from Follow the Money

Dollar, funding currency for the global carry trade?

January 29, 2008

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With the Fed now aggressively cutting US interest rates to keep the bursting of a real estate bubble from devastating the US financial system and economy, is the dollar about to turn into the yen- that is, the key funding currency for the global carry trade?

Mark Gongloff of the Wall Street Journal -- citing a set of currency traders -- posed the question yesterday:

Japan’s yen has been the carry-trade vehicle of choice for years, given the country’s superlow interest rates. The Swiss franc has been another. If the Fed keeps cutting rates, carry-traders might line up to ride the dollar like a birthday pony, with important implications for markets and the economy.

In my view, it will be hard for the dollar to emerge as major funding currency. At least not in the absence of truly unprecedented generosity from the world’s central banks.


Fundamentally, because the US has a huge external deficit and needs to borrow money from the rest of the world even in a slump, while Japan’s slump added to Japan’s external surplus and thus the supply of funds it could lend to the world.

Funding currencies usually have -- in addition to low interest rates - lots of savings, and consequently spare funds to invest globally. That doesn’t sound much like the US.    

The United States own need for funding limits the dollar’s ability to serve as a global funding currency.The US saves far less than it invests, and has to make up the difference by borrowing from the rest of the world. That is a constraint on the United States’ capacity to supply dollars to investors who want to sell (borrowed) dollars to buy higher yielding currencies. 

Or, to put it a bit differently, the only way the US dollar can be a funding currency in a deep macroeconomic sense is if more funds are coming to the US - even with lower interest rates in the US than in the rest of the world -- than are needed to finance the US current account deficit. Those investors borrowing dollars to invest outside the US wouldn’t be borrowing US savings; they would be borrowing the rest of the world’s savings that happens to be held in dollars.

And who might be the source of all those dollars?

Right now, there is only one realistic answer: the world’s central banks. I rather doubt that they are willing to finance both the US current account deficit and a large US dollar carry trade.

I have hardly been a cheerleader for sovereign wealth funds. In my view, they raise at least as many problems as they solve: I would be much more comfortable if sovereign investors stuck to index funds for their equity exposure. But the whole point of sovereign wealth funds is to avoid a world where private investors use dollar supplied by central banks to fund lucrative investments outside the US.  Sovereign funds let governments make such investments on their own.

It is hard right now to say anything is impossible. Five years ago I never would have guessed that the emerging world’s governments would add over a trillion dollars to their external assets in a year, or that the US government would tacitly encourage US banks to be recapitalized by the investment funds of cash-rich (and less-than-democratic) emerging market governments.

But a substantial US dollar carry trade would fly in the face of the United States need to attract large sums of savings from the rest of the world to "fund" its current account deficit.

That of course doesn’t mean that some US investors haven’t sold the dollar to buy foreign assets, or that some foreign investors haven’t borrowed in dollars to invest abroad. Recent market moves suggest that "deleveraging" supports the dollar as well as the yen.

But there is an important difference between post-bubble Japan and post-bubble America: Japan always ran a current account surplus and never needed financing from the rest of the world.   

As US rates fall, though, the US may find it hard to be attract carry trade flows from places like Japan. The dollar may no longer be a destination currency, even if it isnt quite a funding currency.  The absence of a yen/ dollar interest rate differential has in the past been associated with Japanese intervention in the currency market, as the Japanese government picks up the slack from the carry trade.

Something to watch.


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