from Follow the Money

Just how big is the yen carry trade?

March 15, 2007

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Stephen Jen of Morgan Stanley insists not-so-big.  Or at least that the large size of the carry trade cannot be proved – and that the impact of any recent unwinding has been overstated.   That is his long-standing view. In early February, Jen wrote: “So far, our view is that most of the outflows from Japan are benign and stable in nature.”

John Dizard of the FT seems to agree.  He notes that the Japanese authorities estimate that leveraged short-term bets on the yen only total $20-40b.

Others, though, seem to think the yen carry trade is now rather large.

Tim Lee of Pi Economics recently got some support from Jesper Koll of Merrill Lynch.  He also puts the size of the carry trade at close to $1 trillion – and more importantly, says that various players in the market added about $300b to their position over the past year.  The FT:

Merrill Lynch said on Tuesday that its research in the Tokyo interbank market showed that non-Japanese banks’ funding had surged from Y1,500bn to Y7,500bn since the end of 2005.

“This Y6tn ($51bn) surge in non-Japanese funding is a new development that, in our view, points to the true carry of yen-funded leveraged position build-up in the recent past,” said Jesper Koll, economist at Merrill Lynch, who believes “the absolute size [of this carry trade is] maybe around $1tn, with about a third of the positions built up in the past 12 months”

No surprise, many think that even after the market’s recent carry-unwind related wobbles, the are still a lot of leveraged short-yen/ long carry positions out there.  Michael Woolfolk of the Bank of New York for one.  Peter Garnham quotes Woolfolk in the FT:

“I suspect that what little carry trade unwinding was seen in the past two weeks was only the tip of the iceberg compared to the remaining trades that are still on the books” 

Jim O’Neill of Goldman worries a bit more than Dr. Jen.  He also puts forward a slightly lower – but still substantial – estimate of the size of the yen carry trade, roughly 5% of Japan’s GDP, or a bit under $250b:

Jim O'Neill, the bank's chief global economist, said investment firms playing the "carry trade" had been caught on the wrong side of huge leveraged bets against the Japanese yen. "There has been an amazing amount of leverage on currency markets that has nothing to do with real economic activity. I think there are going to be dead bodies around when this is over," he said. "The yen carry trade has reached 5pc of Japan's GDP. This is enormous and highly risky, as we are now seeing."

One approach to estimating the size of the carry trade – and the approach that I think Goldman uses -- takes Japan’s basic balance of payments surplus (the sum of the current account, net FDI flows and net portfolio flows) as a good proxy for the size of the carry trade.  Jamie McGeever of Reuters reports:

There's also an argument to be made that, in effect, Japan's broad basic balance surplus is a fair measure of the overall short yen position.  That comprises the surplus on Japan's current account, foreign direct investment and portfolio flows, which is roughly 4.5 percent of the country's entire gross domestic product -- or around $215 billion at current exchange rates.

Here is the logic of looking at the basic balance of payments, as I understand it.  Japan has a substantial current account surplus, which implies a substantial, ongoing capital outflow from Japan.  Yet, the balance of payments data doesn’t show large portfolio outflows.  Indeed, if I am reading the Japanese BoP data right, Japan experienced a large net portfolio inflow in 2006, and the net portfolio outflow in 2005 was rather small.  Japanese retail accounts seem to have a strong appetite for high-yielding foreign currency debt, but Japanese institutional investors seem a bit more cautious – and foreigners have been buyers of Japanese equities.   The absence of net portfolio outflows implies that other – harder to track – flows have been the main vector bring Japan’s surplus to foreign markets. The BIS recently found that hedge fund returns correlate with the returns on certain simply long carry strategies. 

One part of Merrill’s argument particularly interests me.  If leveraged “long carry” bets are the way that Japan’s current account surplus is lent out to countries that need financing – or, for that matter, lent out to countries that don’t need financing, fueling their reserve growth and thus indirectly financing the US --  thesize of the leveraged long “carry” positions has to keep on growing to sustain the global status quo.  It is kind of like the situation with China’s reserves and quasi-reserves.  China doesn’t just have to hold on to its existing dollars – it needs to keep on buying.   Same with carry traders.    If they weren’t adding to their positions, either Japanese institutions would need to but more foreign bonds and equities, foreigners would need to lose interest in Japanese equities (increasing the net outflow) or the Japanese government would once again need to borrow yen to buy dollars and euros (sort of like 2003 and early 2004).

The Merrill/ Goldman argument also jibes with the huge scale of recent inflows to places like Brazil and India – which is one reason why I find it relatively persuasive.  But there is a risk that these flows are influencing me too much: the scale of “carry” positions in the Brazilian real ($12b according to a recent estimate) or in Turkish lira (foreign holdings of Turkish debt total 43billion lira, or around $30b) are small in the global scheme of things.    That is why I am interested in Macroman’s contrary view. The folks he talks to seem to have different sense than the Goldman/ Merrill research shops.     

And if anyone at Merrill reads this blog and wants to send me the report – my email address is brad dot setser at rgemonitor dot com

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