Can Paul Volcker get away with talking nonsense at Canadian bankers?

The short answer seems to be, yes.
Here's an excerpt from a Paul Volcker speech:
"This phenomenon can be traced back at least five or six years. We had, at that time, a major underlying imbalance in the world economy. The American proclivity to consume was in full force. Our consumption rate was about 5% higher, relative to our GNP or what our production normally is. Our spending – consumption, investment, government — was running about 5% or more above our production, even though we were more or less at full employment.
You had the opposite in China and Asia, generally, where the Chinese were consuming maybe 40% of their GNP – we consumed 70% of our GNP. They had a lot of surplus dollars because they had a lot of exports. Their exports were feeding our consumption and they were financing it very nicely with very cheap money. That was a very convenient but unsustainable situation. The money was so easy, funds were so easily available that there was, in effect, a kind of incentive to finding ways to spend it."
Is Paul Volcker reasoning accurately here? Suppose, for instance, that Indians acquire an increased penchant for importing more and more electronic gadgets from China. And China decides to buy a lot of Government of India securities to artificially strengthen the Indian Rupee. How would this turn out? The FRBM target is to reduce the fiscal deficit to around 3% by next year. As long as the Government maintains a strong fiscal path, and spends in tune with its income; it wouldn't matter whether the G-Secs are held by locals or foreigners; or the People's Bank of China.
PBoC INR denominated forex reserves would in this example strengthen the INR artificially, and that will make life easy for Indian consumers of China's electronics. But as long as the Government finances are strong, we would never go bust as a result of consuming those electronics at those cheap prices. In fact, the more the PBoC buys INR securities, the happier we would have been at this free Chinese giveaway of their electronics.
Paul Volcker is diverting attention from the simple fact that it was the US Treasury that borrowed huge amounts, far in excess of its income, and spent it on various items. The US Treasury is directly responsible for this whole mess. And by having these kinds of speeches, they're proceeding in the direction of more and more Government debt, rather than less, creating a dangerous situation where the Sovereign itself can be forced into default.
Here's the full speech: (I got it from a comment posted at Brad Setser's blog)
I really feel a sense of profound disappointment coming up here. We are having a great financial problem around the world. And finance doesn’t work without some sense of trust and confidence and people meaning what they say. You take their oral word and their written word as a sign that their intentions will be carried out.
The letter of invitation I had to this affair indicated that there would be about 40 people here, people with whom I could have an intimate conversation. So I feel a bit betrayed this evening. Forty has swelled to I don’t know how many, and I don’t know how intimate our conversation can be. But I will, at the very least, be informal.
There is a certain interest in what’s going on in the financial world. And I will disappoint you by saying I don’t know all the answers. But I know something about the problem. Let me just sketch it out a little bit and suggest where we may be going. There is a lot of talk about how we get out of this, but I think it’s worth remembering, or analyzing, how this all started.
This is not an ordinary recession. I have never, in my lifetime, seen a financial problem of this sort. It has the makings of something much more serious than an ordinary recession where you go down for a while and then you bounce up and it’s partly a monetary – but a self-correcting – phenomenon. The ordinary recession does not bring into question the stability and the solidity of the whole financial system. Why is it that this is so much more profound a crisis? I’m not saying it’s going to get anywhere as serious as the Great Depression, but that was not an ordinary business cycle either.
This phenomenon can be traced back at least five or six years. We had, at that time, a major underlying imbalance in the world economy. The American proclivity to consume was in full force. Our consumption rate was about 5% higher, relative to our GNP or what our production normally is. Our spending – consumption, investment, government — was running about 5% or more above our production, even though we were more or less at full employment.
You had the opposite in China and Asia, generally, where the Chinese were consuming maybe 40% of their GNP – we consumed 70% of our GNP. They had a lot of surplus dollars because they had a lot of exports. Their exports were feeding our consumption and they were financing it very nicely with very cheap money. That was a very convenient but unsustainable situation. The money was so easy, funds were so easily available that there was, in effect, a kind of incentive to finding ways to spend it.
When we finished with the ordinary ways of spending it – with the help of our new profession of financial engineering – we developed ways of making weaker and weaker mortgages. The biggest investment in the economy was residential housing. And we developed a technique of manufacturing class D mortgages but putting them in packages which the financial engineers said were class A.
So there was an enormous incentive to take advantage of this bit of arbitrage – cheap money, poor mortgages but saleable mortgages. A lot of people made money through this process. I won’t go over all the details, but you had then a normal business cycle on top of it. It was a period of enthusiasm. Everybody was feeling exuberant. They wanted to invest and spend.
You had a bubble first in the stock market and then in the housing market. You had a big increase in housing prices in the United States, held up by these new mortgages. It was true in other countries as well, but particularly in the United States. It was all fine for a while, but of course, eventually, the house prices levelled off and began going down. At some point people began getting nervous and the whole process stopped because they realized these mortgages were no good.
You might ask how it went on as long as it did. The grading agencies didn’t do their job and the banks didn’t do their job and the accountants went haywire. I have my own take on this. There were two things that were particularly contributory and very simple. Compensation practices had gotten totally out of hand and spurred financial people to aim for a lot of short-term money without worrying about the eventual consequences. And then there was this obscure financial engineering that none of them understood, but all their mathematical experts were telling them to trust. These two things carried us over the brink.
One of the saddest days of my life was when my grandson – and he’s a particularly brilliant grandson – went to college. He was good at mathematics. And after he had been at college for a year or two I asked him what he wanted to do when he grew up. He said, “I want to be a financial engineer.” My heart sank. Why was he going to waste his life on this profession?
A year or so ago, my daughter had seen something in the paper, some disparaging remarks I had made about financial engineering. She sent it to my grandson, who normally didn’t communicate with me very much. He sent me an email, “Grandpa, don’t blame it on us! We were just following the orders we were getting from our bosses.” The only thing I could do was send him back an email, “I will not accept the Nuremberg excuse.”
There was so much opaqueness, so many complications and misunderstandings involved in very complex financial engineering by people who, in my opinion, did not know financial markets. They knew mathematics. They thought financial markets obeyed mathematical laws. They have found out differently now. You know, they all said these events only happen once every hundred years. But we have “once every hundred years” events happening every year or two, which tells me something is the matter with the analysis.
So I think we have a problem which is not an ordinary business cycle problem. It is much more difficult to get out of and it has shaken the foundations of our financial institutions. The system is broken. I’m not going to linger over what to do about it. It is very difficult. It is going to take a lot of money and a lot of losses in the banking system. It is not unique to the United States. It is probably worse in the UK and it is just about as bad in Europe and it has infected other economies as well. Canada is relatively less infected, for reasons that are consistent with the direction in which I think the financial markets and financial institutions should go.
So I’ll jump over the short-term process, which is how we get out of the mess, and consider what we should be aiming for when we get out of the mess. That, in turn, might help instruct the kind of action we should be taking in the interim to get out of it.
In the United States, in the UK, as well – and potentially elsewhere – things are partly being held together by totally extraordinary actions by a central bank. In the United States, it’s the Federal Reserve, in London, the Bank of England. They are providing direct credit to markets in massive volume, in a way that contradicts all the traditions and laws that have governed central banking behaviour for a hundred years.
So what are we aiming for? I mention this because I recently chaired a report on this. It was part of the so-called Group of 30, which has got some attention. It’s a long and rather turgid report but let me simplify what the conclusion is, which I will state more boldly than the report itself does.
In the future, we are going to need a financial system which is not going to be so prone to crisis and certainly will not be prone to the severity of a crisis of this sort. Financial systems always fluctuate and go up and down and have crises, but let’s not have a big crisis that undermines the whole economy. And if that’s the kind of financial system we want and should have, it’s going to be different from the financial system that has developed in the last 20 years.
What do I mean by different? I think a primary characteristic of the system ought to be a strong, traditional, commercial banking-type system. Probably we ought to have some very large institutions – or at least that’s the way the market is going – whose primary purpose is a kind of fiduciary responsibility to service consumers, individuals, businesses and governments by providing outlets for their money and by providing credit. They ought to be the core of the credit and financial system.
This kind of system was in place in the United States thirty years ago and is still in place in Canada, and may have provided support for the Canadian system during this particularly difficult time. I’m not arguing that you need an oligopoly to the extent you have one in Canada, but you do know by experience that these big commercial banking institutions will be protected by the government, de facto. No government has been willing to permit these institutions, or the creditors and depositors to these institutions, to be damaged. They recognize that the damage to the economy would be too great.
What has happened recently just underscores that. And I think we’re at the point where we can no longer fool ourselves by saying that is not the case. The government will support these institutions, which in turn implies a closer supervision and regulation of those institutions, a more effective regulation than we’ve had, at least in the United States, in the recent past. And that may involve a lot of different agencies and so forth. I won’t get into that.
But I think it does say that those institutions should not engage in highly risky entrepreneurial activity. That’s not their job because it brings into question the stability of the institution. They may make a lot of money and they may have a lot of fun, in the short run. It may encourage pursuit of a profit in the short run. But it is not consistent with the stability that those institutions should be about. It’s not consistent at all with avoiding conflict of interest.
These institutions that have arisen in the United States and the UK that combine hedge funds, equity funds, large proprietary trading with commercial banks, have enormous conflicts of interest. And I think the conflicts of interest contribute to their instability. So I would say let’s get rid of that. Let’s have big and small commercial banks and protect them – it’s the service part of the financial system.
And then we have the other part, which I’ll call the capital market system, which by and large isn’t directly dealing with customers. They’re dealing with each other. They’re trading. They’re about hedge funds and equity funds. And they have a function in providing fluid markets and innovating and providing some flexibility, and I don’t think they need to be so highly regulated. They’re not at the core of the system, unless they get really big. If they get really big then you have to regulate them, too. But I don’t think we need to have close regulation of every peewee hedge fund in the world.
So you have this bifurcated – in a sense – financial system that implies a lot about regulation and national governments. If you’re going to have an open system, you have got to get much more cooperation and coordination from different countries. I think that’s possible, given what we’re going through. You’ve got to do something about the infrastructure of the system and you have to worry about the credit rating agencies.
These banks were relying on credit rating agencies while putting these big packages of securities together and selling them. They had practically – they would never admit this – given up credit departments in their own institutions that were sophisticated and well-developed. That was a cost centre – why do we need it, they thought. Obviously that hasn’t worked out very well.
We have to look at the accounting system. We have to look at the system for dealing with derivatives and how they’re settled. So there are a lot of systemic issues. The main point I’m making is that we want to emerge from this with a more stable system. It will be less exciting for many people, but it will not warrant – I don’t think the present system does, either — $50 million dollar paydays in that central part of the system. Or even $25 or $100 million dollar paydays. If somebody can go out and gamble and make that money, okay. But don’t gamble with the public’s money. And that’s an important distinction.
It’s interesting that what I’m arguing for looks more like the Canadian system than the American system. When we delivered this report in a press conference, people said, “Oh you mean, banks won’t be able to have hedge funds? What are you talking about?” That same day, Citigroup announced, “We want to get rid of all that stuff. We now realize it was a mistake. We want to go back to our roots and be a real commercial bank.” I don’t know whether they’ll do that or not. But the fact that one of the leading proponents of the other system basically said, “We give up. It’s not the right system,” is interesting.
So let me just leave it at that. We’ve got more than 40 people here but they’re permitted to ask questions, is that the deal?

