Sunday 15 January 2012

Explaining the Carry Trade

I received several comments on yesterday’s post that the concept of the carry trade was either unknown, or too complicated to understand. Apologies for this: I’ll try to explain this in simpler terms here.

In the currency carry trade, an investor takes out a loan in a stable currency at a low interest rate. For years, the Japanese Yen was the main source of such borrowing.  

The investor then converts these funds into an investment in another, higher-interest currency or deposit account. His/her benefit is the margin between the two interest rates, less any transaction fees or exchange rate losses

Let’s take an example: I borrow EUR 1 million in Japanese Yen at an annual interest rate of 1%.

I take this amount and invest it with the Bank of Cyprus, which is offering 1-year deposit rates of 5%.

At the end of the year, I’ve gained EUR 1,050,000 (or EUR 50,000 of interest), less capital gains tax in Cyprus. I have to re-pay the loan in Yen, which had a rate of 1%, so I have to repay EUR 1,010,000, less any currency exchange losses.

My profit for 1 year is a little less than EUR 40,000.

We have a similar carry trade going on right now with low-cost European Central Bank loans. In Cyprus, for instance, a bank can loan money from the ECB at 1%, and lend the money onward to a company at 7-8%. It can do the same by lending to the Italian government at 7%, if it wants a higher risk. It can lend to consumers via visa card interest rates of 12-14%.

My point is not to minimize the risk of sovereign lending, which is mounting*. My point is that banks benefit from 1% repo lending rates for 3-year loans from the ECB, while the large majority of citizens in the Eurozone typically pay far higher rates.

If the objective were to have banks by government bonds using a share of this ECB funding, it would be far better for the ECB to lend directly to governments, cutting out the banking middleman. This “standard” quantitative easing would send a stronger signal to financial markets and would eventually lead to lower interest rates (although it would also lead to political risk and potentially higher inflation and/or a weakening Euro).

Given that the ECB is ultimately guaranteed by the central banks of the Eurozone central banking system, it seems incredible that private citizens in the Eurozone are essentially guaranteeing the expansion of the ECB’s balance sheet, so that the ECB lends to banks, which in turn either sit on the money (credit expansion has slowed everywhere), or are supposed to “recycle” this money into government bonds.

This will result in outsize profits for the private banking sector. There are also simpler work-arounds to getting the ECB or the national central banks to buy government bonds or provide working capital to companies, which is what this whole process is supposed to result it.

* It is interesting to note that while banks borrowed EUR 498 billion in late December, in early January they had nearly the same amount on deposit with the European Central Bank, in an apparent “flight to safety”.

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January 14, 2012

© Philip Ammerman, 2012

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