A common practice of international investors is to take part in the so-called ‘carry trade’. This involves taking advantage of nominal interest rate differences between countries. For example, assume that interest rates are low in Japan and high in the USA. It is thus profitable to borrow yen in Japan at the low interest rate, exchange it into US dollars and deposit the money at the higher interest rate available in the USA. If there is no change in the exchange rate between the dollar and the yen, the investor makes a profit equal to the difference in the interest rates.
Rather than depositing the money in a US bank account, an alternative is to purchase US bonds or other assets in the USA, where the return is again higher than that in Japan.
If, however, interest-rate differentials narrow, there is the possibility of the carry trade ‘unwinding’. Not only may the carry trade prove unprofitable (or less so), but investors may withdraw their deposits and pay back the loans. This, as we shall, can have adverse consequences on exchange rates.
The problem of an unwinding of the carry trade is not new. It worsened the underlying problems of the financial crisis in 2008. The question today is whether history is about to repeat itself with a new round of unwinding of the carry trade threatening economic growth and recovery around the world.
We start by looking at what happened in 2008.
The carry trade and the 2008 financial crisis
Prior to the financial crisis of 2008, current account deficit countries, such as the UK, USA and Australia, typically had relatively high interest rates, while current account surplus countries such as Japan and Switzerland had relatively low ones. Figure 1 shows central bank interest rates from 2005 to the current day (click here for a PowerPoint).
The carry trade saw investors borrowing money in Japan and Switzerland, exchanging it on the foreign exchange market, with the currency then deposited in the UK, USA and Australia. Hundreds of billions worth of dollars were involved in this carry trade.
If, however, the higher interest rates in the UK and other deficit countries were simply to compensate investors for the risk of currency depreciation, then there would be no excessive inflow of finance. The benefit of the higher interest rate would be offset by a depreciating currency. But the carry trade had the effect of making deficit currencies appreciate, thereby further boosting the carry trade by speculation of further exchange rate rises.
Thus the currencies of deficit countries appreciated, making their goods less competitive and worsening their current account deficit. Between 1996 and 2006, the average current account deficits as a percentage of GDP for Australia, the USA and the UK were close to 4½, 4 and 2, respectively. Between January 1996 and December 2006, the broad-based real exchange rate index of the Australian dollar appreciated by 17%, of the US dollar by 4% and of sterling by some 23%.
Currencies of surplus countries depreciated, making their goods more competitive and further boosting their current account surpluses. For example, between 2004 and 2006 the average current account surpluses as a percentage of GDP for Japan and Switzerland were 3½ and 13, respectively. Their short-term interest rates averaged a mere 0.1% and 1.0% respectively (compared with 3.4%, 4.7% and 5.7% for the USA, the UK and Australia). Yet between January 2004 and December 2006, the real exchange rate index of the yen depreciated by 21%, while that of the Swiss franc depreciated by 6%.
With the credit crunch of 2007/8, the carry trade unwound. Much of the money deposited in the USA had been in highly risky assets, such as sub-prime mortgages. Investors scrambled to sell their assets in the USA, UK and the EU. Loans from Japan and Switzerland were repaid and these countries, seen as ‘safe havens’, attracted deposits. The currencies of deficit countries, such as the UK and USA, began to depreciate and those of surplus countries, such as Japan and Switzerland, began to appreciate. Between September 2007 and September 2008, the real exchange rate indices of the US dollar and sterling depreciated by 2% and 13% respectively; the yen and the Swiss franc appreciated by 3% and 2¾%.
This represented a ‘double whammy’ for Japanese exporters. Not only did its currency appreciate, making its exports more expensive in dollars, euros, pounds, etc., but the global recession saw consumers around the world buying less. As a result, the Japanese economy suffered the worst recession of the G7 economies.
The carry trade in recent months
Since 2016, there has been a re-emergence of the carry trade as the Fed began raising interest rates while the Bank of Japan kept rates at the ultra low level of –0.1% (see Figure 1). The process slowed down when the USA lowered interest rates in 2020 in response to the pandemic and fears of recession. But when the USA, the EU and the UK began raising rates at the beginning of 2022 in response to global inflationary pressures, while Japan kept its main rate at –0.1%, so the carry trade resumed in earnest. Cross-border loans originating in Japan (not all of it from the carry trade) had risen to ¥157tn ($1tn) by March 2024 – a rise of 21% from 2021.
The process boosted US stock markets and contributed to the dollar appreciating against the yen (see Figure 2: click here for a PowerPoint).
