B. The Dollar Carry-Trade in the International Financial Markets and its Implications

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Cuthbert Day
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1 Figure.3 Policy Rates of Major Economics tational and non-monetary rewards that professionals may easily feel are lacking must also be considered. Since HRM can take on the flavor of a bank s management philosophy, consistent supervisory policy implementation is a struggle, so model cases of fostering professionals need to be studied and disseminated. B. The Dollar Carry-Trade in the International Financial Markets and its Implications Chung-Han Kim (chk592@kif.re.kr) Figure.4 VIX, TED, EMBI+ Yoonsok Lee (yslee@kif.re.kr) The carry-trade may be defined as leveraged trading that takes cross-currency positions using interest rate differentials amid conditions of low exchange rate volatility. Low interest rates in the US and other advanced economies and rapid recovery in emerging economies following the global financial crisis created an environment conducive to carry-trading. This paper shall look at recent trends in and the outlook for the carry-trade to provide policy implications regarding capital flows. 1. The Emergence of the Carry- Trade Figure.5 Implied Exchange Rate Volatility by Country As the global financial crisis calmed thanks to aggressive responses by the US and other major economies, global financial market uncertainty eased and the appetite for risk increased. The VIX index, which shows the degree of investor unease, and the TED spread that serves as a risk indicator for bond and credit markets, have been stabilizing downward since With risk aversion easing and the flight to quality phenomenon largely going away, the Emerging Market Bond Index (EMBI+) that gauges the degree of emerging market risk also has been stabilizing downward.

2 Current Issues Figure.6 Exchange Rates & CTRs of Major Economies [Canada] Furthermore, from 2009, global foreign exchange markets stabilized, and countries implied volatility diminished markedly, suggesting that the risk factors involved in the carry-trade are fading away. [Australia] Following the US subprime crisis, the Federal Reserve lowered policy rates nine times from September 2007, while the euro zone and Japan also adopted low interest rate policies. This has widened the interest gap with emerging market economies. Policy rates in the US, the euro zone, and Japan are at unprecedented low levels of 0.25%, 1.0%, and 0.1%, respectively. Conversely, emerging market rates, such as in Brazil and Indonesia, have gone down relatively modestly, widening the interest rate gap with advanced economies to over 5%p. International financial market stability and the interest rate gap have combined to form a favorable environment for the carry-trade. 2. The Dollar Carry-Trade [New Zealand] In the past, the yen was the primary funding currency in the carry-trade, but with the low interest rates in the US, the dollar has predominated since As the Federal Reserve lowered the federal funds rate and conducted quantitative easing policies by buying up government bonds, dollar liquidity swelled. From September 2009, the dollar LIBOR rate dipped below that of the yen (in early October, the 3 month dollar LIBOR rate was 0.28% versus 0.34% for the yen), which expanded the dollar's role as the funding currency. [Brazil] The carry-to-risk (CTR) ratio indicates the level of attractiveness of the dollar carry-trade. The CRT ratio is split into the interest rate gap between the borrowed and invested currencies and the future exchange rate volatility, with the higher the value indicating higher attractiveness of the carry-trade. It can be confirmed that the carry-trade targeting Australia and emerging markets, which boast rapid economic growth and higher interest rates, has been growing recently. For the Australian or New Zealand dollar,

3 [Russia] the CRT ratio has been rising since Beyond this, the Brazilian real, Indonesian rupiah and other emerging market currencies have seen the same phenomenon beginning in The negative correlations between the CRT ratio and the dollar exchange rate of the invested currencies indicate the inflows of overseas capital into the target countries. [Hungary] Meanwhile, US banks overseas lending had been growing through 2007 before diminishing, in 2008 from the global financial crisis. This turned to a dramatic decline in the first half of 2009 before again returning to growth. Net lending growth went from $8.3 billion in 2007 to $2.8 billion in During the first half of 2009, lending growth dropped a full $2.5 billion, but rose $4.6 billion in the second half, and soared $10.2 billion in the first quarter of Thus, one can find indirect evidence of the dollar carrytrade from the increase in US banks overseas lending since the second half of [Indonesia] Funding through short-term and long-term bond issuance in international financial markets is healthy in the US. In the US, the issuance market has been robust, centered on long-term bonds, with total issuance steadily rising. US bond issuance outstanding rose 12.1% from $729.7 billion at the end of 2008 to $6.77 trillion at the end of March Thus, beyond bank lending, bond issuance also indirectly supports the fact that the dollar serves as a funding currency for the carry-trade. [Korea] The CRT ratio for the Korean won has consistently been rising since early 2009, encouraging won-targeted trades. The global carry-trade using low rate dollars as funding is believed to have gotten off the ground in Korea from Korea s policy rate of 2.0% is higher than the US Federal funds rate of 0.25%. Korea s country risk and the liquidity risk in international financial markets eased from 2009, so net purchases of domestic bonds by foreigners persisted. Foreign bond investment inflows were just $7.73 billion in 2008, but rose to $23.72 billion in 2009 and $10.47 billion in the first

