The Great Carry Trade

I was much taken by one of Larry Elliott’s pieces for the Guardian a couple of weeks back. Larry identified several eras: the Great Depression; the Great Compression, the period of strong growth and increasing equality after WWII; and the Great Moderation, the period of low inflation from the late 1990s to the early 2000s. We’re just ending the Great Recession (as this term was overused to describe 19th century episodes, I prefer “the Great Crunch”, which I think has a more modern flavour, but let’s go with Larry’s nomenclature today). I’d like to add to the mix the Great Inflation of the 1970s and 1980s. The question Larry asks is: What now? The Great Escape?

I’d like to argue that we’re likely to enter a period that we might call “the Great Imbalance”, reserving, on second thoughts, the title I’ve chosen – “the Great Carry Trade” – for the underlying cause. In fact, you could argue that the Great Moderation and the Great Recession are merely episodes in the history of the Great Imbalance.

Let’s first consider the causes of some of these various eras. Here’s my simplification of some complex phenomena:

• The Great Depression is so-called because growth stagnated in large part because of a breakdown in trade.

• After WWII trade resumed, but crucially without the Soviet Union and satellites, China and India. Larry’s Great Compression resulted from the growth in this era, together with, crucially, greater bargaining power on the part of workers, as collective bargaining reached its apogee. This combined with a squeeze on that critical resource, oil, to produce the Great Inflation.

• In 1989 the Berlin Wall came down. China and India have since become global players. This has locked in the reduction in workers’ power that occurred when unemployment resulted from the Great Inflation, permitting rapid non-inflationary growth – the Great Moderation.

Now, Larry writes that:

“One feature of the Great Moderation was the build-up in debt that allowed consumers in the US and Britain not just to live beyond their means, but to mop up the excess output from the low-cost factories in Asia. Debt is now being paid back, and it will continue to be paid back as the monetary and fiscal authorities withdraw the emergency stimulus packages of the past 12 months.”

But I’d argue that, far from “the build-up in debt” being a “feature” of the Great Moderation, it is a result of the fundamental cause of the Great Imbalance, that is of the Great Carry Trade.  And the Great Imbalance is not over, because international debt is not, in fact, being “paid back”.  And the Great Carry Trade itself has a cause: the false idol of export-led growth.

Larry also suggests that:

“The Great Moderation … could only be temporary, since its reliance on levels of debt that were only sustainable provided asset bubbles continued to inflate meant we were buying stability today at the expense of instability tomorrow. As such, Alan Greenspan created a housing bubble out of the wreckage of the dotcom bubble, thus disguising the structural problems in the US economy.”

I disagree: the cause of the Great Moderation phase of the Great Imbalance was not the debt, but globalisation. Larry is also writing in the UK, which somehow sidestepped a recession after the dotcom crash, so perhaps sees more stability than Stateside commentators. Regardless, I suggest that the conditions are already in place for the next bubble, because the underlying imbalance has not been addressed.

Larry titled his piece “Eastern promise holds little hope for west”. But why should this be? Growth based on trade is mutual – it’s not a zero-sum game. If I buy Chinese toys for pounds, the only way to zero out the transaction is for British products to be purchased with those pounds. The cash acts as a store of value. That’s the point of it.

But what’s happened is that the pounds and dollars used to purchase goods from China and other countries following a similar strategy has not been spent on imports from UK or US. The ramifications seem no less serious now than when I wrote nearly a year ago. Since then there’ve been a few developments:

• The worst recession for a generation.
• A fall in the value of the dollar (and pound) against the euro.
• A massive recovery in emerging markets in particular, fuelled by investment flows.

But no change in the value of the renminbi against the dollar.

So what’s going to happen?

Let’s consider trade first.  The eurozone was until recently in rough trade balance.  Now, though, the US trade imbalance with China (and others), which is an inevitable result of the currency pegs, will be shared by the eurozone.  Additionally, the eurozone will see a deteriorating trade position against the US (and UK).  In short, the next phase of the Great Imbalance will see the addition of Europe to the debtor countries.  This is inevitable with current policies.

But there’s another feature of what’s going on which leads me to highlight the Great Carry Trade.  Investors – ironically as a result of articles like Larry Elliott’s – see the big opportunities as in the developing countries.  What was a minor part of portfolios is becoming mainstream, egged on by the investment industry.

Why do I talk about a “carry trade”? Well, the effect of investment in higher-yielding currencies is – whether or not one organisation carries out all parts of the transaction – borrowing in the low-yielding currency (the dollar or pound, say) at low interest rates to lend (or invest) in a high-yielding currency (such as the rouble or renminbi).

A key point is that all the dollars or pounds invested come straight back. Think about it: to invest in China, you (or an intermediary) have to sell your dollars to a bank to buy the local currency. These dollars are then available to lend on the international money markets, depressing dollar interest rates. The carry trade is self-fuelling, reinforcing the trade imbalance.

With free-floating currencies, the capital flows will eventually force up the currency of the destination country, and investors will no longer see the opportunities they did. There’ll be some kind of correction, quite possibly an “emerging market crisis”.

But with pegged countries there are fewer ways out. Obviously there is a possibility of investor confidence becoming undermined and an asset (e.g. stock market) bubble bursting, but failing that, either inflation could occur or the currency peg could break. But both of these tend to help the foreign investor, by increasing the value of their assets. The pegging country is likely to find itself in a policy straight-jacket. Increasing interest rates to cool the economy simply encourages the carry-trade. Hinting at appreciation, or a limited appreciation, of the currency is likewise a red rag to a bull. They could try to directly control the capital flows, like Brazil did recently, or try to manage asset values directly. But such policies are difficult to implement. All very unsatisfactory.

I can only conclude that unless emerging market currency pegs are abandoned we will simply have a repeat of recent history, with a slightly different flavour.

Much depends on what happens in the deficit countries. Current policies suggest that governments will try to rein back on their borrowing. That leaves even more potential for bubbles in the property and the corporate capital (equity and bond) markets.

It now seems to me that in the UK, at least, property prices will resume their upward path. This will be driven not by low-income owner-occupiers, and maybe not even by the recent type of buy-to-let investor. Rather corporates will invest, which will increase construction rates (because such investors require large numbers of properties), which will help fuel the economy, sucking in more imports, of course. Foreign buyers will also continue to stoke the market, particularly in London. Interest rate increases to choke this off will have limited impact as they will tend to push up the pound, encouraging the very imports and capital flows that are fuelling the Great Imbalance.

In an even world, investment flows into UK equity and bond markets should, over time, exactly counterbalance flows out. But we live in an uneven world. Furthermore, when capital returns to the UK (or US) it has had the risk taken out of it. Companies, just as in the dotcom boom, will, even when raising equity is possible, still over-leverage.

Where the next gasket blows is anybody’s guess. Remember, excessive capital flows will once again be a global phenomenon. Governments will try to shore things up, but will simply have not enough thumbs to stick in all the dykes that could burst.