Carry Currencies

This post considers how the foreign carry trade affects cash value. To repeat, the carry trade is where a bank borrows money at low rates to invest in higher yielding loans; the foreign carry trade is where banks borrow money from a country with low interest rates, exchange it for a local currency where national interest rates are higher, and then lend that out.

Currencies which underwrite the carry trade will be referred to here as “carry currencies,” vs. “exchange currencies” which form the second leg of the transaction. To be a carry currency, interest rates must be suppressed by the monetary policy of their national central bank, such that it becomes an attractive source of capital for foreign investors. This is true of the yen since the early '90s and of the dollar since 2002.

Now, what we see in this credit meltdown is carry currencies strengthening, and exchange currencies falling off a cliff.

The strength of a carry currency would be similar to the strength of deposits in a credit crisis: e.g. savers are owed their deposits regardless of the performance of the loans they underwrite. Failed loans are a loss to the banks; but even uninsured deposits would only be threatened if the bank outright fails. Likewise, banks still owe back any foreign loans they take as capital regardless of the performance of their loan portfolio. So a carry currency is a safety bet, particularly if governments seem eager to bail out the banks.

During boom times deposits suffer because greater yields can be had elsewhere; and likewise anyone holding a carry currency would be better off converting that to an exchange currency and depositing it in a foreign bank at a higher interest rate.

A general problem for the exchange currency in this system is that if the carry nation is big enough, like the United States and Japan, then exchange nations like Europe would have a huge source of capital to over leverage themselves with risky loans. Whereas American banks had to go scrounging for commercial paper investors and securities buyers to expand their lending portfolio, the Europeans had two of the world’s largest economies to draw their capital from.

How the foreign carry trade plays out will be commented on as it unfolds.