Soon after the market crash, the search for the culprit begins. The choppy trading of the past two weeks has depressed stock prices worldwide, while safe-haven government bonds have rallied. Concerns about the health of the American economy and its expensive technology stocks are part of the explanation for the rise in volatility. Analysts and investors have identified another culprit behind the tumult: the reversal of opaque carry trades, particularly in the Japanese yen.
A carry trade – where investors borrow in a low-interest currency and invest where returns are high – can quickly fail. Traders had made speculative bets based on the assumption that the gap between interest rates in Japan and America would remain wide. But the Bank of Japan’s decision to raise interest rates by a fraction of a percentage point on July 31, while expectations for American rates fell, was enough to expose them to losses. When they unwound their trades, they likely triggered a cascade of forced selling, ranging from American technology stocks to the Mexican peso. But far too little is known about the extent of the carry trade and the risks involved. It’s time to shed light on a murky part of global finance.
What seems clear is that carry trades have increased. One way to see this is by looking at banks’ lending to non-banks. Hyun Song Shin of the Bank for International Settlements (BIS), a club of central banks, points out that yen-denominated cross-border lending from banks to non-banks now stands at 41 trillion yen ($271 billion). That figure has risen 52 percent over the past two years as the Federal Reserve raised interest rates while the Bank of Japan kept its rates mostly unchanged.
However, the fact that banks only lend in yen may greatly underestimate the true scale of the trade. Most foreign currency loans are not found on banks’ balance sheets, but are hidden in the vast world of currency swaps. The yen swap market is worth around $14.2 trillion. These contracts are not counted as debt and do not appear on financial institutions’ balance sheets.
While some swaps probably represent normal hedging activity, another part is probably more speculative in nature. However, in the absence of official data, it is impossible to determine the exact size of this part. Analysts at UBS estimate that the dollar-yen carry trade was around $500 billion at its peak, half of which has now been unwound. Analysts at JPMorgan Chase estimate it is a staggering $4 trillion.
This lack of clarity makes it difficult to say to what extent the carry trade contributed to the recent market volatility. Fortunately, the damage was limited this time. But how severe the next crash might be is unknown.
Crises were often the result of increased financial supervision. The collapse of the German Herstatt Bank in 1974, which triggered a minor crisis in cross-border lending, was a milestone in the supervision of the global financial system. Three years later, the BIS began to publish regular statistics on the risks of large commercial lenders, using data from national authorities.
Central banks and regulators around the world should not wait until a crisis erupts to act. Collecting and publishing detailed data on the flows and participants in the foreign exchange swap market would reveal its riskier elements. Shedding light on the shady and vast swap market would benefit not only the analysts who cover it, but also investors who otherwise have little understanding of how crowded the trades they are entering have become – until it is too late.
© 2024, The Economist Newspaper Limited. All rights reserved. By The Economist, published under license. Original content can be found at www.economist.com.
