The Indian Economy Blog

February 8, 2007

Why Japan Matters To India

Filed under: Business — Edward @ 8:35 pm

Well Nanubhai has certainly stirred up a storm with his overheating post. So now that the intial burst of energy has started to die-down, and the dust has begun to settle, it may be well worth sifting through the various pieces that constitute this whole debate, to try and see what exactly is at issue here, why the issues are important, and what can be learnt from the episode.

Amongst the many topics of not inconsiderable interest would be to think about what can be learnt about the whole development process from studying the Indian case, and this topic is by no means an incidental one, as there are still plenty of countries stuck back-there in the mire of poverty, and if they can learn anything from the Indian example about how economic break-out works, then apart from getting the benefits from its own growth process India can also help others to see how they too might move forward.

So this will be the first of a series of posts to try work through the issues raised, which have, of course, been accumulating fast, indeed such issues seem to be mushrooming far faster than our capacity to assimilate them has.

Today I am going to start the process off with an India-Japan comparison, in part since the India-China one so often generates more heat than light, but also in part since I want to argue that you cannot make any sense of the current ‘capacity growth’ debate in India unless you take into account what is happening in Japan, and the impact of Japanese deflation on the global liquidity situation.

I want to hammer-home here two points concrening what is new and different in the post turn of the century Indian situation, and underline the fact that the presence of these changes make all that talk about growth rates in the 1980s and the 1990s rather dated to say the least.

Firstly India now increasingly forms part of a global economy, so global factors need to be thought about much more than they were say ten years ago. The most obvious example of this is to be found in the rapid acceleration of high value services, and the migration of a lot of ICT related activity to India, a phenomenon which can’t be understood, IMHO, outside of the 1995-2000 internet boom-bust cycle in the USA.

Now the impact of these high value services has been, as many would note, rather more strategic than decisive, since they still account for only a very small share of overall GDP. Thus we could say they have been something of a catalyst to a process rather than the process itself. By the same token, it is now impossible to look at Reserve Bank of India monetary policy outside of the general global liquidity context, things just aren’t decided locally any more.

All this is only going to become even more important as India gradually incorporates in the global economy, and as the share of external trade in GDP only climbs and climbs.

So what is needed insofar as the economic debate in India is concerned is something of a change of mindset. There is a rather dated feel about many of the arguments which are being marshalled around the capacity issue, they seem to have been prepared and honed in the context of yesterday’s problems, and and as a consequence they are often found to be woefully lacking when fielded to confront the problems of today, problems which are in many ways very different from those to be found back in the decade of the 90s. Indeed I think this is precisely why the Economist article is causing so much fuss, since it may quite simply be the last gasp of a view of the world which no longer holds, a view whose closest adherents find it ever so difficult to let go of.

The second point I would want to underline in the appparent high degree of interconnectedness of so many things we are seeing here. Things have suddenly become more complex, and what appears to be a small and isolated phenomenon in one country or region may in fact turn out to have important and significant consequences elsewhere. I could cite the way in which China’s need for soy beans has fuelled a significant national grwoth spurt in Argentina or Brazil, or the way in which climatic change may be accelerated by growth and yet subsequently turn round and have a secondary unexpected impact on growth itself, but today I simply want to think about what is happening to interest rate policy in Japan, and why this is important even (or especially) for people in India.

In order to to this I would refer back to a comment by Andiron in Nanubhai’s post:

“Liquidity has reduced the deficit as payments are lesser, but the risk premium will go up dramatically. As foreign economies cool, remittances to india will dry up leading to more current account problem..(>5%)..A large portion of $ 180 bil reserves is a mouse click away from disappearing.. Lots of palapappans forget, that last 4 yrs were unusual in liquidity.. It is time to pay higher risk premia..”

Now despite the peculiar way in which this is expressed the comment does go straight to the heart of the matter. Have the last four years been unusual in liquidity terms, or can we expect more of the same? This is the issue. In fairness to them I suspect that the writers at the Economist are sort of making the same assumption that Andiron is, whilst I am certainly assuming the contrary, and this is precisely one of the big reasons I imagine that trend growth may well accelerate in India, since cheap finance will be available to make it possible. Is this in iteslf a good thing or a bad thing? Well people can argue afaiac ad infinitum on this, the problem is that it is a very probable reality, and what we need to focus on in this debate is the world we are likely to see, not the one we would like to see.

(Incidentally, I should point out that the liquidity issue is only part of the reason I go with Nanubhai, there are other reasons which I will try and explain in other posts, but the liquidity environment is one part of the picture, and an important one).

Now, OK, why is Japan important?

Japan is important due to the existence of something called the “carry trade”. So just what is the carry trade? Well simply put the carry trade is a phenomenon which is based on the existence of substantial interest rate differentials between countries (with a secondary driver being the anticipated direction of future currency movements). Japan has become an important focus in this trade due to the existence over long periods of time of zero or near-zero interest rates. So if you want to borrow money in a country like India with interest rates significantly above zero, and if you anticipate that over the appropriate time horizon the value of the rupee is going to rise relative to the value of the yen (which given the large anticipated economic growth differential between these two economies seems a reasonable enough assumption) then it makes a lot of economic sense to borrow in Japan and spend in India. The net result of this is that development in India becomes cheaper than it would have been, since the cost of capital – or the so-called risk element – goes down.

