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The carry trade

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The carry trade

Nouriel Roubini, to prolong his 15 minutes of fame, is now warning that a massive carry trade is creating the foundation for the next bubbles. He has been joined by others in making this claim. They point to the continuing fall of the U.S. dollar, rising commodity prices and equity prices in emerging markets as evidence.

If Roubini and the others are right, then there is a serious problem with the U.S. financial system, and unfortunately, only massive nationalization or very restrictive regulations will save us from the unbelievable degree of stupidity and chutzpah permeating this sector. On the other hand, he could be wrong, in which case he should graciously exit the stage and return to academic obscurity.

Roubini claims that hedge funds and other investors are borrowing heavily in the U.S. at rates close to zero. This implies that they are borrowing very short term. They are investing the proceeds in other countries in higher yielding, longer-term assets denominated in currencies other than the U.S. dollar.

Anyone engaged in this carry trade faces several risks. The U.S. dollar could appreciate against many other currencies. Yields could increase all round, thus generating capital losses on the many of the investments at the same time that borrowing costs increase. Prices of foreign assets might fall for other reasons. They might not be able to roll over their short-term borrowings.

The carry trade could turn out to be a disaster. It is far from a sure bet. Remember the Madoff motto: “If it’s too good to be true, it is too good to be true.”

Thus, the question to ask is: Since U.S. banks are reluctant to lend to small and medium size companies in the U.S. because of the perceived credit risks, why would they be willing to lend, at very low rates of interest, to carry trade investors? If some are indeed doing this, so soon after the sub-prime mortgage debacle, then there is a serious systemic problem. Can the people running these institutions be so stupid? Is corporate governance such a joke? And where are the regulators?

This leads me to the other possibility; namely, that loans are not available, or at least, nowhere near the levels suggested by Roubini et al, for the carry trade. If so, then there is no “massive” carry trade underway, although there might be the beginnings of new asset bubbles for other reasons. Thus, Roubini is crying wolf one too many times.

I have not looked at the data. Therefore, I am not sure which is the case. But I cannot believe that bankers are so dumb, and so I am inclined to dismiss Roubini.


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