From capital flight to carry trade!

In an earlier post I had blogged about the possibility of an increase in interest rates amplifying the already large inflow of foreign institutional investments (FII) into India. In a situation where the difference between Indian and global (read developed economies) interest rates widen and rupee is appreciating (against dollar), rupee investments in Indian debt instruments become doubly attractive - higher interest rates and more dollars to be repatriated.

In a recent FT op-ed, Nouriel Roubini cautioned against the globally synchronised rally in equity markets since March and argues that this asset bubble is fuelled by the near-zero interest rates and the weakness of the US dollar, and is driven by "the mother of all carry trades". He writes,

"The US dollar has become the major funding currency of carry trades as the Fed has kept interest rates on hold and is expected to do so for a long time. Investors who are shorting the US dollar to buy on a highly leveraged basis higher-yielding assets and other global assets are not just borrowing at zero interest rates in dollar terms; they are borrowing at very negative interest rates – as low as negative 10 or 20 per cent annualised – as the fall in the US dollar leads to massive capital gains on short dollar positions. In effect, it has become one big common trade - you short the dollar to buy any (Roubini's emphasis) global risky assets... the combined effect of the Fed policy of a zero Fed funds rate, quantitative easing and massive purchase of long-term debt instruments is seemingly making the world safe – for now – for the mother of all carry trades and mother of all highly leveraged global asset bubbles."

Interestingly, the present challenge of managing massive inflows of foreign institutional capital stands in stark contrast to the problems faced at almost the same time last year when foreign investors were fleeing emerging economies in droves driving down currencies and draining off foreign exchange reserves. Since April, FIIs have invested $13.8 billion in India’s stockmarkets, having withdrawn $8.6 billion over the same period last year, and the Sensex has surged by almost 100% since its March lows.

Update 1
Free Exchange has this nice explanation of carry trade and traces two prerequisites - interference in the markets by governments and weak domestic credit demand.

Update 2
Carry trade appraently forms 15-20% of global forex market activity. The Times reports that using "cheap" currencies like the Japanese yen and the Swiss franc to play higher-yielders — often in emerging markets and developing countries — has been a speculative strategy for decades.