THE CARRY TRADE AND FINANCIAL CRISES:

IMPLICATIONS FOR THE UNITED STATES

ELIZABETH POLSTER

ADVISOR: PROFESSOR LANCE KENT

THE COLLEGE OF WILLIAM & MARY

WILLIAMSBURG, VIRGINIA

MAY 2013

ABSTRACT.

This paper will provide the tools necessary to analyze the international carry trade with

respect to the United States: its mechanics, its effects on an economy, and the role of the

US dollar in the international carry trade. Implications for the US and world will then be

derived, with particular attention paid to the prospect of a possible crisis in the foreign

exchange market. Though an international financial crisis due to the collapse of the carry

trade is possible, such an event is contingent on the actions of the Federal Reserve Bank

and unlikely to occur under current circumstances.

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INTRODUCTION.

The carry trade is the ‘most widely-used currency speculation’ in the world.1 It

takes advantage of the foreign exchange market, commands trillions of dollars

worldwide, and yields extraordinary profits to those who speculate in it. Yet this

phenomenon can hardly be described as a miracle. The carry trade has a wide range of

detrimental effects that are imposed upon the currencies involved. Many economists

believe that these effects are building the foundations of the next great international

financial crisis. There is some evidence indicating a growing bubble in the foreign

exchange market, and the bursting of this bubble could be catastrophic. Further,

involvement of the US dollar as a funding currency for the carry trade would worsen the

consequences of such a crisis. The following sections break down the mechanics, effects,

and implications of the international carry trade with particular attention paid to the role

of the US dollar since 2009. The purpose of this paper is to analyze the carry trade with

respect to the possibility of its collapse, and evaluate predictions of an ensuing financial

crisis stemming from such a breakdown. This assessment concludes that despite evidence

of a bubble in the foreign exchange market and precarious domestic economies, a large-

scale financial crisis resulting from the collapse of the carry trade is improbable

considering the current state of the world and US economies.

THE MECHANICS OF THE CARRY TRADE.

Arbitrage from currency trading has yielded substantial profits since the collapse

of the Bretton Woods system in 1971. The worldwide regime of floating exchange rates

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made the carry trade possible: under this system, investors are able to take advantage of

interest and exchange rate differentials between and among countries for profit.

Floating exchange rates allow investors to exploit the differences between

exchange and interest rates between countries in two ways. First, an investor can borrow

some amount of money in a low-interest rate currency, convert these funds into a high-

interest rate currency, and lend the funds in the latter currency at the higher interest rate,

generating profits from this rate differential. This is the most common carry trade

strategy. A second, comparable tactic involves purchasing currencies that are at a forward

discount (currencies for which the future exchange rate at a specified date are lower than

the current exchange rate) and selling currencies that are at a forward premium

(currencies for which the future exchange rate at a specified date are higher than the

current rate).2 The investor can therefore reap the benefits of arbitrage as the currency is

exchanged.

This second version is comparable to the first because the currencies at a forward

premium are essentially serving the same function as a low-interest rate currency, and

currencies at a forward discount are acting as a ‘target’ currency in the same way that a

high-interest rate currency would. These versions can be referred to interchangeably and

yield equivalent results.2 The profits from both types of speculation are essentially an

exploitation of interest and exchange rate differentials across countries, and can produce

high returns with relatively little risk. Craig Burnside has estimated that the carry trade

investments experience only two-thirds of the volatility but comparable returns to

investments in S&P 500 stocks.1

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It is easiest for this type of speculation to occur when there is government

interference in the market.3 The central bank of an economy can choose to keep interest

rates unnaturally low or high with the purpose of easing or tightening financial conditions

and manipulating unemployment.4 The central bank thus inadvertently guarantees that

carry trade investments will yield the desired returns without risk of volatility for some

time. Though floating exchange rates have technically prevailed since the fall of Bretton

Woods, most countries have a system of ‘managed floats’ in which the government

intervenes in the market and influences exchange rates to pursue its monetary policy

objectives.5, 6 The distortion of both exchange and interest rates by governments world-

wide creates an ideal environment for the carry trade.

It is difficult to estimate the scope of the carry trade both within individual

countries and internationally. Tim Lee of piEconomics, a renowned economist who has

worked in asset management around the world for more than twenty years, estimated that

$2 to 3 trillion USD was involved in the carry trade worldwide in 2008, $1 trillion of

which was a part of the yen carry trade (Economist ‘Financial Stability’).7, 8 This sum

implies huge payoffs for investors that play this game.

