Who's dropping the carry trade?

Foreign Exchange

The so-called Bric trade - taking exposure to Brazil, Russia, India and China - has been the staple of emerging market traders over the past few years. However, African currencies, and the South African rand in particular, have also presented mouth-watering opportunities for offshore investors.

One of the most popular strategies has been the carry trade. The concept is pretty simple: investors borrow in the currency of a country with low interest rates, such as Japan, and invest or lend in a higher-yielding currency. Investors profit from the interest rate differential between the two currencies, so long as the exchange rate remains stable. With its benchmark interest rate currently at 9%, it's little wonder that South Africa has been a popular destination for carry trades.

The volume of the carry trade is difficult to assess. Michele Cavallo, an economist at the Federal Reserve Bank of San Francisco, points out: "These strategies are generally conducted through transactions such as currency swaps that are reported as off-balance-sheet items, and therefore hard to monitor."

However, its impact is significant. Johan Botha, an economist at Standard Bank in Johannesburg, says: "The carry trade has had an important effect on the rand."

One side-effect of substantial carry-trade flows is a weakening of the borrowing currency and a strengthening of the higher-yielding currency, and vice versa as these trades are unwound. In fact, the rand has appreciated by around 70% against the dollar since 2002, hitting R5.61 to the dollar on December 23, 2004 - its highest level since November 1998.

However, there are growing signs that the carry trade is losing its sheen. There are two possible factors that could cause carry trades to look less attractive. First, the trade depends on the existence of an interest rate differential between the countries on each end of the trade. An increase in interest rates in the borrowing currency or a reduction in interest rates in the higher-yielding currency would reduce or remove the incentive to enter into the trade. Second, the trade is vulnerable to changes in exchange rates: if the spot currency values change by more than the interest rate differential, the position will no longer be profitable.

Both are threatening the rand carry trade. The rand weakened by around 10% in 2006, ending the year at R6.99 to the dollar (see figure 1). Dealers say this weakening of the currency contributed to an unwinding of existing carry trade positions in the latter half of last year. "Over the past six to nine months, with the gradual depreciation of the rand, I think the carry trade has probably unwound 70-80% of its net position," says Grant Barrow, head of foreign exchange for South Africa at Investec in Johannesburg.

And this weakening trend is likely to continue. The South African government is relatively non-interventionist by emerging market standards. "They don't want to act aggressively on one side or the other side," says one local banker. "They want to be quiet and stable like a central bank in Europe or the US. They don't want to act against the carry trade or the hedge funds or whatever. From a local point of view, that is very impressive."

However, a weaker rand recently appears to have become an explicit government objective, with the aim of boosting exports and reducing the trade gap. In his 2007 state of the nation address on February 12, South African president Thabo Mbeki said the government would review its interest rate and currency policies in order to boost national exports. At the same time, trade and industry minister Mandisi Mpahlwa warned that "the possibility of (the rand's) overvaluation... is a potential problem given that increasing export orientation is viewed as a key employment creation strategy."

Bankers say this translates into a shift in government policy. "The emphasis is becoming more focused on a weaker rand," says Standard Bank's Botha. He adds, though, that this is unlikely to affect the exchange rate in the short term: "I expect the rand to remain relatively stable at an average of R7.30-7.35 to the dollar, with some weakening towards the end of the year."

Meanwhile, the interest rate differential between yen and rand has narrowed - albeit slightly. The Bank of Japan raised its benchmark interest rate to 0.5% from 0.25% on February 21 - its highest level for more than a decade. And while the South African Reserve Bank hiked interest rates four times last year to 9%, further increases are considered unlikely.

"I believe it is possible that we will actually see a cut towards the end of the year - perhaps 50 basis points in October and 50bp in December. But there is no increase on the horizon," says Botha. With inflation forecast to peak at around 5.6% in the second quarter of 2007, there is no need for the bank to keep raising interest rates, he adds.

Nonetheless, the reduced interest rate differential still looks fairly attractive - particularly given that the Bank of Japan has hinted that any further rate increases will occur gradually. In fact, the rand rallied against the dollar in the first three weeks of February, rising from R7.32 on January 29 to R7.09 on February 26. Much of this was attributed to rising metal prices (South Africa is the world's largest producer of gold and platinum), as well as renewed interest from emerging market investors.

It's not the narrowing interest rate differential that may end up being the biggest deterrent to carry trades - it's the volatility of the rand. Over the past year, the currency displayed 14.8% annual volatility - higher than any major G-10 currency, and even higher than major emerging market currencies such as the Brazilian real, Indian rupee, Indonesian rupiah and Turkish lira. And that was a relatively quiet year. "In the past, in 1999 to 2001, we have seen 3-4% daily movement in the rand," says Investec's Barrow. "The past two years have not really been volatile compared with those periods."

Mark Fennell, London-based director of emerging market derivatives and bonds at interdealer broker Tradition, says this volatility could discourage investors from entering into rand carry trades: "The problem is that the currency fluctuation has been considerable. The very best carry trade is the yen/rand pair - that has had a 6% or 6.5% pick-up. But we have seen volatility of 30% at its worst. For most international banks, that is a good reason not to do that trade." Here, there is no conflict between the government's macroeconomic objectives and the desires of offshore investors pursuing carry trade strategies. Mbeki blamed volatility, as well as the strong rand, for poor export performance. Despite its relatively non-interventionist reputation, the South African Reserve Bank has acted to keep the rand from appreciating in the past.

"The government has been keeping a base on the down side," says Tradition's Fennell. "When the rand was trading at around R6 to the dollar, they were quite prominent to keep it above R6, and they're now quite prominent around R7- 7.10. It tends to get bought up quite aggressively around that level."

Accumulation

Late 2006 saw strong accumulation of foreign currency reserves by the country's central bank - $596 million in December alone, the highest amount for 18 months, according to figures from the South African Reserve Bank.

Many bankers, however, believe there is little the South African authorities can do to dampen rand volatility. "It is not that they won't act, but that they can't," says one Johannesburg-based banker.

There is another problem. Much of the carry trade flow is invested in high-grade rand assets, such as government bonds. But supply of these securities is falling behind demand, says Fennell. "We have a liquidity problem at the moment with government stocks - there is not enough issuance. Any investment in rand government bonds from offshore is a problem because there isn't enough to supply the natural onshore demand."

Any further unwinding of existing carry trade positions could contribute to a weaker rand. However, it is not expected to cause increased volatility in the exchange rate. In its 2006 annual report, published in June, the Bank of International Settlements pointed out: "The effect of the reversal of carry trade positions on exchange rate volatility is hard to predict and depends, inter alia, on the speed with which these positions are closed. In some cases, the gradual unwinding of carry trades caused visible changes in exchange rates without a sizeable impact on short-term volatility."

For instance, the New Zealand dollar dropped 12% against the US dollar in 25 days in early 2006, while the Icelandic krona fell 23% over the same period - both attributed to the unwinding of massive carry trade positions.

With so many factors turning against it, is the carry trade likely to remain a major focus for investors? Investec's Barrow thinks not: "In my opinion, the carry trade was a historical fluke."

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