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July-August 2013
The Currency Carry Trade Explained More Clearly, in More Detail and in
the Global Context

Tim Lee tim@pieconomics.com

Summary

• The US dollar carry trade has increased enormously since the 2007-9 financial crisis
because Fed policy has appeared to remove the risk of a strong dollar. In countries where
dollars have been borrowed heavily (the carry trade recipient economies) complacency
about exchange rate risk makes the cost of credit appear lower and therefore the overall
demand for credit higher for any given domestic interest rate.
• A model for the size of the US dollar carry trade based on global foreign exchange
reserves, the US current account deficit and the net foreign assets of US financial
corporations suggests that the dollar carry trade now is likely approaching US$2 trillion,
much higher than at the 2008 peak and higher now than at the 2011 peak.
• Net interbank claims of US banks on related foreign offices are a tiny part of the overall
dollar carry trade but empirically they seem to have been a leading indicator. I have not
been able to find any evidence to substantiate the leading nature of this indicator but
empirically it has continued to work and it has continued to deteriorate.
• The Turkish part of the carry trade is likely to be up to around US$250 billion in size,
accounting for 40-50% of overall credit to the private sector in Turkey and about 10% of
the outstanding dollar carry trade globally. Banks’ foreign currency domestic loans
exceed their foreign currency deposits. The increase in banks’ net foreign liabilities has
funded the difference and also funded their foreign currency reserve deposits at the
central bank. The net foreign assets of the whole system, including the central bank,
cover little more than one month’s current account deficit. At the same time, residents’
foreign currency deposits are well below normal levels. The central bank has no ability to
deal with a return to monetary instability that leads to capital outflows.
• BIS data for global bank net claims on each country reveal that Indonesia can now be
considered amongst the group of major carry trade recipient economies. In the post-2009
‘cycle’ global bank net claims on Indonesia have grown relatively more rapidly than for
the other recipient economies compared with the pre-2008 cycle. Since 2009 each of
Turkey, Brazil, India and Indonesia show a very similar pattern of behaviour for overall
credit growth and for growth of the carry trade, with carry trade-related credit growing
more rapidly than overall credit. A ball park estimate is that these four countries plus
Korea could account for about $1¼ trillion of the overall US$2 trillion carry trade.
• A carry trade collapse would mean an enormous credit crunch for these economies but
the ramifications will be much larger. It will mean a tightening of global credit and
monetary conditions to a greater degree than implied by the raw numbers, with first order
impacts on the US. It will reveal Turkey’s insolvency, pressuring IMF resources. Most
fundamentally it will undermine confidence in central bank policies.

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The Currency Carry Trade at the Macro Level

First, I apologize to those clients who were hoping for a piece on Japan. I will get around to
Japan as soon as I can but, despite having written so much on this topic of the carry trade, I felt
the need to do this, unusually long, ‘monthly’ for three reasons: 1) As a result of client feedback,
for which I am grateful, I have realized that my presentation of my work on the carry trade has
been a bit confusing and, as a result of this, not always convincing. Here I try to do a better, and
hopefully much clearer, job of putting all the pieces together and putting them in context; 2) I
have done quite a lot of completely new work which I think is very revealing and informative
and has broader implications; 3) I think this is the crucial issue right now. I think it is very little
understood, and given that I have done so much work on this topic I feel it is where I can provide
the most value-added to clients relative to my competitors.

In recent notes I have focused on data series that I consider to be indicative of the trend in the
carry trade but which are by no means measures of the size of it. I have focused on these series
because they are available in a timely fashion and I have felt this is important at what I consider
to be a critical juncture in terms of timing. But the drawback of this has been that some
perspective has been lost, making some of my notes confusing. Here I look at the carry trade
from the ‘top down’, starting with the broad measures of the dollar carry trade and putting the
shorter term indicators into perspective. In this ‘monthly’, for ease of understanding, I also
present all charts in the same way from the perspective of the carry trade – when the lines on the
charts are rising the outstanding carry trade is getting bigger.

To recap, I consider a currency carry trade to be any transaction/structure in which an investment


in or holding of an asset in one currency with a relatively higher prospective yield is financed by
borrowing in a different currency with a lower interest rate. This is broader than what some think
of as the ‘carry trade’, as being only speculative trades conducted by hedge funds or other
investment companies. My definition encompasses, for example, non-financial businesses in
emerging economies financing domestic investment by borrowing in dollars or other lower
interest rate currencies. It is possible to take an even broader view of the carry trade, including
non-leveraged investments in which an investor in one country buys an asset in another country
and currency rather than his own simply because it has a higher yield (Japanese institutions and
investors, for instance, have commonly done this). Although this does not involve borrowing it
does have the characteristic of assuming away currency risk, which is common to currency carry
trades.

The key, which defines a carry trade, is that at least part of the prospective return from the trade
or deal derives from the yield differential between the currency of the investment and the
financing currency, thereby implicitly depending on the failure of the higher interest rate
currency to depreciate in line with the interest rate differential, the latter being inevitable over
time if currencies move in line with purchasing power parity and according to the expectations
priced into forward exchange rates, given a condition of covered interest rate parity.

As I have noted before, the willingness to engage in currency carry trades tends to be related to
the overall willingness of market participants to engage in spread compression trades in general,
including those that result in the compression of credit spreads. What links them is central bank

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moral hazard. Pure currency carry trades should be unprofitable over time if markets are
efficiently priced but they can look very profitable if it is believed that central banks will try to
slow or prevent currency adjustments when they would otherwise occur, as indeed the Turkish,
Brazilian and Indian central banks have been doing very recently. Central bank intervention
gives the carry trader the time and ability to exit the trade with much of the interest rate pick-up
intact, ultimately to the cost of taxpayers in the countries with the interventionist central banks.
Similar can apply to yield spread compression trades in general.

