Context: Unwinding of the Yen carry trade was one of the reasons behind the fall in global markets recently.
What is carry trade?
- Carry trade involves borrowing at low interest rate in one country (in one currency) and investing in another country (in another currency) where interest rates are higher to achieve higher returns.
- This is possible when central banks of different countries try to keep their interest rates at a level that suits their specific economic conditions. The difference in the interest rates in the respective countries enables the carry trade.
- The carry trade also take advantage of the weakening currency of the low interest rate country to offset any conversion expenses.
What is Yen carry trade?
The yen carry trade involves borrowing in low-interest Japanese yen and investing in higher-yielding assets in other countries to profit from the interest rate differential and potential currency movements.
e.g., Japan central bank (the Bank of Japan) had kept interest rates at 0% between 2011 and 2016 and, in fact, pushed them even below zero (-0.10%) since 2016 to stimulate economic activity.
Such low interest rates incentivise investors to borrow cheaply in yen and invest in other countries (such as Brazil, Mexico, India and even the US) in a bid to earn better returns.
How did it impact global markets?
- While Bank of Japan kept its interests lower, other central banks kept raising their interest rates in the wake of Russian-Ukraine war which incentivised yen carry trade.
- However, Bank of Japan increased its interest rates by around 60 basis points in the last 6 months. it led to investors who had borrowed in yen and invested in Brazilian real or Mexican peso or Indian rupee, selling their assets in international markets (Unwinding of yen carry trade).
- This unwinding of yen carry trade also strengthened Yen’s exchange rate against currencies like dollar, real, rupee, peso etc.