Now applying normal Econ 101 type market reasoning to this situation you might imagine that the result of this process would be that interest rates in India would go down and those in Japan would go up, based on the increased availabilty-of and demand-for funds. Well if you thought this you would be half right and half wrong. Long term rates in India will of course be pulled down by this process, and this will give a lot of headaches to people over at the RBI in implementing monetary policy since their ability to control both rates and the money supply will be affected. But interest rates in Japan will not necessarily be affected at all, since Japan has long been caught in a rather strange and unique situation known as a liquidity trap. Now the easiest way of describing the problem is to say that the Bank of Japan has created a kind of monetary black hole (via a policy known as quantitative easing) and what this means effectively is that the more quickly the bank throws money into the economy the more quickly it disappears, without – and this is the key point – having any noteable impact on the country’s inflation rate (Japan has been struggling since the early 90s with a phenomenon know as deflation). As a consequence interest rates in Japan do not move up, so the two country mini-market model (Japan-India) process descibed above simply does not equilibrate, and Japan acts as a kind of negative attractor (deliberately using a term from chaos theory) for interest rates, gradually sucking in the rest.

Well, it isn’t all quite as simple as this, but I imagine you may be getting the picture.

So just how important is the yen carry trade?

Well as the ever excellent Brad Setser points out (citing the FTs Gillian Tett) no-one really knows, but the number might be anything up to a trillion dollars. This number is almost certainly rather on the high side, but that being said, there is a very, very large quantity of money going the rounds here. As Gillian Tett says:

Just how large the carry trade is, nobody really knows … But whatever the precise number, what is clear is that carry trades have been fuelling the dash into risky assets in the past couple of years.

After all, with Japanese interest rates at rock bottom and the yen on a downward path, it has been frighteningly easy for any hedge fund to borrow in yen, invest in something yielding, say, 5 per cent a year, apply a bit of leverage and – hey presto – produce returns of 20 per cent, or more. Conversely, if an investment bank wants to create a collateralised debt obligation but cannot sell the riskiest debt tranche, it can put this on its own books – funded by ultra cheap yen. The yen has thus been tantamount to the ATM of the global credit world – spewing out (almost) free cash.

Given this you can understand just how much the leaders of the G7 would like the Bank of Japan to start raising rates, and how much this is going to be talked about this weekend in Essen. And much as I hate to have to disagree with Anantha Nageswaran, I take the view that the world’s central bankers haven’t stopped trying to intervene in market processes over the last twelve months, by forcing up interest rates to what they call normalised rates. In the case of the EUs ECB they have only met with moderate results in their crusade (and with potentially worrying consequences as we may be about to see in Germany), and in the case of Japan the most that they have been able to extract is one quarter point raise. And according to Bank of Japan policy board member Hidehiko Haru, gioven that internal consumption in Japan is congenitally weak and that there’s no imminent threat that rising prices will cripple economic growth (indeed there’s every danger of falling back into deflation) then there’s no hurry to start raising rates again any time soon.

Also, of course, it isn’t only from Japan itself that the carry trade is at work. Andy Mukherjee in an interesting Bloomberg column recently drew attention to the possibility that people might like to borrow in yuan to buy rupees. The rationale for this may seem strange, but Andy explains it like this:

According to the ABN Amro economists, the appreciation in the Chinese currency is already in the price: Forward traders expect the yuan to rise about 5 percent against the U.S. dollar in one year. The risk of a sudden, large revaluation, from its current level of about 7.78 to the dollar, is low.Even if you agree with this assessment, how do you borrow yuan to buy rupees, beating capital controls in both China and India? The offshore forward markets may offer a solution.”

“The implied interest rate on borrowing yuan for one year, according to my Bloomberg, is just 0.15 percent in the non- deliverable, offshore forward market where trades are settled in U.S. dollars. That compares with an inter-bank rate of 0.63 percent on borrowing Japanese yen.
One-year non-deliverable forward contracts on the Indian rupee currently offer implied interest rates of 7.93 percent. There is, thus, a neat 7.8 percent interest-rate differential — or “positive carry” — to be pocketed from selling yuan forward (against the dollar) and buying rupees forward (against the dollar).

But back to our main topic: just why is it that Japan is finding it so difficult to raise rates and bring an end to the yen carry trade? Well here’s the rub, at least if you are a writer at the Economist it is, since the underlying issue is a demographic one, but not this time the demographic dividend which India is just begining to benefit from at this point, and which they seem to want to attempt to trivialise so much, but rather the demographic penalty of an ageing society which is busying diverting resources away from consumption and towards saving. And what do you think our dear friends at the Economist have to say about all of this? That Japan is underheating? Not at all: Japan’s recovery is going from strength to strength. Talk about the world turned upside down.