The broader significance of currency carry trades is that they increase the demand for credit at a
given interest rate. For instance, imagine an entrepreneur in Turkey considering the viability of
different investment projects. The rates of return on the different projects look unattractive when
set against financing costs at Turkish interest rates. But if the entrepreneur is used to borrowing
in US dollars, at a lower interest rate, and is complacent about the inherent exchange rate risk,
then magically the projects can appear viable. In other words, central bank moral hazard, which
leads to complacency about exchange rate risk, means that demand for credit within Turkey can
be higher for any given Turkish interest rate. By the same token, a carry trade unwinding that
occurs as exchange rate risk aversion increases sharply must mean a contraction in credit and
tightening of monetary conditions.

The US dollar carry trade has increased enormously since the 2007-9 financial crisis because the
Fed’s commitment to very low interest rates and accommodative monetary policy has, at least
until recently, appeared to remove the risk of a strong dollar. Dollar financing, for those around
the world who can access it, has therefore seemed to be a very cheap source of funds. In
addition, the demonstrated willingness of the Fed to provide dollar financing via liquidity, or
currency, swaps, to other central banks has seemingly removed the risk to borrowers around the
world that dollar financing could be unavailable if and when financing has to be extended or
rolled over.

Although it is impossible to quantify the outstanding dollar carry trade in any exact way, because
the foreign (non-US) borrowing of dollars involves a cross-border flow there are many different
economic data series that are related to the carry trade that when looked at together can give a
strong clue to its development over time, if not its exact size. These include data for banks’
foreign assets and foreign liabilities (picking up foreign borrowing that occurs via the banking
sector), other available interbank data, balance of payments (capital flow) and foreign debt data.

In the case of the US, which has to be the ultimate provider of dollar financing for dollar carry
trades, a broad indicator for the carry trade can be derived by looking at the net foreign assets of
all US financial companies together with the US balance of payments, which would have to
reflect flows of dollar carry trade financing as a capital outflow. In the past, I often used the
IMF’s series for the net foreign assets of US financial corporations but for a long time the IMF
stopped updating this series. This has now changed and the data is now available again,
somewhat revised, up to the first quarter, and shown in the chart following. This series is for net
foreign assets, not merely net foreign lending, and will therefore include equity holdings. To this
degree, it will overstate the dollar carry trade, perhaps substantially. However, on the other hand,
there could be dollar carry trade transactions that are not included in this series because they do
not involve claims of US financial corporations. A Turkish or Brazilian company, for example,

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could finance a domestic investment by issuing a dollar corporate bond that is bought by a US
investor that is not a financial company. This would be a dollar carry trade but would not be
included within the net foreign assets of US financial corporations and therefore not picked up in
this series. It is unlikely that most US hedge funds are included within ‘US financial
corporations’. A US hedge fund could borrow dollars from a US financial corporation (which
would be a domestic loan and not a foreign asset for the US financial corporation) to finance the
purchase of a high yield domestic currency bond issued by a foreign entity. This would clearly
be a currency carry trade but would probably not be picked up in the series for net foreign assets
of US financial corporations.

Net Foreign Assets of US Financial Corporations (US$ billion)


2500

2000

1500

1000

500

0
Dec-01

Dec-02

Dec-03

Dec-04

Dec-05

Dec-06

Dec-07

Dec-08

Dec-09

Dec-10

Dec-11

Dec-12
Jun-02

Jun-03

Jun-04

Jun-05

Jun-06

Jun-07

Jun-08

Jun-09

Jun-10

Jun-11

Jun-12

Jun-13
So this series includes some things that are not dollar carry trade but excludes some things that
are. On balance, it might be reasonable to guess that it overstates the size of the dollar carry
trade, but probably not by much. It certainly seems to be a good directional indicator, and it is
notable that the mid-2011 peak was so much higher than the 2008 peak and the most recent data
suggest that the outstanding currency carry trade now is somewhat larger than at the mid-2011
peak. The latter is not what I had expected to happen; I argued that the 2011 peak represented the
final peak of the carry trade but the fact that it seems I was probably wrong about this can help
explain much of what else has happened in markets. The most recent data, showing net foreign
assets at US$2¼ trillion is, I think, consistent with my guesstimate that the outstanding dollar
carry trade is in the region US$1½-2 trillion in size – probably closer to US$2 trillion now. This
is substantially larger than estimates of the size of the outstanding yen carry trade at the 2007-8
carry trade peak. (I estimated US$ 1 trillion for the yen carry trade at the peak).

The increase in the net foreign assets of US financial companies in any period (the first
derivative of the line in the above chart) is a balance of payments capital outflow from the US
that ‘provides dollars’ to the rest of the world. It is not the only ‘provider of dollars’; there is US
corporate foreign direct investment, for instance. But, unlike Japan, the US is not a natural carry
trade funding country because it is a current account deficit economy. The current account deficit

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must be financed with a net capital inflow, not the outflow implied by the build-up of the dollar
carry trade. What makes the difference is the continuous accumulation of dollar assets
(Treasuries, agency securities, equities etc) by the overseas official sector – central banks, with
their foreign reserves, and sovereign wealth funds. As long as this is greater than the US current
account deficit then, simplifying, there is room for the build-up of the private sector dollar carry
trade. This is what I have called the ‘circular flow of dollars’.

The limitations of the data make necessary some major simplification and heroic assumptions.
Central bank foreign reserve data is available but the breakdown by currency is not
comprehensive and sovereign wealth funds are excluded. As already mentioned, there are
elements in the picture other than merely the current account, foreign reserves and financial
corporations’ net foreign assets. However, I have found a simplifying approach that makes use of
just these three elements.

The chart below shows the US current account deficit cumulated over time (i.e. a running total)
and the total of foreign reserves held by the world’s central banks.