Although this depreciation of the yen helped Japanese exports, it also led to rising prices. Japanese inflation rose steadily throughout 2022. In the 12 months to January 2022 the inflation rate was 0.5% (having been negative from October 2020 to August 2021). By January 2023, the annual rate had risen to 4.3% – a rate not seen since 1981. The Bank of Japan was cautious about raising interest rates to suppress this inflation, however, for fear of damaging growth and causing the exchange rate to appreciate and thereby damaging exports. Indeed, quarterly economic growth fell from 1.3% in 2023 Q1 to –1.0% in 2023 Q3.
But then, with growth rebounding and the yen depreciating further, in March 2024 the Bank of Japan decided to raise its key rate from –0.1% to 0.1%. This initially had the effect of stabilising the exchange rate. But then with the yen depreciating further and inflation rising from 2.5% to 2.8% in May and staying at this level in June, the Bank of Japan increased the key rate again at the end of July – this time to 0.25% – and there were expectations that there would be another rise before the end of the year.
At the same time, there were expectations that the Fed would soon lower its main rate (the Federal Funds Rate) from its level of 5.33%. The ECB and the Bank of England had already begun lowering their main rates in response to lower inflation. The carry trade rapidly unwound. Investors sold US, EU and UK assets and began repaying yen loans.
The result was a rapid appreciation of the yen as Figure 3 shows (click here for a PowerPoint). Between 31 July (the date the Bank of Japan raised interest rates the second time) and 5 August, the dollar depreciated against the yen from ¥150.4 to ¥142.7. In other words, the value of 100 yen appreciated from $0.66 to $0.70 – an appreciation of the yen of 6.1%.
Fears about the unwinding of the carry trade led to falls in stock markets around the world. Not only were investors selling shares to pay back the loans, but fears of the continuing process put further downward pressure on shares. From 31 July to 5 August, the US S&P 500 fell by 6.1% and the tech-heavy Nasdaq by 8.0%.
As far as the Tokyo stock market was concerned, the appreciation of the yen sparked fears that the large Japanese export sector would be damaged. Investors rushed to sell shares. Between 31 July and 5 August, the Nikkei 225 (the main Japanese stock market index) fell by 19.5% – its biggest short-term fall ever (see Figure 4: click here for a PowerPoint).
Although the yen has since depreciated slightly (a rise in the yen/dollar rate) and stock markets have recovered somewhat, expectations of many investors are that the unwinding of the yen carry trade has some way to go. This could result in a further appreciation of the yen from current levels of around ¥100 = $0.67 to around $0.86 in a couple of years’ time.
There are also fears about the carry trade in the Chinese currency, the yuan. Some $500 billion of foreign currency holdings have been acquired with yuan since 2022. As with the Japanese carry trade, this has been encouraged by low Chinese interest rates and a depreciating yuan. Not only are Chinese companies investing abroad, but foreign companies operating in China have been using their yuan earnings from their Chinese operations to invest abroad rather than in China. The Chinese carry trade, however, has been restricted by the limited convertibility of the yuan. If the Chinese carry trade begins to unwind when the Chinese economy begins to recover and interest rates begin to rise, the effect will probably be more limited than with the yen.
Articles
- A popular trading strategy just blew up in investors’ faces
CNN, Allison Morrow (7/8/24)
- The big ‘carry trade’ unwind is far from over, strategists warn
CNBC, Sam Meredith (13/8/24)
- Unwinding of yen ‘carry trade’ still threatens markets, say analysts
Financial Times, Leo Lewis and David Keohane (7/8/24)
- The yen carry trade sell-off marks a step change in the business cycle
Financial Times, John Plender (10/8/24)
- Forbes Money Markets Global Markets React To The Japanese Yen Carry Trade Unwind
Forbes, Frank Holmes (12/8/24)
- 7 unwinding carry trades that crashed the markets
Alt21 (26/1/23)
- A carry crash also kicked off the global financial crisis 17 years ago — here’s why it’s unlikely to get as bad this time
The Conversation, Charles Read (9/8/24)
- What is the Chinese yuan carry trade and how is it different from the yen’s?
Reuters, Winni Zhou and Summer Zhen (13/8/24)
- Carry Trade That Blew Up Markets Is Attracting Hedge Funds Again
Yahoo Finance/Bloomberg, David Finnerty and Ruth Carson (16/8/24)
- Currency Carry Trades 101
Investopedia, Kathy Lien (9/8/24)
- Carry Trades Torpedoed The Market. They’re Still Everywhere.