Footnote: some good background explanation into the real ongoing difficulties Japan has in raising domestic consumption and interest rates can be found in these two posts (and here) from Claus Vistesen.


  1. Of course the Indian economy will be severely impacted if risk appetite wanes and the carry trades unravel. Unlike China, most of the money flowing into India is FII money, not FDI (though that’s changing now). So it’s all waiting to be taken out. The stock market is dependent on FII flows, so that will crash, money supply will dwindle, interest rates will rise, the rupee will fall, import prices including the price of oil will rise and whooosh, the air will be out of the India bubble.
    Thankfully, far more is at stake in the carry trades than the Indian economy—the last time the yen rose sharply was in 1998, which led to the collapse of many hedge funds and LTCM. Also, surely Japan doesn’t want another Plaza Accord.But it’ll pay to look closely at what’s happening in the G7 and keep your finger poised on the sell button.

    Comment by akhondofswat — February 9, 2007 @ 12:05 am

  2. @akhondofswat

    “Of course the Indian economy will be severely impacted if risk appetite wanes and the carry trades unravel.”

    Interesting idea, and surely this is right, but have you read the post? I was trying to argue that it is well nigh impossible for the carry trade to unwind at the present time and for Japan to raise interest rates in any substantial way. Even the euro may be about to pause if you look at Trichet’s speech today. It will certainly be interesting to see – given the downturn which is taking place in the German economy – whether he is able to raise one more time in March. The reason for this is pretty simple, since the financial markets are also awash with funds given the high savings rates of the ageing populations in many developed countries, what Bernanke calls the savings glut.

    Now you may well disagree with this analysis, but it would be nice to have a reason advanced as to why it may be wrong. Simply repeating the old ‘crime and punishment’ risk argument simply will not do anymore.

    Comment by Edward — February 9, 2007 @ 2:11 am

  3. And what do you think our dear friends at the Economist have to say about all of this? That Japan is underheating? Not at all: Japan’s recovery is going from strength to strength. Talk about the world turned upside down.

    I think the Economist can very well still say that Japan is underheating. The Economist’s original argument for Japan’s recovery is the growth in its nominal GDP. But several points suggest underheating in Japan in addition to nominal GDP growth, for example, the labor market in Japan has actually tightened during this recovery. Hence, Japan’s nominal GDP growth might instead be driven by foreign demand (namely China), not domestic. If that is the case, one can argue that Japan is recovering while underheating. Deflation in Japan is also being controlled by China’s construction boom, driving world prices up for steel and raw materials.

    Comment by J. Yin — February 9, 2007 @ 4:29 am

  4. I started following this topic closely ever since unwinding of carry trades in May2006 caused sensex to plunge over 20 percent.

    Your statement….
    “I was trying to argue that it is well nigh impossible for the carry trade to unwind at the present time and for Japan to raise interest rates in any substantial way.”

    –All you need is for the market sentiment to change, and the carry trades will begin to unwind. If traders can smell that Japanese will in foreseable future begin upping their rates, then its enough trigger for traders to reduce their exposure towards carry trades.
    I very much doubt that Jap’s will make their intentions public knowledge, hence they are keeping quiet on their interest rate directions.
    Usually in all economies, real estate price increases are always followed by interest rates hikes. After a decade real estate in Japan is begining to move upwards. My logic [though narrow minded] tells me that its a matter of time when interest rates there will begin rising.

    god bless the common man on the street, when FII’s press the sell button

    Comment by Anil Passi — February 9, 2007 @ 5:15 am

  5. “All you need is for the market sentiment to change”

    Again, yes, well quite! But the point is I think that there is a major disconnect in mindset between the way market traders are approaching this and the way macro economists are. And at the end of the day market traders are dependent on fundamentals, and to understand these they need the macro economic perspective. The big issue is can Japan raise interest rates?

    I am arging that the economic fundamentals – an ageing and saving society, congenitally weak internal demand, a dependence on external growth and exports, and a deflationary environment which is proving well-nigh impossible to shake off – all mean that Japan will not be seriously raising interest rates any time soon. We may of course see another small quarter point raise if there is enough pressure from the G7, but this wouldn’t be what the Japanese economy needs, and would only IMHO make the internal management problems worse – remember they have to move shortly to fiscal tightening in a fairly big way since Japan has the highest government debt to GDP ratio on the planet – so my feeling is that if they do raise even slightly they will fall into recession (if they aren’t heading there already) and then they will be back to the zero rate very quickly indeed.

    These sort of problems can’t be resolved by market spin, or push-button reactions I’m afraid, all that happens here is that you get to lose a lot of money if you push the wrong button at the wrong time, and this won’t do anything to unwind the carry trade.

    “If that is the case, one can argue that Japan is recovering while underheating.”