Global Central Bank Foreign Reserves Compared With the US Cumulative


Current Account Deficit (US$ trillion)
14 -14

12 -12

10 -10

8 -8

6 -6

4 -4

2 -2

0 0

-2 2
Mar-60
Mar-62
Mar-64
Mar-66
Mar-68
Mar-70
Mar-72
Mar-74
Mar-76
Mar-78
Mar-80
Mar-82
Mar-84
Mar-86
Mar-88
Mar-90
Mar-92
Mar-94
Mar-96
Mar-98
Mar-00
Mar-02
Mar-04
Mar-06
Mar-08
Mar-10
Mar-12

Total world central bank foreign reserves


US cumulative current account deficit, inverted on right hand scale

In principle, the ability of the US to provide dollars to the rest of the world as carry trade funding
should be at least somewhat related to the difference between these two major elements, at least
in part for each element. So what I have done is a simple regression model that attempts to
explain the series for the net assets of US financial corporations (the earlier chart) from these two
balance of payments-derived factors. The model outcome is shown over the page and, as can be
seen, is pretty good.

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Estimates for the US Dollar Carry Trade (US$billions)
2500

2000

1500

1000

500

0
Dec-01

Dec-02

Dec-03

Dec-04

Dec-05

Dec-06

Dec-07

Dec-08

Dec-09

Dec-10

Dec-11

Dec-12
Jun-02

Jun-03

Jun-04

Jun-05

Jun-06

Jun-07

Jun-08

Jun-09

Jun-10

Jun-11

Jun-12

Jun-13
Net foreign assets of US financial corporations
Model based on global foreign reserves and US cumulative current account deficit

This chart is saying that we can mostly explain the outstanding dollar carry trade, as
approximated by the net foreign assets of US financial corporations, as a function of the
difference between global foreign reserves and the US current account deficit cumulated over
time. The difference between global foreign reserve accumulation and the US current account
deficit explains the largest part of the capital outflow from the US represented by the build-up of
the dollar carry trade. It is the foreign reserves accumulated by overseas governments and central
banks that are the major offset to the carry trade outflows from the US, given that the US is a
current account deficit economy and not a surplus country as Japan was in the era of the yen
carry trade.

To the extent that this simple model can be relied upon, it then enables a slightly longer historical
look at the dollar carry trade, or at least a very rough estimate for it, given that the data for US
financial corporations’ net foreign assets do not have a very long history. This is shown in the
chart below, covering the period since the beginning of the secular asset bubble.

Model Estimate of the Outstanding US Dollar Carry Trade (US$ billions)


2500

2000

1500

1000

500

0
Mar-93

Mar-94

Mar-95

Mar-96

Mar-97

Mar-98

Mar-99

Mar-00

Mar-01

Mar-02

Mar-03

Mar-04

Mar-05

Mar-06

Mar-07

Mar-08

Mar-09

Mar-10

Mar-11

Mar-12

Mar-13

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This chart shows clearly the peak in the dollar carry trade that occurred leading into the Asian
and LTCM crisis, with the decline continuing into the 2001-2 global recession. The dollar carry
trade unwinding that occurred in 2008 and 2011 seems to be underestimated by the model but I
believe that the relative size of the dollar carry trade at the successive peaks is likely fairly
accurately estimated by the model. (Also we must remember that in 2007-8 the unwinding of the
yen carry trade was at least as important as the unwinding of the dollar carry trade). Jumping
ahead of this ‘monthly’ temporarily, the chart below, in which I compare the development of the
model estimate with the total of bank net foreign liabilities for key emerging economy carry
trade recipients (Brazil, Turkey, Korea, Poland, Hungary) shows a gratifyingly close
relationship, giving a lot of credibility to this model estimate, in my view.

Indicators of Dollar Carry Trade (US$ billions)


2500 400

350
2000 300

250
1500
200

150
1000
100

500 50

0 -50

Model estimate of outstanding US dollar carry trade

Total of bank net foreign liabilities for Brazil, Turkey, Korea, Poland, Hungary (liabilities shown as
positive number)

EM bank net foreign liabilities are shown as a positive number on the right hand axis

The Interbank ‘Leading Indicator’ for the Carry Trade

Up to this point in this ‘monthly’ I have been focusing on the dollar carry trade from the US
lending side. When I have discussed the currency carry trade in the past, most of the time (not
all) I have been focusing more on data that looks at the carry trade from the borrowing country
side. Carry trade dollar lending could take the form of lending (from US institutions or entities)
to private non-banks (mostly companies), banks, or governments overseas. I tend to gloss over
foreign government dollar borrowing but as long as dollar financing is ultimately financing
higher yielding investments in a different currency then the dollar lending can be considered to
be carry trade. Dollar lending to banks outside the US could take the form of purchases of bank
debt or interbank loans. In this case of lending to non-US banks, the loans are in turn likely to be
funding for dollar loans that are being made by those banks to companies or other entities in their
home territories. This year I have been particularly focusing on one small element; bank-to-bank

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lending in the form of US banks’ net claims on ‘related foreign offices’, which is one line in the
weekly Fed report on US commercial bank assets and liabilities.

My attention to this has been mainly because this is a data series that is released weekly and is
very timely, and earlier this year I began to notice a potentially critical new development in this
series. The updated chart is below. From conversations with clients I realize that this chart has
caused some confusion and I want to point out two things about the construction of the chart:

US Banks' Net Claims on Related Foreign Offices (brt fwd 26 weeks) and Turkish
Foreign Reserves, weekly data
100 120

0 110

-100 100

-200 90

-300 80

-400 70

-500 60
October-07

October-08

October-09

October-10

October-11

October-12

October-13
April-07

April-08

April-09

April-10

April-11

April-12

April-13
January-07

January-08

January-09

January-10

January-11

January-12

January-13

January-14
July-07

July-08

July-09

July-10

July-11

July-12

July-13
US banks' net claims on related foreign offices (US$bn) brought forward 26 weeks
Turkey foreign reserves (US$bn) RHS

First, I derive the series (red line in the chart) by multiplying the series in the Fed release by
minus one i.e. I take the inverse. The series is net (i.e. the difference between assets and
liabilities for US banks) and the Fed places it on the liabilities side of the balance sheet whereas I
want to consider it as a net asset for US banks, not a net liability. Looked at my way, as in the
chart, the series has not often been positive (left axis). Mostly, and particularly now, it is sharply
negative. I have been asked: how can there be a carry trade if this series is negative? Firstly, we
have to remember it is only a tiny part of the overall dollar carry trade, at best. Secondly, and
more importantly, I believe that the totals of interbank assets and of interbank liabilities –
particularly liabilities – from which this series is calculated as a net balance are not all to do with
the carry trade. In particular, I think it is likely that the overseas ‘related foreign offices’ of US
banks maintain liquid claims on the US banks for clearing and other purposes, much as US banks
maintain reserve deposits at the Fed. This would be a continuously existing liability of the US
banks that would tend to make this series negative, other things being equal. My view – and this
is mostly empirical – is that large changes in this series, when they occur, are mostly to do with
developments in the carry trade. In other words, I view the absolute level of this series, in terms

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of the number on the axis, as unimportant; it is the change that counts. When it is falling sharply,
as now, it is pointing to carry trade contraction.