Finimize, Stéphane Renevier (13/8/24)
Questions
- What factors drive the currency carry trade?
- Is the carry trade a form of arbitrage?
- Find out and explain what has happened to the Japanese yen since this blog was written.
- Find out and explain some other examples of carry trades.
- Why are expectations so important in determining the extent and timing of the unwinding of carry trades?
Since coming to office two years ago, Shinzo Abe’s government has been determined to revive the Japanese economy. The policy has involved ‘three arrows‘: expansionary fiscal policy, expansionary monetary policy and supply-side reforms. But figures just out show that the Japanese economy is back in recession. The economy shrank by 0.4% in quarter 3, having shrunk by 1.9% in quarter 2.
This has come as a huge disappointment for Mr Abe, who has staked his political reputation on escaping from deflation and achieving sustained economic growth. In response, he has called a general election to put a revised economic plan to the electorate.
The main cause of the reversal into recession has been an increase in the sales tax on all goods, which has dampened spending. The tax rise, planned by the previous government, was to help reduce the deficit and start tackling the huge public-sector debt, which, at over 230% of GDP, is by far the highest in the developed world. Another rise in sales tax is due in October 2015 – from 8% to 10%. Mr Abe hopes to cancel the rise and it is this that he may put to the electorate.
So what is the outlook for Japan? Will quarter 4 show economic growth, or will pessimism have set in? Will the Bank of Japan introduce even more quantitative easing, or will it wait for the latest increase in QE to take effect (see the blog post, All eased out: at least for the USA and UK)?
The following articles look at the implications of the latest news, both for Japan and globally, and at the options for the government and central bank.
Articles
Japanese economy falls into surprise recession Independent, Maria Tadeo (17/11/14)
Japan’s economy makes surprise fall into recession BBC News (17/11/14)
Coming to a crunch: Time is running out for Abenomics The Economist (20/11/14)
Japan’s economy: Delay the second consumption tax hike The Economist (17/11/14)
Defying Expectations, Japan’s Economy Falls Into Recession New York Times, Jonathan Soble (16/11/14)
Japan shocks as economy slips into recession CNBC, Li Anne Wong (17/11/14)
Japan Unexpectedly Enters Recession as Abe Weighs Tax: Economy Bloomberg, Keiko Ujikane and Toru Fujioka (17/11/14)
The world should be wary: Japan’s economic woes are contagious The Guardian, Larry Elliott (17/11/14)
Why is Japan heading to the polls? BBC News (18/11/14)
Previous news items on this site
A new economic road for Japan? (January 2013)
A J-curve for Japan? (May 2013)
Japan’s three arrows (June 2013)
Abenomics – one year on (December 2013)
Japan’s recovery (January 2014)
Japan’s CPI: An Update (May 2014)
All eased out: at least for the USA and UK (November 2014)
Data
Quarterly Estimates of GDP Japanese Cabinet Office
Japan and the IMF IMF Country Reports
Economic Outlook Annex Tables OECD
Questions
- Give details of the Japanese government’s three arrows.
- Discuss the pros and cons of the rise in the sales tax. Is it possible for the rise in the sales tax to increase the size of the public-sector deficit?
- What have been the effects of Japanese government policies on (a) prices of goods and services; (b) living standards; (c) asset prices?
- Who have been the gainers and losers of the policies?
- How is the Japanese situation likely to effect the value of the yen? How is this, in turn, likely to affect its trading partners? Could this set off a chain reaction?
It is rising inflation that typically causes problems for countries, whether it is demand-pull or cost-push. However, one country that has not been subject to problems of rising prices is Japan. Instead, this economy has been suffering from the gloom of deflation for many years and many argue that this is worse than high inflation.
Falling prices are popular among consumers. If you see a product whose price has fallen from one day to the next, you can use your income to buy more goods. What’s the problem with this? The Japanese economy has experienced largely stagnant growth for two decades and a key cause has been falling prices. When the prices of goods begin to fall over and over again, people start to form expectations about the future direction of prices. If I expect the price of a good to fall next week, then why would I buy now, if I can buy the same good next week at a lower price? 
But, when next week arrives and the price has fallen as expected, why would I purchase the product, if I think that the price fall is set to continue? The problem of deflation is that with continuously falling prices, consumers stop spending. Aggregate demand therefore declines and economic growth all but disappears. This is the problem that the Japanese economy has been faced with for more than 20 years.
However, the latest data from Japan shows core consumer prices growing faster than expected in December 2013, compared to the previous year. This figure was above market forecasts and was the fastest rate of growth in the past 5 years. These data, together with those on unemployment have given the economy a much needed boost.
