The New Chinese Carry Trade

The old Japanese carry trade, many a speculator’s bankroll in the glory days between 2003 and 2007, is dead, buried, and gone, a casualty of the crisis.

But I believe that it has now been replaced, on a much larger scale, having much more of an impact, helping fuel yet another asset value spec frenzy on a scale that is more dangerous than the last.

Our regulatory authorities are, of course, oblivious.

This new carry trade I will call the Chinese Carry Trade, although it may be more accurate to call it the overseas-trading-partner carry trade.

I should warn that below I am not going to make an iron-clad empirical case. Most of the evidence that I have pulled together is indirect. This will be the first of two or more posts, this one laying out the theory, later posts offering some of the evidence and more detailed support.

The Old Japanese Carry Trade

In the old Japanese carry trade, speculators with connections would borrow copious amounts of money from Japanese banks, short term (on essentially commercial paper terms), at very low interest rates (below 1%), exchange yen for the dollar, invest or lend in the U.S. at higher returns with typically longer duration, which required that short-term Japanese loans be rolled over.

Obviously speculators tapping into the Japanese carry trade faced exchange rate risk. But the Yen rose on net between 2003 and 2007. From January 2005 until June 2007, probably the hottest period for the Japanese carry trade, the Yen rose from about 103 to nearly 125, adding leverage to the gains already made on interest rate spreads.

A simple example: borrow a billion yen at 0.5%, at an exchange rate of 100, convert to 10 million dollars, lend at 4.5% for a year, convert the 10.45 million dollars at a new exchange rate of 120, receive 1.254 billion yen, pay interest charges of 5 million yen, leaving a profit of 249 million yen, a return of 25% on the borrowed money and an astronomical rate of return on the much narrower equity base used to secure the loan.

Independent of the crisis, the Japanese carry trade was doomed once the dollar began to plunge from its June 2007 high to its current level of around 95. Any interest rate spread profits would be wiped out by exchange rate losses.

Sterile Dollars in China

The China carry trade works a little differently. First, dollar-denominated financial assets flow to China in exchange for merchandise flowing this way, a consequence of our massive merchandise trade deficit with China

See the chart labeled Merchandise (Goods) Trade Deficit with China, which shows our merchandise (goods) trade deficit with China for the last 10 years. In recent years we have been running a merchandise deficit of around $250 billion annually. (We ran a services surplus with China of about $7 billion in 2009, trivial when compared to goods).

Most of those bookkeeping-entry dollars, initially in the hands of Chinese manufacturers and merchandisers, are swapped at banks and ultimately the People’s (PBC) Bank of China for the renminbi at the current fixed exchange rate of 6.83. Dollars in China in some form or another now exceed $2 trillion.

For much of it, at some point, the PBC converts the sterile dollars to low-yield U.S. Treasury Securities by indirectly participating in U.S. Treasury auctions.

But not all of it ends up held as U.S. Treasury Securities. Without doubt some of it stays in dollar bookkeeping-entry form (as a dollar-denominated bank debit in China or elsewhere) whereupon it can be leant to … well, anyone who has sufficient connections and business interests and who want to borrow dollars for whatever reason they want to borrow them.

That might include Chinese speculators, both in China and overseas, who would use this funding to buy U.S. residential real estate or stocks, either in the U.S. market or any other market that accepts dollars.

If this is happening, note that there is no exchange rate risk because the originating loans can be paid back in dollars (unlike the Japanese carry trade, where the loans had to be paid back in Yen).

The Connection to Stock Market Bull-Creep

I think this is happening, and I think that the phenomenon, in addition to funding much of the foreclosure real estate sold through auctions, is creating a steady demand flow for U.S. stocks and is contributing to the current bull-creep. (I do not believe that this is the only reason for the bull-creep).

But am I right? Is this happening? If so the evidence is all indirect and not very compelling. I admit that. For one thing the Bank of China is not very opaque. Their public data are not very good and I don’t believe all of it.

But I will continue to investigate this and will relay what I discover.

Do any of you agree with me? Have you seen any evidence of this? For those of you with China connections, do you know of any specific transactions that fit the scenario described above? If so I would sure like to hear about it, either in comments or by email.