Yen Carry Trade – Unwinding the Story of this Global Event!

What’s the Point?

At the Bank of Japan’s (BOJ) Monetary Policy Meeting held on July 31, 2024, the short-term interest rate (uncollateralized overnight call rate) was raised from “around 0 to 0.1%” to “around 0.25%”. This announcement led the Nikkei-225 Stock Average (Tokyo Stock Exchange) to fall by 20% between July 31-August 05, 2024, the worst fall since 1987. Additionally, weak employment data showed signs of US economy slowing down, sparking concerns of a recession and a hard landing. All these have led to concerns around reversal of the Yen carry trade leading the global markets to witness significant volatility. The US 10-year Treasury yields dropped by 55 bps (from 4.28% to 3.73% between July 24, 2024 and August 05, 2024). Indian markets have also been impacted, but appear well-placed in the global context, with resilient balance sheets of the Government, financial system and corporates.

What is a Carry Trade?

A carry trade is a hugely popular trading strategy where an investor borrows from a country with low interest rates and reinvests the money in assets of another country with a higher rate of return. Such forms of trades have been one of the biggest sources of flows in the global currency market.

Japanese Yen is considered one of the most widely used currencies for carry trades. In a “Yen Carry Trade”, investors borrow at a low interest rate in Japan and purchase assets in another country with higher returns, such as overseas equities and bonds. Let’s understanding this through a simplified example:

Source: Bloomberg

As we can see from the table above, as US Dollar strengthens relative to Japanese Yen (between March 29, 2024 and July 18, 2024), investors gain from borrowing in Yen and investing in dollar assets. But as US Dollar weakens relative to Japanese Yen (between July 18, 2024 and August 05, 2024), investors who have remained invested in assets denominated in US Dollar will witness a loss in their position.

With US equities and T-bills having been a favourite in recent times due to the strengthening of the US Dollar, the Yen has been popular for carry trades because Japan has maintained a zero-interest rate policy for over two decades, barring short periods in 2006-2008, to combat persistent deflation.

Implication of Bank of Japan’s stance on its Monetary Policy

Japan has opted for a more restrictive monetary policy by raising its short-term interest rates and laying out a plan to reduce the amount of its monthly outright purchases of Japanese Government Bonds (JGBs).

In its Guideline, BOJ highlighted the presence of upside risks to prices and expects to moderate inflation by withdrawing liquidity by ~400 billion yen each calendar quarter (~3 trillion yen by January-March 2026). Since a rise in interest rates attracts foreign investments, it raises the demand for the domestic currency. Hence, BOJ’s announcement has led to a strong appreciation of Yen versus US Dollar after many years. For investors involved in a FX carry trade, this rate hike implies that they would look to quickly unwind their positions in order to cut losses.

Source: Chart 1: Bank of Japan (Statements on Monetary Policy 2024), Chart 2: Bloomberg, as on August 05, 2024

Potential Risks to India as a result of the Interest Rate Hike

• At end-March 2024, India’s external debt was placed at US$664 billion. Considering ~5.8% of this debt is denominated in Yen, which has appreciated 7.7% versus the Rupee between July 29, 2024 and August 05, 2024, the impact of Yen Carry Trade could be felt through currency impact on the loans undertaken by Indian companies.
• As per July 2024 data by NSDL*, the total Assets Under Custody (AUC) (inclusive of equity, debt and hybrid) held by Japanese Foreign Portfolio Investors (FPIs) was ₹2.29 lakh crore, of which ~2.18 lakh crore is in equities. With Japanese FPIs accounting for ~2.85% of the total FPI AUC, there could be some degree of near-term impact due to unwinding of trades (Total FPI Outflows: ₹10,073.75 crore on August 05, 2024 as per National Stock Exchange).

Conclusion

The world of geopolitics and global monetary policy remains VUCA – Volatile, Uncertain, Complex and Ambiguous. In such an environment, India offers a relative oasis with strong growth and resilience through balance sheets across Government, financial system and corporates. While there could be risks of outflows from FPIs in the near term, in the medium to long term FPI flows could be positive considering India’s fundamentals and current weight for India for FPIs. With Indian markets currently at above average valuations, significant negative changes in the global economic could lead to volatility in Indian markets. In that light, investors must take a long term view and stay invested.

Sources: Bloomberg, BOJ, *National Securities Depository Limited, and other publicly available information.

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