[Song Seungseop's Financial Light] Investment or Arbitrage... 'Carry Trade'

Borrowing at Low Interest Rates to Invest at High Rates
Investment Technique Originated in 1990s Japan
0% Yen Carry Trade Becomes a Major Trend
Consider Exchange Rates, Interest Policies, and Fees

On the 26th, amid trade tensions between the United States and China, the Japanese yen's value rose intraday to 104 yen, its highest level since 2016. At the KEB Hana Bank Counterfeit Response Center in Euljiro, Seoul, an employee is organizing yen currency. Photo by Moon Honam munonam@

[Asia Economy Sejong=Reporter Song Seung-seop] Since last year, major countries have started raising their benchmark interest rates to curb rising inflation. Except for Japan. The Bank of Japan stubbornly maintains interest rates in the 0% range, contrary to other major countries. As this situation has continued for a long time, an investment technique has gained attention. It is the 'Carry Trade.'

Carry Trade refers to an 'investment technique' where money is borrowed at a low cost and invested in places with high returns to make a profit. It sounds obvious, but when examined closely, it is not that simple. Carry Trade typically involves 'currencies.' It generates profits by borrowing from countries with low interest rates and depositing or investing in banks in countries with high interest rates. Literally, it is a transaction that 'carries' funds (Carry) and trades (Trade).

For example, an investor borrows 10 billion yen in Japan at an annual interest rate of 1%. If this money is deposited in a U.S. bank with a 3% deposit interest rate, the investor would earn a simple 2% return. If the investor takes risks and invests in higher-yielding U.S. bonds or real estate, even greater profits can be made. At first glance, Carry Trade seems like an excellent investment technique that is both stable and profitable.

Status of Japanese investment inflows relative to GDP of major countries as of December last year.

Therefore, Carry Trade became wildly popular in Japan, where it first emerged. After the collapse of the bubble economy, Japan applied very low interest rates close to 0% since the 1990s. Money could be borrowed almost for free. Japanese investors borrowed money very cheaply and deposited it in overseas banks or purchased high-yield assets to make money. As this investment technique became known, foreign investors also began borrowing yen to lend money to other countries.

However, Carry Trade was not a dream investment technique that guaranteed huge profits. Its weakness lies in interest rate and exchange rate fluctuations. What happens if the lending institution starts raising interest rates after borrowing cheaply? What if the interest rate of the bank where the money is deposited or the yield on the invested bonds falls? Large losses are inevitable. Changes in each country's tax system or currency exchange fees are also factors to consider.

Vulnerable to Interest Rate and Exchange Rate Fluctuations... Side Effects of Capital Outflows in Emerging Markets

Impact of liquidating carry trade investments using the dollar. Data from Korea Development Institute (KDI)

Carry Trade using the yen was no exception. In 2008, the world faced a great recession triggered by the global financial crisis that started in the U.S. Major advanced countries began lowering interest rates to revive the plummeting economy. The U.S. Federal Reserve (Fed) even lowered the benchmark interest rate to the 0% range. As the cost of funding and yield difference disappeared, investors withdrew funds invested in yen.

This caused unexpected side effects. As Carry Trade became popular, emerging and developing countries with high interest rates attracted a lot of capital. These capital-scarce countries were able to grow by utilizing funds inflowed through Carry Trade. The problem arose when funds were withdrawn due to Carry Trade. Asset prices plummeted, financial markets became unstable, and corporate and household consumption contracted. As a result, Carry Trade was criticized for not helping but rather creating bubbles in overseas markets.

To prevent Carry Trade, emerging countries established various systems. The 'Tobin Tax' is a representative example. James Tobin, a Nobel laureate and professor at Yale University, proposed imposing a transaction tax on funds invested in 'foreign exchange, bonds, derivatives,' etc., to prevent rapid capital inflows and outflows. Since Carry Trade is essentially a simple arbitrage transaction, this system aligns with the intention to block it. Brazil is one of the representative emerging countries that introduced the Tobin Tax.

Recently, after the Bank of Japan (BOJ) raised interest rates, warnings about Carry Trade using the yen have emerged. Last month, the BOJ raised the allowable fluctuation range of long-term interest rates from ±0.25% to ±0.5%. With interest rates rising, the cost of borrowing yen has also increased. Concerns were also fueled by forecasts that the BOJ will inevitably continue raising interest rates. However, some analysts argue that since Japanese interest rates are still low, Carry Trade will continue.