For this speculation to work, there must be a ‘funding’ currency and a ‘target’

currency.9 Popular funding currencies in recent years have included Japan, the Eurozone,

Sweden, and Switzerland: these economies have all sustained low interest rates for years.

Popular target currencies include Australia, New Zealand, Turkey, and a number of

emerging economies, all of which are marked by higher interest rates.8 Thus, a trader will

borrow yen from Japan at a low interest rate, turn around and lend that money in

Australia at a high interest rate, and yield a profit from the interest rate differential.

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Burnside, et al. have found that there are especially large gains from diversifying carry

trade investments across a number of countries.1

The role of the yen in particular must be noted when mentioning the funding

currencies of the carry trade. The yen has for decades been the carry trade’s most

prominent and popular funding currency: it is regarded as a ‘safe currency’ because low

interest rates are guaranteed for extended periods of time. Japan maintains low inflation

and a trade surplus, which further encourages investors to use this market.10 As

mentioned earlier, the yen may have been involved in one-third to a half of all carry trade

activity in recent years, with totals amounting up to $1 trillion USD.11

The carry trade has been traditionally analyzed using standard international

finance models. Two such models, the ‘uncovered interest parity condition’ and

‘traditional risk factor’ models, are often used to evaluate the carry trade. These models

are commonly employed to predict financial trends, especially in the foreign exchange

and asset markets, and they break down the mechanics and effects of the carry trade

within the confines of theory.

The uncovered interest parity (UIP) condition states that ‘the interest rate

differential between riskless assets denominated in foreign and domestic currency is

equal to the rate at which the foreign currency is expected to depreciate against the

domestic currency.’9 While this condition predicts that high interest rate currencies will

depreciate when involved in trade, we find that the opposite occurs in reality. It is

assumed that under this theory, the difference in interest rates between two countries

reflects the rate at which investors expect the high-interest rate currency to depreciate

against the low-interest rate currency. All currencies should ultimately move towards an

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equilibrium in which they equally offer the same expected rate of return to investors. 12 If

this condition were to hold, the carry trade would not be profitable: investors engaging in

this speculation would receive no net payoff. However, this is not the case in reality. We

find that this traditional model fails to explain the carry trade; in fact, it contradicts it.2, 9, 13

In his research, Craig Burnside analyzes traditional risk factor models such as the

CAPM, Fama-French three factor, and the consumption-CAPM models and finds that

risk-based explanations of the carry trade are uncorrelated with its returns. Burnside

concludes that there is no unifying risk-based explanation of returns for the carry trade,

especially in relation to the stock market.13 These models, which are customarily used to

explain the returns to investments such as stock market ventures, also fail to describe the

profitability of the carry trade.

According to these economic models, the carry trade should not yield profits.

However, the volume of money involved in the carry trade suggests that these predictions

do not hold, and that the carry trade is in fact profitable. As these prominent models have

failed to explain the carry trade’s success, economists can only form hypotheses for

alternative explanations. Several additional theories could serve as potential explanations

for the carry trade’s high rate of return, including the chance of a ‘peso event’ or

crash/disaster risk, and the inevitably disastrous long-term strategy of the carry trade.

Burnside’s most promising offering in describing the high returns to the carry

trade is the possibility of a ‘peso event’. This alternate explanation relies on extreme risk

aversion to events that have not yet been observed. Essentially, there could be an external

disaster so severe that it would wipe out any profits from the carry trade, and the chance

of this happening in the future is enough to yield investors high returns now. Such an

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event would likely have to occur when there are losses elsewhere in investors’

portfolios.13 Measuring the usefulness of this model is difficult due to the inherent

complications of analyzing rare or hypothetical disasters, and it is difficult for this single

theory to justify the consistently high returns to the carry trade.

Perhaps more reasonably, Brunnermeier and others have found that currency

traders are subject to ‘crash risk’: there is a chance that carry trades can suddenly unwind

if risk appetite and funding liquidity decrease.9 Because the carry trade relies on these

two factors in order to be successful, the sudden loss of either or both would result in

huge losses within the foreign exchange market. The possibility of such an event may

justify some of the returns to carry trade investments: it is estimated that disaster or crash

risk may account for about a quarter of the excess returns in the carry trade.14

Similarly, some data show that the carry trade will be successful only in the short

run. In the long run, yields would be wiped out in a currency devaluation or inflation.15

Either of these events would negate the carry trade’s profits, because the carry trade relies

on currency and interest rate stability. Even if they do not happen suddenly, as supposed

in the crash risk theory, these events will inevitably occur in the long term. Therefore, the

carry trade is profitable only in the short term. The probability that currency devaluation

or inflation will occur increases not only in the long term, but additionally so in countries

with weak economies.