Brad Setser's "China Yoke" Theory - replete from direct quotes

Here’s one link to Brad Setser’s analysis on what led to the ongoing crisis:
According to Brad Setser, the People's Bank of China encouraged Americans to "turn a home into an ATM":
“Absent a large savings surplus in Asia and the oil exporters, rising US rates would have choked off the housing bubble much earlier. High long-term rates aren’t conductive to rising home prices — and without rising home values it is hard to turn a home into an ATM.…Central banks reserve growth in the savings surplus countries carried this surplus to the US. … The process that led to the boom in risky assets was indirect: Central bank demand for safe assets drove down the return on safe assets and encouraged private sector risk taking. Private banks, famously, didn’t want to sit out the dance.”
APART from blaming the PBoC for the mortgage boom (you need to closely follow each of his essays to know that he’s actually referring mainly to the PBoC in the above paragraphs) Brad Setser also blames the United States Public Debt on imports from China here:
“Remember this the next time someone argues that the US will be borrowing more from the rest of the world to finance its fiscal deficit: the total amount the US borrows from the world is defined by the current account deficit and the current account deficit clearly went down in the fourth quarter even as the US fiscal deficit (and the Treasury’s borrowing need) soared.”
Here Brad Setser revises economic history by claiming that the excessive lending by private banks that weren’t regulated properly by the Federal Reserve was actually a result of China’s exchange rate policy. Excerpts:
“By holding US interest rates down and the dollar up, China’s policies discouraged investment in tradables production in the US while encouraging investment in the interest-rate sensitive sectors that weren’t competing with Chinese production. This isn’t too say that the US didn’t already have a slew of policies in place to encourage investment in housing. It did — from the Agencies to ability to deduct mortgage interest from tax payments. But the surge in demand for US bonds from the world’s central banks reinforced those policies.…More money was allocated to home construction (for a time) and less to investment in the production of goods for export than otherwise would have been the case.…Those who attribute the growth of the past several years solely to the market miss the large role the state played in many of the world’s fast growing economies. Conversely, those who attribute all the excesses of the past few years to the market miss the role that governments played in financing many of those excesses …”
Me: So you see, Brad Setser also blames China for the fact that there wasn’t much investment in industrial production facilities in the US the last several years. Either you need to follow Brad Setser’s “China Yoke” theory of the crisis, or get down to brasstacks and fix some simple lending norms for retail loans in the US to prevent this sort of thing from happening again.

My Comments and views censored by Dr. Brad Setser (the latest set)

Following is a set of comments I posted on the blog page of Dr. Brad Setser. They have been deleted and now I'm pasting them here so anybody who's interested can read them here.

Here's Brad' Setser's advocacy on financing US Treasuries from a small private cartel instead of the PBoC

Brad Setser:That implies, if the Pandey/Setser estimates for official purchases are right, that private investors snapped up more Treasuries than the world’s central banks…My guess is that the Treasury market will be driven by developments in the US – not developments in China – in 2009.
Me:What will any reasonably smart, thinking person, think when they read this?
When we discussed how China’s purchase of Treasuries affects the $11 trillion home mortgage boom, we reasoned how flows matter. Mostly, the $11 trillion boom was fueled by flows from China’s Treasury purchases.Now we’re looking at the impact of China’s Treasury purchases on the market for Treasuries itself - and we aren’t seeing much of an impact there.
Most of those smart people who’re thinking this will also type in that you’ve made a great, wonderful analysis, and never raise this point. Some of them might actually even cheerlead your post here.

Let’s hope private market participants don’t bet on high Treasury Bond prices now. Jansen’s post suggests the classic rupture of Government Bond prices. Central Bank demand for Treasuries remained high on the day he reports on, yet prices crashed and yields rose. This is very good news for equity markets and home prices.People are clearly demanding higher yields now.

Here are some comments I made in response to comments from other blog participants:
@ KT Cat - can you consider not interpreting things as “horrible”,”dreadful”, and “shrinking” without more reasoning than you present above?
Banks are trying to dispose of a large set of foreclosed homes together, say, in a block worth around $30 million, to small groups of private investors. Sales volumes are a bit down because these negotiations take more time than a fire sale.Banks are also disposing of foreclosed properties in some areas individually; that typically goes faster.
Lower demand for Treasuries at higher Treasury prices is again very good news for the US economy.
I don’t understand what you mean by“Japan’s economy is getting killed”.
I explained yesterday that Japan’s exports and imports are down more than China’s because of lesser credit growth in the Japan economy than China, but Brad deleted my post.Once the credit problems are solved things will be much better for Japan.

jim:…they invest on fundamental strengths that are dominating the market place …
Me: Fundamental analysis based on earnings, etc in my opinion is like a relative grading system. You can put a buy,hold or sell recommendation on a particular equities by comparing them with others. The underlying assumption is that your analysis is largely to allocate a certain fixed amount of capital amongst different equities. You can also account for the differential impact of macroeconomic or other ‘market risk’ events on different equities.But in terms of determining the overall direction of indices, that part of fundamental analysis isn’t particularly useful. It’s not easy to discount future cash flows, arrive at a fixed number for the ‘present value’ of the stock and use that as a basis to be a successful investor. Your ‘present value’ rarely ties in with the market’s, especially with wide fluctuations in multiples. It’s best to recognize that, even by the conceptualization of capital market theory, market risk can at best be diversified away to reduce its impact,not eliminated. Successful investment therefore requires understanding the full spectrum of fundamental analysis, macroeconomic analysis and most importantly, the geopolitical underpinnings of international finance.Earnings are definitely weak in US equities and will probably grow slowly for some time. But the reason to go long is a market bottom, a shift in the debate to when things will get better, from how much worse things will get before they get better.Of course my actual strategy is long in the Nifty, and not the Dow, and the two things are quite different.Nomura Holdings recently hired 50 team leads with long expertise in US equities and they’re rapidly setting up a sizeably large US equities unit. If they don’t have plans to invest in US equities, or advise clients to do so, these hiring decisions wouldn’t be rational.