    Of course J Yin, this is the case. But this is something new. This means that Japan’s economy is no longer structurally normal, it is indefinitely dependent on export driven growth. This is where the Economist and others read things wrong, since they anticipated a second leg, with the recovery becoming sustainable by moving over to domestic demand lead growth. This is where they got it wrong, since this simply hasn’t happened, and there is no sign in the data that it is going to happen and there are good theoretical grounds for assuming it won’t. The labour market tightening isn’t translating into wage push. Demographics can help you understand why it isn’t.

    So at the end of the day this isn’t about market sentiment, ideology, or cheerleading. There are facts on the ground to take into account, macroeconomic facts, and these quite simply can’t be ignored. This is why we all need a change of mindset.

    You are right of course to draw attention to the way in which both Japan and Germany have become dependent on China. But as China tries to get away itself from investment driven growth, then these two are going to need some new customers. The weakening in demand for machinery and equipment in China is already becoming evident in the December data for Germany and Japan, which is why they need some new customers quickly, and this is just another reason why India looms large in 2007 and 2008, since my guess is that it is “everyone off to India” time.

    This is also why I think we will see a shift away from middle class domestic-demand driven growth in India, and a move towards manufacturing to some extent, with more emphasis on exports, since this will be necessary to justify and pay for all the technology which is about to be introduced.

    As I say, to get to grips with all of this you need to think marco economics, not market trading.

    Comment by Edward — February 9, 2007 @ 1:45 pm

  6. Since it is relevant, and I am sure many readers are at a loss to evaluate the significance of all of this I am posting below a long extract from an FT article today. Those of you who are interested in market trading please note this bit:

    “Market observers said hedge funds were no longer listening to BoJ guidance on interest rate policy after last month’s surprise decision. Days before the bank left rates on hold, futures markets had been predicting an 80 per cent chance of an increase to 0.5 per cent.Kiichi Murashima, economist at Nikko Citigroup, said: “We cannot know what is driving the bank’s thinking. It is a terrible situation. Communication with the markets has been quite bad.””

    Now this is not simply bad communication from the BoJ but an indication of real problems they are having in the real economy. Now if Claus and I are right they will quite simply be unable to comply with all these requests to raise. This is the issue. The other issue will be what happens when the markets really wake up to this reality.

    Interest rates decision poised on knife-edge
    By David Pilling in Tokyo

    Published: February 8 2007 22:00 | Last updated: February 8 2007 22:00

    The Bank of Japan’s decision over whether or not to raise rates at a policy board meeting later this month is poised on a knife-edge, judging by comments from one of the board’s more dovish members on Thursday.

    Hidehiko Haru, one of nine board members, confirmed his moderate outlook when he said in a closely scrutinised speech it was “imperative that we firmly maintain easy monetary conditions” to put “the nation’s economy on a sustainable growth path”.

    The question of when the BoJ will raise rates has attracted international scrutiny in the lead-up to the meeting of the Group of Seven industrial nations due to open today, particularly from Europe where Japan has been accused of keeping the yen artificially low.

    Hiroshi Shiraishi, economist at Lehman Brothers, said of Mr Haru’s comments: “There’s something for everyone here.” He suspected Mr Haru could be persuaded to vote for a rate increase if Toshihiko Fukui, the bank’s governor, pushed hard.

    Market observers said hedge funds were no longer listening to BoJ guidance on interest rate policy after last month’s surprise decision. Days before the bank left rates on hold, futures markets had been predicting an 80 per cent chance of an increase to 0.5 per cent.

    Kiichi Murashima, economist at Nikko Citigroup, said: “We cannot know what is driving the bank’s thinking. It is a terrible situation. Communication with the markets has been quite bad.”

    Some economists say there is evidence the BoJ has changed from a forward-looking to a backward-looking policy framework.

    According to Mr Mur-ashima, the bank should either have raised rates in January or changed its economic outlook, which suggests inflationary pressure will gradually take hold as profits feed through into higher wages and consumption. That has been slow to happen, as the bank has admitted. “If in February the bank sticks with the status quo, many people will conclude that the bank has given up its forward-looking framework,” he said.

    The bank could be emboldened to raise rates if fourth-quarter growth numbers, due to be released next week, rebound strongly from a weak third quarter. Economists said the bank would look particularly at the consumption component, seeking confirmation that its central scenario for the recovery remained on track.

    Comment by Edward — February 9, 2007 @ 1:58 pm

  7. “The other issue will be what happens when the markets really wake up to this reality.” The markets have bet on the carry trades continuing a long while ago. That is why stock prices are at record highs in spite of all the dire warnings of slowing global growth or liquidity being withdrawn. So if you’re right and Japan continues to be the fount of liquidity, the party will get even better.
    The worry is, we all know what happened after Irving Fisher talked of stocks reaching a “permanently high plateau”.

    Comment by akhondofswat — February 9, 2007 @ 4:14 pm

  8. @akhondofswat

    Hi, thanks for getting back. This should be a debate, no-one has a monopoly on the truth, but I am just trying to get people to think out of the box.

    “So if you’re right and Japan continues to be the fount of liquidity, the party will get even better.”

