February 7, 2017    4 minute read

How Carry Trade Made the Financial Crisis Worse

Assessing the Damage    February 7, 2017    4 minute read

How Carry Trade Made the Financial Crisis Worse

A carry trade strategy means institutions borrowing money in countries with low interest rates like Japan and then converting into currencies from, countries with high interest rates such as Brazil – usually through buying bonds denominated in those currencies – making a profit on the difference between the two.

The growth in this kind of financial activity was one consequence of increased globalisation leading to free capital flows between countries and the ability to form financial contracts spanning many countries simultaneously.

In the years up to 2007, the yen depreciated significantly due to the outflow of capital from Japan, which reduced the value of financial institutions’ debts to Japanese banks. By investing money in other countries with high interest rates, traders were consequently able to make significant abnormal returns on their carry trades.

Even to this day, traders are known to exploit low interest rate environments and interest rate differentials between countries through investing in carrying trades, which has partly led to the US dollar soaring against emerging market currencies.

Carry Trades and the Financial Crisis

The carry trade strategy was originally highly profitable, but its success was often dependent on the movement of currency exchange rates. As long as the yen was depreciating, investors made huge returns. The unwinding of the carry trade strategy therefore intensified the impact of the financial crisis on emerging markets.

The carry trade strategy fell apart after the bailouts of institutions like Bear Stearns and the collapse of Lehman Brothers in 2008. Lehman Brothers were allowed to go bankrupt without full protection for its creditors or those who it had financial contracts with. This meant that there was panic in the system on a global scale. Confidence fell sharply and financial institutions in Japan were not willing to indulge in lending for carry trades anymore.

They consequently stopped providing as much credit to local and foreign traders, meaning that the value of the yen increased sharply since there was no longer as much outflow of capital. In addition, any debts owed by hedge funds to Japanese institutions suddenly became much larger in value, due to currency appreciation, which damaged their ability to repay.

What Happened?

There was a wave of defaults and banks in countries like Iceland and Brazil, who were thus on the brink of financial insolvency due to huge losses faced on their loans. In any case, traders were forced to withdraw money from countries which originally had high interest rates like Brazil and Iceland in order to repay some portion of their debts, meaning that their currency values weakened significantly.

This was a crisis in itself but was made worse by the fact that hedge funds who had borrowed in one currency and lent in another now suffered huge losses. Such effects suggest that the carry trade strategy was partially responsible for making the 2007 financial crisis a multinational one instead of one simply confined to US banks.

Dealing with Capital Flight

Governments and central banks have since implemented capital controls to reduce short-term currency outflows. This can result in a severe currency devaluation following an exogenous economic shock, which also impacts upon market sentiment. Iceland, for example, introduced controls to prevent investors, which had built up big positions in Icelandic assets, from liquidation, thus limiting subsequent conversion into foreign currency and eventual capital flight.

It was reported that even those leaving Iceland to go on holiday or study abroad had to present travel documents to banks and undergo strict screening before converting Kronur to foreign currency. Although most of the capital controls have been phased out to make things easier for the public, Iceland’s banks are still not allowed to move capital freely outside the country.

China’s Case

Although not strictly related to carry trades, China’s capital controls have also helped stop investors from withdrawing huge amounts of money from the country when market expectations of interest rates and economic growth fall: its residents are only allowed to change up to $50,000 per year.

However, many businessmen use illicit methods to transfer currency out of the country, and illegal money changing has now grown into a huge ‘shadow economy’ in and around China. This is yet another example showing that, while authorities can try to prevent capital flight and carry trades, it is not always guaranteed to yield the desired results.

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