@DOR: Residential investment in the US was at levels of $600+ billion, out of a $14 trillion economy, even at inflated prices.The direct output effect of a collapse in residential investment is small. The US was perhaps just as much of a Hollywood Economy, rather than a Home Building Economy during the boom.That would be consistent with a 43% share of services in GDP.Home Equity Withdrawals financed 3-4% of PCE. Annual increases in o/s consumer credit were 1% of GDP.US consumption wasn’t mainly driven by using homes as ATMs,though that conceptualization is attractive.35% of US homes were owned outright in 2007. 5% of the remaining 65% homes had mortgages that were both ARMs and subprime. The mythical American risky borrowers were therefore few.The recent collapse can be explained by the non availability of normal credit. For instance, even qualifying home buyers may not get a mortgage loan. People with a good income and finances may not get approved for a car loan. Similarly, difficulties in segments like student loans, corporate working capital loans, export credit, letters of credit, etc have disrupted the US economy.A certain level of credit is neither good or bad by itself, but only in comparison with income and overall balane of assets and liabilities. Once normal credit flows are re started, things will be much better for the US economy.But growth will be slow because the destruction of personal net worth due to fall in home prices needs to be worked off by US consumers.

A few (seemingly forgotten) basic characteristics of the US economy

1) The US economy is more of a services economy than a products economy.In 2008, services totaled $ 6139.8 b out of the GDP of $14264.4 b, which is 43.04% of GDP.Durable goods were $ 944.40 b and non durable goods were $ 2846 b, giving a total of only 26.57% of GDP for goods altogether.
2) Services exports from the US are more than services imports, and the US has a trade surplus in the services category.Services exports were $551 b and imports were 407 b, giving a surplus of $144 b or so, which tho isn;t a major percentage of GDP.
3) Trade deficit is a small percentage of GDP for the US: The overall trade deficit including goods and services was $ 529 b in 2008 (according to above NIPA tables). (I noticed another table in which the non seasonally adjusted balance for 2008 overall is -$677 b). Overall, the US trade deficit is only 3.71% of GDP.
4) The goods deficit is insignficant in comarison to the total size of the US economy. For 2008, the goods deficit is around $ 821 b, which is around 5.76% of the US economy.
5) In 2008, Government consumption expenditures and gross investment (including Federal, State, local, defense, etc) totaled $ 2914.9 b. The US Government is therefore ~20.43% of the US economy.
Link to BIPA tables

Anlaysis of US Consumer Credit Growth - Thank Paul Swartz

Here’s another essay from Paul Swartz at Brad Setser’s blog analyzing recent changes in US consumer credit from the Fed’s g19 release.
Following is my comment on the Q4 2008 consumer credit levels:
In the g19 release, it’s clear that absolute total consumer credit o/s. contracted from $2585.3 billion in October 2008 to $ 2582.6 billion in November 2008. Then, in December 2008, it increased to $ 2596.0 billion. So I think Paul’s interpretation that consumer credit grew after the TARP I funds sank in, albeit slowly, is correct.The summary at the top of the Fed’s g19 release probably deals with decreases at ‘annual rate’; which might be some statistical measure other than the absolute o/s numbers in Q4 ‘08.
Personal Consumption Expenditure levels in the United States between 2004 and 2008, according to the National Income and Product Tables from BEA:
2005 $8,893.70
2006 $9,357.00
2007 $9,892.70
2008 $9,930.20
The total PCE 2005-2008 was $38,073.60 billion.
From the Fed’s g19 release linked above, total consumer credit outstanding grew from $2191.60 billion at the end of 2004 to $2562.30 at the end of 2008, an increase of $ 370.70 billion. Increases in consumer credit funded only 0.97% of total US PCE between 2005 and 2008.
Here's a link to the Fed’s Flow of Funds release for reference to the general credit growth data for all sectors.

Revisting the Yen Carry Trade Mechanics

At this post on Brad Setser's blog in February 2007, you see an interesting discussion of the yen carry trade size and mechanics, which I’m re producing below. (The content is from the RGE monitor web site)

Andrew Rozanov of State Street knows a thing or two about how official institutions manage their money (that is a big part of his current job) and a thing or two about Japan (he was based in Tokyo for some time). In response to my previous post, he noted that much of the yen carry trade is now done through the swaps market – or off balance sheet. Hedge funds don’t really need to “borrow” yen and then buy higher yielding currencies – they do the same thing in the derivatives market, or pay a bank to do it for them. I have – with his permission – reprinted his comment below. It inspired a nice discussion.
UPDATE: State Street also seems to know a thing or two about the size of the carry trade. See the FT.
I took a number of things away from the discussion:
1) The obvious, what happens off balance sheet matters. The absence of strong growth in cross-border yen lending isn’t evidence that folks aren't betting on continued yen weakness – or that interest rate differentials will remain large enough to offset any uptick in the yen.
2) A trillion is probably a bit too high an estimate of the size of the yen carry trade, at least if we are talking about bets from the “leveraged” hedge fund community.
3) We shouldn’t forget about leveraged Japanese day traders … who, in aggregate, have become big players. Fx accounts with generous margin are the rage in Tokyo.
4) It is hard for competitive money managers to be on the sidelines and avoid putting on various kinds of carry trades right now.
Andrew Rozanov writes:
“as volatility remains low and carry keeps being profitable, for a commercially driven fund management shop it is becoming more and more painful to stay away from these trades, certainly if you are in competition with others in raising money from investors. Just plot the returns from a simple carry basket on Bloomberg's FXIP (I suggest using long GBP at 50% and long EUR at 50%, while short JPY 50% and short CHF 50%) -- and then look at the statistics below for one-year return, volatility and the Sharpe ratio. They are phenomenal! And what do investors more often than not look for when comparing and choosing hedge fund managers? Why, high and stable returns at relatively low volatility - strategies with very high Sharpe ratios! Never mind the higher moments and fat tails...”
I would note that volatility is also low for some emerging market currencies. Volatility in the Brazilian real/ dollar, for example, has collapsed – because the central bank has resisted market pressure for further appreciation in the real. The same thing incidentally happened in Turkey in 2005. Low observed volatility makes the real-denomianted carry trade even more attractive. And that pulls in even more money. It probably isn’t an accident that Brazil added over $5b to its reserves in January. There are a lot of different cross-currency carry trades out there that have attracted a lot of attention.
Andrew Rozanov’s comments are reprinted in full below
Andrew Rozanov:
I would like to commend those astute commentators who pointed out the direct relevance and central role of the forward currency swaps market in facilitating carry trades. It is arguably the easiest and most preferred method to put on a 'carry trade' by the leveraged community. It was described several years ago in a book written for a Japanese audience by a former Moore Capital trader, Ken Shibusawa, who currently runs his own hedge fund advisory firm in Tokyo (Japanese website for his company: http://www.shibusawa-co.jp/index.html). According to him, essentially the press has got it all wrong. Yes, the underlying economics of a typical carry trade is to 'borrow' in low-yielding currency (e.g. the yen) and then 'lend' on in higher-yielding currency (e.g. the dollar), but when we discuss the actual mechanics of it, hedge funds and other highly leveraged players typically would not engage in any actual borrowing or lending. To the extent a hedge fund would consider putting on such a trade at all, it would most likely do it in the following way, or some variation thereof (we use US$/JPY levels as in Ken Shibusawa's example in the Japanese book): Step 1. Buy US$ / Sell JPY in the spot market (say, at 120) Step 2. Buy JPY/ Sell US$ in the spot market (again, at 120) Step 3. Buy US$ at a discount / Sell JPY at a premium in the forward market (say, 3 months forward at 118.50) Step 4. Buy UST in the spot market Step 5. Borrow US$ against UST in the repo market Some comments are in order. 1. A typical currency forward swap is step 2 + step 3. However, if that's all you do, you will be expected to deliver your US$ for settlement on T+2. But remember, we are looking at a hedge fund, who does not have the money to deliver and who wants leveraged carry. Thus, he needs to create this exposure with as little initial cash outlay as possible. The best way to do that would be to take an outright forward position in the market. 2. An astute observer will have noticed that the cumulative effect of steps 1 through 3 is precisely to create such an outright forward position, whereby our hypothetical hedge fund is now short the yen and long the dollar at 118.50 on a 3-month horizon (in other words, the hedge fund promised to pay 118.50 in 3 months time for an asset which is currently trading at 120 - and the lower the US$/JPY volatility, the higher the chance that the forward contract will have converged at or around the original spot price of 120). 3. But if a hedge fund wants an outright forward position, why go through the hassle of steps 1-3? Well, it all has to do with costs and liquidity. Apparently, it is cheaper and easier to put on such a position in the currency swap market rather than as an outright forward - as the market supporting corporate and 'real money' hedging activity, it is the most liquid. 4. Notice how the trade is structured in two separate legs. There is the FX market leg, where the hedge fund puts on a position to earn the carry from the interest rate differential in the two short-term markets. Then there is the UST leg, which is a completely separate transaction: longer duration US Treasuries are purchased to earn a higher yield, but they are financed in the repo market (of course, this example assumes a 'normal' upward sloping yield curve in the US). So if (and it IS a huge if) all goes as planned in the US$/JPY and UST markets, the total carry earned on the trade is the sum of FX market carry (i.e. short term interest rate differential) and UST market carry. Another way of putting it: the hedge fund earned money from two major risk sources: currency mismatch risk and duration mismatch risk. 5. In his book, Ken Shibusawa makes an interesting observation: many press commentators focus on what they can trace in the spot markets (i.e. step 1 and step 4), and often do not pick up on simultaneous transactions in derivative markets (i.e. combination of step 2 & 3, step 5). Thus, the tendency is to interpret this as hedge funds borrowing yen and selling yen spot, thus procuring dollars and then investing these dollars in long maturity UST). While the underlying economic logic and principle is the same, the mechanics are totally different. 6. Ken Shibusawa quips in the book that while much press attention at the time was focused on global macro hedge funds, it was probably relative value shops that were particularly keen on putting on massive yen carry trades in 1997-98, following the relative success of their "Japan risk premium" carry trades in the previous years. One final comment from me: as volatility remains low and carry keeps being profitable, for a commercially driven fund management shop it is becoming more and more painful to stay away from these trades, certainly if you are in competition with others in raising money from investors. Just plot the returns from a simple carry basket on Bloomberg's FXIP (I suggest using long GBP at 50% and long EUR at 50%, while short JPY 50% and short CHF 50%) -- and then look at the statistics below for one-year return, volatility and the Sharpe ratio. They are phenomenal! And what do investors more often than not look for when comparing and choosing hedge fund managers? Why, high and stable returns at relatively low volatility - strategies with very high Sharpe ratios! Never mind the higher moments and fat tails...

