FX International Payments
By Frances Coppola
Every business has assets. These might be fixed assets, such as plant and machinery, or they could be financial assets, such as cash and bonds. Many of these assets are held, or “carried,” for long periods. In the financial world, the cost of holding an asset is known as the “cost of carry.” If the return from carrying an asset is larger than the cost of carry, the asset is said to have “positive carry.” Conversely, if the cost of carry is larger than the return, the asset has “negative carry.”
Assets such as gold and commodities naturally have negative carry. There are physical costs involved with holding those assets, such as storage charges and depreciation – these are their cost of carry - and they don’t bear interest. Thus, as long as the price remains stable after taking into account foreign exchange rate movements (since these assets are typically priced in U.S. dollars), the net return is negative. But when the price rises more than the cost of carry, these assets have positive carry.
Conversely, most financial assets – loans, stocks and bonds – naturally have positive carry, since bonds and loans pay interest and most stocks earn dividends. Borrowing to finance stock or bond purchases reduces positive carry. But it would be unusual for an investor to finance investments by borrowing at higher rates than the expected return on the assets. However, positive carry can turn negative if an asset is financed in a different currency from the one in which it is denominated. A sharply falling FX rate can raise the cost of funding and wipe out the asset’s return.
In its simplest form, a carry trade involves borrowing a low-return asset and lending a high-return one, profiting from the spread between the interest paid and the interest charged. Bank lending is an interest carry trade, since banks profit from the difference between the interest rates they pay on deposits and the interest rates they charge for lending. Often, an interest carry trade involves maturity mismatch, since longer-term lending typically carries higher interest rates than short-term. For example, a bank might lend for five years at a relatively high fixed rate, funding it with low-interest deposits that can be withdrawn on demand. Of course, this exposes the bank to interest rate risk: if interest rates rise significantly during the five-year loan term, the bank may find the loan becomes a negative carry asset. Banks and investors may use interest rate swaps to protect themselves against adverse movements in interest rates when holding fixed-rate debt assets.
Carry trades are extensively used in the FX market. In a cross-currency carry trade, investors borrow in the currency of a country with low interest rates and lend or invest in the currency of a country with high interest rates, earning a profit from the spread between the two rates after exchange rate differences are taken into account.
The principle of “uncovered interest rate parity” says that the exchange rate of any two currencies should adjust to eliminate any possibility of making a real profit from an interest rate differential.1 Similarly, the Law of One Price says that the real carry cost of an asset should be the same in every country: we have previously explained how foreign exchange rates adjust to eliminate price differences.
But in practice, carry trades can be extremely persistent. Because the FX component of a cross-currency carry trade involves selling the low-interest-rate currency and buying the high-interest-rate one, the carry trade itself tends to make the exchange rate of the low-interest-rate currency fall relative to the other. If carry trades are sufficiently large in volume they can cancel out any tendency for exchange rates to equalize, enabling profits to be made over long periods of time.
One of the longest-running FX carry trades was between the Japanese yen and U.S. dollar. In the 1990s, the Japanese economy was in the doldrums due to a slow-motion banking collapse that started in 1990 and lasted for most of the decade.2 To support the economy, the Japanese central bank progressively cut interest rates from 6 percent in 1991 to 0.5 percent in October 1995.3
Between 1990 and 1994, the U.S. Federal Reserve also cut interest rates, from 6 percent to 3 percent. But it then raised them. By April 1995, rates were back to 6 percent, and remained between 4 and 6 percent until 2001. In the aftermath of the September 11th attacks, the Fed cut rates again – but so did the Bank of Japan. Japanese interest rates hit 0.1 percent in 2002 and remained there until 2007, far below anything dreamed of by the Fed at that time.
Such a persistent interest rate differential between the yen and the dollar created a profit opportunity for investors. And they took advantage of it. Borrowing yen and lending U.S. dollars became a fashionable trade: the yen became the funding currency of choice for many U.S. dollar investments, from commodities to equities and emerging market bonds.4 As a result, the yen weakened significantly against the dollar,5 increasing the returns from the carry trade still more and encouraging more investors to borrow in yen and lend in dollars.
Towards the end of 2006, the Japanese central bank started to raise interest rates. By mid-2007 they had reached 0.75 percent and the yen’s exchange rate was rising versus the U.S. dollar. In July 2007, the Fed started to cut interest rates sharply as the U.S. entered recession and the subprime crisis gathered pace. American interest rates continued to fall for the next year: by December 2008 the Fed Funds rate was at 0.16 percent and the interest differential with Japanese interest rates had completely disappeared. Very low U.S. interest rates coupled with a dramatic rise in the yen’s exchange rate made funding in dollars more attractive. So investors switched from funding in yen to funding in U.S. dollars, reversing the carry trade.6
The sudden unwinding of a large, long-running carry trade such as the yen-dollar trade can have unfortunate consequences. A carry trade like this is a source of cheap credit for the rest of the world. When it is suddenly withdrawn, the effects are similar to a “sudden stop” – the sudden withdrawal of funding that can spell disaster for countries dependent on external sources of finance.7 In 2007-8, countries that had benefited from yen-funded dollar investments experienced dramatic falls in their currency exchange rates.8 There was also serious trade disruption due to extremely high currency volatility.9
When there is free movement of capital, cross-currency carry trades inevitably appear when central banks use short-term interest rates to influence domestic economic conditions. While exchange rates remain stable, they can be a good source of funding for businesses and governments around the world. However, sudden changes in exchange rates and/or interest rates can cause a carry trade to unwind, with potentially disastrous economic consequences.
With 17 years experience in the financial industry, Frances is a highly regarded writer and speaker on banking, finance and economics. She writes regularly for the Financial Times, Forbes and a range of financial industry publications. Her writing has featured in The Economist, the New York Times and the Wall Street Journal. She is a frequent commentator on TV, radio and online news media including the BBC and RT TV.
1. “Uncovered interest rate parity,” Investopedia; http://www.investopedia.com/terms/u/uncoveredinterestrateparity.asp
2. The Japanese Banking Crisis of the 1990s: Sources and Lessons,International Monetary Fund; https://www.imf.org/external/pubs/ft/wp/2000/wp0007.pdf
3. “Interest rates, Discount Rate for Japan,” St. Louis Federal Reserve statistical database (FRED); https://fred.stlouisfed.org/series/INTDSRJPM193N
4. “Stage is set for revival of the yen carry trade,” Financial Times; http://www.ft.com/cms/s/0/24be4ec4-28bf-11df-b86f-00144feabdc0.html?ft_site=falcon&desktop=true#axzz4g1FfZIQ3
5. “Japanese yen / U.S. foreign exchange rate,” St. Louis Federal Reserve statistical database (FRED); https://fred.stlouisfed.org/series/DEXJPUS
6. “Beware the unwinding of the yen carry trade,” Financial Times; http://www.ft.com/cms/s/0/0952b150-a622-11dd-9d26-000077b07658.html?ft_site=falcon&desktop=true#axzz4g1FfZIQ3
7. Capital flows and Capital-Market Crises: the simple economics of sudden stops, Journal of Applied Economics; http://www.columbia.edu/~gc2286/documents/ciecpp5.pdf
8. Exchange rates during financial crises, Bank of International Settlements; http://www.bis.org/publ/qtrpdf/r_qt1003f.pdf
9. “Yen carry trade unwinds,” Bullion Vault; https://www.bullionvault.com/gold-news/yen_carry_trade_101620084