Borrowing in Yuan and Investing in Bucks

It is no wonder that so many of the so-called economists employed by investment banks and hedge funds keep up constant pressure on central banks, especially Asian ones, to keep rates low. Without that there would be no fuel for the carry trade, which has enriched so many ill-deserving bulge-bracket gamblers and could potentially result in the near-collapse of the global financial system. Although hitherto this game has mainly been played in Japanese yen, the latest currency to join the carry-trade bonanza is the Chinese yuan.

The game is played by borrowing billions of dollars worth of yen with their negligible interest rates to invest in high-yielding currencies such as the New Zealand and Australian dollars, pounds sterling and the US dollar itself. It is a self-reinforcing game in it that it enables potentially weak currencies to remain relatively strong. It is of course no coincidence that four afore-mentioned currencies are all those of countries with huge and entrenched current account deficits – from 3% to 7% of GDP. Japan’s surplus meanwhile has risen despite increased competition from Korea, Taiwan and – to a lesser extent -China.

The latest throw of the dice proffered as an “investment idea” is to take advantage of the low cost of borrowing in yuan in the offshore market. The implied cost of 12-month money is just 0.7 percent, which makes it about as cheap a funding currency as the yen. Meanwhile the rate of appreciation of the yuan is – according to the argument – slow and predictable, with the People’s Bank of China reluctant to allow the currency to float up and jeopardize both its gargantuan trade balance and its mountain of US dollar reserves.

Meanwhile there are huge gains to had from higher interest rates in Asian currencies such as the won, baht and ringgit, not to mention the perennial Aussie and Kiwi currencies. Much the same argument can be made for the borrowing Taiwan dollars where interest rates have been almost as low as in yen and where the currency has been held down to keep within sight of the yen.

There is no doubt that huge of amounts of money have been made from the carry trade by investment banks, thus far mainly at the (indirect) expense of Japanese savers. But the tempo has picked up as investment bank balance sheets have ballooned and additional Asian currencies have entered the carry-trade play.

But the bigger the bets, the bigger the danger, particularly when the practice seems to fly in the face of economic fundamentals and traditional assessments of what makes a strong currency. Even on other short-term assessments, the yuan and NT dollars look highly dangerous funding currencies. The higher yielding Asian currencies have already appreciated very significantly – the won is up 32 percent against the yen and has also risen significantly against the yuan.

So what happens if the Bank of Korea decides enough is enough and is prepared to put exchange rate management ahead of dampening its domestic housing bubble? Or US pressure on Beijing combined with continuation of the obvious excess of Chinese growth results in a much faster rate of yuan appreciation? Or that the Japanese finally figure out that only the government and a few exporters benefit from an artificially weak yen?

The notion that it is smart to borrow yen and NT dollars to buy such high yielders as the Philippine peso can only be sustained by those with the very shortest term view of the financial world. Yet the peso has been one of the world’s strongest currencies over the past year, notwithstanding its almost total reliance on remittances, a still-abysmal level of growth and investment and relatively high interest rates.

At some point of course it will hit home that countries with excess consumption and feeble savings are weak, not strong. But for now the bankers and fund managers can play their high risk games. Once upon a time, when these players were as yet unborn, bankers learned in the nursery that currency mismatches were one of the more dangerous games in town.

They were the single most important factor in the Asian financial crisis of 1997-1998. And for those with longer memories they caused such corporate disasters as that which struck Hong Kong’s giant Hutchison group in the mid-70s, delivering the company into the hands of its main banker, HSBC, which sold it on to Li Ka-shing.

Hutchinson had borrowed heavily in “cheap” Swiss francs to fund activities in currencies that subsequently fell rapidly against the Swiss currency. It remains to be seen whether some future crisis will deliver a similarly prominent company – or more likely some brash investment bank – into the hands of a similarly astute buccaneer like Mr Li.