Second, in the chart I shift the series forward by six months because empirically I have found it
to be a leading indicator most of the time. I have been asked why does this chart show the carry
trade falling sharply now when my other charts show the carry trade still increasing and also why
should this particular series be a leading indicator for the carry trade? A small part of the answer
is to do with data timeliness. This series is right up to date while other carry trade indicators I
look at currently run up to April at best. I expect to see clear signs of carry trade contraction
when May and June data become available for those other indicators. However, this does not
answer the leading indicator question. In the chart I have shifted forward the net interbank claims
series by six months; implicitly I am saying that I can predict from this series that the carry trade
will still be contracting into next year.

Well, I cannot really, at least not from this chart alone. The lead time is variable – it was not six
months in 2008, as is clear from the chart – and I have chosen six months as having the look of
the best fit. But why should there be any lead time at all? As already mentioned, this net
interbank series is only a tiny part of the overall carry trade. For it to be a leading indicator
would imply that somehow it is more sensitive to developments that impact the carry trade as a
whole and that other, larger, parts of the carry trade must be lagging indicators. I have to admit
that this does seem a bit far-fetched. My argument has been entirely empirical and although this
may be unsatisfactory, it has worked well so far. I first pointed out in the March ‘monthly’ that
this interbank indicator had turned down and was pointing to coming carry trade contraction and
I backed that up in subsequent short notes. This turned out to be correct, leading me to wish that
I had put more weight on it before, which might have prevented me from making previous
premature forecasts of the carry trade’s demise.

Having said that, though, I have been looking in depth at banking data, particularly for Turkey,
trying to find some convincing evidence, from the carry trade recipient side, that international
interbank positions lead the broader carry trade. I have to report that I have not found this
evidence, at this point casting some doubt on my ‘leading indicator’. The Turkish banking data is
very informative though, and because I think Turkey will prove to be crucial, I cover the data in
the following section.

Carry Trade Unravelling Will Expose Turkey’s Fundamental Insolvency

I first made the argument that Turkey is insolvent and will require an international bailout in a
note on December 1st, 2011 (‘Turkey Will Require a Large Bailout’, December 1, 2011). At that
time I estimated that a bailout would be at least US$100 billion. Subsequently, the credit rating
agencies upgraded Turkey to investment grade, the bubble became even bigger and I increased
that estimate. I did accept, in my April ‘monthly’ this year, that the scale of commodity price
collapse that will likely accompany carry trade unraveling will lead to a dramatic improvement
in Turkey’s current account that will hasten Turkey’s adjustment and perhaps reduce the
necessity for an even larger bailout. Nevertheless, I am still confident that a Turkish debt write-
down and bailout will take place.

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The Turkish data provide a good illustration of how the carry trade fits into the broader financial
picture, with the caveat that, as I keep reminding, there are no exact measures. There are, I
believe, three major elements to the Turkish carry trade; Turkish entities’ (companies and
individuals) foreign currency borrowing from Turkish banks, Turkish entities’ foreign currency
borrowing directly from overseas banks, and foreign investor purchases of Turkish debt
instruments, both foreign currency and domestic currency. The data for all three components,
particularly the latter, can include non-carry trade elements and the sum of the three components
could involve some double counting. The carry trade components may not all be dollar carry
trade – there could be other currencies, such as the euro, involved. In the chart below I show two
of these components – domestic foreign currency credit extended by Turkish banks (I am using
the data for deposit money banks – i.e. commercial banks - only) and outstanding portfolio debt
liabilities held by foreigners, calculated cumulatively from the balance of payments rather than
using the debt data directly.

Two of the Major Components of the Turkish Carry Trade (US$ billion)
140

120

100

80

60

40

20

0
Dec-05

Dec-06

Dec-07

Dec-08

Dec-09

Dec-10

Dec-11

Dec-12
Aug-06

Aug-07

Aug-08

Aug-09

Aug-10

Aug-11

Aug-12
Apr-06

Apr-07

Apr-08

Apr-09

Apr-10

Apr-11

Apr-12

Apr-13
Foreign currency credit extended by Turkish banks (US$ billion)
Portfolio debt outstanding (calculated cumulatively from bop, US$ billion)

In the latest data the sum of these two components comes to roughly US$250 billion. Given that
we are missing one component here, but there is double counting and the other factors I mention,
I would hazard a guess that the total Turkish dollar carry trade outstanding is roughly in the ball
park of this number. That would mean that the Turkish carry trade represents very roughly 10%
of the outstanding global dollar carry trade based on my earlier estimate of the total.

The foreign currency credit extended domestically by Turkish banks bears the closest
relationship to my model estimate of the outstanding dollar carry trade globally (bottom of page
6), as shown in the chart over the page.

Turkish residents have historically always held foreign currency deposits, particularly dollars, in
the Turkish banks, a legacy of Turkey’s high inflation history. At the same time the Turkish
banks hold large dollar reserve deposits at the central bank. I have discussed these complicating

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factors in notes before but I have tended to focus on the ‘gross’ numbers for central bank foreign
reserves, bank foreign currency lending and bank net foreign liabilities, principally because of
comparability with other carry trade economies that I include together with Turkey in my charts.
But I notice that in recent media reporting, the ‘net’ number for foreign reserves has most often
been referred to, so it is worth looking at the total picture here.

