Soon after markets tumble, the search for the culprits begins. Choppy trading over the past two weeks has put a dent in stock prices globally, while safe government bonds have rallied. Concerns about the health of America’s economy and its expensive tech stocks are part of the explanation for the surge in volatility. Analysts and investors have identified another culprit behind the tumult: the reversal of opaque “carry trades”, particularly in the Japanese yen.
A carry trade—in which investors borrow in a currency where interest rates are low, and invest where returns are high—can quickly unravel. Traders had made speculative bets based on the assumption that the gap between interest rates in Japan and those in America would remain wide. But the Bank of Japan’s decision to raise rates by a fraction of a percentage point on July 31st, while expectations for American rates were falling, was enough to expose them to losses. As they unwound their trades, they are thought to have set off a cascade of forced selling in everything from American tech stocks to the Mexican peso. But far too little is known about the scale of the carry trade, and the associated risks. It is time to shed light on a murky part of global finance.
What seems clear is that carry trades have grown. One way to see this is to look at banks’ lending to non-bank institutions. Hyun Song Shin of the Bank for International Settlements (BIS), a club of central banks, notes that yen-denominated cross-border lending from banks to non-banks now runs to ¥41trn ($271bn). The figure has risen by 52% in the past two years, as the Federal Reserve raised interest rates while the Bank of Japan mostly stayed put.
Bank lending in yen alone is likely to be a vast underestimate of the true scale of the trade, though. Most foreign-currency borrowing is not found on banks’ balance-sheets, but hidden in the wider world of foreign-exchange swaps. The market for swaps involving the yen runs to around $14.2trn in size. Those contracts are not counted as debt, and go unrecorded on the balance-sheets of financial institutions.
Although some swaps are likely to represent ordinary hedging activity, another chunk probably reflects more speculative trades. But a lack of official data makes it impossible to say precisely how big that chunk is. Analysts at UBS, a bank, estimate that the dollar-yen carry trade reached around $500bn at its peak, half of which has now been unwound. Those at JPMorgan Chase put it at a staggering $4trn.
This murkiness makes it hard to know precisely how much the carry trade contributed to recent market volatility. Fortunately, there was little damage this time. But there is no knowing how severe the next blow-up could be.
Increased financial supervision has often followed crises. The collapse of Germany’s Herstatt Bank in 1974, which caused a minor crisis in cross-border lending, was a landmark moment in the monitoring of the global financial system. Three years later, the bis began to publish regular statistics on the exposures of major commercial lenders, using data from national authorities.
Central banks and regulators around the world should not wait for a crisis to act. Collecting and publishing detailed data on the flows and participants in the market for foreign-exchange swaps would uncover its riskier elements. Shining a light on the shadowy and enormous swap market would benefit not only the analysts who monitor it, but also the investors who otherwise have little understanding of how crowded the trades they are piling into have become, until it is too late.
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