When the Bank of Japan raised its overnight rates in February this year, the impact was felt across all financial markets. The catalysts to these reactions were the Chinese stock market, the US prognosis of a slowdown and the political tensions in Iran. However, a large part of the financial instability was blamed on the carry trade unwinding in Japan. This article attempts to explain the story of carry trade in Japan and its role in financial integration across the world.

On February 27, 2007, the Shanghai Composite Index fell by 8.84%. This was the largest single-day fall since 1997. This was the start of a worldwide crisis in global financial markets. Financial circles saw in the next few days a meltdown in stock markets across the world. It was suggested that one of the main reasons for the crisis was the unwinding of the Japanese carry trade.

Carry trade involves an investor borrowing in a low cost currency and investing the same in a high yielding currency. The underlying expectation is that the currency in which the investment has been made should be stable. So, the difference in yields as well as expectations of stable currency values drives the investor. Yen carry trade is borrowing at low interest rates in Japan and buying higher yielding assets in the US and London as well as the Euro Zone. Australia, New Zealand and even South Africa have been a destination for the Japanese yen, given the high interest rates in the receiving economies. The interest differential between the US and Japan at present is more than 4% and dollar is expected to steadily rise against the Yen. In fact, the theory of uncovered interest rate parity suggests that if there exists an interest differential on two financial instruments with identical risk, but the instruments are issued in different currencies, then the difference in return reflects the expected movement in interest rates.

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