And, for those of us without the financial sophistication to understand why anyone would both buy US$ for yen and sell US$ for yen in the spot market, Andrew noted:
Let me try and answer your question about why go through steps 1 and 2 by considering the other options. 1. If you do only step 1, you are going long USD and short JPY in the spot market. There are two problems with this approach as far as leveraged carry trades go. First, it's not leveraged - you will need to come up with the entire notional amount of JPY to settle this trade in two working days (T+2), so you're not really 'borrowing' anything. Secondly, you're not really trading for carry. Instead, you're putting on a directional bet: you buy US$ at 120 and hope it appreciates (or JPY depreciates), but you're not picking up any interest rate differentals. Incidentally, this type of trade typically favours high volatility environment - remember, volatility cuts both ways, so if you want to make money from a large swing up in the dollar (or swing down in the yen), you would be implicitly betting on high, not low vol. Carry trades, on the other hand, are typically low vol trades: any additional depreciation of the yen would be icing on the cake, but your main bet is that the world stays stable and predictable while you earn your carry on a leveraged basis (i.e., interest rate differential multiplied by leverage). 2. What about taking only steps 2 and 3 - i.e., the foreign exchange swap? The good news is this gives you carry: you buy 120 yen for every dollar now (on T+2) and at the same time contract to sell the newly acquired yen in 3 months' time, such that 118.50 buys you a dollar - in other words, you sold the dollar now at 120 and bought it back in 3 months at 118.50, earning the carry in the process. But the bad news is that, just like in the first comment above, you do not get any leverage, since you will need to provide an initial cash outlay on T+2 to settle the leg in step 2. 3. Why not forget steps 1 and 2 altogether, and just go for step 3? This is entirely legitimate and certainly doable. In the FX market, such a transaction is called an 'outright forward'. You agree with your counterparty bank to go long USD and short JPY based on today's spot price, but with settlement in 3 months' time - you will negotiate and agree the spot price, and then the bank will adjust it by the interest rate difference. No cash flows occur on T+2, you have effectively secured a leveraged position, and you've bought US$ at 118.50 in 3 months. Voila! The only reason you would consider doing something a bit more convoluted (like going through steps 1 to 3 above) is if it helps you save costs and earn even more money. And in competitive markets like FX you get the best prices and execution where the liquidity is the deepest. And the liquidity of spot and FX swap markets has always been (and I believe still is) much better and deeper than in the outright forward markets. Just have a look at Table B1 on page 5 of the BIS Triennial Central Bank Survey at the following link (last survey done in 2004): http://www.bis.org/publ/rpfx05t.pdf
Hellasious and Tmcgee also chimed in; Hellasious noted the growth in outstanding yen forwards. Tmcgee argued that these are notional numbers, so they only give a loose idea of real exposure. He also noted the role of Japanese fx margin traders – something that the FX team at Citi also likes to highlight.

