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Morgan Stanley Refutes The Carry Trade Thesis

FYI | Jun 21 2006

By Greg Peel

As outlined in It’s The End Of The World As We Know It, If The Yen Carry Trade Is Reversed (15/06/06), this is the notion:

When US interest rates were low, there was excess global liquidity. Easy monetary policy was a strategy the Fed used to drag the US back from the tech wreck. It allowed for cheap US dollar borrowings that could be reinvested for higher returns elsewhere. When US rates began to tighten, investors across the globe then turned to zero interest, yen-denominated borrowings to finance speculation in every market available – from stocks and bonds to real estate, emerging markets, gold, commodities and more. That "free" money is why we have experienced a serious of asset bubbles. The Bank of Japan (BOJ) had financed the lot.

Now that Japan has ended quantitative easing, as is about to abandon its zero interest rate policy, the game is up, and investors all over the world will need to reverse their positions before the yen appreciates. If the yen appreciates they risk losing everything. This has started all ready (we are correcting) but we are yet to see anything like the trillions of dollars that must exit all markets. This could bring down the entire financial system.

"This thesis is seriously flawed", says Morgan Stanley’s senior economist in London, Stephen Jen. For starters, Jen disputes that the fear-mongers even know how quantitative easing (QE) worked.

Japan’s QE policy involved printing massive amounts of money in order to hold the yen relatively stable. The carry trade notion assumes that this money then disappeared out the door for foreign use in investment everywhere. Jen suspects some investors may not realise that excess reserves were effectively "bottled up at the BOJ" anyway, and not even available for the Japanese economy, let alone other markets.

"With interest rates already at zero", says Jen," there was no constraint on bank borrowing, and the excess liquidity was ‘trapped’ in the banks’ deposits with the BOJ". As such "the dismantlement of QE had zero impact on the amount of ‘money’ or bank credit available for use by Japanese or non-Japanese borrowers".

The yen carry trade could be implemented from either within Japan or by foreigners. The first should result in noticeably high capital outflows from Japan.

Since the introduction of QE in 2003, notes Jen, total Japanese portfolio outflows have been around US$170 billion per year. Given that some US$7 trillion flows into US securities each year, it’s hard to argue that Japanese outflows are supporting US or global asset prices.

There is, however, a level of concern emanating from the fact that since the introduction of the zero interest rate policy (ZIRP) in 1999, cumulative flows have totalled close to US$1 trillion. This would affect the yen cross-rates and smaller markets, says Jen, if Japanese repatriation were to become an issue. But Jen does not see wholesale repatriation as likely.

In the case of foreign investors running yen carry trades, the data is scant. (Not because it hasn’t happened, but because it is difficult to specifically measure). Either way, Jen suggests the evidence is not supportive of the claim.

The Bank for International Settlements (BIS) reported that the stock of outstanding yen-denominated claims, held by both Japanese and non-Japanese, did rise noticeably in the fourth quarter of 2005. However, Jen notes yen loans from Japanese banks have declined steadily since 1995. Outstanding overseas loans in yen rose in 2004, but declined again in 2005 to be US$181 billion by year-end.

Since banks don’t usually take large currency risks, says Jen, by having large open positions on currencies, non-Japanese banks’ yen loans should, in theory, be offset by yen-denominated liabilities. Thus foreign yen carry trades should show up only in yen-denominated cross-border loans extended by Japanese banks.

The total stock of loans in yen accounts for only 5% of all cross-border bank loans. The total change in the stock of cross-border yen loans in 2005 was also 5% of all cross-border loans. Hence there is no indication Jen can find from these data to suggest large new cross-border yen loans were extended by banks in recent quarters at a pace that is out of line with historical averages.

Furthermore, in 2005 there were an additional US$1.2 trillion of US dollar cross-border loans and US$1.3 trillion of euro cross-border loans extended. Does this means there are trillions of US dollar and euro carry trades out there as well?

No, says Jen. It means there are many reasons why cross-border bank loans are extended.

Jen is not arguing that there is no such thing as the yen carry trade, and that the BOJ has no effect on global asset prices. When ZIRP ends and Japanese rates rise, capital outflows from Japan will "clearly be adversely affected and, ceteris paribus, some risky assets could be hurt". But Jen believes it unreasonable to think that BOJ tightening will trigger a collapse in global equities, commodity prices etc.
"Even massive money printing by the BOJ failed to support the Nikkei for years and so I don’t see how money from Japan could have such a big impact on the world. Monetary tightening by the BOJ will have no more and probably less of an effect on asset prices than if the Fed or the ECB tightens."

Jen believes global asset prices will remain vulnerable for many reasons, but not just because of the BOJ’s intention to tighten.

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