Carry Trade

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Context

• On August 5, major stock markets worldwide experienced their sharpest decline in decades.
• Various factors contributed to this jittery investor sentiment, including fears of a potential economic recession in the US and rising geopolitical tensions in West Asia.
• However, a significant new global trigger was the unwinding of the yen carry trade.

What is Yen Carry Trade?

The Concept

• Global investors often seek opportunities to maximize returns by borrowing money in countries with low interest rates and investing it in countries with higher interest rates.
• This strategy, known as a carry trade, involves converting borrowed currency into one with higher yields.

The Role of Japan

• A notable example is Japan, where the central bank (the Bank of Japan) maintained ultra-low interest rates of zero percent between 2011 and 2016, and even below zero (-0.10%) since 2016.
• This policy aimed to stimulate economic activity. However, Japan’s low interest rates encouraged investors to borrow yen cheaply and invest in higher-yielding assets in other countries like Brazil, Mexico, India, and the US.
• Such transactions are referred to as yen carry trades.

Recent Changes

Interest Rate Adjustment

• From mid-March to the end of July this year, the Bank of Japan increased its interest rates by 35 basis points, bringing the rate to 25% from its previous level of -0.1%.
• Although this may seem minor, especially compared to higher rates in countries like India, it was a significant shift in Japan’s monetary policy. This adjustment led to what is known as the “unwinding” of the yen carry trade.

Impact on Investments

• The rate hike triggered a sell-off by investors who had previously borrowed yen and invested in assets in other countries.
• The increase in Japanese interest rates led to a strengthening of the yen against other currencies, such as the dollar, Brazilian real, Mexican peso, and Indian rupee.

Consequences of Yen Trade Unwinding

• The strengthening of the yen caused a reevaluation of investments funded through yen carry trades.
• Investors, responding to the higher costs of borrowing and the appreciating yen, began liquidating their international assets, contributing to the sharp decline in global stock markets.

PRACTICE QUESTION Q. What does a carry trade involve? A.Borrowing in a low-interest currency and investing in a high-interest currency B.Investing in stocks to capitalize on currency fluctuations C.Trading government bonds to influence exchange rates D.Using high-risk assets to achieve high returns  Answer: A. Borrowing in a low-interest currency and investing in a high-interest currency

 SOURCE: INDIAN EXPRESS