Carrying on About Carry Trade

There is certainly much flurry and debate at the moment on carry trade and Japan's inability or according to some duty to raise rates in order to normalize the global environment of excess liquidity. First off, we have the Economist which follows up on the situation in the latest print edition with an article as well as the economics focus column. The Economist invokes the Yen as the world's most undervalued currency and notes how growth in Japan should be strong enough for the BOJ to begin slowly unwinding the carry trade.

Even if Japan is not intervening to hold down its currency, the yen is still misaligned. A country with one of the world's largest current-account surpluses and low inflation (but no longer deflation) should have a much stronger currency. Japan's economy is no longer flat on its back. Last year it grew by an estimated 2.3%, and it is forecast to maintain a similar pace this year. As a result, Japan does not need such low interest rates or a super-cheap currency any more. Indeed, Japan's abnormally low rates could be viewed as a form of intervention to hold down the yen.

The Bank of Japan (BoJ) bowed to government pressure and held rates unchanged at 0.25% in January. But figures due on February 15th, which are expected to show that GDP grew at an annual rate of 3.5-4% in the three months to December, could give the bank the green light to raise rates at its next meeting. This weekend the G7 could usefully back such a move.

The Economist also notes the recent warning voiced by Nouriel Roubini over at RGE where the professor worries how a relatively small market correction could send the world spinning as the carry abruptly unwinds.

Nouriel Roubini, at Roubini Global Economics, says that the lesson of 1998 is that it takes only a small piece of positive news to unravel such trades. Suppose there is suddenly some good news about the Japanese economy at the same time as America's appears to be stalling. An initial rise in the yen could cause today's carry trades to unwind just as rapidly, causing the currency to soar, American interest rates to rise and risk spreads to widen. The volume of yen-related leverage is probably greater now than in 1998.

The G7 should be concerned about carry trades not just because they could suddenly unwind and trigger financial turmoil but also because the yen's misalignment is distorting the world economy.

So, the Yen is undervalued and it should be up to the BOJ to begin acting on the signals transmitted by the markets and start to raise rates to normalize the situation. Furthermore, the global financial system is at considerable risk if the carry trade unwinds abruptly in deja-vu situation like after the Russian default in 1998. Well, I am not sure that I subsribe to the totality of the view presented here. Indeed, when it comes to the BOJ and how it should begin to raise rates I am outright at odds with the traditional economic analysis. As such, Edward is much more to the point over at Bonobo Land ... (and here)

So what I can't understand is why people want to keep putting pressure on Japan (well I can understand, the carry trade and all that), but I can't understand why more people are not able to think about this situation, about why it is happening, and about what the long term implications are.

Simply pushing for the BoJ to raise interest rates is only going to push Japan back into deflation, and why anyone would want that outcome is beyond me.

This is indeed the point and we should really think about Japan here but also how Japan's situation relates to the global phenomenon of excess liquidity and indeed how this feeds back to other countries. Once again Edward provides help with his recent killer of a note over at IEB in which he relates Japan's situation and carry trade to India's sizzling growth.

What we really need to do at this point is to take it easy and try to look at the facts. The inflation figure is very likely to drop into deflationary territory in Japan this Spring on the back of persistingly sluggish household spending and a downtrend in headline inflation. This means that the BOJ won't be able to raise and thus that the carry trade continues (so yes, hedgies can breathe a bit more freely now). In terms, of Roubini's warning he might be right but remember that the situation is very different now than it was in 1998 and that the global search from yield has even prompted some countries to try to hold back the tide of capita inflows (i.e. Thailand). In essence, we also, as I have been arguing strongly before, need to take a long hard look at Japan and its growth path which is exceedingly driven by exports. Once again ... and I really do not like repeating myself, the inability/reluctance to factor in the demographic component in the economic analysis is at heart of much of the (perceived) misalignment of the Japanese currency and (sadly real) misalignment of main stream economic analysis and commentatory on this topic.  

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