The potential danger of losing all profits in the case of an external disaster, a

sudden loss of funding, or long-term currency devaluation and inflation could explain at

least part of the high returns of the carry trade.16 However, the carry trade remains the

‘unsolved puzzle’ of currency markets. While economists still struggle to find a plausible

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explanation for the success of this type of speculation, the carry trade has continued to

yield high returns worldwide for more than thirty years.2

EFFECT OF THE CARRY TRADE ON AN ECONOMY.

Engaging in this type of speculation is not without consequences. The carry trade

will affect the currencies involved along with other areas of the economy. It has both

affected and been affected by the global financial crisis of 2007. Many have also

predicted that the carry trade is driving a foreign exchange market ‘bubble’ and will

eventually cause widespread financial crisis.

The conditions necessary for the carry trade to exist will preemptively create an

unhealthy environment for the economy as a whole even before the carry trade becomes

involved. In order to stimulate growth, central banks often purchase their own bonds in

order to inject money into the economy, lower interest rates, give banks more money to

lend, and fuel borrowing and spending. Such policies occurred on a large scale following

the onset of the global financial crisis in 2007. However, by attempting to stimulate the

economy, a central bank can cause some damage to the economy and can also set up the

economy for unhealthy speculation through the carry trade.12

Once interest rates (or the value of the currency) are lowered in a country,

investors may flood in to take advantage of artificially low rates. When the carry trade

takes hold and gains volume, it will continue to exacerbate preexisting unstable

conditions. Contrary to the UIP condition, the carry trade will put downward pressure on

its funding currency (causing it to depreciate) and upward pressure on its target currency

(causing it to appreciate).2, 17 Essentially, because they involve selling funding currencies

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and buying target currencies, carry trade investments on a large scale can cause

additional excess supply of the funding currency and excess demand for the target

currency.2 This results in added exchange rate movements: the low interest rate currency

depreciates further, and the high interest rate currency continues to appreciate.8, 18 Recall,

these trends have already begun because the central bank implemented monetary policy

to manipulate the interest and exchange rates. After the carry trade takes hold, such

movement becomes self-perpetuating: the appreciation of the high-interest rate currency

will encourage investors to enter the carry trade, causing the exchange rate differential to

expand further away from equilibrium.2

By aggravating interest and exchange rate movements, the carry trade will affect

other areas of the economy. Lowering the exchange rate, increasing in the domestic

money supply, and causing a depreciation of the domestic currency means that it will

take more of the domestic currency to buy a unit of foreign currency, and the domestic

currency will become ‘weak’ relative to the other currency. The result will be cheaper

domestic products for foreign consumers, and more expensive foreign products for

domestic consumers. Exports will be encouraged and imports will be suppressed.12

Though this may be beneficial for consumers of domestic products, domestic producers

will suffer as their products must sell at lower prices. Overall, these trends lead to

economy-wide imbalances. Importantly, a depreciation of the domestic currency in this

way will also make it more difficult for domestic debtors to repay their foreign debts,

which can have particularly severe consequences under certain circumstances. In the near

future, as many economies slowly recover from recession, the ability to repay massive

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debts will be increasingly important. The consequences of such a divergence in the

interest and exchange rates from their equilibrium are therefore vital to consider.

