Carry on, Traders! The carry trade and capital controls

Last year, I wrote about the build-up of international hostilities on the currency war front as China and the US faced off against each other on China’s interventionist policy of maintaining an undervalued yuan and the US policy of quantitative easing (read: printing billions of dollars). I ended the post with the question: would other economies escalate the war by intervening to fight the appreication of their currencies? Early in 2011, they most certainly appear to have done just that. I had documented how by October 2010, Brazil, Korea and Thailand had already implemented measures to check the inflow of capital across their borders. Earlier this year, the drumbeats of war sounded again as Chile – the ultimate free market poster child – declared that it would defend the peso by accumulating foreign reserves, China-style.  Colombia, Mexico and Peru also have ambitious reserve accumulation programmes while Brazil announced a raft of new rules checking speculation in the real.

While there has been increased volatility in international capital flows in the last three months, the direction of flows from richer economies to the developing world remains consistent. Part of the reason for the large interest in emerging markets is straightforward: in the aftermath of the financial crisis, there are very few avenues left for high-growth investment in Europe, and even the US. With their young, fast-growing populations and low income base, emerging market economies (EMEs) represent a tremendous growth opportunity to investors.

This, however, doesn’t explain the substantial trade in bonds that is taking place with foreign investors purchasing huge volumes of fixed income products in EMs. These traders are largely engaged in the carry trade: an investment strategy by which traders look to reap the benefits of interest rate differentials between one economy and another. Such traders purchase, say, a ten year bond issued by the South African government (on which they earn around 8 per cent per annum) and finance this purchase by taking short positions, or selling, say, a US bond on which they pay barely 2 per cent. The net difference is locked as carry profits.

Surely this kind of arbitrage is unsustainable? Else, why aren’t we all FX traders? In equilibrium, there ought to exist parity between interest rate differentials, current exchange rates and expected future exchange rates as reflected in the price of forward currency contracts. Fundamentally, high interest rate currencies ought to be expected to depreciate relative to low-interest rate currencies – and this expected depreciation is reflected in the price of forward currency contracts. In efficient markets, the price of forward contracts knocks out any profit opportunities from interest rate differentials. More intuitively, a high interest rate economy is associated with higher levels of inflation, and even as the holder of an emerging market bond earns a higher rate of interest, the value of the bond itself should be eroded by the higher rate of inflation. Fortunately for the carry traders, the world is very far from equilibrium right now (and FX markets were probably never efficient in the first place). Interest rates in advanced economies have been artificially low for over two years in an attempt to support failing financial sectors and faltering growth. As a result, interest rate differentials no longer represent real differences between economies and are not counter-balanced by expected currency movements. The effect has been a swelling of carry trade fuelled by huge purchases of emerging market assets, leading to an appreciation in those currencies.

And there’s more, too. Carry traders are benefiting from a double bet: that emerging market currencies will continue to appreciate in the near future. In other words, traders pick up not only interest differential profits but also the profits from an appreciation of the currency in which their bond or other asset is denominated. Reads rather like that game of “heads I win, tails you lose” – at the losing end of which Dhoni seems to perpetually find himself.

Small wonder, then, that emerging economy governments are on the warpath. However, the unilateral actions of various economies worsen the chances of correcting global macroeconomic imbalances – a root cause of the financial crisis in the first place. The IMF is trying to broker peace by laying down rules for imposing capital controls: mostly focused on targeting short-term speculators rather than drowning out all capital movements. However, in an environment of little international cooperation, there seems no hope for an easy end to the war.

Finally, just to upset the picture I have outlined, there are a lot of variables which threaten the status quo. Europe certainly seems resigned to the doldrums but a recent improvement in US growth numbers led to a sudden repatriation of capital to the US. Fears of inflation in EMs, most notably in India, China and even Brazil, have already arisen and could potentially scare off investors overnight. The recent commodity price surge, particularly in oil, mirroring the rapid increases in commodity prices between late 2007 and mid 2008, will widen current account deficits and put downward pressure on the currencies of oil and other commodity-importing economies.  These uncertainties are exacerbated by the herd mentality of the swarms of carry traders, who tend to ride momentum waves. Even small exchange rate movements could lead many traders to junk a certain currency overnight, setting up a self-fulfilling prophecy of rapid capital outflows and currency depreciation. The one certainty seems to be that global financial stability will continue to be fragile in 2011. And that Dhoni will keep losing the toss.