Turkish Banks' Foreign Currency Lending and Estimate of Global Dollar


Carry Trade
120 2300

110 2100

100 1900

90 1700

80 1500

70 1300

60 1100

50 900

40 700

30 500
Dec-05

Dec-06

Dec-07

Dec-08

Dec-09

Dec-10

Dec-11

Dec-12
Aug-06

Aug-07

Aug-08

Aug-09

Aug-10

Aug-11

Aug-12

Aug-13
Apr-06

Apr-07

Apr-08

Apr-09

Apr-10

Apr-11

Apr-12

Apr-13
Foreign currency credit extended by Turkish banks (US$ billion, left axis)
Estimate of outstanding global dollar carry trade (US$ billion, right axis)

The chart below shows Turkish deposit money banks’ outstanding foreign currency credit and
foreign currency deposits, in billions of US dollars:

Turkish Deposit Money Banks Foreign Currency Credit and Deposits


(US$ billion)
140

120

100

80

60

40

20

0
Dec-05

Dec-06

Dec-07

Dec-08

Dec-09

Dec-10

Dec-11

Dec-12
Aug-06

Aug-07

Aug-08

Aug-09

Aug-10

Aug-11

Aug-12
Apr-06

Apr-07

Apr-08

Apr-09

Apr-10

Apr-11

Apr-12

Apr-13

Foreign currency credit outstanding Foreign currency bank deposits

At face value it might be tempting to interpret this as a positive picture; banks’ foreign currency
assets, in the form of domestic loans, now exceed deposit liabilities. This would be a wrong
interpretation. A factor that is not appreciated is that foreign currency deposits which, as the

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chart shows, have barely been increasing, are now far below historic norms relative to total
money supply. The serious risk here is that once monetary instability returns, Turkish residents
will attempt to rebuild foreign currency deposits, requiring banks to obtain foreign assets,
resulting in huge capital outflow. I discussed this in detail as long ago as the September 2010
‘monthly’ and revisited the issue in the ‘bailout’ note of December 2011. At that time I argued
that this kind of scenario would result in a collapse of the lira exchange rate to at least TRY3.6 or
a capital outflow of at least US$30 billion, or some combination of both, being necessary to
restore foreign currency deposits to something closer to their historic levels relative to the money
supply and the economy.

Given that the commercial banks also have, now very large, foreign currency reserve deposits at
the central bank, there is an obvious ‘funding gap’ between their total foreign currency assets,
including the foreign currency lending, and their foreign currency deposits. This is filled by net
borrowing from abroad; the net foreign liabilities that I show in my regular carry trade chart for
the major carry trade recipient economies.

Here I show the data for only the commercial banks (deposit money banks). This represents most
of the banking sector, but not quite all of it. The data I show in my regular charts is for the total
banking sector.

The data suggests to me that the larger part of the foreign borrowing by the Turkish resident
banks is from their own branches abroad. This comparison is shown in the chart below.
Presumably some of these branches would be US-based, providing the link to the US banking
system that comes through in my US carry trade charts.

Turkey Deposit Money Banks Net Foreign Liabilities and Borrowing from
Overseas Branches (US$ billion)
120 -120

100 -100

80 -80

60 -60

40 -40

20 -20

0 0

-20 20

Turkish bank branches abroad foreign currency claims on domestic banks (left axis)
Net foreign liabilities (right axis)

The following chart shows the bank net foreign liabilities again (blue line in the chart above),
together with bank holdings of foreign currency reserve deposits at the central bank and central
bank gross foreign reserves. Foreign currency reserve deposits have risen sharply in the past
couple of years because of central bank regulatory changes. In the statistics they do not count as

pi Economics July-August 2013 12


foreign assets for the banks because for the banks they are a claim on a domestic institution (the
central bank), not a foreign one. However, an alternative way of looking at it would be to
consider that these foreign currency reserve deposits are really only, in effect, foreign assets that
the central bank is holding on trust for the banks. (I do not know about the actual legal position
on this issue). Looked at this way would make the banks’ net foreign liabilities much smaller but
by the same token would make the central bank’s true foreign reserves much smaller also. This is
the picture shown in the second chart, below.

Turkey Banking System Foreign Assets/Liabilities (US$ billion)


120 -120

100 -100

80 -80

60 -60

40 -40

20 -20

0 0

-20 20

Banks' foreign currency reserve deposits at central bank


Central bank gross foreign reserves
Bank net foreign liabilities (right axis)

Turkey Banking System Net Foreign Assets/Liabilities (US$ billion)


70 -70

60 -60

50 -50

40 -40

30 -30

20 -20

10 -10

0 0

-10 10

-20 20

-30 30

Central bank 'net' foreign reserves


Banks' 'net' net foreign liabilities (net of reserve deposit at central bank) (rhs)

pi Economics July-August 2013 13


I have always looked at these numbers in ‘gross’ terms – as in the chart on page 8, showing gross
foreign reserves, released weekly and currently at US$103 billion according to the latest data.
However, I have noticed that in media and analyst comment on the present Turkish situation the
figure for foreign reserves routinely quoted is US$40 billion, which would be the ‘net’ number,
net of bank foreign currency deposits at the central bank. This is the number in the chart shown
at the bottom of the previous page. It is interesting that, looked at this way, the series for central
bank foreign reserves and bank net foreign liabilities both peak in the spring of 2011, which is
when I always argued that the carry trade peaked. However, in the case of Turkey this is not
what the broader measures, shown in the chart on page 10, suggest; they would say that the carry
trade is at a peak now.

However we look at it, it is quite clear that if we add the central bank and the commercial banks
together (the gap between the two lines in the previous chart), the net foreign assets of the whole
system are pretty minimal – barely more than one month’s current account deficit at recent rates.
The central bank has no ability to deal with a run on the currency that sees a capital stop and an
attempt by Turkish residents to restore foreign currency deposits to normal levels. It will be
relying on liquidity swaps from the Fed but the Fed, in turn, will have to be willing to keep
extending dollar credit to a country that is insolvent – and has been for some time, whatever the
rating agencies say.