Recent government policy has been focused on boosts in government spending, with an aim of reducing the value of the currency (click here for a PowerPoint of the chart). Such policies will directly target aggregate demand and this in turn should help to generate an increase in national output and push up prices. If the price trend does begin to reverse, consumers will start to spend and again aggregate demand will be stimulated.
The future of the economy remains uncertain, though the same can be said of many Western economies. However, the signs are good for Japan and if the recovery of other economies continues and gathers pace, Japan’s export market will be a big contributor to recovery. The following articles consider the Japanese economy.
Japan inflation rises at fastest pace in over five years BBC News (31/1/14)
Benchmark Japan inflation rate hits 1.3% Financial Times, Jonathan Soble (31/1/14)
Japan’s inflation accelerates as Abe seeks wage gains Bloomberg, Chikako Mogi, Masahiro Hidaka and James Mayger (31/1/14)
Japan inflation quickens to over 5-year high, output rebounds Reuters, Leika Kihara and Stanley White (31/1/14)
Japaense inflation rises at fastest pace in over five years at 1.3% in December 2013 Independent, Russel Lynch (31/1/14)
Why Abenomics holds lessons for the West BBC News, Linda Yueh (18/12/13)
Questions
- Why is deflation a problem?
- Using an AD/AS diagram, illustrate the problem of expectations and how this contributes to stagnant growth.
- How will a lower currency help Japan?
- What is the likely effect of a sales tax being imposed?
- Does the fact that unemployment has declined support the fact that consumer prices are beginning to rise?
- What government policies would you recommend to a government faced with stagnant growth and falling prices?
- How important are expectations in creating the problem of deflation?
The new Japanese government under Shinzo Abe, which took office on 26 December 2012, has been pursuing a policy of weakening the yen. Using a combination of low interest rates, quantitative easing, expansionary fiscal policy and a declared aim of depreciation, the government has succeeded in driving down the value of the yen.
Since mid-November last year, the yen has depreciated by 28% against the dollar, 30% against the euro and 21% against sterling. The effective exchange rate index has fallen by 22% (see first diagram below: click here for a PowerPoint of the diagram).
But will this depreciation succeed in stimulating the Japanese economy and will it improve the balance of trade? The hope is that the falling yen will boost export sales by making them cheaper abroad, and will reduce the demand for imports by making them more expensive in Japan. The balance of trade will thereby improve and higher exports (an injection) and lower imports (a withdrawal) will stimulate aggregate demand and economic growth.
Traditionally Japan has run balance of trade surpluses, but since July 2012, it has been running monthly deficits – the longest run of deficits since 1980. But depreciation cannot be expected to turn this position around immediately. Indeed, theory suggests that the balance of trade is likely to deteriorate before it improves. This is known as the J-curve effect and is illustrated in the second diagram below. As page 768 of Economics, 8th edition states:
At first a devaluation or depreciation might make a current account deficit worse: the J-curve effect. The price elasticities of demand for imports and exports may be low in the short run (see Case Study 25.1 in MyEconLab). Directly after devaluation or depreciation, few extra exports may be sold, and more will have to be paid for imports that do not have immediate substitutes. There is thus an initial deterioration in the balance of trade before it eventually improves. In Figure 25.12 [the second diagram], devaluation takes place at time t1. As you can see, the diagram has a J shape.
Evidence suggests that the first part of the ‘J’ has been experienced in Japan: Japan’s balance of trade has deteriorated. But there is debate over whether the balance of trade will now start to improve. As the article by James Saft states:
But a look at the actual data shows Japanese companies, like British ones during a similar bout of currency weakness in 2008, appear to be more eager to use a newly competitive currency to pad profits through higher margins rather than higher export volumes. Thus far, Japanese exporters appear to be doing just that. Despite yen falls the price of Japanese exports in local currency has barely budged.
“Japanese companies have not actually cut the foreign currency prices of their exports. Just as with the UK exporters, the Japanese have chosen to hold foreign prices constant, maintain market share, and increase the yen value and thus the yen profit associated with yen depreciation,” UBS economist Paul Donovan writes in a note to clients.
The extra profits earned by Japanese companies from export sales may be stockpiled or paid out in dividends rather than reinvested. And what investment does take place may be abroad rather than in Japan. The net effect may be very little stimulus to the Japanese economy.
As stated by Saft above, the UK had a similar experience in the period 2007–9, when sterling depreciated some 27% (see the second diagram). The balance of trade improved very little and UK companies generally priced goods to markets abroad rather than cutting overseas prices.
