It is partly financed by short-term capital inflows called “carry trade,” where speculators -- such as highly leveraged hedge funds -- borrow in low-interest currencies such as the Japanese yen and invest in high-interest currencies such as the Turkish lira. This is uncovered interest arbitrage, although the term “carry trade” is now used more broadly for yield arbitrage across all types of securities. There is no reliable data on carry trade; however, the Chicago Mercantile Exchange net short positions in yen futures indicate that it could be as large as $1 trillion. Although carry trade is found among the 10 major currencies, I will focus on the implications of carry trade for emerging market currencies, especially the Turkish lira. According to the uncovered interest rate parity condition, high interest currencies should depreciate and low interest currencies should appreciate, making it equally attractive to hold low-interest and high-interest currencies. In practice, however, the opposite happened during the last 30 years, rewarding the carry traders for their speculative activity, with some notable exceptions. In the late 1990s, during the Asian financial crisis and the Russian default, the yen appreciated suddenly hurting the carry traders badly. That is why The Economist magazine in its most recent issue likened carry trade to “picking up nickels in front of steam rollers.” Carry traders can make steady small gains from interest rate differences, but eventually might get wiped out by sudden and sharp appreciation of the low-interest currencies borrowed without cover, as well as the collapse in the prices of the securities bought with the high-interest currencies. This stream roller might crush not only the carry traders on its way but also engulf the high-interest rate countries in severe financial crises, even those with floating currencies.
Carry trade has depressed the value of the yen, giving Japanese exporters a competitive advantage against their US and EU rivals. Japan has resisted outside pressure to intervene in the FX markets to support the yen -- regarded as the weakest major currency. Carry trade has also pushed up the value of emerging market currencies, such as the Turkish lira, eroding the competitive advantage of their exporters.
Last week, the Bank of Japan doubled the short-term interest rate from 0.25 percent to 0.50 percent -- compared to 17.5 percent in Turkey -- the first raise since last July when it had increased the rate from 0 percent. This last raise had no significant effect on the yen because interest differentials remain huge and financial markets do not expect further Japanese interest rate increases soon. This might give false comfort to carry traders that there would be no significant upward pressure on the yen from higher interest rates. The real spoiler in this high stakes gamble, however, could be sudden increased currency volatility as was the case in the late 1990s. In October 1998, the yen appreciated by 13 percent in just three days.
Furthermore, FX rates are affected not only by interest rate differences but also real economic growth rate differences. A sustained rise in Japan’s real economic growth, even when not accompanied by higher interest rates, could push the yen higher and force carry traders to unwind their positions in panic, triggering a global financial crisis. Such a crisis could also be triggered by a sudden increase in risk-aversion toward emerging markets, following a major terrorist attack or natural disaster. Increasing political uncertainty in Turkey, caused by forthcoming presidential and parliamentary elections, as well as a worsening conflagration in the Middle East, could also increase the risk for the Turkish lira carry trade.
Such a financial crisis could have a devastating effect on Turkey, which would face massive short-term capital outflows, causing the lira to depreciate sharply. We had a taste of this during last spring’s mini crisis, when carry traders unwound their positions in an emerging-market stock sell-off. The Turkish Central Bank had to increase interest rates sharply as the lira dropped in value due to portfolio capital outflows.