Throughout the years the carry trade has been a driver of not only economy-wide

but global financial imbalances.19 In fact, some sources see evidence that the carry trade

was an important factor behind the 2007 credit bubble. According to Lee, high currency

misalignments caused in part by the carry trade created enormous current account

imbalances. Deviations from fair, equilibrium market values are reflected in a number of

industries, most notably credit and real estate.20 It is possible that the carry trade helped

drive divergences between money and credit growth in the US prior to 2007, which only

exacerbated the oncoming crisis.21

However, the onset of the global financial crisis weakened the carry trade to some

degree. This was evident in Japan in 2008: the yen gained strength after the start of the

crisis, signaling risk aversion and an unwinding of the yen carry trade.22 After this initial

stumble, the carry trade found growth during the crisis. Data show a ‘new appetite’ for

risk after 2009, especially in the Eurozone.23 The European Central Bank raised interest

rates across Europe in 2011, which reinvigorated the carry trade by widening the gap

between the yen (as the funding currency) and the euro (as the target currency). 24, 25, 26

Since 2009, there has been further evidence of a return of the carry trade.26, 27 Though the

carry trade may have helped to drive the global financial crisis, we are now seeing its

return despite worldwide economic downturn. As previously mentioned, investors are

again taking advantage of distorted interest rates between depressed economies in search

of profit.

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It is clear that the carry trade can have detrimental effects on individual

economies and the global financial system as a whole. Some theorists therefore predict

that the next big financial crisis will occur in the foreign exchange market. Because the

carry trade causes its target currencies to appreciate and its funding currencies to

depreciate, if enough money is involved in speculation, a bubble can be formed in the

foreign exchange market from this movement.28

The exchange rate is always moving to eventually converge on one of two

possible equilibria: its fundamental equilibrium or a ‘bubble’ equilibrium. As the

exchange rate starts to move in one direction, it will attract investors (such as speculators

in the carry trade) to reinforce the movement. As speculators hold on to their carry trade

investments, the currencies involved are prevented from returning to their fundamental

equilibria. This continuous acceleration leads to the build-up of an exchange rate

‘bubble’, which will continue to move away from fundamental exchange rate values.

After a noticeable spike, the upward movement slows and fundamentalism becomes the

more profitable option. Speculators will ‘unwind’ their carry trades and a decline is

triggered to return to fundamental equilibria.9, 29, 30 The severity of such a crash would

depend on the volume of the carry trade and foreign exchange market, but Lee has

estimated losses at $30 trillion worldwide if such an event were to occur in the near

future.20

Is it possible that this type of financial crisis could occur? Many economists have

seen evidence that a foreign exchange bubble is forming. The actual collapse of the

global carry trade would occur when there is a credit contraction or a correction of

imbalances (when target currencies begin to depreciate and funding currencies begin to

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appreciate).31 A negative shock to the interest rate differential could trigger a liquidity

crisis in the funding economy and amplify a financial crisis in the recipient economy.32

These sudden shocks would likely also have to occur during a period of great uncertainty

in the foreign exchange market due to some political or economic event.30

Some are beginning to expect such an event in the near future. There is evidence

that foreign exchange imbalances have increased in the last two years, perhaps sending

the market closer to its tipping point. Recipient currencies are overvalued and current

account deficits are increasing, likely due to both central bank distortions and the carry

trade.31 A sudden correction of these imbalances could trigger the start of the decline of

the carry trade, leading to a foreign exchange market crash.

It is important to note that a foreign exchange market crisis will only be

exacerbated the larger the bubble grows. Additionally, the carry trade has helped to

provide funding to some emerging economies (those serving as target economies) during

the global financial crisis, and the loss of this funding in a foreign exchange crisis while

these countries still need support would only cause greater economic collapse

worldwide.8

Has a hint of these dramatic effects been evident in the past? Because the regime

of floating exchange rates has prevailed since 1971, we only have several decades to

examine for examples. In his 1987 analysis of the foreign exchange market, Wing Thye

Woo found that there had been only two speculative bubbles in the foreign exchange

market since the fall of the Bretton Woods system, the most notable occurring from 1978

to 1980. These bubbles had occurred in periods when there was both significant change

in foreign exchange fundamentals and great political or economic uncertainty. Woo

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concluded that ‘destabilizing speculation does not constitute the behavioral norm in

foreign exchange markets.’30 Therefore, though foreign exchange market bubbles have

occurred in the past, they have deflated without worldwide financial crisis. It is possible

for divergences to occur between currencies without creating an immense bubble or a

catastrophic fall in the foreign exchange market. Nevertheless, it is important to

continuously monitor this market and the carry trade, especially if there is evidence of a

speculative bubble, in order to predict its course and ultimate end. It is not impossible for

an international foreign exchange market crisis to occur.

THE ROLE OF THE US DOLLAR IN THE CARRY TRADE.