I always argued that the carry trade could end in one of two ways: one way is that foreign
creditors simply cut off funds; the second way is that demand for credit in recipient countries
weakens to the extent that there is no demand for funds - even at the low level of US interest
rates demand for credit dries up. In this second case, the recipient currencies would then weaken
because there would be no natural financing for current account deficits. The weakening of the
currency feeds back into further carry trade contraction because it reawakens currency risk
aversion (given that complacency about exchange rate risk is necessary for the carry trade to
exist in the first place). I also argued that the second possibility is more dangerous because the
first possibility – which is what happened in 2008 – is likely to be addressed via central bank
liquidity swaps i.e. in this case, the Fed providing the dollars that the private markets are no
longer willing to supply. Of course, that is exactly what the Fed and other central banks did in
2008, the moral hazard of which then encouraged the carry trade to become even larger
subsequently.

The Bank for International Settlements produces data for the total of all credit (bank and non-
bank, including from overseas) extended to the private non-financial sectors of the 40 major
economies. In the chart following I compare the annual growth rate of the total credit series for
Turkey (underlying data in lira terms) with the growth rate of my estimate of the total carry trade
(based on the series shown in the chart on page 10). Unfortunately, the data history for my carry
trade estimate is short, so the chart only goes back to 2007. The BIS total credit data only runs up
to the end of 2012 currently. Based on my estimate, at the end of 2012 roughly 40-50% of the
total credit extended to the Turkish private sector would be carry trade-related i.e. the extension
of the credit is reliant on the lower level of foreign, particularly, US interest rates.

Although we have BIS data only up to the end of 2012 it seems most likely that the total credit
series will have decelerated further in 2013 even as the carry trade has accelerated. This parting

pi Economics July-August 2013 14


of company between the two series dates clearly to mid-2012 – something that comes across in
other charts that I have shown in the past – which is when global central bank ‘unconventional
monetary policies’ went into overdrive. In other words, the opposite of my second scenario for
the ending of the carry trade is what has happened since the middle of last year. Even as credit
demand has weakened in Turkey, the policies of the major central banks, together with the rating
agencies, have encouraged even more foreign credit to be thrown in Turkey’s direction, leading
to a greater proportion of decelerating credit in Turkey being carry trade related. As the chart
shows, this is a different backdrop from 2008 and a much more dangerous one. If, as I suspect,
the carry trade is now on the verge of implosion, it will mean a massive credit crunch for Turkey.

Turkey Carry Trade Related Credit and Total Credit (%yoy of Lira data)
70

60

50

40

30

20

10

0
Dec-07

Dec-08

Dec-09

Dec-10

Dec-11

Dec-12
Sep-07

Sep-08

Sep-09

Sep-10

Sep-11

Sep-12

Sep-13
Jun-07

Jun-08

Jun-09

Jun-10

Jun-11

Jun-12

Jun-13
Mar-07

Mar-08

Mar-09

Mar-10

Mar-11

Mar-12

Mar-13
-10

-20

-30

Outstanding Turkish carry trade related credit %yoy (pi Economics estimate)
Total credit of all types to the private sector (BIS estimate)

In the last 2-3 weeks, as Bernanke has calmed nerves in the markets, there has been the sense
that the carry trade is picking up again. I do not see how this can last. To use the old cliché,
Turkey is like the cartoon character run off the edge of the cliff, only it ‘ran off the edge of the
cliff’ a long time ago now, and it is a very long way down from here.

The Carry Trade in the Broader Context; BIS Data

Quite a few years ago now I did two or three studies of the IMF data for bank net foreign
liabilities for all countries to determine which countries would be most vulnerable to dollar carry
trade contraction. This was subject to the limitations of the IMF data which, for example, do not
include the relevant data for India. With the addition of India later, amongst the emerging
economies, I concluded that Turkey, Brazil, India and Korea were the four key countries and I
use, for example, the aggregate of foreign reserves for these four countries in one of my regular
carry trade indicator charts. (Poland and Hungary I also include in various charts but they are
more euro and Swiss franc based carry trade, rather than dollar).

pi Economics July-August 2013 15


Now, in May and June, the market has, in a sense, spoken and the key countries are Turkey,
Brazil, India and possibly Indonesia. Indonesia did not come out of the earlier studies because
the Indonesian banking sector had net foreign assets until mid-2011 and even now Indonesian
bank net foreign liabilities are not large. Korean bank net foreign liabilities remain large but, as I
have noted in previous work and has been clear in my regular charts, they have been coming
down since 2008 partly because of regulatory action by the Korean authorities.

The BIS produces data, which I have used before, which is broader in scope – reporting the
global banking system’s net exposure to each country individually not just the net foreign
liabilities of the banks of each country – with the drawback that the data is only quarterly and is
less timely (up to the final quarter of 2012 at the moment). This data potentially can pick up
more of the carry trade than simply bank net foreign liabilities. For instance, if a Turkish
company borrows dollars directly from the overseas branch of a Turkish bank the BIS data will
include this but it will not be included in the IMF-based measure of bank net foreign liabilities
because no domestic Turkish bank is involved in this particular transaction.

Global Banks' Net Claims on Carry Trade Recipients (US$ billion)


250

200

150

100

50

0
Sep-01

Sep-02

Sep-03

Sep-04

Sep-05

Sep-06

Sep-07

Sep-08

Sep-09

Sep-10

Sep-11

Sep-12
Mar-01

Mar-02

Mar-03

Mar-04

Mar-05

Mar-06

Mar-07

Mar-08

Mar-09

Mar-10

Mar-11

Mar-12

Mar-13
-50

Brazil Turkey India Korea Indonesia

On this chart the difference in trend between Korea and the other four is very clear. The pattern
of developments for the other four countries is almost identical, bearing in mind that the chart is
showing absolute dollar levels and the size of the various economies is different. I am not
meaning to sound the ‘all clear’ on Korea but this does go along with one of the conclusions of
the April ‘monthly’, on the impact of carry trade unwinding as it affects commodity prices,
which was that Korea is the best positioned amongst the carry trade recipient countries.

