The Yen Carry Trade: A Delicate Balance in the Global Financial Landscape

The yen carry trade, a widely-used trading strategy, has recently come into the spotlight as a result of the recent selloff in shares of US technology giants. This article delves into the intricacies of the yen carry trade, its implications for the global financial markets, and its potential impact on Indian equities.

Unlocking the Secrets of the Yen Carry Trade

The Allure of Borrowing Low, Investing High

A carry trade is a popular investment strategy where an investor borrows from a country with low interest rates and a weaker currency, and then reinvests the funds in assets of another country with a higher rate of return. This strategy has been one of the biggest sources of flows in the global currency market, with the Japanese yen being one of the most widely used currencies for this purpose.

The Yen's Unique Position

Japan's long-standing zero-interest rate policy, implemented to combat persistent deflation, has made the yen an attractive currency for carry trades. Investors, including retail Japanese investors, have been borrowing at low interest rates at home and purchasing assets in other countries with higher returns, such as overseas equities and bonds. The US equity market has been a particular favorite in recent times, as the dollar has strengthened.

The Yen's Sudden Surge

Last week, the yen rose over 3% against the dollar after the Bank of Japan (BoJ) raised interest rates to 0.25% and announced it would reduce bond purchases. Expectations of interest rate cuts by the US Federal Reserve also contributed to the dollar's weakness. While rates in Japan are still low, the BoJ's moves are seen as signals that it is moving towards the normalization of monetary policy. Sharp moves in the yen are relatively rare, which is why it has been a preferred currency for carry trades. For these carry trades to be profitable, the yen must remain weaker. When the yen strengthened against the dollar, investors rushed to square off or unwind their bets on the yen as part of the carry trade to avoid losses.

Quantifying the Yen Carry Trade

It is difficult to pinpoint the exact quantum of yen carry trades, but data from the Bank for International Settlements (BIS) suggests that cross-border yen borrowing has increased by 2 billion since the end of 2021. While it is not known how much of this is for short-term speculation in overseas assets, Dutch bank ING has stated that these unhedged cross-border yen loans could represent a "substantial layer" of the carry trade.

The Ripple Effect of Yen Carry Trade Unwinding

The reversal of the yen carry trade has had repercussions on markets worldwide. Market watchers believe the severe selloff in shares of US-based mega technology giants late last week could be partly attributed to the unwinding of these carry trades. The selloff in the US spilled over to Asian equities as well, including India's markets.

The Impact on Indian Equities

It is not entirely clear how much money has flowed into India as part of yen carry trades. However, brokers have suggested that it would be safe to assume some carry trades have involved Indian equities, which have been among the top-performing markets worldwide in recent years. According to NSDL data, the assets under custody of Japanese foreign portfolio investors (FPIs) in domestic equities as of June 30 was ₹2.05 lakh crore, the second-highest after US FPIs at ₹30 lakh crore. A stronger yen could also be a cause of concern for some Indian companies that have borrowed in yen but have not hedged against a sharp up-move in the currency.