The role of the dollar in the international carry trade in recent years must be

discussed. The dollar’s involvement in the carry trade is particularly crucial when

considering a potential foreign exchange crisis because the dollar holds a distinctive

position as the world’s reserve currency. Since 2009, economic data supports the

conclusion that the US has, like the yen in recent decades, become a funding currency for

the carry trade. This is evident from extended low interest rates and a significant

movement of investors shifting from the yen to the dollar.

US benchmark interest rates dropped from 5.2% in 2007 to 0.125% in 2009, when

the Federal Reserve Bank cut interest rates to stem off the effects of the recession. These

rates have remained ultra-low ever since.33 Though the Fed hopes this sustained policy

will encourage lending and spending and eventually increase exports, the immediate

effects of this ‘easy money’ policy include not only ease of borrowing, but a depreciation

of the dollar and quelling of imports.34

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The Federal Reserve accomplished its suppression of interest rates by three

methods: the reduction of the discount rate, an increase in bank reserves, and (most

importantly) ‘open market operations’, wherein the Fed purchases massive amounts of

US Treasury Bonds, increasing their price, lowering their yield to artificial levels, and

increasing the domestic money supply. These actions have suppressed interest rates

beyond their natural levels, and the subsequent easing has been described as

‘unprecedented’ and even ‘experimental’.35, 36

The ramifications of the Fed’s suppression of interest rates are essential to

analyzing the possibility of future crisis. By implementing these ‘easy money’ policies,

the central bank may be doing more harm than good, and setting the economy up for

future damage. Through open market operations, the Fed essentially monetizes the

government’s debt by buying government securities and injecting cash into the market.

These operations put downward pressure on the dollar, causing it to depreciate, and lower

the relative price of US goods. US consumers will benefit in their ability to borrow more

at a lower interest rate and from relative lower prices, but domestic producers will lose

profit from having to sell at these prices. Though consumer borrowing and spending is

increased, an increased money supply will lead to inflation in the US economy.12 Thus,

the implications of a manipulated money supply and interest rate can be detrimental for a

number of reasons.

Such movement can also encourage unhealthy growth through the carry trade.

The US’ abnormally low interest rate (close to Japan’s rate of 0.10%) is the first

indication of a carry trade episode.37 Since this low rate was set in 2009, speculators have

flooded the market34 with the purpose of borrowing money at a very low rate and likely

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re-lending it in a higher interest rate currency. Indeed, the International Monetary Fund

observed in 2009 that the US dollar had begun to serve as a funding currency for the

carry trade, with the Eurozone and emerging economies as target currencies.23 Many

South American economies, along with Turkey, India, and others, have sustained interest

rates above 7.5%, providing markets for investors to lend in.37

Economists have thus observed carry trade speculators shifting from using the

yen to the dollar as their funding currency. The yen carry trade lost two-thirds of its value

from 2007 to 2009; using Lee’s estimation of the yen’s carry trade, this would mean a

loss of around $600 billion.19 Similarly, Forbes estimated the volume of the US carry

trade at $500 billion around the same time.38 The evidence suggests that there has been a

clear increase in the dollar carry trade since the reduction of US interest rates in 2009.

Any distortions in the dollar caused by either the Federal Reserve or the carry

trade are especially significant when the dollar’s role as the world’s reserve currency is

considered. The dollar is held internationally by central banks and other financial

institutions as a means of paying international debt or influencing exchange rates.

Usually, holding the dollar as a reserve currency will minimize other countries’ exchange

rate risk.39 However, the depreciation of the dollar and the creation of a foreign exchange

market bubble, both of which can be caused or exacerbated by the carry trade when the

dollar is used as a funding currency, may have a dramatically more detrimental effect

when considering the international community’s reliance on the dollar. In short, a

potential foreign exchange crisis would be significantly worsened if the dollar is

involved.

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Evidence shows that these exact movements have taken place in recent years. The

IMF noted that the dollar has depreciated since the US interest rate was lowered in 2009,

and popular target currencies for the carry trade (notably the euro and the currencies of

some emerging economies) have appreciated.23 Though a number of central banks caused

a distortion of exchange rates by using monetary policy to manipulate growth after 2007,

it is not unreasonable to assume that some of this movement may also be the result of

intensified carry trade activity.

Growing interest and exchange rate divergences can be found worldwide.

However, because the US dollar holds a unique position in the world economy, the

consequences of the carry trade using the US dollar will have additionally severe

implications for both the US and world.

GLOBAL IMPLICATIONS.

