Economic Rebalancing

The global economy is horribly out of balance, with the United States going deeper into debt each year as a result of a huge trade gap. This blog describes the process of global economic rebalancing. If you have any comments or questions about the posts here, please don't hesitate to use the comments section.

Sunday, May 06, 2007

How Big is the Yen Carry Trade?

In this article Japanese bureaucrat Hiroshi Watanabe says that there won't likely be a "hasty unwinding" of the Yen Carry Trade, and hints that the total size of speculative carry trades is around $100 billion, rather than $1 trillion as some estimate. I'm skeptical of these claims, as I believe the YCT suits the profit motives of Japanese bankers very well for now. It's also providing cover for the Bank of Japan to reduce its US treasury holdings, and if the trade doesn't keep expanding, then the demand it is creating for trade gap dollars and new US debt will disappear, pressuring the Yen back up, which doesn't suit the Japanese government's political motives very well at the moment.

To try and get an idea of how big the YCT has become I took a look at grwoth in various portions of the Japanese money supply:

Based on an exchange rate of 120 Yen = 1 Dollar...
From April of 1998 to April of 2001 Japanese M2+CDs grew $471 Billion, while M3+CDs grew $636 Billion (meaning non-M2 components of M3 declined sharply) and Broad Liquidity grew $1,020 Billion.
From March of 2001 to March of 2004 Japanese M2+CDs grew $956 Billion, while M3+CDs grew $61 Billion (meaning non-M2 components of M3 declined sharply) and Broad Liquidity grew $328 Billion.
From March of 2004 to March of 2007 Japanese M2+CDs grew $281 Billion, while M3+CDs grew $626 Billion, and Broad Liquidity grew $902 Billion.

As I read it, the Japanese government and Bank of Japan were busy running up debt and stuffing money into people's pockets as an attempt to stimulate the economy during the recession years of 2001-2003. Since then they've been draining liquidity, but the Yen carry trade has picked up the slack, causing the total money supply to grow much more rapidly.

For the $100 billion estimate to be true, domestic Japanese credit expansion would likely be responsible for the bulk of the surge in broad money. For the $1 trillion estimate to be true the Yen carry trade would likely be making up for a several hundred billion dollar liquidity drain by the BoJ. My own hunch is that the total amount of borrowing in Yen for speculative carry trade bets by investors outside of Japan is probably over $500 billion. On top of that, the amount of official Japanese money invested abroad is about $1 trillion and there may be another $1 trillion in private Japanese money invested abroad.

The borrowed money for speculative purposes is quite a racket for Japan, where a portion of global investment returns are steadily cyphoned off by Japese banks. Watanabe doesn't forecast a "hasty" unwinding, but a slow and painful unwinding would be just as bad for the pension plans and other investment pools run by global hedge funds. Keeping the slow bleed going forever is probably plan A. Japan has the ability to stuff liquidity back into the system, just as they did during 2002-2004 in a way that can keep the Yen's rise unhasty. Foreign borrowers will have to pay back their Yen loans at a greater cost than they bargained for if the BoJ handles things in the best interests of Japan. Western politicians and bankers play along because for now it means a stimulated economy and short term profits.

If plan A fails, and some systemic shock causes a sudden rush by carry traders to get out, then plan B, a hasty rise in the Yen and forced liquidation of foreign carry traders probably works out best for the Japanese as they wouldn't want to let foreign hedge funds get off too easily. After a thorough cleansing of the trade I could see the BoJ rushing back in with another round of liquidity to return the Yen to manufacturing friendly levels. With the Yen near four year highs, entering new carry trades is probably an especially bad idea around now, and its not surprising to see the Watanabe trying to be more encouraging of sucker bets. While he says that the trades "won't be unwound in a hasty way," the 20% rise in the Yen we saw in 1998 would work very well as part of plan B today.

The Yen Carry Trade has been a big part of global economic imbalances and like the rest of the imbalances I believe it must eventually come back into balance one way or another. As we see the rebalancing process taking hold via a strugling US economy and declining US consumer purchasing power, I expect we'll also see a big drop-off in US investment returns as a result of either a gradual or "hasty" unwinding of the carry trade.


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