Hellasious and Tmcgee also chimed in; Hellasious noted the growth in outstanding yen forwards. Tmcgee noted that these are notional numbers, so they only give a loose idea of real exposure and noted the role of Japanese fx margin traders – something that the FX team at Citi also likes to highlight.
Hellasious:
I urge everyone to visit the BIS site and look up the relevant FX forward data for yen. The amounts have jumped very substantially from $2.3 trillion to $3.8 in 5 years. A big part of the increase has come in just 6 mos., going from $3.1 to $3.8 trillion between Dec. 2005 and June 2006 (latest available data).
Tmcgee cautioned:
I think $1 trln is a slightly ridiculous number, even if you include the sheer Japanese foreign asset holdings that don't really constitute carry trades per se, just a hunt for higher yields. Also, the BIS derivatives data gives some clues on potential size of carry trades. But I believe they also are all notional numbers, like the US OCC data, which means they're always growing at a fairly rapid pace -- because both sides of the trade are counted. The funny thing is now people are freaking about the size of the carry trade even though one of the supposed culprits of the unwinding of carry trades last april/may (incorrectly) -- a drop Japan's monetary base from the BOJ ending quantitative easing -- is still shrinking 21% yr/yr. and other BIS data -- reporting banks' cross-border positions vis-a-vis all sectors, by domestic and foreign currency -- shows no explosion of yen liabilities among major global banks.
Reporting bank yen cross-border positions vis-a-vis all sectors (blns USD) liabilities:
Domestic currency: December 04: $240.9; Sept 06: $235.9Foreign currency : December 04 $433.1; Sept 06 $457.6 We know the IMM speculative yen short data, so we have a vague since carry trades are popular. But as the Wachovia anlaysis points out, the evidence is far from compelling. ….
Also, no one seems to mention the role of Japanese FX margin trades in the carry trade. Check out data from the Tokyo Financial Exchange, which gives just a small peek into the explosion of margin trading here. These margin traders are quick to take profits when cross/yen hits new highs, but also buy the higher-yielding currencies (like the Aussie, on serious leverage) on any sharp pull-backs. And since so much money is waiting in Japan for moments of yen strength to invest abroad, it tends to put a floor under not only dollar/yen, but also euro/yen and sterling/yen …
BSetser edits: Data presentation edited for clarity, punctuation added.
And Cassandra always has a thing or two to say about the yen and yen carry trades.
Even if Tmghee is right and total carry trade exposure is significantly under $1 trillion, it scale of the carry trade seems to have increased significantly recently. And a lot depends on how the capital outflow from real money Japanese accounts over the past few years should be interpretted. Is it international diversification, money that is unlikely to return to Japan should relative interest rates change and/ or the yen start to appreciate? Or is it a bit more fickle, and perhaps be inclined to act a bit like leveraged money should conditions change?
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Comments
In the FX forward swaps market there are no "notional" amounts. All amounts are real and outstanding. If you put on a dollar/yen swap trade for $100 million you have to deliver $100 million in cash and receive the equivalent in yen, in cash, on spot settlement date. When the forward date comes, you will return the yen and receive back the dollars, again real money flows. This is not an option or futures trade, but a real swapping of large amounts of money. The amounts outstanding are thus very important and indicative.
Reply to this comment By Hellasious on 2007-02-04 16:32:32
hellasious -- would you mind if i made use of your comments on the preceding post in this post? My sense was that tmghee was arguing that "notional" amount may not reflect the banks ultimate risk -- take an example I happen to know well. Turkish banks were keen (in 05) to swap $ for long-term lira. International investors took a generally unhedged lira position in this swap (the banks that did the swap did so more their hedge fund clients ... who wanted more lira duration than was available in the government bond market). The turkish banks had $ to swap from their domestic dollar deposits so they were hedged, and they used the swaps to finance a fraction of the long-term mortgage lending. So the turkish banks effectively had offset both legs of the swap -- they had $ and long-term lira liabilities on balance sheet, and they used the offbalance sheet swap to match the two. that may nor may not be relevant here -- i generally know more about how folks manage their EM exposure than about stuff among the g-10.
Reply to this comment By bsetser on 2007-02-04 17:23:12
Dear Brad, You are welcome to use any comments you find useful. The banks' ultimate risk may not be direct market risk, as such, but credit risk. Bank A's dealing room may be running a perfectly matched book, but a crucial question is who is on the other side of the trades. If other large banks, then they are 99% fine - but no one can make any money that way, of course. It would be as if a bookie laid every single bet he got against another reputable bookie, instead of running his own book. There are only two ways for a bank's dealing room to make money: taking proprietary positions for the bank's own risk (gambling) or taking advantage of customer flows to make a spread (acting as bookie). Under most circumstances, bank dealing rooms are not so much gamblers as bookies - they just want to make the vig. It is therefore crucial for them to pick their customers with care because, unlike the heavies, they cannot threaten their customers with permanent visits to the aquatic domain if they fail to make good on their losses. The phenomenal rise of hedge and private equity funds has increased the systemic appetite for risk - there are many more gamblers out there willing to bet and that is why, pari pasu, the price of risk has collapsed (low risk premiums). Many large banks, seeing an opportunity, have jumped in with "three feet": a) They act as bookies on more and larger bets (more vig). b) They loan margin money to their "prime" hedge fund and private equity customers to make more and bigger bets (loan sharking). c) They take advantage of large customer trade flows, trading along with them for their own account and risk (like a bookie betting alongside a large gambler). Obviously (b) generates more (a) - and that is where most of the risk resides. For as long as the customers keep winning the process generates huge and increasing fees, interest income and trading gains for the banks own P&L. But if, for whatever reason, gains become losses and the customers cannot meet margin calls then the downward spiral begins. Everyone can easily understand what this means. Even a cursory examination of how debt has exploded in the past few years, particularly that of the financial sector, points to serious leverage being responsible for pumping up all asset prices. The yen carry trade is but a part of this process. Regards
Reply to this comment By Hellasious on 2007-02-05 02:25:14
Call me dumb, but I still fail to see how doing step one and two will give any leverage? Assuming step one and two are equal and opposite (EaO) transactions, their aggregate effect will be 0 (in fact, less due to spread and internal processing costs). On T+2 I will still have both USD and JPY inflow and outflows (matching, assuming no spread). Transacting two EaO spot transactions and making money out of it seems to me like a financial perpetum mobile?
Reply to this comment By Guest on 2007-02-05 06:14:30
hey brad -- please feel free to use whatever you find helpful. and to andrew -- fair enough on the japanese household assets. i see that on the boj flow of funds data, the amount of household money in japanese investment trusts (mutual funds) rose 33.6% yr/yr as of sept 2006 to 59.68 trln yen ($493 bln at a Y121 rate), a record high. and most of the new growth is in foreign assets. so including such funds with that of margin traders (though still comparatively small), maybe $1 trln is not so far fetched. i just find the fears about the yen carry trade speculative fervor a bit far fetched, in part because there have been several shake-outs of such trades in the past two years to keep anyone holding such positions on their toes (and i'm talking purely in yen terms -- perhaps a wider basket of carry trades including yen/Swiss franc/etc helps protect such trades). on the BIS data, i'm still not sure. i can't see how the massive yen carry trade would elude such bank lending stats. which jibes in tokyo about the difficulties foreign banks have tapping the overnight call market at times, though that may just be the difference between on balance-sheet and off/OTC, as mentioned. what's also weird is how the gross market values of OTC FX derivatives have shrunk on the BIS data between 12/04 and 6/06 even as notional amounts have risen sharply. and the biggest risers notionally in percentage terms are the aussie and kiwi (+54.5% and +193%), and the yen at 34.4% even as the euro grew 29.0% and USD 23.5%. here's what the san francisco fed had to say about it: http://www.frbsf.org/publications/economics/letter/2006/el2006-31.html the BIS itself was more circumspect last year. i think the big fear is leverage. that's what 1998 was all about. i think there is leverage this time, but not nearly that severe. and there is a big japanese domestic story that explains the yen's weakness, that is getting branded a little too easily as the gigantic and potentially world-wrecking yen carry trade. cheers
Reply to this comment By tmcgee on 2007-02-05 07:15:20
Asian Central Banks attempt to combat Asset Bubbles http://www.bloomberg.com/apps/news?pid=20601089&sid=ajbIBdY0Pf7E&refer=china Not only did last year's higher interest rates fail to curb overinvestment, they may even have helped draw in all that cash. The People's Bank of China raised its benchmark rate twice last year; while higher rates kept consumer prices contained, they encouraged even more investment and growth by offering enhanced returns. China's M2, the broadest measure of money supply, rose 16.9 percent to 34.6 trillion yuan ($4.46 trillion) in December, the highest since figures became available in June 1998. In Thailand, M2 in November reached a record 6.92 trillion baht ($197 billion). China's rate increases last year failed to cool an investment boom that stoked the fastest growth since 1995. The central bank also increased the amounts banks have to set aside as reserves four times since June to discourage excessive lending. That helped slow money supply growth to 16.9 percent in December from 19.2 percent in January 2006. Even so, urban real estate prices in China rose faster. Prices for apartments and offices in 70 cities increased 5.4 percent in December from a year earlier, after a 5.2 percent gain in November, according to the National Development and Reform Commission. Central bank Deputy Governor Wu Xiaoling said Jan. 25 in Davos, Switzerland, that China will tighten environmental controls to rein in overinvestment. Such measures ``would only slow growth marginally,'' says David Cohen, an economist at Action Economics in Singapore. ``Short of establishing currency controls like we've seen in Thailand, I don't think measures to reduce property prices across the region will have much of an impact,'' says Eugene Kim, chief investment officer of Tribridge Investment Partners Ltd. in Hong Kong, a hedge fund managing about $100 million. ``The wealth out there needs to go somewhere.'' ``There is too much money globally chasing meager returns, and the liquidity has found its way to asset markets,'' says Arjuna Mahendran, chief Asia strategist at Credit Suisse Group in Singapore. ``There is no perfect solution. If the flows aren't absorbed, you'll have a crisis at some stage.''
Reply to this comment By Dave Chiang on 2007-02-05 08:12:01
"Low observed volatility makes the real-denomianted carry trade even more attractive. And that pulls in even more money." That's why I referred to the phenomenon as a strange attractor when I worked up my follow-up commentary on your post yesterday. Dave Iverson Economic Dreams-Nightmares
Reply to this comment By Guest on 2007-02-05 09:04:54
See also the blogger "Macro Man" and his possibly-sour-grapes antithesis (he went short Yen/$ recently) which pulls together a good amount of data to assert Yen carry is really no big deal right now. Viz http://macro-man.blogspot.com/2007/02/nouriel-roubini-is-big-fat-idiot.html and ignore the title.
Reply to this comment By wcw on 2007-02-05 09:56:58