To illustrate the similarity of trend for the other four economies, and focusing on Indonesia, in
the chart following I show Turkey and Indonesia together but on different scales (left and right
axes) to align the series. This is circumstantial evidence that Indonesia should be viewed as a
carry trade recipient, in the same light as the other countries. But, as already mentioned, the size
of Indonesia’s bank net foreign liabilities is much smaller, both absolutely and relatively, and the

pi Economics July-August 2013 16


persistent weakness of the Rupiah goes back well before the episode of carry trade unwinding
that took place in May and June.

Global Banks' Net Claims on Turkey, Indonesia (US$ billion)


160 60

55
140
50
120
45
100
40

80 35

30
60
25
40
20
20
15

0 10
Sep-01

Sep-02

Sep-03

Sep-04

Sep-05

Sep-06

Sep-07

Sep-08

Sep-09

Sep-10

Sep-11

Sep-12
Mar-01

Mar-02

Mar-03

Mar-04

Mar-05

Mar-06

Mar-07

Mar-08

Mar-09

Mar-10

Mar-11

Mar-12

Mar-13
Turkey (lhs) Indonesia (rhs)

This BIS data for global bank net claims on the country, needless to say, is not the same as the
carry trade. For instance, in my attempt to estimate the Turkish carry trade, in the charts on pages
10 and 15, I include portfolio debt liabilities held by foreigners. These foreigners may well be
non-banks. A classic carry trade, in the minds of most observers, would be a leveraged bet in
Turkish credit taken by a hedge fund – but this would not be included in the BIS data for global
bank net claims on Turkey. That having been said, the BIS data likely gives a decent read on the
trend and it is useful to compare it with the BIS’s own data for total credit extension for each
country. In the charts following I compare the annual rate of growth of total credit and of global
bank net claims for each of Turkey, Brazil, India and Indonesia.

Turkey: The Carry Trade and Credit (%yoy of dollar data)


80

60

40

20

-20

-40
Sep-02

Sep-03

Sep-04

Sep-05

Sep-06

Sep-07

Sep-08

Sep-09

Sep-10

Sep-11

Sep-12
Mar-02

Mar-03

Mar-04

Mar-05

Mar-06

Mar-07

Mar-08

Mar-09

Mar-10

Mar-11

Mar-12

Mar-13

Total credit to private sector %yoy Global bank net claims on Turkey (%yoy)

pi Economics July-August 2013 17


These charts are all in dollars and therefore the annual growth rate is impacted by exchange rate
movements which at certain times have been severe. Bearing all this in mind, the chart on
Turkey (bottom of previous page) gives a similar message to the chart on page 15, in which I
compare the growth of total credit with the growth of pi Economics’ estimate of the carry trade
(over a shorter time frame). The chart using the BIS data goes only to the end of 2012 whereas
my own estimates suggest the carry trade accelerated in early 2013. The picture then is that for
most of the time in this ‘cycle’ the growth of the carry trade has exceeded the growth of total
credit.

Brazil: The Carry Trade and Credit (%yoy)


160
140
120
100
80
60
40
20
0
-20
-40
-60
Sep-02

Sep-03

Sep-04

Sep-05

Sep-06

Sep-07

Sep-08

Sep-09

Sep-10

Sep-11

Sep-12
Mar-02

Mar-03

Mar-04

Mar-05

Mar-06

Mar-07

Mar-08

Mar-09

Mar-10

Mar-11

Mar-12

Mar-13
Total credit to private sector %yoy Global bank net claims on Brazil (%yoy)

Based on the BIS data, the same seems likely to have been true in Brazil – the data is very
similar over the current cycle. (The difference looks less on the chart only because the scale of
the Brazil chart covers a wider range).

India: The Carry Trade and Credit (%yoy of dollar data)


80

60

40

20

-20

-40

Total credit to private sector %yoy Global bank net claims on India (%yoy)

pi Economics July-August 2013 18


Indonesia: The Carry Trade and Credit (%yoy of dollar data)
80

60

40

20

0
Apr-04

Apr-09
Sep-04
Feb-05

Sep-09
Feb-10
Jun-03

Jun-08

Jun-13
Jul-05

Jul-10
Mar-02

Mar-07

Mar-12
Dec-05

Dec-10
Oct-06

Oct-11
Aug-02

Aug-07

Aug-12
Jan-03

Nov-03

Jan-08

Nov-08

Jan-13
May-06

May-11
-20

-40

Total credit to the private sector %yoy Global bank net claims on Indonesia (%yoy)

For India (bottom chart of previous page) the same pattern also holds true. For Indonesia (chart
above) the more rapid growth in global bank net claims post-2009 relative to before is notable.
This is consistent with the bank net foreign liabilities data, already referred to, which suggests
that the appearance of a substantial dollar carry trade is a more recent phenomenon in Indonesia.

As already mentioned, global bank net claims on a country are by no means a comprehensive
measure of the carry trade. My own estimate for the Turkish carry trade is about 75% bigger than
the size of global bank net claims on Turkey. If the same very roughly held true for the other
countries – there is no necessary reason why it should but it makes for an interesting back-of-the-
envelope estimate – then it would suggest that the carry trade could make up between a quarter
and a third of total credit extension to the private sectors of each of Brazil, India and Indonesia. It
would also suggest that for the five countries Turkey, Brazil, India, Korea and Indonesia the total
carry trade could be as much as $1¼ trillion, leaving up to US$750 billion accounted for by all
other countries.

The collapse of the dollar carry trade will obviously be a disaster for these countries, creating a
huge credit crunch in their economies. But why should it matter – as I contend it does – for the
rest of the world? Based on the BIS data it can be estimated that total credit extension to the
private sector for the whole world economy is roughly around US$100 trillion. A halving of the
US$2 trillion carry trade would therefore reduce total global credit by only about 1%, seemingly
a relatively trivial amount. It is easy to understand why the majority of Wall Street participants,
even if they understood these issues – which they do not - would find all this fairly irrelevant.