4 Current Issues Table.3 Net Growth of US Banks Overseas Lending (Unit: $100 million) Bank Loans Q 2Q 3Q 4Q 1Q Source: US Federal Reserve (Flow of Funds Account). half of 2010, and it is assumed that a portion of this capital owes to the carry-trade. 3. Dollar Carry-Trade Outlook & Implications Since 2009, it is estimated that large-scale dollar carrytrades have been conducted in the international financial markets though from the middle of 2010, though this somewhat moderated from global destabilizing factors, such as the sovereign debt crises in southern Europe. Owing to the debt crises in southern Europe, however, the low interest rate regime that has propped up the dollar carry-trade looks set to continue for the time being. Figure.7 Bond Issuance in International Financial Markets [US] The possibility does exist that dollar carry-trade funds will be unwound depending on how Europe s debt crises turn out. The EU s stress tests of European banks found just 7 of 91 banks to have failed the test, and although the stress test results were favorable, European countries fiscal austerity measures to address their excessive sovereign debt problems will inevitably have a contractionary effect on the economy, and this continues to be a destabilizing factor for the global financial markets. In the longer term, the dollar carry-trade may not continue to grow as the US moves away from its low interest rate policies. The yen carry-trade is driven by Japan s low interest rates during its over 10 year-long recession. As the US recovers from the global financial crisis, its low interest rates are projected not to last, bringing down the dollar carry-trade with it. [Japan] Yet even if the dollar carry-trade does not last into the long-term, multiple currencies feature low rates, so the carry-trade is expected to persist using such countries for the funding currency. Yen, euro, Swiss franc, and pound-denominated funds are being traded at sub-1% rates. As the euro weakens from the fiscal crises in southern Europe, the funding currency for carry-trades could switch from the dollar to the euro.

5 Figure.8 Capital Outflows from Equities, Bonds, and Borrowings Source: BOK. Excessive inflows of carry-trade funds bring about currency appreciation and monetary volume increases, so exchange rate policies need to factor in such potential side effects. The growth of the dollar carry-trade is highly likely to further push down the dollar and push up target countries currencies, cutting into such countries current account surpluses. Carry-trade fund inflows may also limit the effectiveness of monetary policy by applying downward pressure on market rates. Funding flows from the dollar carry-trade do improve target countries foreign currency liquidity, but as the potential for sudden capital flight down the road also exists, such flows are highly likely to act as a financial destabilizing factor. If carry-trade funds rapidly flow out, this will send market and exchange rates soaring and destabilize target country economies, particularly for emerging markets. Since carry-trade positions take much longer to build than to unwind, this capital flight must be guarded against. More stringent monitoring of changes in global market conditions and capital movements, and greater international coordination are needed to guard against the potential for sudden outflows. C. FX Financing and the Interconnectedness of Financial Markets Min-Kyu Song (mksong@kif.re.kr) Table.4 Banking Sector External Debt from Borrowings (Billion US doallar, %) External debts Korean banks (54.9) (45.1) (40.7) (37.8) (37.0) Foreign bank branches (45.1) (54.9) (59.3) (62.2) (63.0) Note: Figures in parentheses are shares. Source: BOK. 1. Introduction The recent global financial crisis has highlighted the critical role of financial markets in the propagation of adverse shocks. Together with the rest of the world, the Korean economy was hit hard in mid-september 2008 following the bankruptcy of Lehman Brothers. Korea experienced massive capital outflows and serious difficulties in refinancing foreign currency denominated

Global liquidity: selected indicators 1

8 October 14 Global liquidity: selected indicators 1 Highlights Indicators of global liquidity point to a continued strengthening of risk appetite and loosening of credit conditions in the spring and summer