The Carry Trade and the Supply of Japanese Yen

Money is created by banks when people borrow it into existence. In the US, there are no shortage of people wanting to borrow money for consumption or investment. In Japan finding borrowers is a bit problamatic because, culturally speaking, the Japanese are very good savers. The Japanese government has done it's part in running up huge debt until recently:


In June 2003, with the Fed cutting interest rates to an ultra-low 1.00%, and deflation remaining a real problem in Japan, the Bank of Japan went wild printing Yen and buying dollars. This forced the Yen down and boosted Japanese manufacturing, allowing the the BoJ to ease off. Since then the BoJ has wisely been selling US treasuries and soaked up much of the liquidity they had added to fight off deflation:


More recently, I believe foreign carry-traders are behind much of the borrowing that has kept deflation from taking hold in Japan. In June of 2004, the Fed began raising US interest rates from 1.00% all the way up to 5.25% two years later. With each hike, the value of the dollar was boosted relative to the Yen because of the Yen carry trade became much more attractive. As more carry traders borrowed Yen and purchased US dollars or other currencies it helped expand the Japanese money supply.



The carry trade is serving the policy needs of the BoJ and Japanese government very well for now. With each new Yen borrowed into existence, it stimulates the Japanese economy. Japanese exporters have an easy time unloading the dollars they receive from American consumers and Japanese bankers profit from interest payments on the money they create and loan.

On the American side, Wall Street is making a killing off of the easy short term gains. Bonuses for investment bankers are at an all time high. Unfortutely the profits are mostly temporary. The carry trade is so large that it cannot be unwound successfully for most participants (who are mainly hedge funds). The Bank of Japan will be in control of the exchange rate as carry traders get squeezed out of their positions. I expect it will slow and steady, so that Japanese banks get repaid on their loans before most of the capital . Meanwhile hedge fund investors will be the ones left holding the bag.