In my view, there are four reasons why the dollar carry trade is critical and its unwinding will
have ramifications far beyond the relatively small number of countries in which it has played a
very large role in credit creation:

pi Economics July-August 2013 19


1) The impact on global credit and money of a major carry trade unwinding will be larger than
the simple arithmetic suggests. As I started by explaining, the existence of the carry trade shows
that the perceived cost of credit is lower than the true cost of credit. A carry trade unwinding
therefore raises the perceived cost of credit and tightens money and credit conditions. This
extends to more than just the countries for which the carry trade is largest. As long as the carry
trade is growing rapidly, as it has been, it contributes to global credit growth. Its unraveling can
result in an outright reduction in global credit. The impact on global credit growth is larger than
the simple ratio of the carry trade to total global credit would suggest, and will be occurring at a
time when global money and credit growth is already low by historic standards. On top of that,
as we are already seeing, currency weakness in the most impacted countries leads central banks
in those countries to raise interest rates and/or take other tightening measures, adding further to
credit and money restriction.
2) There is a direct effect for the US. As I have emphasized in my short notes, to the extent that
the US banking sector plays a role in the extension of dollar carry trade credit then a contraction
of the carry trade acts to reduce US money supply growth. On top of that, because the carry trade
represents a large global short dollar position, its unraveling must drive up the dollar, potentially
extremely sharply. A much stronger dollar and a reduced rate of monetary growth cannot help
but be a major negative for a US economy that is already barely growing.
3) Against a background of a weak global economy and weak credit and money growth there
will be serious contagion effects. Turkey’s insolvency will finally be revealed. At a time when
the other impacted emerging economies will also be in difficulty, an IMF bailout will stretch
IMF resources. This will also have ramifications for the Eurozone, where it is now becoming
recognized that further bailouts will be needed.
4) From a much broader perspective, the currency carry trade is the visible manifestation of the
Fed’s moral hazard creating policies. The commonly held view is that the Fed is pumping vast
quantities of money into the markets and that is driving them up. In reality, money and credit are
growing only fairly slowly in the US and slower still in Europe. It is more the idea that central
banks will not tolerate declining asset prices that is causing them to be bid up, more than the
amount of money per se. Central banks have created the sense that rising stock markets are a
one-way bet, but this is taking place against a background of limited liquidity and deficient
savings in the broader economy. At the margin the growth of the currency carry trade has been
an important contributor to that limited amount of liquidity and therefore an important part of the
transmission mechanism from central bank policy stances to rising asset prices. Without it, there
is little to keep asset prices up and it will be much easier than market participants realize for
sentiment to shift from seeing central banks as all-powerful to perceiving them instead as being
impotent in the face of severe deflationary pressure and crashing markets.

Well I Told You Once and I Told You Twice

This could be the last time – in fact it will be the last time – that I include the forecast box in the
‘monthly’. For some years the feedback from my clients on these forecasts has been negative;
clients have told me that they distract from the work and are likely detrimental to my business.
From my perspective, they were meant to encapsulate in just a few numbers the essence of the
big picture view that comes out of my work. But, of course, the pi Economics’ research covers a
lot more than the currencies and the US market that I include in the forecast. This year, although
I have continued to be wrong about US equities, I could claim that I have correctly pointed to

pi Economics July-August 2013 20


imminent problems in Brazil, Turkey, that I pointed to the improved outlook for Hungary
relative to Poland and the other emerging markets, that I was correct (in the May ‘monthly’)
about the European crisis reemerging in Portugal, as seems to be happening, that I have been
more right than wrong on the US dollar and gold. But being so wrong on the S&P forecast
arguably diminishes the value of all my other work.

It has been put to me that it would be more useful, from an asset allocation perspective, if I could
somehow summarize and distil the work that appears in the ‘monthlies’ and my other notes on
the markets/economies that I cover down to a page or so ‘forecast’, which at least makes clear
my relative expectations for each of the markets/asset classes that I cover, possibly with a ‘bullet
point’ comment. I am going to attempt to do this, on a monthly basis, beginning shortly.
Ultimately I will likely incorporate it in the ‘monthlies’ but I will probably produce it as a
separate note initially.

In the meantime this is the final forecast in the old form. If I continued to produce them, they
would be likely to remain the same now, anyway. They reflect my expectation that we must have
a severe deflation shock coming, and that the timing is difficult but it could happen at any time
and is likely to be very violent when it does. I have been expecting this for at least three years
and it has not happened, but the way that markets and economies have developed over these
three years only serves to make it more likely, and not less, in my view. I know these forecasts
look extreme and ridiculous in the eyes of most but in a deflation shock of the severity I expect
they are unfortunately very plausible. The unraveling of the currency carry trade, which I have
discussed again in this ‘monthly’, is a central part of this expectation and I believe the evidence
says that it has already begun, which makes the one year horizon perhaps – finally - realistic.

Now (July 23, 13) 12 mths out change

S&P 500 1692 500 -70%

10yr Treasury* 2.5% 1.2% -130bp

$/Euro* 1.32 0.8 -39%

Yen/$ 100 70 43%

$/Pd 1.54 1.20 -22%

Gold 1,343 450 -66%

DISCLAIMER: The data presented in this document, and on which the analysis is based, comes from sources that
we believe to be reliable, but neither pi Economics nor its members can be held accountable for any inaccuracies in
that data. All forecasts and statements about the future, even if presented as fact, should be treated as judgments, and
neither pi Economics nor its members can be held responsible for any failure of those judgments to prove accurate.
It should be assumed that pi Economics, LLC and the members of pi Economics, LLC hold investments in securities
and other positions, in equity, bond, currency and commodities markets, from which they will benefit if the forecasts
and judgments about the future presented in this document do prove to be accurate.

pi Economics July-August 2013 21