Carry trade

Financial globalization has confronted central banks with carry-trade activities. These are cross-currency strategies that seek yield gains through leveraged borrowing at low interest rates in the funding currency to invest in high-yielding currencies (the Japanese yen–Australian dollar was a famous carry pair before the collapse of Lehman Brothers on 15 September 2008).

A carry trade is a risk-trading practice par excellence. Carry profits are wiped out if the target currency depreciates suddenly or if funding conditions change suddenly (see Brunnermeier et al., 2008). When confronted with such scenarios, carry traders exit rapidly and, in doing so, they put further depreciating pressure on the target currency.

Research identifies two carry-trade strategies. One involves exchanging the funds borrowed in the spot currency market in order to hold high-yielding assets in the target currency, in the form of bank deposits or tradeable domestic assets (Galati et al., 2007). However, investors need not get exposure to domestic assets. Through derivative instru- ments, carry traders can take positions that bet on future movements of the target cur- rency (Kaltenbrunner, 2010). There are clearly pro-cyclical effects: increasing demand for domestic assets during boom times and rapid price falls when carries unwind.

Financial actors engage in carry trades depending on their risk preferences, ability to mobilize leveraged funding, and access to assets in the target currency. Banks resident in the country of the target currency become key nodes in carry-trade networks. Indeed, one important development that has contributed to the rapid proliferation of carry trades is changing business models in banking. Departing from the traditional relational banking model, banks in open financial systems have become complex conglomerates that under- take proprietary trading, market making, and asset–liability management. Thus, banks resident in high-yield countries can engage in carry trades directly through proprietary trading, if they have access to cross-border funding (see Galati et al., 2007). Alternatively, resident banks lend the target currency to non-resident investors (hedge funds, global banks, real money funds, and so on) or enter derivative transactions with non-residents, earning profits from arbitraging the spot/forward rates (see Fritz and Prates, 2013).

Another well-documented carry-trade activity involves the central bank directly through its sterilization operations (see Gabor, 2012). If the central bank responds to excessive capital inflows with sterilized reserve accumulation, banks often treat sterili- zation instruments as a carry-trade target asset. In this case, sterilized currency inter- ventions have perverse effects, increasing capital inflows and pressures on the exchange rate.

Given the key role of domestic banks as nodes in carry-trade networks, carry-trade activity strengthens the interconnectedness of markets and actors. It connects currency markets to interbank money and asset markets; and all these to stress in key financial centres such as London or New York. Paradoxically, however, central banks encounter serious difficulties in measuring carry-trade activity (see Galati et al., 2007). Data on individual transactions motivated by cross-currency trading strategies are not readily available. Data on net positions in carry pairs on currency futures markets provide only a partial picture since large carry players, such as hedge funds, prefer over-the-counter transactions, mostly off balance sheet. Conversely, carry-to-risk ratios only reflect the attractiveness of a given carry trade (ex-ante, risk-adjusted profitability) but not actual carry volumes (Curcuru et al., 2010). Balance-of-payments statistics are ill-suited to provide the real-time data necessary to monitor such short-term trading strategies. Indeed, the global financial crisis that erupted in 2008 illustrates an asymmetry of meas- urement: it is easier to gauge the magnitude of carry trades when these unwind by observ- ing the simultaneous exchange-rate depreciation and rapid falls in asset prices.

The United Nations Conference on Trade and Development (2007) and the Bank for International Settlements (see Galati et al., 2007) first highlighted the difficulties that carry trades pose for central banks. Carry trades divorce exchange-rate movements from international trade activities. Instead, short-term capital flows driven by specula- tive intentions contribute to exchange-rate appreciation. Currency dynamics depend on policy choices in key financial centres that provide funding currencies (see Gabor, 2012). This highlights the consequences for central banks in high-income countries, as their efforts to stimulate lending with low interest rates and unconventional liquidity injections may instead spill over into the asset markets of high-interest rate countries. Further, central banks have limited tools to measure and monitor the extent of carry-trade activ- ity even though there is increasing evidence that carry trades contribute to systemic risk because of increased interconnectedness, cross-border exposures, and larger swings in financial cycles (see Hattori and Shin, 2009).

Regulators are less likely to constrain carry trades during good times, because these improve the liquidity of domestic asset markets, easing funding constraints for the economy. When concerns for exchange-rate volatility and financial instability trump the drive for financial deepening, central banks tend to tighten regulation. One avenue is to impose residency-based capital controls that either increase costs of carry (such as a withholding of tax on non-resident purchase of domestic assets, including sterilization instruments) or constrain outflows (for example, Ukraine introduced waiting periods for non-residents to convert the proceeds from sale of domestic assets in 2008). Alternatively, central banks can place restrictions on resident banks’ transactions with non-residents (on derivative markets) and on their proprietary trading. The stigma attached to such measures reduced considerably once the International Monetary Fund officially endorsed capital controls in 2010.

See also:

Asset management; Capital controls; Capital flight; Financial instability; Liability man- agement; Sterilization.