Brad, you were puzzled by why the Chinese currency might become a carry currency rather than a target. Some reasons for the Yuan being used by some in the carry trade are pointed out in Bloomberg editorial: http://bloomberg.com/apps/news?pid=20601039&refer=columnist_mukherjee&sid=aTyGjtMJxPM4
Reply to this comment By OldVet on 2007-02-05 12:41:00
I saw the mukherjee piece, and was still a bit confused ... it feels like a mix of an onshore/ offshore artibtrage (offshore RMB pay less than onshore -- so a good funding currency; onshore = 2% plus and the currency appreciation) and a bet that the RMB will appreciate by less than other asian currencies (destination currencies) with a bit more carry. OK, fair enough. but it also seems like the investment and commercial banks have a lot of demand for folks who want RMB simply for the appreciation (now that the pace seems a bit stronger), and are looking for someone else who wants to, in effect, sell RMB ...
Reply to this comment By bsetser on 2007-02-05 13:34:04
Anyone care to explain "Guest's" question about they steps 1 and 2 offer leverage. I agree with Guest that they seem to offset at T+2 and it is not clear to me how leverage is achieved through the first two steps. If anyone truly understands this, an explanation would really be appreciated.
Reply to this comment By Gamma on 2007-02-05 15:26:33
a couple of comments on macroman -- (the content, not the title ... ) 1) Re: Why isn't Japan's trade surplus bigger -- a) lags -- yen wasn't so weak not so long ago (04). watch 07 b) oil c) yen is only weak v. rest of the g-3. it isn't obviously weak v. the yuan d) don't forget about japan's exploding income surplus 2) positioning the macro funds that I know of tend to fund their long Nikkei positions with yen ... their hedging as the Nikkei rose was supposedly a source of pressure on the yen (i.e. higher yen = more unrealized profits in $ that needed to be protected v. slides in the yen). but that was an 05 story, not an 06 story what strikes me as different this time around is that I get a sense that -- as a result of diversification -- there are a lot more Japanese short yen positions (long kiwi, long us bonds, long european stocks, long you name it) than before. Mostly real money. but still mostly unhedged. If folks suddently started to hedge v. $ weakness or euro weakness v. the yen, that could potentially move the market. and, as for the limited on balance sheet cross border yen lending, i trust andrew rozanov. this is now done primarily thru swaps. finally, there is a lot of anecdotal evidence and market evidence (look at the swiss franc as well as the yen, and at destination currencies like the real) that lots of folks woke up on January 1 and answered the how will i earn my 2/20 in 07 question with the "put on a nice little carry trade" and then as the trade performed well, well, it got harder to sit on the sidelines/ take the other side. anyone out there short brazilian real local rates? outright short -- not hedging v CDS? My guess is no. it costs too much.
Reply to this comment By bsetser on 2007-02-05 15:29:29
"...Net six-month fund flows into the yen, the lowest-yielding currency of the 19 in its basket, are at their most negative since March 2000. They have only been more negative for 5 per cent of the time since State Street started tracking them in 1995. Similarly, net flows into the Swiss franc, the 17th lowest-yielding currency, have only been more negative for 4 per cent of the time since tracking began. By contrast, net fund flows into the Brazilian real, the highest yielding currency, have only been more positive 6 per cent of the time..." http://www.ft.com/cms/s/fd5df8a2-b544-11db-a5a5-0000779e2340.html
Reply to this comment By Guest on 2007-02-05 17:23:14
actually short real brazil bonds is strongly positive carry for a leveraged investor. ntn-b's yield 7.80 or so + sub 4% inflation funded at 13%. i think the long inflation linked trade in brazil is popular for its compelling fundamentals despite carry.
Reply to this comment By pb on 2007-02-06 10:32:37
pb -- i fear that I wasn't clear, i wasn't thinking "real" as in inflation indexed but "real" as in denominated in Brazilian real. and, judging from the price action and the brazilian reserve growth, there aren't many who are short brazilian real denominated assets. http://www.bloomberg.com/apps/news?pid=20601086&sid=aJIVQ4OEnyBo&refer=latin_america
Reply to this comment By bsetser on 2007-02-06 14:34:59
Brad, Either way, carry in brl debt (real ot nominal) is negative due to the inverted curve, with the nominal debt less so than inflation linked, and shorting is a positive carry trade when funded locally. If funded in usd, it is positive carry, but less so than just a simple currency trade. In other words, you decrease your carry while taking on more volatility/duration/credit risk, etc. I would agree that carry is the story in brl ndf and the currency futures on the BM&F, while the bonds are a different story (structural change in inflation, expected rate cuts, improving credit) in which leveraged investors are willing to pay away carry to go long.
Reply to this comment By pb on 2007-02-06 14:49:42
Guest, Gamma - Looks like I'm not doing a very good job of explaining what I mean... Sorry about that! Let me try and go about it from a slightly different angle. Imagine you are a bank dealer who has various corporate and institutional customers. Let's say Customer A (who could be a hedge fund, but not necessarily) comes to you and asks you to quote US$/JPY outright forward for 3 months. You offer him a quote. Based on that, he sells you JPY and buys US$ (say, US$ 100 mn) for settlement in 3 months. What does this mean? This means that you are now long JPY / short USD on a 3-month horizon. This essentially has 2 risks for you: spot rate risk and term structure risk (or, in other words, risk related to changes in the interest rate differential). Of these two, the spot rate risk is by far the largest and most volatile. So, unless you want to take an active proprietary position of being long JPY / short USD 100 mn on a 3-months horizon, you need to hedge this position. Thus, the first thing you do is you sell JPY / buy USD 100 mn in the spot market. Now you have only one problem remaining: duration mismatch. And there are two possible ways to solve this. Option 1 - Theoretical: actual borrowing and lending Having sold JPY and bought 100 mn USD in the spot market, you can borrow yen which you'll deliver and settle on T+2, while taking physical delivery of the US$ 100 mn. This gives you the dollars you'll need to deliver based on your outright forward obligation in 3 months' time. But for now you place these US$ 100 mn on deposit. In 3 months' time, you get the US$ + US$ interest, deliver against the yen, and repay the yen loan + JPY interest. While you could do this in theory, nobody ever does this in practice - too impractical, too much of a hassle, but most importantly - every act of borrowing and lending expands your bank's balance sheet, with obvious consequences for regulatory capital, etc. Instead, banks do the following: Option 2 - Practical: hedging in the spot + FX swap markets Go back to the point when you just ended up with the risk on your book of long JPY / short USD 100 mn on a 3-month horizon. Again, you hedge it first in the spot market - buy USD 100 mn vs JPY. Then, you do an FX swap transaction. Remember, an FX swap has two legs: buy currency A and sell currency B spot, and AT THE SAME TIME sell currency A and buy currency B for future delivery, say, 3 months forward. If you do this, the first leg of the swap CANCELS OUT the spot transaction you just did previously to hedge your spot risk (i.e. buy USD 100 mn and sell JPY, then sell USD 100 mn and buy JPY at the SAME spot rate), so no physical cash flows are triggered on T+2. All you are left with is a 3-month obligation from your original transaction with Customer A to deliver US$ 100 mn and receive yen AND your new obligation to receive US$ 100 mn and deliver yen in 3-months' time from the second leg of your FX swap hedge. You are now fully hedged! Notice how your transaction in the spot market and the first leg of your FX swap transaction CANCEL EACH OTHER OUT, leaving just an outright forward, which hedges your original obligation to customer A. It is EXACTLY the same concept as in my previous carry trade example of Spot Trade + FX Swap Trade, where step 1 and step 2 cancel each other out, leaving only step 3 - the outright forward. The only difference is that in my earlier example you're not doing it to hedge your risk, but to take risk in the most efficient and cheapest way possible. Hope this helps explain it a little better. Regards, Andrew
Reply to this comment By Andrew Rozanov on 2007-02-06 18:42:07
Thanks Andrew for explaining that again.
Reply to this comment By Gamma on 2007-02-07 14:11:53
Thanks Andrew. What confused me was why making an explicit FX step with outright forward (if you can get an outright forwad with favourable rate). The way you describe it (FX spot + FX swap) now is what I thought of when looking at the article originally.
Reply to this comment By enderv (was:Guest) on 2007-02-08 01:35:28
I have been discussing the yen carry trade in my work for some long time and I have enjoyed this discussion.The $1 trillion estimate comes originally from a piece of work I did, and I thought it only fair to contribute my explanation for anyone interested. In the work I accept that guesstimates for the size of the carry trade that can be derived from balance of payments and banking statistics fall in the range US$100-350 billion. However, as has been noted here, it is not necessarily the case that carry trades will show up in these statistics. Carry trade transactions could be on the other side, for instance, of hedging by Japanese exporters in the forward currency market, which would not show up in bank balance sheet statistics. The one trillion number is less a genuine 'estimate' than an indication of what I believe to be the order of magnitude. My guess is that the outstanding carry trade is probably even larger than this. There are a number of connected reasons for believing this, which I will try to summarise briefly; 1) The big adverse development in the Japanese balance of payments data (IMF data) that occurred subsequent to the massive intervention up to March 2004 was the deterioration in 'monetary capital' (i.e. increase in Japanese banks' net foreign assets). This suggests that it is carry trades that have weakened the yen, not Japanese institutional or retail funds going into foreign securities, and it suggests that the moral hazard created by the intervention was the original cause. 2) Indications of the carry trade such as Japanese banks' gross foreign assets, cumulative short-term net foreign lending from the Japanese bop, the spec net short position on the Chicago IMM correlate quite well with each other and also with the yen rate. I think these indicators do not tell us the size of the carry trade but they do tell us the direction. Again, these suggest that it is the carry trade that has been responsible for yen weakness. 3) Carry trade currency relationships are now enormously out of line with fair values. I have the yen about 30% undervalued against the dollar. The Turkish lira I have 130% overvalued against the yen, which is extraordinary. Turkish inflation is 10%, but the lira simply will not go down (bar the episode last spring). 4) The Japanese MOF/BOJ had to acquire roughly US$500 billion to prevent the yen appreciating up to March 2004. The yen is now much lower in real terms. Logically the amount of intervention next time round is going to have to be much greater - my estimate is roughly US$2 trillion. The idea that the carry trade is, say, only US$200 billion is inconsistent with this in my view. 5)There seems to be a relationship between the yen and the enormous credit bubble which now completely dominates global financial markets and the economy. In my work I had a chart (mainly for fun) showing the very close relationship between Goldman Sachs share price in dollars and the S&P 500 in terms of yen. There are plenty of other similar relationships I think you could show. When you add all this together, it is simply not plausible, in my view, that the carry trade could be as small as most observers are saying. The observed impact that the carry trade is having on the currency and other markets is too great. As to why hedge funds, investment banks and others have not been frightened out of it, I think they have 'learned' that it 'always works' in the end, much as technology growth stock investors 'learned' in the second half of the 1990s. They do not see how it could possibly go badly wrong until Japanese rates have been raised significantly, and they see no prospect of that. Tim Lee
Reply to this comment By Tim Lee on 2007-02-08 10:42:17
Can one actually capture the spread yen/dollar: ~5% leverage 2.7x = 13.5%/yr and have your original principle 100% safe?
Reply to this comment By Guest on 2007-06-08 17:36:56