Data have shown that the carry trade can worsen preexisting unstable domestic

economic conditions, exacerbate a foreign exchange market crisis, and potentially cause

an international financial crisis; it is also clear that the US dollar is now involved in the

carry trade as a prominent funding currency. The question must therefore be asked: is a

foreign exchange crisis imminent, and will the dollar play a principal role in such a

crisis? The following discussion examines the likelihood of such an event and its global

consequences.

Low interest rates in the US have created a global dollar carry trade that is

‘driving capital flows into emerging markets’ and could lead to the creation of asset

bubbles in those economies.36, 40 As discussed earlier, divergences in exchange rates are

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causing movement towards an exchange rate bubble equilibrium, consequent growth of a

foreign exchange market bubble, and acceleration toward crisis.29 It is likely that a bubble

has been formed in the foreign exchange market in recent years due to low interest rates

and heightened carry trade activity in the US, and increased investment and currency

appreciation in the carry trade target economies. If US interest rates remain low for an

extended period, the dollar could continue funding a growing foreign exchange market

bubble. It is possible that this bubble could build but not burst for some time.23 In the

meantime, carry trade activity would continue to contribute to the assets of banks in those

economies involved, but any growth would be unhealthy and speculative. This ‘growth’

would essentially feed the foreign exchange bubble.36

There will be several indicators of the potential bursting of the foreign exchange

market bubble. After the foreign exchange market spikes, acceleration will slow and

speculators will begin to look toward fundamentals for a more profitable investment. The

crash will begin.29 Therefore, a spike in the foreign exchange market may indicate the

final stage of the bubble. Several events could cause the collapse of the global carry

trade and therefore the bursting of the foreign exchange bubble: the correction of

exchange rate imbalances, a negative shock to the interest rate differential, or the rise of

long-term interest rates in a prominent funding currency such as the US dollar or

Japanese yen.

Because the carry trade relies on an extended interest rate differential between

countries, a correction of the currently distorted interest rates (or, similarly, a correction

of exchange rates to their fair floating values) would trigger a liquidity crisis in the

funding currency and deliver a huge shock the carry trade.30, 31, 32 A central bank could

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have a number of reasons to correct the interest rate differential or revalue/devalue its

currency, some of which will be discussed in the following section, using the United

States’ Federal Reserve as an example. Though such action is unlikely, it could occur

under certain circumstances, and a central bank would be wise to pursue a very gradual

(rather than sudden) correction of imbalances in such a situation.

In addition to a sudden adjustment, the rise of long-term interest rates (especially

in the US or Japan, as these economies provide the primary funding currencies for the

carry trade) would wipe out investors’ carry trade yields, result in a rush to sell

investments, and deliver enough of a shock to the foreign exchange market to cause the

bubble to burst.38

Foreign exchange imbalances have increased since 2010,31 along with the US

dollar’s prominence in the global carry trade.38 It is likely that if exchange rate

imbalances or the interest rate differential were to correct in the current environment, the

world would experience a financial crisis as a result of the collapse of the global carry

trade. There is little incentive for exchange or interest rates to return to their natural

values during the current recession. As the US barely begins to recover from the global

financial crisis of 2007, and much of the rest of the world still flounders, central banks

are likely to keep interest rates low to stimulate lending and spending in their economies.

Policies of ‘quantitative easing’ or ‘easy money’ are maintained in order to give an

economy a chance to gain strength during recession.41 Since many of the world’s

economies still have much recovering to do, it is very unlikely that interest rates will be

abruptly raised. The US Congressional Budget Office’s interest rate projections show at

least two more years of sustained US short term interest rates at 0.125%.42

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By involving many different currencies, the potential of collapse in the

international carry trade puts much of the global economy at risk. Though a purposeful

sharp correction of interest and exchange rate differentials is unlikely, the balance of the

foreign exchange and money markets has been significantly distorted by domestic

monetary policies and exacerbated by the carry trade, making these markets increasingly

susceptible to crash. This precarious setting has particular implications for the United

States, as this economy holds the most power to tip the scales either towards safety or

crisis.

IMPLICATIONS FOR THE UNITED STATES.

The role of the US dollar in the carry trade is decisive because of its status as the

world’s reserve currency. Adverse consequences to the dollar will be amplified

internationally because of this status. Therefore, the Federal Reserve Bank’s policies in

addressing a foreign exchange bubble are imperative to averting disaster to the global

economy. This final section will review the dollar’s critical function in the global

economy, its already weakened position, and its role in the international carry trade

before analyzing the policy decisions available to the Federal Reserve Bank to lower the

risk of a future financial crisis stemming from the carry trade.