    Well, probably it will, but not necessarily in the form which you are thinking. I was reading in Bloomberg this morning about the state of the property sector right now:

    “Shares of Unitech Ltd., India’s largest real-estate developer by market value, soared 26,869 percent during the past three years. Anant Raj Industries Ltd., a competitor, leapt 39,548 percent.”

    “Both have dropped at least 5 percent from peaks in November and December and further losses may lie ahead. The highest interest rates in four years, tighter lending requirements and seven share sales this year are hurting real-estate stocks. Those companies had rallied as a property boom pushed apartment prices in southern Mumbai to near-Manhattan levels.”

    So one good guess is that we may see some sort of correction, but probably a limited one. But given the abundant liquidity what would be the consequence of this:

    Well what may well happen is a correction in the property market, but we need to think beyond this. Any such correction will take the impetus out of the middle class consumer growth sector, and cool things down a bit on the one hand, but this may merely mean that the growth impetus will then move onto the investment leg. This is something India badly needs to equilibrate the growth process. But this will mean an expansion in infrastructure and an increase in export oriented industries.

    So it will solve some of India’s issues, since it will take some of the pressure of the agricultural sector by providing work for some of the youngsters, but it will only add to some of the global imbalances issues as India begins to export more to pay for the technology it is now going to import. Good news for Germany and Japan, bad news for the US, the UK, France etc etc.

    These are my off the cuff thoughts right now.

    “The worry is, we all know what happened after Irving Fisher talked of stocks reaching a “permanently high plateau”.”

    Yep, but I am not talkimng about a steady-state permanently high plateau, I am talking about India moving from being a developing economy to becoming a developed one. Best guesses suggest that this may take 20 years, and during those 20 years we will see very strong and sustainable impetus. I even think we could see peak Indian growth breaking all known records, but this is just a guess. We will see.

    Of course I am an admirer of Fisher’s theory of debt deflation, but I don’t think this is applicable to the Indian situation right now.

    Some of the middle classes who are overstretched will undoubtedly feel the wealth effect of any correction, but this will only change the composition of economic growth, not its magnitude, which I imagine is only going to go up.

    Recession? Come off it, pull the other one :).

    The planet needs India, otherwise global growth will slow significantly, and I don’t think anyone at the end of the day wants that.

    Comment by Edward — February 9, 2007 @ 5:25 pm

  9. Look, what I want to stress is that this whole debate should be data driven, and not the focus of any old opinions just because they feel good. All of this is about to be tested.

    Now remember what I waqs saying about China slowing and the effect on Japan and Germany only above. Well here’s the latest from Bloomberg:

    Japan’s Machinery Orders Fall, First Drop in 3 Months

    Japan’s machinery orders fell in December, signaling economic growth may slow this year as companies scale back spending on factories and equipment.

    Non-government orders, excluding shipping and utilities, declined a seasonally adjusted 0.7 percent from November, the Cabinet Office said in Tokyo today. The result was in line with the median estimate of economists surveyed by Bloomberg News.

    A slowdown in corporate spending, the main driver of growth in the world’s second-largest economy, may undermine the Bank of Japan’s case that interest rates need to rise from 0.25 percent to prevent excessive investment. Sales at Advantest Corp. and NEC Corp. fell in the third quarter as demand for electronics cooled.

    “This will make it more difficult for the Bank of Japan to cite concern that capital spending could overheat as a reason for raising rates,” said Seiji Adachi, senior economist at Deutsche Securities Inc. in Tokyo. “Capital spending may have peaked.”

    “The yen weakened to 121.34 per dollar at 1:55 p.m. in Tokyo from 121.15 before the report. The yield on 10-year government bonds fell 4 basis points to 1.695 percent.”


    Of course all of this will impell them into India. China is clearly slowing its investment rate.

    Here’s another indication of how this is affecting Germany, from Forbes yesterday:

    “German exports unexpectedly fell in December, a report from the Federal Statistics Office showed today, adding to signs the economy is cooling.”

    “The brightest spot for Germany has been in exports of industrial goods with especially strong exports to China. But this is changing as China makes more of these capital goods itself. Chinese exports to Germany have risen sharply while German exports to China have been flat.”

    Comment by Edward — February 9, 2007 @ 5:30 pm

  10. I am not sure about Bloomberg’s reports but Japan is estimated to grow at 4% in Q4, highest in two years (expansion higher than US), although growth was steadily declining until Q3.

    Also, at the moment, India is still a small market, but with high growth, for lot of companies (with few exception like cell phones). Until India is a $2 or $3 trillion economy, it is hard case to make that planet needs India, especially as an export market.