Only 3% of US consumption came from higher Home Equity!

There is a general misconception that the housing boom was the main source of US consumption. That boom seems to have ended decisively. Therefore, ordinary investors frequently wonder how the US economy will recover.
In an essay from Paul Swartz at Brad Setser's blog the US mortgage credit levels are examined in relation to the housing boom.
This paper by Alan Greenspan and James Kennedy is referenced in Paul Swartz’s essay.
Here’s my analysis of the percentage of US consumption that came from cashing out on US home equity:
Only 3 percent of spending (2001-2005) came from using homes as ATMs!!!
An excerpt from the Greenspan/Kennedy paper linked above:
” According to our estimates, from 1991 to 2005, equity extracted from homes was used directly to finance an average of close to $66 billion per year of PCE, about 1 percent of the total (lines 9 and 10). From 1991 to 2000, equity extraction financed an average of 0.6 percent of total PCE, but since then that share has risen to almost 1-3/4 percent. If we include non-mortgage debt repayments (in which, as mentioned above, installment debt is used as bridge financing for PCE, with home mortgage debt as the ultimate source of funding), equity extraction financed an annual average of about $115 billion of PCE from 1991 to 2005, 1.7 percent of total PCE (lines 12 and 13). By this broader measure of PCE funding, equity extraction financed 1.1 percent of PCE from 1991 to 2000 and close to 3 percent from 2001 to 2005.”
In my simpler words:People got money out of the mortgage boom by selling homes, taking out new home equity loans and taking cash out refinancing loans. They repaid some non mortgage debt and spent other money directly on personal consumption expenditure. The total of that non mortgage debt repayment and the PCE is only 3% of the total PCE in the US economy for the years 2001-2005!
Since 2005 is the last year of data in the paper linked above, I've separately calculated the percentage for that year below: (Please refer to Table 2 in the paper) For 2005, line (1) in Table 2 shows a total home equity free cash extraction of $ 1,428.9 billion. $ 143.9 billion of that was used to repay non mortgage debt (line 5), and $ 182.7 billion was used for PCE (line 9).According to NIPA total PCE in 2005 was $8893.7 billion. $326.6 billion, or just 3.67% of PCE was financed by using homes as ATMS in 2005.Suppose from the NIPA table you exclude “durable goods” PCE altogether. Of the total non-durable goods PCE, only 4.14% came from using homes as ATMs. If using homes as ATMs only funded a small percentage of the PCE in US GDP, there’s a great deal of hope for US economic recovery once the ongoing credit squeeze is sorted out with the Geithner bank bailout plan.

THE U.S. Housing Market

As of 2007, there was one housing unit available for every 2.35 persons in the United States. As of 2007, around 5.61% (7.19 million out of 128.20 million) of housing units were newly constructed within the previous 4 years. Around 10.22 % of housing units (13.11 million out of 128.20 million) in 2007 were technically ‘vacant’ (they were either just vacant, or were meant for occasional use).This data shows that in 2007 an equilibrium between the number of available housing units of good quality, the U.S. population, and the average size of an American household was approaching. Even as housing starts were proceeding at a hectic pace, occupation demand for new units peaked out, with more than 10% of existing units being technically vacant.Increasing inventories, decreasing starts, flattening home prices, and unwinding of highly leveraged housing investments marked the market adjustment to this new equilibrium.In 2008, the correction over extended itself, leading to a general implosion of credit in unrelated sectors. A housing recovery is on since December 2008 with falling inventories, and increasing sales volumes. My guess is that home prices will just stabilize somewhere, and mortgage credit will gorw very slowly, allowing further re distribution of home ownership over time rather than a further rapid expansion of the supply of homes in the U.S.
Data Summary:As of 2007, there were 128.20 million housing units in the United States. Of these , 13.11 million units were vacant. Owners occupied 75.65 million and renters occupied 35.05 million units. Of the 13+ million units considered vacant, 2.94 million units were for occasional use. So it seems that holiday homes, etc are included in that 13+ million as ‘vacant’. As of 2007, out of the total 128.20 million units, 7.19 million units were newly constructed within the previous 4 years. Around 8.71 million of these units were mobile/manufactured homes.As of July 01, 2007 the population of the United States is estimated to be 301.29 million and as of July 01, 2008 the population estimate is 304.06 million.Dividing the 301.29 million population by the 128.20 million housing units, you can conclude that there was one home for every 2.35 persons in the United States as of 2007.
Data sources:Housing units data:American Housing Survey:2007(U.S. Census Bureau)http://www.census.gov/prod/2008pubs/h150-07.pdf(Go to page 16 in the PDF file, enlarge to something like 200% and have a look at the bold line in Table 1A-1: Introductory Characteristics - All Housing Units)
Population Estimates data:
U.S. Census Bureau, Population Estimates Program, American Factfinder:
http://factfinder.census.gov/servlet/DTTable?_bm=y&-geo_id=01000US&-ds_name=PEP_2008_EST&-_lang=en&-mt_name=PEP_2008_EST_G2008_T001&-format=&-CONTEXT=dt
(The population estimates are in the table at this page above)