As previously discussed, the US dollar has a critical function in the global

economy. Foreign monetary authorities worldwide hold large dollar reserves as a means

of financing their own debt or influencing exchange rates.43 This system customarily

helps balance the foreign exchange market and minimizes the risk of exchange rate

aberrations.39 However, the dollar’s role as a reserve currency also bears heavy

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responsibilities for the Federal Reserve Bank, whose actions affect the value of the dollar

in the global economy. The dollar must remain relatively steady in order to support the

exchange rates of other countries. A sudden appreciation of the dollar, together with

rising interest rates in the US, would cause the relative price of imports to fall in the US

but rise in foreign economies, as the relative price of exports would rise in the US and fall

in foreign economies. The overall consequences of such movements in these relative

prices would be deflation in the US and inflation in foreign economies.43 Sharp

movements in the dollar exchange rate will thus have consequences not only for the US,

but for economies that trade in the US dollar as well.

In some ways, the Federal Reserve Bank has already employed hazardous policies

and failed to keep the dollar steady, harming both the US and world economies. In order

to stimulate growth after 2007, the Fed lowered interest rates by purchasing bonds and

increasing domestic money supplies. Thus, the domestic money market in the US was

falsely inflated in order to drive down the interest rate. By manipulating the supply of

money, the Fed also caused the dollar to depreciate against other currencies.12 This setting

allowed speculators to take advantage of a depressed interest rate and dollar for profit in

the carry trade.

Since 2009, the low interest rates imposed by the Federal Reserve have stimulated

the use of the dollar in the carry trade. Because the exchange rate is largely set by supply

and demand for a currency in the foreign exchange market, and the carry trade warps the

supply of its funding and target currencies, involvement in the carry trade will cause the

dollar to depreciate further.2, 44 There has been clear evidence of a weakening dollar since

2009, and Lee predicts that the dollar will continue to depreciate as long as US interest

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rates are held artificially low and the carry trade exploits the dollar for funding. 19, 44 A

number of economists see these conclusions as reason to believe that the dollar is

bringing the carry trade close to the disastrous edge of a foreign exchange market bubble.

The potential international consequences of a collapse in the carry trade and

foreign exchange market will be drastically more severe if the carry trade is supported by

the US dollar rather than another funding currency (i.e., the Japanese yen). Though any

low-interest rate currency is able to serve as a funding currency, the yen has been the

carry trade’s primary funding currency for decades. Economists previously believed that

an unwinding of the yen carry trade (caused by a rise in the value of the yen or a rise in

Japanese interest rates) would cause market chaos because the yen was so deeply

involved in the carry trade.11 However, such an event has not taken place so far, and Woo

shows that the foreign exchange market has been able to deflate past bubbles without

serious damage.30 It is essential to keep in mind that past foreign exchange market

bubbles occurred while the yen and other currencies funded the carry trade. Because the

yen is not the world’s reserve currency, Japan is able to manipulate its exchange rate

without severe international consequences. Policies involving the US dollar have more

significant implications. The dollar’s exchange rate movements will be felt worldwide

through the reserve currency holdings of foreign banks, and an appreciation of the US

dollar will have repercussions in the many countries with dollar reserves. Since the dollar

began to weaken due to the Federal Reserve Bank’s ‘easy money’ policies since 2009,

other economies have tried to depress their currencies to stay competitive with the dollar

as it continues to depreciate.42 A drastic increase in the US dollar would thus generate a

huge shock to the foreign exchange market and these individual economies.43

E. Polster 22

Such a shock would not only trigger a global financial crisis, but would have

severe consequences for the US economy itself. If the global carry trade were to collapse

due to a sudden correction of interest or exchange rate differentials, extreme inflation

would take hold outside the US. Because the value of the US dollar would reverse, the

price competitiveness of US products would fall, and deflation would take place at

home.45 A sharp appreciation of the dollar, the consequent drop in export demand, and

high interest rates in the US would inhibit growth and result in severe economic

downturn.46

Because the dollar holds a position as both the world’s reserve currency and the

carry trade’s primary funding currency, the consequences of a collapse of the foreign

exchange market bubble would be catastrophic to both the US and global economies. The

responsibility of the Federal Reserve Bank to maintain balance in the foreign exchange

market is therefore unparalleled. This weight has become particularly severe since 2009,

as the US carry trade feeds a growing foreign exchange market bubble. Implications for

the United States now include the responsibility to help return current exchange rates to

their fundamental values without sparking a financial crisis.