But times were different then. The world was plunging into recession. Now global markets are mildly growing or static. Nevertheless, there is a danger that the upward slope of the J-curve in Japan may be pretty flat.
Articles
Weak yen a boon for investors, not Japan Reuters, James Saft (14/5/13)
Japan’s Trade Data Suggest Even Lower Yen Needed Wall Street Journal, Nick Hastings (22/5/13)
2 Misunderstandings About Japanese Trade Seeking Alpha, Marc Chandler (22/5/13)
Japanese trade deficit widens Financial Times, Ben McLannahan (22/5/13)
Data
BIS effective exchange rate indices Bank for International Settlements
Japan’s balance of trade Trading Economics
UK Trade, March 2013 ONS
Questions
- Explain the J-curve effect.
- Why is there some doubt about whether the Japanese balance of trade will improve significantly?
- What will be the consequences for Japanese growth?
- If foreign currency prices of Japanese exports do not change, what will determine the amount that Japan exports?
- What other measures is the Japanese government taking to stimulate the economy? What will determine the size of the multiplier effects of these measures?
- Using data from the ONS plot the UK’s quarterly balance of trade figures from 2007 to the present day. Explain the pattern that emerges.
Japan’s general election on 16 December was won by the centre-right Liberal Democratic Party (LDP), led by Shinzo Abe. It gained a two-thirds majority in the lower house. It returns to power after losing to the Democratic Party in 2009. Previously it had been in office for most of the time since 1955.
The LDP has promised to revive the flagging Japanese economy, which has been suffering from years of little or no growth and returned to recession last quarter. Economic confidence has been damaged by a dispute with China about the sovereignty over some small islands in the East China Sea. The economy, whose exports make up some 13% of GDP, has suffered from the global slowdown and a high yen. The yen has appreciated against the dollar by around 40% since 2007.
The economy has also suffered from the shutdown of all its nuclear reactors following the earthquake and tsunami last year. Nuclear power accounted for over 30% of the country’s electricity generation.
Mr Abe promises to revive the economy through fiscal and monetary policies. He plans a fiscal stimulus package in early 2013, with increased government expenditure on infrastructure and other public-works. He also wants the Bank of Japan to increase its inflation target from 1% to 3% and to achieve this through various forms of monetary easing.
The initial reactions of markets to the election result were favourable. The stock market rose and the yen fell.
However, as the following articles discuss, there are dangers associated with Mr Abe’s policies. The expansionary fiscal policy will lead to a rise in the country’s general-government debt, which, at some 240% of GDP, is by far the largest in the developed world. This could lead to a loss of confidence in Japanese debt and a fall in the price of bonds on the secondary markets and a rise in government borrowing costs. Also, a depreciation of the yen, while welcomed by exporters, would increase the price of imports, including food and raw materials.
Changing of guard in Japan as PM concedes vote CNN, Yoko Wakatsuki, Brian Walker, and Hilary Whiteman (17/12/12)
LDP Win Clears Pipes for Japan Fiscal Spigot Bloomberg Businessweek, Toru Fujioka (17/12/12)
Economic implications of Japan’s election Huffington Post (16/12/12)
Japan economy contracts again Taipei Times (11/12/12)
Japan elections: Shares rise and yen weakens on Abe win BBC News (17/12/12)
Shinzo Abe’s challenges in reviving Japan’s economy BBC News, Puneet Pal Singh (17/12/12)
Can Shinzo Abe Save Japan? Slate, Matthew Yglesias (30/11/12)
Deflation only natural when politicians refuse to fix oversupplied Japan Japan Times, Teruhiko Mano (17/12/12)
New Year messages from Japan BBC News, Stephanie Flanders (18/12/12)
Japan – Muddling On Or Growing Stronger? Seeking Alpha, Anthony Harrington (12/12/12)
Japanese government unveils £138bn stimulus package The Guardian (11/1/13)
Questions
- Using macroeconomic data from sources such as sites 6, 7 and 9 in the Economics Network’s Economic Data freely available online, describe Japan’s macroeconomic situation over the past 10 years.
- Why has the Japanese yen appreciated so much in recent years?
- What forms could monetary easing take in Japan?
- Why might it prove difficult to stimulate the Japanese economy through fiscal and monetary policies?
- What undesirable side-effects might result from expansionary fiscal and monetary policies?
- What structural weaknesses are there in the Japanese economy that have hindered economic growth? What policies might the new Japanese government pursue in tackling these structural weaknesses?
