This is shaping up to be the year of the big global squeeze on easy money. The Fed, of course, has been in credit-tightening mode for about two years now, but the European Central Bank and monetary authorities in India, South Korea, Iceland, and Turkey have been ratcheting up interest rates in 2006 either to stamp out incipient signs of inflation or to defend a currency under attack.
On July 14, the easiest money regime on the planet is expected to get into the act. The Bank of Japan likely will raise a key short-term rate by 25 basis points from near-zero levels, the first tightening move inside the world's second-biggest economy since August, 2000. That may not seem like anything more than a baby-step adjustment, but some market watchers think it could cause a worldwide market upheaval. Why? It has a lot to do with what market pros call the "yen carry trade," the practice by hedge funds and other speculators to borrow cheaply in yen to fund risky purchases in emerging-market debt and stocks or U.S. Treasury bonds.
Hedge fund guru George Soros late last month placed blame squarely on the Bank of Japan for the emerging-market blowout in May that caused a selling panic in Iceland and also unnerved investors in Turkey and India (see BusinessWeek.com, 5/23/06, "India's Market Turns Down the Heat"). Soros pointed out to reporters in Turkey that when the Bank of Japan in early March ended its five-year policy of so-called quantitative easing, in which it regularly flooded $200 billion-plus into the Japanese banking system, the move "had a global effect on currencies, bonds, and stocks" (see BusinessWeek.com, 3/9/06, "BoJ: Cash Machine No More").
RATE-HIKE RATIONALE. In other words, it was as if a giant spigot of global finance had been abruptly turned off. And investors who had raised yen to finance their purchases, expecting the easy-money policies of Japan to continue, moved en masse to unwind their positions. That let loose the market declines in May, and now a further sell-off may be coming as the BoJ gradually raises interest rates going forward.
The whole phenomenon of the yen carry trade is a subject that draws scads of attention, but rarely ever much clarity. Bank of Japan Governor Toshihiko Fukui and his policy board make monetary calls based on the condition of the Japanese economy—not the funding needs of global hedge funds. The decision to draw down excess reserves in the banking system made sense given that Japan's money-center lenders are profitable, healthy, and don't need excess cash.
Raising rates also is a rational move if the BoJ believes in the robustness of Japan's two-year economic recovery and sees the big risk now as inflation, not the spiral of declining prices or deflation that harmed the economy earlier in the decade.
SOME NAGGING QUESTIONS. Some economists, though, believe the BoJ shouldn't pull the trigger, for reasons that have nothing to do with the yen carry trade (see BusinessWeek.com, 7/7/06, "Bank of Japan's Inflation Avoidance"). Others argue that the yen carry trade, if unwound quickly, could cause big disruptions.
UBS Senior Economic Adviser George Magnus has analyzed Japan's direct investment and portfolio flows, bank and nonfinancial lending, trade credit flows, financial derivatives, and a category called "other investments" and has come up with a figure of roughly $100 billion in 2004 and 2005 that could have found its way into the carry trade. That's not huge, but the fear is that the money could have been used as down payments on highly leveraged derivative trades of a far larger size.
Trouble is, and Magnus concedes this, there is no way of knowing exactly how much of that $100 billion was actually diverted for yen carry trades on risky emerging-market assets. His analysis also begs the question of how Japan banks could be a "conduit" for global finance when its lending growth was actually negative all of this decade until last year, given the persistent weakness of the Japanese economy since the mid-1990s.
NO WORRIES. Also, carry trade skeptics such as Morgan Stanley global economist Stephen Roach point to other data compiled by the Bank of International Settlements like cross-border lending in yen by Japanese banks. It actually has declined in relative terms, compared to total global cross-border lending, from 12% to 4% in recent years.
And even if you buy into the idea that the yen carry trade is huge, if somewhat hard to nail down statistically, is a Bank of Japan hike of its overnight call rate from near-zero levels to maybe 0.5% over the next six months really that scary a prospect? The rough equivalent to that benchmark in the U.S. is the Fed Funds rate, now at a much, much higher 5.25% and perhaps heading higher still. Bottom line: One shouldn't get hysterical about an imminent Bank of Japan interest rate hike.
If you insist on worrying about the global economy, better to get riled up about a Chinese economy showing signs of overheating, North Korea's missile-happy regime, or a killer asteroid careering toward the planet unbeknownst to us all. For now, you can probably scratch the yen carry trade from your list of monsters lurking in the closet.