The havoc wreaked by the unwinding of yen carry trades in 2008 in financial markets may be a distant memory for some of us in the wake of the current rally in global equity markets.
However, it is a scene that could be replayed some time down the road and this is not good news for a recovering global economy. Only this time, the currency with the starring role is the US dollar.
In recent months, the rapid rise in US dollar carry trades has set alarm hells ringing. These trades have been flooding emerging markets with liquidity and driving up asset prices to levels that do not commensurate with economic fundamentals.
Asset bubbles are building up in equities and commodities, and over the longer term, inflation will become a threat. Asian currencies have been appreciating so far this year as a result, led by the Indonesian rupiah, South Korean won and Indian rupee.
Of late, we have been hearing more and more talk that some central banks in emerging markets are considering imposing some form of capital control to battle the surge in the inflow of short-term capital, or hot money.
Last month, Brazil did just that when it imposed a 2% levy on foreign investment in equities and fixed income assets. Taiwan, meanwhile, is reported to have imposed a ban on overseas investors placing funds in its time deposits.
Indonesia has postured that it is studying limits on foreign ownership of central bank certificates to tame the volatility of the rupiah.
Fortunately, or unfortunately, for Malaysia, depending on how you want to look at it, such speculative capital inflow has not been as heavy as for other markets in the region. It is unfortunate, one must say, because yes, there is a return of hot money, but it isn’t coming this way. The ringgit has appreciated 4% against the greenback since the end of May – from RM3.51 on May 28 to RM3.369 on Nov 25. In comparison, the rupiah has risen 9.2% – from 10,351 to 9,395 – over the same period.
It shows that foreign investors are ignoring our markets and we have to ask ourselves why. A fund manager just back from New York and London lamented last week that it has been very difficult selling Malaysia these days.
On the other hand, it is fortunate for Malaysia because hot money has not chased up asset prices to unrealistic levels yet.
The heart of the matter is, will the US dollar carry trade hurt global markets just like the yen carry trade did in 2008 when it started unwinding?
A currency carry trade is the selling of a currency with low interest rates and the buying of a different currency that provides better yields. In the 1990s the yen carry trade was prevalent because the Japanese central hank maintained a very loose monetary policy, keeping rates at around 1% to boost growth.
As a result, investors took opportunity, selling the yen for other currencies and investing in assets that provided better yields, especially in the US, Europe and Australia.According to news reports, the yen funded some US$6 trillion in overseas assets.
But the crunch came in 2006 and 2007, when the US banking system went into a tailspin and the US dollar depreciated. There was an exodus from these currencies and a flight back to the yen, the full impact of which was felt in 2008.
This time round, the US dollar is at the centre of the carry trade because the US undertook a quantitative easing policy more than a year ago to pump-prime growth. This means investors have been able to borrow US funds at zero cost and put them into assets in the emerging markets with higher yields.
The International Monetary Fund (IMF) warned recently that the US dollar is serving as the funding currency for carry trades and is putting upward pressure on the currencies of emerging markets as well as the euro. This is potentially explosive as it can create asset bubbles and lead to another global financial crisis, it noted.
“Capital flows driven by yield differences are complicating monetary response in emerging economies,” it warned, noting that some countries were already resorting to the use of capital controls. Other policy responses include raising reserves and allowing the currency to appreciate.
Up to this point in time, the US dollar carry trade has yet to play itself out. When the crunch will come is anybody’s guess, but when it comes, financial markets will have to brace for yet another financial crisis that could quickly derail the fragile recovery in the global economy, some economists have warned.
In this regard, emerging markets are vulnerable because most of the speculative funds have come to this side of the world, largely because Asia is expected to emerge the fastest from the recession and post some of the highest growth rates in the world.
US dollar carry trades are not sustainable because US interest rates are not likely to stay at zero forever. In fact, with the US economy showing some green shoots of recovery in the third quarter of this year, focus has begun to shift towards defining an appropriate time for the exit of economic stimulus plans.
Be that as it may, there is consensus that the US is not likely to reverse its quantitative easing any time soon. But when interest rates start to rise again – and they will – that’s when things can become hot. By then, it may be too late to panic. So perhaps, some form of capital control at this point in time may not he such a bad idea after all.
Source : The Edge