Yen carry trade back in the news

The yen carry trade is back in the news following the global credit crunch. Some Gulf investors - including institutions, meaning asset management firms or government investment arms for example, and family offices - are among those who have been using or considering this trading strategy as a way to benefit from low interest rates in Japan. So what is a currency carry trade?

A currency carry trade is a strategy by which an investor borrows money in one currency at a low interest rate (in this case the yen) to invest in another currency at a higher interest rate (the dollar) to benefit from the difference between the two. This is as relevant to investors in this region as it is in Europe or the US.

Is this easy money? No, to the extent that the investor who follows this type of strategy bears the rate of exchange risks. In fact, the investor has an obligation to repay his loan in the borrowed currency. If ever that currency appreciates sharply against the currency in which he invested, he can lose a great deal of money. So this type of strategy is generally used by hedge funds that have the advantage to be able to use significant leverage.

Some particularly audacious speculators have taken advantage of the current configuration of interest rates to initiate considerably riskier transactions. By investing their yen in more yielding assets (for instance Chinese equities), these speculators are accumulating risks: that of a sharp rise of the yen, and also that of a fall on the Shanghai Stock Exchange.

The evolution of the yen has in fact become an indicator of investor risk appetite. At the time of the equity market correction, in March 2007, currency trends were also violent. In fact, these periods of volatility oblige investors to re-assess their assets in terms of exposure to risk or even rapidly to unwind some of their riskier positions. Some of the appreciation of the yen in March could be linked to the unwinding of yen carry trade transactions.

Although the situation regarding speculative positions and leverage strategies is still disturbing, this is because, in the event of a market turnaround, the unwinding of those strategies exaggerates panic trends, amplifies the flow of capital towards less risky assets and increases volatility. Nevertheless, the weakness of the yen cannot be attributed exclusively to hedge funds and to carry trades. In fact, the particularly low level of rates in Japan has led some Japanese savers, particularly for their retirement savings, to seek more attractive returns beyond their frontiers.

The official financial data shows that the phenomenon could involve as much as 40,000 billion yen, but only one quarter can be attributed to short positions held by currency traders and hedge funds. The remaining amount of 30,000 billion yen therefore corresponds to assets held by Japanese savers abroad.

- The writer is head of the Middle East, Dexia Asset Management.