Yen Carry Trade
The yen carry trade is a financial strategy in which investors borrow money in Japanese yen at near-zero interest rates and use the proceeds to invest in higher-yielding assets in other countries. The profit is the spread between the near-zero borrowing cost in Japan and the higher return earned abroad. In the 2000s, this mechanism channeled enormous sums of Japanese capital into US financial markets, inflating the conditions for the 2008 crisis.
Japan entered a prolonged deflationary period after its own real estate and stock market collapse in 1991. To combat deflation, the Bank of Japan kept interest rates near zero for years, hoping to stimulate domestic lending and spending. Japanese financial institutions borrowed at these rates but, rather than lending domestically into a stagnant economy, deployed the capital into US treasury bonds and other dollar-denominated assets offering returns of 4 to 5 percent. Borrowing at 0 percent and lending at 5 percent is an almost risk-free profit, as long as the exchange rate remains stable.
The yen carry trade became a massive channel of capital movement. Enormous sums flowed from Japan into the US financial system, adding to the liquidity already entering from GCC oil revenues, Chinese trade surpluses, and European pension funds. All of this foreign capital needed somewhere to go, and Wall Street obliged by creating ever more complex financial products, including the CDOs backed by subprime mortgages, to absorb and generate returns on this flood of investment.
The structural danger of the carry trade is that it is self-reinforcing on the way up and catastrophic on the way down. As long as the yen remains weak and US assets rise, the trade generates easy profit. But if either condition reverses, the unwinding is violent. Borrowers must sell their US assets to repay yen-denominated loans, which crashes the assets they are selling, strengthens the yen, which increases the cost of repaying the loans, which forces more selling. This dynamic played out sharply in 2008 and again in brief episodes in subsequent years.
The yen carry trade illustrates how the global financial system, coordinated through exchange rates and central bank policy, channels capital from one part of the world economy to another in ways that are largely invisible to ordinary participants. Japan's domestic deflation problem was the proximate cause, but the effect was to funnel Japanese savings into speculative American mortgage markets, socializing the eventual losses across millions of people on both sides of the Pacific who had no idea they were connected.
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Frequently asked questions
What is the yen carry trade? ＋
The yen carry trade involves borrowing Japanese yen at near-zero interest rates and investing the money in higher-yielding assets in another country, typically the US. The profit is the interest rate difference. In the 2000s, Japanese institutions borrowed at 0 percent from the Bank of Japan and bought US treasuries at 5 percent, channeling vast sums into American financial markets.
Why is the yen carry trade dangerous? ＋
The carry trade is stable until it is not. When confidence breaks, everyone must sell their foreign assets simultaneously to repay yen loans. That selling crashes the assets, strengthens the yen, makes the loans more expensive to repay, and forces more selling. The unwinding is fast and severe. In 2008, the collapse of yen carry trade positions amplified the global financial crisis and spread losses into markets far removed from US mortgages.