Balance Sheet of The Federal Reserve Bank

Here's a link to the latest Federal Reserve Bank Balance Sheet.
The 'US Treasury, supplementary financing account' has a balance of $199,950 million as of 11 FEB 2009. This item is the balance in one of the Treasury's accounts with the Fed. The Treasury supplementary financing account was created in response to the 2008 credit crisis. That's why you see that the change in the account since 13 Feb 2008 is the same as the current balance in the account.
The US Treasury supplementary financing account is a part of factors absorbing reserve funds, other than reserve balances. What this means is that the Fed, in its role as the banker to the US Treasury, has given a credit of $199 mn to the US Treasury in an account, and the Fed has a liability to pay this amount to the Treasury.
Normally, when the US Treasury issues debt securities, it should receive the cash, and instead, here it's received a liability from the Fed. The balance in the 'Treasury cash holdings' account is $ 273 million as of 11 Feb 2009. Since 13 Feb 2008, the Treasury's cash balance at the Fed decreased marginally by $ 2 million.
This is an example of how the Fed's balance sheet expanded to provide credit to banks in response to the 2008 credit crisis. Basically, the Fed borrowed from the US Treasury and then extended credit to the banks in turn. The Treasury borrowed from the market, including foreign central banks, during 2008.
Have a look at the various items in 'total factors supplying reserve funds', which represents the Fed's assets. You get a series of items there, such as credit extended to AIG, purchases of Agencies, Mortgage Backed Securities, and so on. The money borrowed from the market in the name of the US Treasury was then lent to the Fed; the Fed then purchased MBS, and so on; in turn the Fed extended credit to the banks. The US Treasury now owes money back to the subscribers of bills and bonds; and that has to be paid mostly out of the general revenues of the Congress.
Through this route, banks have exchanged bad debts with the Fed, in return for fresh credit from the Fed, so they're no longer liable for those losses. The Fed is relying on the Treasury to payout as its bills mature. The Treasury is relying on its fiscal resources to pay those bills. The Fed will experience the losses from bad debts on its books in due course. And American taxpayers lent ~ $ 2 trillion in 2008 to banks, with no discussion on the issue in Congress. In spirit, this is a diversion of Congressional appropriations to the Federal Reserve, which is a transgression of the intentions of the Federal Reserve Act. The legal technicality probably is that the Treasury supplementary financing account can be taken as a deposit made by the US Treasury at the Fed, which in letter perhaps makes the Fed's action legal.

The US Trade Balance with China

The US Trade Balance with China (2001-2008) totals to $1.41 trillion.
From the US Govt. census web site I totaled the trade balance with China for the last 8 years:
Year $ million
2001 $83,096.10
2002 $103,064.90
2003 $124,068.20
2004 $161,938.00
2005 $201,544.80
2006 $232,588.60
2007 $256,206.70
2008 $246,453.10
TOTAL ------------- $1,408,960.40
Reference: http://www.census.gov/foreign-trade/balance/c5700.html
The total US Trade Balance 1992- 2007 is $ 5.39 trillion.
Year $ Million
1992 -$39,212.00
1993 -$70,311.00
1994 -$98,493.00
1995 -$96,384.00
1996 -$104,065.00
1997 -$108,273.00
1998 -$166,140.00
1999 -$265,090.00
2000 -$379,835.00
2001 -$365,126.00
2002 -$423,725.00
2003 -$496,915.00
2004 -$607,730.00
2005 -$711,567.00
2006 -$753,283.00
2007 -$700,258.00
TOTAL -$5,386,407.00
Reference: http://www.bea.gov/newsreleases/international/trade/tradnewsrelease.htm

Total United States Public Debt outstanding:

$ 10,717,280,371,345.89

Reference: http://www.publicdebt.treas.gov/


China has an estimated $ 1.45 trillion of USD denominated foreign exchange reserves, consisting of US Treasury and Agency debt.
(from Brad Setser's estimates and links below)


"Consequently it should be a surprise that China’s government now has close to a trillion in Treasuries. OK, not quite a trillion. But darn close. $860 billion or so at the end of November and – if current trends continue — over $900 billion at the end of December. China also has $550 billion or so of Agencies, which are effectively now backstopped by the Treasury. That works out to an enormous bet by China’s government on US government bonds. "
- Dr. Brad Setser
Reference:
http://blogs.cfr.org/setser/2009/01/30/secrets-of-safe-a-trillion-or-close-of-treasuries-here-a-trillion-there-and-pretty-soon-you-are-talking-about-real-money/


http://www.cfr.org/content/publications/attachments/CGS_WorkingPaper_6_China.pdf

http://www.bea.gov/newsreleases/international/trade/2009/pdf/trad1108.pdf

A few notes on the US Govt. finances and the value of the US Dollar

Fortunately my views on the US Govt. finances aren’t controversial at all and I’m just repeating what something called the accountability office has been repeatedly warning for quite some time.USG has a total debt of $10 trillion plus and the lowest estimate of this year’s deficit is “more than $1 trillion”, from Brad Setser. Other commentators are guessing anywhere from $2 trillion to $ 3 trillion.If the US Govt. is paying interest on its $10 trillion debt, that interest is being paid out of more borrowings, rather than from its own surplus.The US latest annual trade deficit with China is close to $20 billion. Even if you assume trade deficits with China have been at the same level for the last 8 years, you’re only accounting for a max of $ 160 b in USG Govt. debt, with an assumption that each dollar of China trade deficit leads to a dollar of USG debt.Where’s $160 billion over EIGHT years and where’s a TOTAL USG debt of more than $ 10,000 billion?In this analysis we’re ignoring the estimates that very soon trillions in medicare and social security are going to fall due in the next few years, so the USG deficits are likely to widen further rather than soften.Despite these terrible looking numbers I don’t expect the USG to default in the immediate future. To paraphrase Dr. Roubini, let me now explain in detail why.

Sorry small correction: China has a trade surplus of around $200 billion and around 40% of its exports are to the US. So the latest US trade deficit with China is likely closer to $ 80 billion, and not $ 20 billion as I mentioned above. The trade deficit with China accounts for something like 45% of the overall US trade deficit.Even with this correction, it’s easy to see that the level of total USG debt can’t be explained by China imports, or imports overall, over the last 8 years.

Why at least 2014?As of now the US dollar has a “unique role in international trade” and thereby offers “an exorbitant previlege” to the US Govt. to run “painless deficits”. (These are official terminologies so there’s nothing controversial in using them.)The dollar’s unique role is that most of the international trade amongst third-party nations is settled in USD. Of this, the most compelling is the trade in crude oil, a commodity that most countries import.Till recently around 63% of foreign central bank reserves were held in USD. Combined these together, and you get a realistic explanation for why the USD is overvalued more than 1000% in most exchange rates.This situation never came about as a result of “mercantilism”.This is more a result of US foreign policy objectives since the 1970s, starting with Middle-East military agreements, and the exercise of other geopolitical influence to make sure that the surplus of oil-exporting nations can be accumulated in USD and recycled.The USG will stop receiving foreign funding only when foreign central banks shift away from the USD for their reserves. That requires a shift away from trade settlement in USD. This process requires a widespread perception and understanding that the US geopolitical influence is at an end. That influence is derived from the US military.Unless the US military loses its ability to dominate the world, there will be no complete drain on foreign funding for the USG.Secure in this knowledge, advantages can be gained by asking China to strengthen its RMB, so that the Chinese economy can suffer a further pandemonium, and just as in the case of Argentina in 2001-2002, larger chunks of the local equity market can be purchased by foreign investors at 10 cents on the dollar.

Since 2008: German foreign minister Steinbruck said in media interviews that he prefers a combination of USD, EUR, JPY and RMB as forex reserves rather than predominantly USD. GBP was conspicuously absent in his list. At Davos, Russia’ Putin warned against excessive reliance on one reserve currency. Iran’s Ahmedinijad made self congratulatory speeches in which he claimed that his decision to replace the USD with EUR in Iran’s reserves was both politically and economically advantageous. Even French President Sarkozy expressed misgivings about the USD prior to the 1st G-20 crisis summit.The update is that Russia seems to be rapidly exchanging USD from its reserves for trade & political advantages, a move that Dr. Roubini predicted in his writing with the topic something like “Decline of the American Empire” in late 2008 which is there on his web site.Last week, Russia made out a $350 million loan to Cuba in exchange for information and drilling rights in the Cuban part of the Gulf of Mexico. At a summit of the newly rejuventated CSTO (Collective Security Treaty Organization), Dmitry Medvedev offered a full $2.15 billion to Krygystan, $ 2 billion in loans and the rest in aid.Now I have given you the direction in which you need to reason to know when the USG may at all be forced to default. You have to know the geopolitics from Darfur to Afghanistan, and it’s no joke. My guess is that it will take at least a few more years for the ROW to come to any drastic conclusions about the “value of the US dollar”.