From one of the internet's tiny treasures, Delancey Place:
Today's selection -- from The Rise of Carry by Jamie Lee, Kevin Coldiron, and Tim Lee.
A major economic phenomenon of recent decades has been the growth of the “carry trade,” whereby an investor borrows in a currency with low interest rates (such as dollars) and then lends or buys debt in a currency with high interest rates (such as Turkish lira), pocketing the difference. This encourages a large flow of money into these countries with high interest rates, helping to encourage rapid growth in borrowing by the private sector in that economy -- a boom. That inflow of money also has the effect of strengthening the currency of that borrowing currency, causing or exacerbating a trade deficit/current account deficit. But the boom leads to overbuilding and overcapacity, and the stronger currency leads to a loss of competitiveness, which leads to an inevitable withdrawal of money by investors from that economy and a crash in the currency and decimation of that economy. Carry trade investors, if they avoid these periodic and inevitable crashes, do well. If not …
"[In Turkey], continuous rapid credit growth, a large real estate bubble, and high inflation, would have long since found itself in a crisis similar to the 1997-1998 Asian crisis. But year after year yield-seeking capital continued to flow into the country, and the economy consequently kept going -- and the bubble kept growing. Turkey, more visibly than any other single part of the global economic picture, was testament to the power and size of the global bubble in carry that developed out of the 2007-2009 global financial crisis."A lesson of Turkey's experience is how the global carry bubble masks the development of serious underlying economic problems, preventing analysts using standard macroeconomic metric from foreseeing crisis until the moment it impacts. For instance, standard indicators of economic health such as the ratio of foreign debt to GDP are seriously distorted by the carry bubble. The carry bubble means huge flows of capital into the higher interest rate county – such as Turkey over many years up until about 2016 – which tend to drive up the exchange rate for the currency, rendering the currency more and more overvalued. As already noted, the comparatively firm trend of the currency exchange rate only helps to attract more capital, because carry traders stand to benefit from both a large interest rate differential and, potentially, currency appreciation if the trend continues.
"Sustained very high interest rates -- which underpin the country's status as a carry recipient -- must be associated with high inflation. For example, over the whole period from the end of 2002 until the beginning of the climax of the global financial crisis in August 2008, Turkey’s consumer price index (IMF measure) increased by 83 percent. The US consumer price index rose by 20 percent over the same period. This is a big difference, and not-withstanding that sometimes rapidly growing developing economies can have higher rates of consumer price inflation without suffering loss of trade competitiveness, one would assume that such a big differential in inflation would be offset by at least some currency depreciation – in the context of the need to maintain trade competitiveness. Yet over the same period, Turkey’s currency, the lira, appreciated, and not by a little – by about 35 percent, a substantial currency appreciation....
....MUCH MORE
