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Oct 27, 2008 | 14:22 GMT

The Financial Crisis, the Carry Trade and the Global System

Mario Vedder/Getty Images
Summary
The G-7 rich countries have met to discuss the ongoing financial crisis. The unwinding yen carry trade absorbed most of their attention. Meanwhile, signs indicate that in the United States, banks' fears of making loans are receding steadily. None of which means that the global system is out of the woods.
The G-7 countries met the weekend of Oct. 25-26 to discuss the ongoing financial crisis, with the unwinding yen carry trade absorbing most of their attention. In short, the carry trade is what happens when investors take out negligible cost loans in Japanese yen, and then invest that money abroad where it can earn a higher return. Ordinarily, that drives the yen down and the value of the target currency up. But when the target country has financial problems — as most are just now — this carry trade unwinds as investors panic. The money flow reverses, plunging the target currency and spiking the yen. In a capital crunch, a collapsing currency is among the worst things that can happen to a country dependent upon foreign investment. (And this is precisely what is happening now in many countries that depend on carry trade.) As for Japan, the only dynamic part of its economy is dependent upon exports, and a rising currency is tantamount to the kiss of death for exports. In essence, the carry trade's unwinding is hitting everyone where it hurts the most. The carry trade has been building for over a decade as Japan's economic malaise deepened, and now it is unwinding in a matter of weeks. Estimates as to how much money is involved range from $1.5 trillion to more than $6 trillion — more than enough to greatly destabilize large portions of the global economy, considering the speed at which the unwinding is occurring. The yen briefly hit a 13-year high of 90 to the U.S. dollar over the weekend. Unfortunately, there really is not much that can be done under normal circumstances to stanch the flow. Bets that were safe for the carry trade for the past decade no longer are, and the people involved are trying to flee to safety. The only way to stop such movements is via capital controls, which would halt all capital outflows from a country. So far at least, such drastic options are not being dusted off. So until countries begin to get truly desperate, the unwinding of the carry trade will continue. But there is a bit of good news out there. While the crisis is rapidly mutating as it spreads, it originated with a liquidity crunch in the United States. As the crunch bit, banks became afraid to lend cash to other banks, bringing most banking activity to a halt and all but guaranteeing a recession. Therefore, most American government efforts revolve around plans to get banks lending again. Such plans include an effort to use $250 billion to purchase bank shares to directly recapitalize banks so they do not feel threatened, another $500 billion to purchase questionable assets from the banks to clean up their balance sheets and make them more trustworthy, higher government guarantees on deposits to prevent bank runs, and guarantees on interbank lending to remove fear. The bank share purchase program begins making funds transfers Oct. 27, and taken collectively, the measures are having an impact. Collectively, the measures are encouraging money to flow into the banks rather than away from them, with the idea being that cash-rich and confident banks are the best way to get growth going again. The best indicator to watch to evaluate progress on the international credit market is the London Interbank Offered Rate (LIBOR), a measure of the rate that banks charge each other for loans. Specifically, STRATFOR is watching the three-month LIBOR for the U.S. dollar as a measure of bank confidence. (The overnight rate is too volatile, and the five-year rate is simply too long a time horizon to evaluate the current crisis.) In essence, the higher the LIBOR, the less willing banks are to lend. Since the government began intervening in the market in mid-October, the three-month U.S. dollar LIBOR has steadily fallen, indicating that the fear is receding steadily. None of which means that the global system is out of the woods. There is certainly a recession to be fended off, and the U.S. Federal Reserve Board is signaling that it will soon return interest rates to the post-Sept. 11 lows of 1.0 percent, a move that has a hint of desperation to it. But capital is starting to flow again — in the United States at least — so there is some light coming in through the trees.
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