Reverse carry trade borrowing is deadly

By now, you are familiar with the carry trade, where one borrows in one’s own currency in order to invest in higher yielding foreign assets, often times with significant leverage. The Japanese were famous for making this trade in Australian Dollars, U.S. Dollars, you name it.

What a lot of people don’t realize that everyone and his brother was doing the reverse carry trade as well. This is a trade where one borrows abroad in a currency where interest rate are low and then invests that money at home.

Both trades can make one a lot of money, especially using leverage. And indeed, for quite some time, many have made a killing simply by performing this trade. However, both trades carry some risks. The normal carry trade carries currency risk — i.e. the currency in which you invest your funds falls more than you collect in excess returns before you can repatriate your funds. The reverse carry trade is a problem if your credit comes due and you are unable to rollover this foreign currency debt — i.e. you essentially default because no one will lend to you in the foreign currency.

Of the two trades I find the reverse currency trade much riskier than the carry trade. Let me give you a few examples why.

First, there’s Iceland. This small country of 300,0000 turned itself into a financial services powerhouse, leading to unsustainable spending growth. In order to get there, its banks needed to g abroad to increase their asset base. However, along the way, these companies started to do the reverse carry trade. When Iceland, the country, and its banks ran into difficulties, no one wanted to lend to the Icelandic banks. As a result, result, Kaupthing became the first European issuer to default on Japanese Yen denominated bonds.

Kaupthing Bank hf today became the first European borrower to default in Japan’s samurai bond market after the state-controlled bank missed its last chance to make a 450 million yen ($4.8 million) coupon payment.

Two investors in the Reykjavik-based bank’s 50 billion yen in 1.8 percent notes, who declined to be identified, said they hadn’t received funds that were originally due on Oct. 20. Kaupthing had a one-week grace period to make its payment, according to the terms of the sale prospectus.

Yields on the bonds have risen as high as 45,000 basis points over the one-year yen swap rate to nearly 451 percent as investors hurried to unload the securities in recent days.

A basis point is 0.01 percentage point.

Then, there are the stories behind the Fed’s need to extend swap lines to every Tom, Dick, and Harry central bank around the world. You were probably wondering where all the money Alan Greenspan printed went. Well, some of it went to our own mortgage bubble in the good ol’ U.S. of A. But, some of it also went to foreign banks that proceeded to finance their own speculative binges abroad. Houston, we have a problem — these banks can’t roll over their dollar-denominated. The credit markets have come unstuck and everyone is in a panic. What to do?

Enter the Fed. Basically, the Fed is acting as a global lender of last resort by offering virtually unlimited dollars to the ECB, the Swiss central bank, the BoE, the South Korean central bank, as well as the Mexican and Brazilian central banks. Needles to say, this is not good for the U.S. dollar’s value over the long-term. But, who else is going to step in here?

All of these central banks need the money for their domestic financial institutions. So rather than leave these banks at the mercy of the global credit markets, Ben Bernanke and company have stepped in and given the money to the local central banks who then help these companies by loaning them the dollars to roll over their debt or by helping them get out of dollars and into their own currency. Again, swapping out of dollars means less demand for the Greenback and a lower U.S. Dollar.

Finally, there’s this little story I caught at Bloomberg today.

Imre Apostagi says the hospital upgrade he’s overseeing has stalled because his employer in Budapest can’t get a foreign-currency loan.

The company borrows in foreign currencies to avoid domestic interest rates as much as double those linked to dollars, euros and Swiss francs. Now banks are curtailing the loans as investors pull money out of eastern Europe’s developing markets and local currencies plunge.

“There’s no money out there,” said Apostagi, a project manager who asked that the medical-equipment seller he works for not be identified to avoid alarming international backers. “We won’t collapse, but everything’s slowing to a crawl. The whole world is scared and everyone’s going a bit mad.”

Foreign-denominated loans helped fuel eastern European economies including Poland, Romania and Ukraine, funding home purchases and entrepreneurship after the region emerged from communism. The elimination of such lending is magnifying the global credit crunch and threatening to stall the expansion of some of Europe’s fastest-growing economies.

“What has been a factor of strength in recent years has now become a social weakness,” said Tom Fallon, emerging-markets head in Paris at La Francaise des Placements, which manages $11 billion.

It makes you want to cry — this is a hospital for Pete’s sake. And they are getting caught up in this global currency and credit crisis. But, that’s the carry trade for you.

From where I am sitting, a lot of the recent turmoil in emerging markets is a direct result of the reverse currency trade — borrowing at low rates in foreign currency in order to invest at home. Argentina, Brazil and half of Asia blew up less than 10 years ago for just these reasons.

When will they learn? Do people have that short a memory.

Related posts
Currency crisis is gathering storm
The carry trade unwinds and it’s not pretty
Currency crisis is gathering storm
A shift to Eastern Europe and emerging markets too
Asia is next
Japan’s easy money policy was the trigger for the tech wreck

Iceland Kaupthing Defaults on Samurai Bonds as Yields Hit 450% – Bloomberg
`Panic’ Strikes East Europe Borrowers as Banks Cut Franc Loans – Bloomberg

  1. Anonymous says

    I don’t think this is a reserve carry trade. It is a bona fide carry trade. You are borrowing in a lower yielding currency and investing in higher yielding assets. This is no different than US-based hedge funds borrowing in yen to fund their dollar-denominated speculations.

  2. Edward Harrison says

    fair enough. No one uses that term. But, I have done so to highlight the different risks in hedge funds or banks or hospitals or sovereigns borrowing in foreign currencies versus borrowing in their home currency.

    Because of currency risk, one could see the real cost of their liabilities sky rocket by borrowing in foreign currency. To my mind, borrowing in a foreign currency is much riskier than investing in one.

  3. AnonymouSpain says

    Some people in Spain have been encouraged by their banks (!!!) to move their mortgages to yen, in order to avoid the higher EURIBOR rates we have seen in the past 2 years. I gather the bank gets some fees for the operation, and the customer bears all the risk.

  4. Edward Harrison says

    My terminology “reverse carry trade” seems to be more in favour than I thought. Willem Buiter uses it in his essay about the Eastern European crisis. Here is the link and the quote:

    The return of capital controls

    In most CEE countries, households and non-financial corporations played the reverse carry trade by borrowing in the foreign currencies with the lowest interest rates, oblivious to the exchange risk this involved. These CEE counterparts of Mrs Watanabe did so without having any natural foreign exchange hedges (foreign currency assets or income) and without taking out any synthetic hedges. Households throughout CEE have Swiss-franc-denominated residential mortgages. I am surprised there weren’t more yen-denominated residential mortgages taken out! With the sharp decline in the external value of their currencies (the Polish zloty has declined against the euro by more than 35 percent since its peak in mid-2008, the Hungarian forint by 26 percent and the Czech koruny by 22 percent), the real value of their debt and debt service has increased sharply. Fortunately, most of these mortgages have long remaining maturities.

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