble bursts.


Tim Lee is the founder of financial economic consultancy pi Economics.

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