TOKYO:The recent sharp depreciation of the yen is believed by economists to be the result of a giant credit bubble which, if it bursts, could destabilise the global financial system.
The bubble is the result, they say, of the gap between Japan’s super-low interest rates of 0.25 % and those in the United States and the eurozone, which encourages investors to borrow cheaply in yen to invest overseas.
This practice, known as ‘carry trade’, means that speculators exchange yen into other, higher yielding currencies, driving the weakness of the Japanese currency, which was a hot topic at a weekend meeting of world finance chiefs.
The Swiss franc has also been affected by carry trade— though to a lesser degree— due to relatively low Swiss interest rates of 2.0 %.
The more the carry trade succeeds, the more people it attracts, said Noriko Hama, an economics professor at Doshisha University in Kyoto.“It tends to feed the depreciation” of the yen, she added.
No one knows the exact magnitude of the yen carry trade. Conservative estimates put its value at upwards of 200 billion dollars.
Some others estimate it to be much higher. Tim Lee of the US research firm Pi Economics reckons that the true size could be in excess of one trillion dollars— equivalent to the annual national output of Canada.He believes the yen is 29 % undervalued against the dollar.
“The yen is a foolproof indicator that we are in the midst of a gigantic bubble. The yen has been falling persistently despite being undervalued and despite Japan having zero inflation,” he wrote in a recent study.“The yen carry trade is ballooning as never before and is now larger than ever. There is no doubt whatsoever that this credit bubble will end extremely badly,” he warned.
Analysts say it is very hard to estimate the exact extent of the phenomenon.“It is very difficult to come to grips with the depth of the carry trades,” said Markus Krygier, the head of forex strategy at the German investment bank Dresdner Kleinwort.
However, he predicted that carry trade would start shrinking if the US Federal Reserve moves to cut interest rates by the end of the year as he expects.Many economists expect the Bank of Japan meanwhile to raise its interest rates again at some point this year, reducing the appeal of carry trade.
“To deflate a bubble orderly has a lot to do with luck. It is something that is very difficult to engineer, particularly if the bubble has been inflated” for quite a long time, said Krygier.He said that the current situation has echoes of 1998 when the yen shot up almost 20 % in just three days as the Russian financial crisis and prospects of a Japanese interest rate rise triggered a reverse in carry trades.
Krygier expects the dollar to finish 2007 at 100 yen, down from about 121 now. Lee at Pi Economics goes even further, predicting the dollar will sink to 70 yen over the next year.
“As long as the credit bubble goes on the yen will be weak. When the credit bubble turns to bust the yen will be extremely strong,” he wrote.Such a sharp appreciation of the yen would pose a serious threat to Japanese exports and the overall economy, analysts said.
“If you start to see an appreciation of the yen, then the carry trade unwinds very quickly, the rush for the exit gathers momentum, and not everyone can get out to the door,” said John Shepperd, another economist at Dresdner Kleinwort.“In terms of the global economy, we will see a massive withdrawal of liquidity,” he said, adding that there could be a “sharp setback in equity markets” in the United States and Europe.
For analysts at the investment bank Barclays Capital, it would be risky for global monetary authorities to try to deflate the credit bubble.“Carry trades are a function of the low volatility environment in financial markets, which is partly due to G7 (the Group of Seven rich nations) central bankers’ success in maintaining low and stable inflation,” they argued.
“Policy coordination against carry trades would only fuel a sharp unwinding of those trades and pose the very risks to financial market stability that G7 officials seek to avoid,” they wrote in a note to clients.