LONDON: Emerging economies may be on the cusp of a great unwinding of borrow-low invest-high carry trades, through which an estimated $2 trillion has flooded mainly into their debt markets in the past five years.
The latest cycle of carry trades is the third in little over two decades and its estimated size is roughly double that of its predecessor. A reversal poses a specific risk to debt markets, especially in China, where investors who facilitated a corporate lending binge face both currency and credit losses.
With investors demanding higher compensation for growing political and economic risks, even aggressive interest rate hikes by emerging market central banks defending their currencies may not be enough to keep the carry party swinging.
Since the Federal Reserve started offering cheap money under its quantitative easing policy in late 2008, emerging banks and corporates have issued substantial volumes of foreign currency-denominated bonds and borrowed heavily from overseas banks.
According to Bank of America Merrill Lynch, external bond issuance from emerging markets more than doubled to $2 trillion in the five years to end-September 2013. Including bank loans, EM had attracted investment from abroad totalling $5 trillion by autumn 2013, nearly $2 trillion more than five years ago.
In return, investors enjoyed quick profits by borrowing in low-yielding currencies like the dollar and euro to invest in high-yielding emerging debt.
Some retail investors have begun unwinding these trades. EPFR-tracked bond funds have lost over $11bn this year, compared with outflows of $14bn for the whole of 2013.
But institutional investors - which make up the bulk of EM carry trades — have yet to head to the exits.
“On a net basis it has not unwound, or in fact it may have increased further ... But as some people put it, carry is a rental profit. You have to give it back at some point,” said Salman Ahmed, strategist at Lombard Odier Investment Managers.
“This time, carry trades are more concentrated in the high-duration corporate bond market. Money went into the 10-year and seven-year debt. It’s a much riskier situation because you have FX exposure and underlying credit and duration exposure.”
Duration is a commonly used measure of risk that indicates how price-sensitive a bond is to changes in interest rates.
Average interest rates in emerging economies have bounced off post-crisis lows after aggressive monetary tightening by the likes of Turkey and Russia. But analysts said that was unlikely to kick off a new round of carry trades.
“EM carry is happening at a time when developed equities are doing well. There’s competition between DM and EM,” Ahmed said. “You are choosing 10 percent carry and political and FX risks, or a 15 percent gain without any risks. Carry may have to go further higher to bring people back.”
Emerging markets have seen carry trades fuel a boom-and-bust cycle before. The first, driven by foreign banks, funded East Asian economic expansion before ending in 1997 with the Asian financial crisis.
Reuters
