The Yen Carry Trade

In the liquidity trap, Japan's ultra-low short-term interest rates lead to a phenomenon popularly referred to as the "yen carry trade". Defined narrowly, carry trade refers to transactions that combine term-structure risk with currency risk. Suppose a speculator, who need not be a Japanese national, borrows short in Tokyo in yen at less than 1% in order to invest long-term in 10-year Australian government bonds bearing 6.27%. That is hyper risk taking beyond the ordinary course of business or household behavior. There is the risk that short-term rates will increase relative to long everywhere, or that long rates in Australia increase further so as to reduce the capital value of the bonds, and then there is the specific risk that the yen will appreciate against the Australian dollar. In this last case, our speculator could have trouble re-paying or rolling over his short-term yen loan.

How much of Japan's large current account surplus today is intermediated by the yen carry trade so narrowly defined is anybody's guess. But I suspect that it is much less than that done through the more traditional forms of international financial intermediation associated with insurance companies and the like -and thus much less than what the financial press thinks.

However, the carry trade does contribute to the potential volatility of the yen/dollar exchange rate. With any hint of, or rumor that, the yen might appreciate, carry-trade speculators with their short-term yen liabilities may well react first. They rush to cover their short positions in yen by not renewing loans or simply buying offsetting yen assets. This quickly adds to the upward pressure on the yen so as to trigger a run that induces mainline financial institutions to start selling off their dollar assets as well, which the BoJ buys as per the positive spikes of official reserve accumulation in Figure 15. By making the yen/dollar rate more volatile, carry traders heighten the exchange risk to mainline financial institutions. Thus, indirectly, do carry-trade speculators widen the interest differential between dollar and yen assets necessary to maintain (an uneasy) portfolio equilibrium where mainline Japanese financial firms hold some of both.

But our concern here with the mechanics of runs and negative risk premia in interest rates should not detract from how expensive foreign exchange instability has been for Japan's economy. The extraordinary appreciations of the yen through the mid- 1990s threw the economy into a deflationary slump. The subsequent low interest rate liquidity trap prevented the Bank of Japan from re-inflating the economy to escape from the slump. And, during Japan's lost decade from 1992 to 2002, massive fiscal deficits have also failed to stimulate private spending while leaving the Ministry of Finance very leery of increasing today's huge public debt even further.

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