    Comment by Chandra — February 10, 2007 @ 12:23 am

  11. This whole carry trade discussion confuses me. There is an article today (dated Feb 9) in the Morgan Stanley Global Economic Forum titled “Further Thoughts on the JPY Carry Trades” by Stephen Jen and Luca Bindelli and Charles St-Arnaud. They write

    “… in trying to quantify the size of the JPY carry trades, it may be useful to identify different types of these flows/positions. In a previous note, we proposed three types of JPY carry trades. Type 1 JPY carry trades consist of net fixed income outflows from Japan. This is the type of JPY carry trade we assume most investors have in mind — net fixed income outflows propelled by interest rate differentials. Type 2 JPY carry trades, we proposed, consist of ‘JPY duration trades’, whereby Japanese investors borrow short and lend long in the JPY market, to take advantage of the steep yield curve in Japan. To the extent that these positions affect the shape of the yield curve, they should also indirectly influence the JPY. Type 3 JPY carry trades consist of non-Japanese residents borrowing in JPY outside of Japan. We have already written a piece dismissing the importance of this type of JPY carry trades.

    These three types of JPY carry trades are not exhaustive. We propose additional types of JPY carry trades. Type 4 could consist of hedging positions: e.g., foreign equity investors hedging out their Nikkei exposure by buying USD/JPY forward. Type 5 carry trades may include non-commercial speculative short-JPY positions, such as those tracked by the IMM. Type 6 JPY carry trade may consist of off-balance sheet swap positions.

    Quantifying these different types of JPY carry trades is very difficult. Not only is it difficult to quantify each type of carry trade, these different carry trades in the spot, forward and swap markets are not additive. It is misleading to ask ‘how big the JPY carry trades are’; it would be even more misleading to offer one number in response to this question. ”

    Question for Edward: do you agree with this analysis of types of carry trades? What exactly are the mechanisms by which carry trades are financing fixed asset investment in India?

    Comment by SatishT — February 10, 2007 @ 11:02 am

  12. Hi Chandra

    “I am not sure about Bloomberg’s reports but Japan is estimated to grow at 4% in Q4″

    Yes, this is the estimate that is knocking around at the moment, the official data for Q4 will be released on Monday. The thing is Japan’s economy has been growing at a tidy clip over the last two years or so – much faster than in the 4 or 5 previous years, but the key point about this is that the growth has been very largely export driven. Domestic consumption has been trending down. Actually we might have seen a slight rebound in December, but the bottom line picture is that any increase in consumption in Q4 needs to be seen in the context of the very low level reached in Q3, so all we are talking about is a slight rebound which still follows the general trend.

    Japan principally needs the Chinese market, the US, and to a lesser extent Europe. This is now a structural issue and it simply isn’t going to go away. Japan has the highest median age of any country on the planet and it is steadily rising (currently around 44). On agregate, and following the well known life cycle pattern of saving and investment (Modigliani), the Japanese save a significant portion of any additional income obtained from economic growth. As a result, internally, the CPI permanently hovers around the deflation zone, and this is why we continually see these extraordinary liquidity conditions as the BoJ struggles to try and cope.

    This situation is to some extent reproduced within the eurozone with Germany (which has the second highest global median age, and which exhibits the same structural characteristics as Japan – congenitally weak internal consumption, export dependence, high savings rates, low inflation) taking the role of Japan, and with the low interest rates which the ECB gets stuck with as a consequence creating important asset price booms in places like Ireland, Spain and Greece.

    This situation – which involves the world’s No2 and No 3 economies – is creating an important problem at the global level, and this situation is strongly associated with the whole global imbalances problem.

    “it is hard case to make that planet needs India, especially as an export market.”

    At the present time what you are saying is correct. I am simply trying to peer out into the future. What is important in global terms is where the growth is going to come from. Up to the present time China has been the key. But the administrative measures to reduce the investment rate which the Chinese government has been taking may well be slowing the Chinese economy a little, and any moves to loosen the yuan peg further and let it rise will only add to this effect since export growth will weaken and the demand for investment related products from Germany and Japan to fuel the growth in export industries will reduce accordingly.

    So since these two need to export to live they will need new customers, and this is where I am arguing that India coming online will be important. What matters at this point are not the absolute numbers, but the rate of growth in the market. I am arguing that this rate of growth will likely be high, and that the cheap money which will continue to flow to india – despite the best efforts of the RBI remember the yield curve is still inverted – will make it relatively cheaper to pay for this invesment. So you have a relatively favourable tailwind, with suppliers who wish to sell aggresively, and money available to fund the process. This is very different from earlier times when a high risk premium had to be paid to get the funds to get your hands on any such technology.

    And remember, all I am trying to do here is situate the debate about “India overheating” which has been advanced by the Economist. I am simply suggesting that far from India overheating all the conditions are there for an acceleration in growth in India.

    What may be the case, as I have already mentioned, is that some of the rise in eg property values may have gotten out of line with the overall rate of growth, so we may well see some sort of correction at some point, but I am also arguing that far from derailing Indian growth this will simply serve to rebalance it.

    I am not convinced that the middle class consumption lead growth model is sustainable for India for much longer. There are well known skilled labour supply constraints which will operate in the high value services sector, and so growth here may not be so spectacular as it has been, and I think that it is this that may well have been leading the people at the Economist astray.