Therefore, it is necessary for the Fed to raise interest rates very gradually in order

to avoid an international financial catastrophe. If the interest rate differential is steadily

corrected, the US economy will maintain growth as it pulls out of the recession, and

investments will remain intact.47 The carry trade will not experience a spike and collapse

as speculators abruptly unwind their investments. As with past bubbles in the foreign

exchange market, unhealthy speculative growth will slowly deflate and return to its

fundamental equilibrium.29, 30 It is far more likely that this situation – the gradual increase

E. Polster 23

of interest rates and slow deflation of the foreign exchange market bubble – will occur

rather than the alternative, a sudden correction of imbalances and collapse of the carry

trade.

However, it is difficult to predict the Fed’s decisions in such a problematic

setting. Though it would be foolish for the Fed to rapidly increase interest rates, the bank

may have reason to do so in the near future. Since the economic downturn of 2007, the

Fed has kept interest rates low with the purpose of stimulating growth, and has vowed to

do so until the unemployment rate falls to a healthier level. However, despite years of

‘easy money’ policies, the US has not yet seen dramatic economic growth or a healthy

unemployment rate. Because holding interest rates artificially low continues to depreciate

the dollar and hurt US producers, the Federal Reserve may begin to raise interest rates

before it has achieved its goals to avoid further injury to the dollar.48

If the Fed were to reverse its monetary policy in this way, the abrupt revaluation

of the dollar and an increase in interest rates would be detrimental to the US economy

independent of a crash in the foreign exchange market. If the Fed stopped buying

government securities in order to raise interest rates it would become harder to borrow

within the US. The dollar would suddenly appreciate, and this revaluation would make

US goods more expensive for foreigners while foreign products became cheaper for US

consumers. Foreign investors would face a higher cost of entering the US market, and US

consumers would be hurt by higher prices and low export demand. The result would be

deflation in the US and inflation in foreign nations.12, 49

Though the United States has inadvertently caused unhealthy speculation through

ultra-low interest rates and a depreciating reserve currency, it is possible for the Federal

E. Polster 24

Reserve to prevent future financial crisis in the foreign exchange market by avoiding a

sudden correction of interest and exchange rate differentials and gradually seeking to

return these rates to their equilibrium market values. It is imperative that the Federal

Reserve practice the utmost caution when implementing monetary policy under the

current circumstances to avoid severe damage to both the US and world economies.

Careful and very gradual action could lead the foreign exchange market away from the

brink of a speculative bubble and towards healthier fundamentals.

CONCLUSION.

A thorough analysis of the carry trade’s mechanics and effects taken with respect

to the US and the current global financial crisis yields a prediction that the collapse of the

global carry trade and a subsequent foreign exchange market crisis is possible but largely

dependent on the future actions of the Federal Reserve Bank.

The carry trade, which defies economic theory and generates inexplicably riskless

and high returns, can be detrimental to the economies it works within. Distortion of

currency supply will force the carry trade’s funding currency to depreciate and its target

currency to appreciate, resulting in the formation of a bubble in the foreign exchange

market if enough money is involved in the trade. The eventual bursting of such a bubble

would cause financial catastrophe worldwide.

The severity of such a crash would be exacerbated considering the role of the US

dollar, the recent prominent funding currency of the carry trade, as the world’s reserve

currency. A foreign exchange crash could be caused by the sudden correction of

exchange or interest rate imbalances, which the carry trade relies on for its success. A

E. Polster 25

revaluation of the US dollar would be additionally detrimental to the US economy

independent of the foreign exchange market. It is unlikely that these imbalances will be

suddenly corrected given the circumstances of the global financial crisis of 2007, as many

central banks are keeping interest rates unnaturally low in order to stimulate growth and

recover from the current recession. If the Federal Reserve Bank very gradually raises

interest rates, growth can be maintained and the bursting of the foreign exchange bubble

can be averted. Therefore, if the Fed exercises caution, a devastating collapse of the carry

trade is unlikely to occur under current circumstances.

E. Polster 26

1

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