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Dollar's fall could explode global yen carry trade

Section: Daily Dispatches

By Leo Lewis
The Times, London
Wednesday, March 19, 2008

Deepening misery on Wall Street, prophesies of recession, and the recent freefall of the dollar could set off a $300 billion (L148 billion) time bomb in the global yen carry trade, dealers are warning.

The carry trade, which involves cheaply borrowing the Japanese currency to buy other assets, comes unstuck in volatile currency markets. If the carry trade does implode, sending the yen to new heights against a wide basket of currencies, dealers say, the cast of victims could include individuals, corporates, and hedge funds.

The yen is at a 12-year high against the greenback and Tokyo-based economists are speculating that a severe crash in the carry trade could trigger a more devastating ruction in the $1 trillion overseas investments of Japanese mutual funds as the dollar/yen exchange rate edges toward the pain threshold of individual investors.

Hedge funds have long used the carry trade for cheap leverage, but there are also thought to be vast exposures to yen volatility in the Thai, Korean, and Indonesian banking sectors, where the Japanese currency has been borrowed heavily to meet funding needs. The British banking sector turned to a version of the carry trade -- yen-denominated bond issuance -- when credit conditions tightened around the Northern Rock crisis. Indian banks' use of the carry trade surged 180 per cent between 2005 and 2007. Because the trade has been so popular, Goldman Sachs analysts said yesterday that the sharp fall in the US dollar against the yen had prompted them to reassess the "cash-call risks" for Asian banks and corporates.

But the practice is also uniquely sensitive to general global risk appetites: When investors batten down the hatches, as they have done in the wake of the Bear Stearns collapse, the carry trade unwinds, often spectacularly.

It was advanced fear of that unwind, currency analysts at Mitsubishi Tokyo UFJ said, that has caused so much volatility over the past few days in the so-called yen cross trades -- where the low Japanese lending rate is exploited to buy high-yield currencies such as the New Zealand dollar, the South African rand, the Mexican peso, and the Icelandic krone. Sudden spikes in the yen against the Australian dollar, euro, and sterling, Nomura dealers said, indicated a first wave of fleeing from carry trades as risk appetites collapse.

Last August, as global markets were hit with the first blast of the sub-prime crisis, it was predominantly Japanese individuals, who had made investments in overseas currencies on trading websites, who were burnt.

But as the dollar continues its fall, the carry trades of a second, much larger group are threatened, David Woo, an FX analyst for Barclays Capital, said. Asian corporates are holding a series of deeper yen-carry positions in the form of of long-dated options, which amount to about $300 billion. They are more sensitive to forward exchange rates than spot forex prices but are still vulnerable to the sub-prime meltdown.

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Yen carry trade: the appeal and the ploy

-- The yen carry trade is a "cheap money" gambit that exploits the extraordinarily low borrowing rates available in Japan. It is notoriously hard to quantify but is understood to have supported a series of the asset bubbles around the world in the past few years, from Indian property to fine wine and art.

-- Japan's low interest rates, an anomaly in the financial world, result from Japanese central bank monetary policy, which has, Richard Jerram, the Macquarie economist, said, "defied orthodox economic thinking for more than 20 years."

-- The ploy involves borrowing yen and immediately selling them for a currency that is either itself a higher-yield instrument (e.g., the New Zealand dollar) because of the interest rates in the other country, or using them to buy higher-yield or higher-risk instruments (e.g., Turkish stocks). Because it combines risks of high leverage with risks inherent in a higher-yield asset class, the carry trade is highly sensitive to foreign exchange moves and liquidity fears.

-- Japanese individuals, after unhappily watching their stock market languish for years and their post office savings earning virtually nothing, were eager adopters of the yen carry trade. Online forex brokerage houses offered huge leverage opportunities, and many Japanese leapt on the bandwagon.

-- Hedge funds and corporations conduct a bigger form of the trade. Central banks see the carry trade as a culprit in global mispricing of risk.

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