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Mon, Feb 12, 2007 - Page 11 News List

Analysis: G7 warns investors on dangers of using `carry trades'

AGENCIES , TOKYO AND ESSEN, GERMANY

Jean-Claude Trichet, president of the European Central Bank, during a press conference in Frankfurt, Germany, on Thursday.

PHOTO: EPA

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 destabilize the global financial system.

The bubble is the result, they say, of the gap between Japan's super-low interest rates of 0.25 percent and those in the US 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 percent.

The more the carry trade suc-ceeds, 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 US$200 billion.

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 US$1 trillion -- equivalent to the annual national output of Canada.

He believes the yen is 29 percent undervalued against the US 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 foreign exchange 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, Krygier said.

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 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.

Still, the G7 industrial powers, under pressure to address the decline of the yen, warned investors on Saturday that they could get burned betting in one direction when Japan's economy was continuing to strengthen.

In a statement issued after talks in Essen, Germany, the G7 said the recovery of Japan's economy was solid and warned against carry trades.

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