A V Rajwade: Yen's exchange rate and carry trade

WORLD MONEY

The main reason underlying the weakness of the Japanese currency is the carry trade.

The weakness of the Japanese yen has been a worry for the Europeans for some time. The cross rate against the euro had moved from JPY 140 to close to JPY 160 since the beginning of last year and, in real terms, was at its weakest since 1970 (but towards the end of last week the rate had recovered sharply to 155). According to some analysts, the yen is even more undervalued than the Chinese yuan, in real effective terms. But the G7 statement at the end of the February meeting was stronger in relation to China than Japan. As for the latter, it said, "Japan's recovery is on track...we are confident that the implication will be recognised by market participants and will be incorporated in their assessment of risk...exchange rates should reflect economic fundamentals." The pious expression about economic fundamentals is, in many ways, a myth. In the last few years alone, the euro has moved between $ 0.82 and $ 1.33, and this has happened with little change in arguably the two most important economic fundamentals to the external value of a currency, namely inflation and external balance. The fluctuations in the yen have been even more pronounced, from a high of 80 yen to a dollar in April 1995 to JPY 146 in August 1998, and in recent years from 105 yen to 122 yen.

To come back to the yen's present exchange rate, the currency, somewhat strangely, weakened in the wake of the Japanese central bank increasing the short term rate from 0.25 to 0.5 per cent on February 21, the highest level for a decade. The short-term rate was zero from 2001 to mid-2006 and 0.25 thereafter, after the Bank of Japan announced the end of a decade of deflation. One wonders whether the central bank action was aimed at achieving any result other than to display its independence "" as recently as the previous meeting, when the central bank held the rate steady, it had been criticised for succumbing to political pressure not to raise the rate, even when economic growth is strong, at an annual rate of 4.8 per cent in the last quarter of 2006.

The main reason underlying the weakness of the Japanese currency is the so-called "carry trade". To be sure, the current account surplus has dropped for the third year in succession and Japanese exports now comprise 6 per cent of the world total, just 50 per cent of the proportion 10 years back. But the current account remains in strong surplus and the Bank of Japan has reserves of $ 900 billion, next only to China's trillion dollar hoard. The carry trade involves borrowing in a low interest rate currency and investing the proceeds in higher interest rate assets keeping the exchange risk open. So long as the borrowed currency does not appreciate against the invested currency more than the interest differential, the carry trader makes a gain. (Often, traders prefer to sell the low-interest currency forward, rather than borrowing and investing, but the economics is the same.) Given their extremely low interest rates, presently the two most popular currencies are the Japanese yen and the Swiss franc "" on the other hand, the most popular currencies to invest in are the Australian and New Zealand dollars, both relatively high interest rate currencies. The hedge funds are investing an estimated $ 100 billion, that too on leveraged basis, in the carry trade. Interestingly, even mortgage loans in countries like Hungary, Romania and Latvia are being written in the Japanese and Swiss currencies! Last week, there were some signs of the yen carry trades reversing, with the yen strengthening to JPY 117.70 last Friday.

The Indian corporate sector too has been indulging in carry trade on a large scale. Taking trade credit in foreign currencies is a form of carry trade and one wonders whether the Governor had this in mind when, in response to a media query, he made a reference to higher interest rates attracting more foreign capital in the Indian market. In my view, it is unlikely that rising interest rates would attract more institutional funds in the bond or equity markets, so long as the expectation of further hikes in interest rates remains.

However, what it does do is increase the attraction and improve the economics of taking credit in foreign currency on, say, imports. To the extent the rupee does not fall more than the interest differential, foreign currency credit benefits the borrower. And, if exchange rate policy is seen as supporting a strengthening of the currency, the attractions are even stronger: incidentally, the RBI does not seem to be able to monitor the data in relation to short term trade credit very effectively.

But to come back to G7, the quoted statement cautions market participants against expecting a continuation of the Japanese currency weakness. Indian companies resorting to short-term credit in foreign currency would also do well to pay heed to it: the history of financial markets suggests that those caught in the rush to exit, rarely escape unscathed.