    Part of the reason that the middle class model is not sustainable is that it tends to leave out the other India, which has up to now not benefited from the improvement in the Indian economy to anything like the extent the urban middle classes have, and in particular I am thinking here of all those tens and hundreds of millions still stuck in the agricultural sector.

    But India still has another leg to fall back on, and that is the industrial manufacturing one, and the export incomes that the expansion in this can generate. Of course here the reforms do become important, but I still feel that all of this is very doable.

    So if we come back to the bottom line issue, the capacity question, what I am arguing is that the labour is there, the capital is there, the external global demand is there, and there are plenty and plenty of MNCs just queueing up to get in on the act. At the end of the day I just don’t see the problem, or even what all the fuss is about.

    But of course in order to get through to understanding this you do need to be clear about Japan, this is the key, since otherwise the point akhondofswat raised right at the start of this thread would come into play, and the applecart could well be upset.

    Comment by Edward — February 10, 2007 @ 11:17 am

  13. Following up on Chandra’s point, here are some extracts from the latest Bloomberg piece on the Q4 Japan GDP estimates. Of course all the talk about the Q3 weather situation is essentially a red herring, since the trend is a pretty long term one. People are simply being mislead by the labour market conditions, since the Japanese labour market is largely tightening as more and more members of Japan’s ageing population simply exit the market at the upper end.

    Japan GDP Growth Likely Quickened on Consumer Rebound

    Japan’s economic growth probably accelerated in the fourth quarter as consumer spending rebounded from the biggest drop in almost a decade.

    Gross domestic product in the world’s second-largest economy expanded at an annual 3.8 percent pace in the three months ended Dec. 31, according to the median estimate of 24 economists surveyed by Bloomberg News. The Cabinet Office is scheduled to release the figures at 8:50 a.m. on Feb. 15.

    Bank of Japan Governor Toshihiko Fukui cited lackluster consumer spending and slow inflation as reasons his policy board kept interest rates at 0.25 percent at its last two meetings. A fourth-quarter rebound in household outlays was probably the result of better weather rather than evidence of a sustained recovery in spending, given Japan’s slow wage growth.

    “Spending will be strong, but that’s more of a reaction from last quarter and won’t say anything decisive about the strength of consumption,” said Junichi Makino, a senior economist at Daiwa Research Institute in Tokyo. “The Bank of Japan won’t be able to act on the report, especially with consumer prices so close to zero.”

    Much of Japan’s 0.9 percent drop in consumer spending in the third quarter was because unusually wet weather kept shoppers at home. Private consumption, half of the economy, climbed 0.9 percent in the fourth quarter, economists surveyed said.

    Inflation slowed last month, another reason the Bank of Japan may be reluctant to raise rates at its February meeting. Core consumer prices, which exclude fresh food, rose 0.1 percent in December, unexpectedly slowing from 0.2 percent in November.

    “Everyone knows the GDP report will be strong and I don’t think consumption is going to be the linchpin” for higher rates, said Glenn Maguire, chief economist for Asia at Societe Generale in Hong Kong. “A February move is ruled out simply because the CPI is so close to zero.”

    Comment by Edward — February 10, 2007 @ 11:23 am

  14. This post has been a bit confusing. What is the point of this post? It seems to be a mixture whatever the blogger has read over the past week and an attempt to link all of it with India.

    How big is India’s trade as a percentage of the total global trade? Last I heard, it was somewhere around a percentage and a bit more. I am sure it has increased a lot but by how much. I am sure it hasn’t shot up to 15%.

    The current boom in India is a domestic one. It has been fueled by local demand, is part of the business cycle and hence the concerns regarding overheating.

    I believe that remittances won’t fall drastically unless there is a severe recession abroad. It has social reasons.

    The RBI is much more proactive in using a wide-range of tools unlike the free-marketist central banks of the West. In fact, many Westerners have started lamenting at how so many policy tools are no longer being used by their respective central banks. In India, not only the interest rate but the bank reserve ration and mandatory conditions for extension of credit are used. I believe that these policies can keep a lid on any problems in the future.

    As for the global liquidity glut, the US, China, Japan and other Asian economies are in a trap not knowing how to escape. Thailand tried with capital controls but had to step back the very next day. Whenever this global scheme stops, a lot of people are going to be in trouble.

    Comment by yum yum — February 11, 2007 @ 7:37 am

  15. Indian economic boom is fueled by consumption is
    no doubt to anybody at all.But the consumption is
    led by production from other countries.Thus there
    is the deficits india posses at 5 to 6% of GDP.
    The deficit is managed by currency investments
    (deposits=remittances,stocks=FII,service exports
    =IT exports).IN times of crisis all of these investments
    will disappear in click of a mouse and automated sells.
    If yen carry trade ends,india cannot finance its
    consumption and finally has resort to production.
    Production doesn’t come easy.Greenfield investments
    would get lot of scrutiny for infrastructure,ease
    of business etc which india lacks.sooner india will
    experience pain when it find no financier for its
    consumption.Its all going to be very painful for
    india.An hyperinflation is in cards for india,a prelude
    to its disintegration just like collapse of yugoslavia

    Comment by Satish — February 11, 2007 @ 9:50 pm

  16. Really good couple of posts. Both the “India Overheating” and the yen carry trade issues have been dwelt at in length by various capital market commentators over the past couple of weeks, so it will make for interesting times ahead.

