by Raj Nambisan – DNA Money

All liquidity starts in Japan, the world’s largest creditor country. When rates go up here, rates go up everywhere. — Jesper Koll, chief economist for Japan, Merrill Lynch

These nineteen words form the microcosm of the current global stock market mayhem. Jesper Koll was referring to the universal bogey called the yen carry trade. It’s a business where “trillions” of dollars are involved. “Trillions”, because nobody on earth has any idea how big a Frankenstein has been spawned by this vast and prolonged leverage.

Which brings us to the question, what are yen carry trades?

Since March 2001, Japanese interest rates have ruled at 0%. Leveraging the yen thus offered gains of about 300 basis points (“3%” in layman terms) on a platter to anybody wanting to earn.

Just borrow in yen, convert the money into dollars, buy US treasuries that yield about 4.5%, pocket the difference -- after deducting expenses including about 100 basis points in hedging cost.

A caveat is due here: to earn from US treasury bills, the yen/$ rate has to remain steady. But investing in high-yielding emerging market equities like India is far more lucrative.

Why have yen carry trades unraveled now?

The answer lies in the unexpected surge in growth in Asia’s largest - and the world’s second-largest — economy to 4.8%% in the fourth quarter of 2006. This figure may be raised to 5.1%, Koll told Bloomberg, because corporate investments surged 16.8%, the fastest increase since 2002, data released on Monday show. This growth forces the Bank of Japan to increase rates.

Look at it another way: for years, Bank of Japan has bankrolled the yen-carry trade across the globe and you know what Koll means.

The alarms started going off in the leveraged world when Japan first raised its interest rates to 0.25% on July 14, 2006. This was further raised by 25 basis points on February 21, 2007. The problem is, returns on carry trades move inversely to the appreciation in yen.

So, as a carry-trader, if you have borrowed in yen, you have two worries: you need to pay more by way of interest (when you borrowed, it was at 0% interest, now you have to cough up 0.5%), and your principal has suddenly bloated too (you borrowed in yen, converted the money into dollars and invested. With the dollar weakening against the yen, to pay back the principal, you need more dollars to get as many yens now).

On a mark to market basis, thus, a borrower ends up being worse off every minute he holds on to the trade. There are two exit routes available now - close out positions, take the loss, or hedge using swaps.

Another related development is that one-month deposit rates in Japan has risen 13 basis points to a six-year high of 74 basis points, according to Bloomberg data. Singapore-based Callum Henderson, head of currency strategy at Standard Chartered Bank, told Bloomberg this means Japanese money is definitely going home. “The spike in short-term Japanese rates will exacerbate the rally in the yen,” he said. The appreciation, thus, can feed on itself as the economy surges ahead.

Which brings us to the most important point, what would India’s exposure to yen carry trades?

It may be more than what analysts estimate, as the form of carry-trade varies. In October 2005, BusinessWeek estimated that more than half the money coming into Indian stocks from abroad is of Japanese origin.

An RBI spokesperson could not provide DNA Money disaggregated data on yen inflows on Monday. There is no data with Bank of Japan or the Bank of International Settlements on global yen carry trades, either.

Data in public domain show Deutsche Asset Management has raised nearly a billion dollars from Japan, for investment in India, beginning from December 2004, while Fidelity Investments has a $1.4 billion fund. In all, about half-a-dozen such mega funds exist in Japan.

Merrill Lynch Investment Managers and JP Morgan Fleming Asset Management have also raised monies.

The sums, thus, are difficult to quantify, but the form itself may give the extent to which India is exposed to the yen.

Some of the forms are:

• Japanese investors in India. Funds that borrowed in yen and invested in Indian assets in many forms — equities, real estate, stock futures arbitrage, interest rates and credit spreads.
• NRIs exposed to yen borrowing and deploying the money in Indian deposits to take advantage of higher carry and weaker yen.
• Banks and corporates which borrowed in yen and hedged the principal but not interest payments.

This plus many other forms that we do not know of are leading to yen strength translating into weakness in Indian asset classes.

Has the world seen a yen carry trade unwinding earlier? Only once, in October 1998, which led to the spectacular collapse of Long Term Capital Management in the US. The Federal Reserve had to bail out US banks and brokerages then.

Courtesy: DNA Money