Sunday, September 6, 2015

Understanding the global Carry Trade

Stop blaming China—the problem is bigger than that

 Everyone is blaming China for the recent stock-market rout, but this blame is misguided. China was the beneficiary of global expansion of money supply at the hands of activist central banks. In fact, my view is that Chinese leadership had little to do with the growth "miracle" it experienced over the last decade.
        
As central banks in the U.S., Japan and Europe eased policy, money sought a higher-yielding home in China. This capital inflow was the cause of the growth "miracle" and now that the expansionary monetary policy is ending, it is only natural that the Chinese economy would begin to slow. Unfortunately, this "search for yield" has created the largest shadow banking system the world has even seen … and it could be in trouble.


According to the Bank for International Settlements (BIS), since 2010 the amount of U.S. dollar-denominated debt issued by foreign companies has grown by 50 percent from $6 trillion to $9 trillion. The proximate cause of this debt buildup was the impact of U.S. Federal Reserve quantitative easing on bond yields — as the Federal Reserve bought bonds, yields were pushed lower and investors were forced to search globally for higher-yielding financial instruments. This demand for yield fueled a credit binge of unprecedented scale.
"Unfortunately, this "search for yield" has created the largest shadow banking system the world has even seen … and it could be in trouble." -Brian Kelly
The epicenter of this pro-cyclical expansion of credit was the fast-growing emerging markets. Investors perceived that investing in countries like China, Brazil and Turkey was worth the risk, especially if emerging-market companies were offering higher yields. Some of the credit extended to emerging-market companies was used for real economic projects, but a BIS report released in late August concludes that most of the money was simply invested in higher yielding shadow-banking instruments. This is the so-called global carry trade.

The global carry trade works like this: An emerging-market company issues bonds denominated in U.S. dollars; critically, the yield on these bonds is above the yield of U.S. corporate bonds but BELOW the yield on shadow-banking instruments within the emerging markets. The relatively higher yielding bonds attract investors searching for yield; at the same time, the emerging-market company can invest the proceeds of the bond sale into higher yielding instruments. The emerging-market company earns the difference between its low yielding U.S. dollar bonds and its high yield emerging-market investments. This is financial engineering by another name.

The global carry trade works especially well under three conditions: 1) There is a large interest-rate differential between the U.S. and the emerging country, 2) The emerging country's currency is rising, and 3) Currency volatility is very low. All three of these conditions have been present since 2010 and have been fuel for this massive build in debt. However the economic slowdown in China coupled with the U.S. Federal Reserve ending quantitative easinghas resulted in a strong U.S. dollar (weak emerging-market currencies) and tremendous currency volatility — thereby significantly reducing the attractiveness of the carry trade.

The credit expansion of the carry trade resulted in emerging-market money supply growth that was the basis for economic growth. In fact, it was the virtuous spiral of credit/money growth fueling economic growth that produced investor demand for emerging market bonds. Now, I fear, that process is beginning to reverse.
 
The reversal of this process means a reversal of the capital flows from emerging market back to the United States. The strength of the U.S. dollar and weakness in emerging market currencies is a reflection of the process reversing. What this means is that the world is beginning a global deleveraging on a scale that it has never experienced. One of the knock-on effects of this global deleveraging is a slowdown in China. I do not mean to suggest that the sky is falling, but markets do not like uncertainty and investors tend to shoot first and ask questions later. Therefore we are probably in for a lot more volatility.


This global deleveraging is the cause of all the market turmoil, including the problems in China.

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