    As far as the JPY carry trade issue goes, its really difficult to determine what the implications for India are. Current estimates, based on OTC volumes in FX derivatives, place the carry trade at about USD 1 trillion. However, given that an investor could theoretically earn an attractive spread in any market worldwide by buying “free” money, even by buying Sterling gilts, or Eurobonds, and not necessarily branch out into riskier emerging markets, it is difficult to estimate what volume of JPY borrowing is actually channeled directly into India.

    Query – you talked at length about the problem the BoJ has had with raising interest rates, and how this hasn’t really reduced the carry trade. Any thoughts about a more activist exchange rate policy, especially since Japan is sitting on some record high reserves? Essentially, if the first stage in the value chain isn’t controllable, i.e. the presence of “free” money cannot be controlled, why not make it harder to convert it into FX?

    Comment by The Buddha Smiled — February 12, 2007 @ 1:06 am

  17. Satish, it is not foreign production that causes domestic consumption in India. It is the availability of capital. The foreign exchange – earned as well as remittances, are not being saved and invested but rather used for consumption. This is more like Latin America than any of the economic success stories.

    I do believe that remittances will remain fairly even unless there is major global economic bust (a deep recession or even a depression.)

    buddha Smiled, you are talking about capital controls. It is a policy tool but it is blasphemy to even advocate it. You will be fired and thrown into jail in most developed countries (ok I exaggerated about the jailing part.)

    Thailand tried to impose capital controls and it immediately caused chaos. Japan doing that is just unimaginable. It is downright scary. We will see what happens if there is bust. Maybe there won’t be. What do we know.

    Comment by yum yum — February 12, 2007 @ 5:40 am

  18. Hi everyone,

    Sorry I have been so long in getting back, but I have been truly busy. A number of very interesting points have been raised.

    First Stephen Jen. I think the piece by Stephen Jen is very interesting, and really everyone who can should try and read it even if it is rather technical.

    @ Satish

    “Question for Edward: do you agree with this analysis of types of carry trades? What exactly are the mechanisms by which carry trades are financing fixed asset investment in India?”

    I think at this point it is not a question of either agreeing or disagreeing with Jen. He is making a useful contribution to the discussion. In particular he notes:

    1/. “the concept of ‘JPY carry trades’ is ill-defined”, this is a huge gap in the present debate, and for something which has suddenly become so important this lacuna is massive.

    2/ “Specifically, given the vastly different types of JPY carry trades (conducted in the spot, forward and swap markets), we don’t understand how some commentators can sum up numbers that are intrinsically not additive.” I absolutely agree with him here, we need to discriminate.

    3/ “Quantifying these different types of JPY carry trades is very difficult.” There is a real problem knowing what is happening at the moment.

    4/. This seems important: “foreign currency investment trust fund (ITF) flows…..foreign currency ITFs did show a drastic increase in 2005 and 2006, compared with previous years. In the final months of 2006, these subscription rates rose to the US$10-13 billion a month range. These flows are indeed large. Importantly, we should note here that, while uridashi flows are genuine ‘JPY carry trades’, foreign currency ITF flows are partly equity flows and are therefore technically not pure JPY carry trades.”

    Now this raises an interesting and important question. Japanese tarditional home bias? Has this changed permanently and irrevocably? That is what if the Japanese economy never “recovers” in the traditional sense of recovery. The G7 sort of discounts this:

    “Japan’s recovery is on track and is expected to continue. We are confident that the implications of these developments will be recognized by market participants”

    was the wording of the communiqué. But is this spin? Do they really believe this? I find that hard to accept at face value. Surely they can’t be SO stupid. They must have been briefed on what is actually happening in Japan and on the genuine concerns of the Japanese about their recovery (as per bloomberg quotes above). So what we have here is a massive effort of will, an attempt to steer markets towards a position which may be unsustainable. I would say that this was dangerous.

    So what I am saying is the if the level of home bias has changed permanently in Japan, we should expect to see a continuing outflow of funds and a continuing low value of the Yen regardless of what the Japanese MoF does. But all this needs a lot more thought in the details, and in that sense I am still in no position to answer the second part of Satish’s question. In any event the end result is the carry trade doesn’t unwind and India gets to grow slightly faster than most people are imagining, and gets development a little bit on the cheap.

    OK, sorry, that’s all I have time for now. More later hopefully.

    Comment by Edward — February 15, 2007 @ 4:45 pm

  19. Edward, thanks for the candid response. Given the level of uncertainty about the nature and volume of JPY carry trade flows, and the mechanisms by which they affect India’s economy, all the discussion (speculation?) about the importance of JPY carry trade for India seems a bit premature to me. But then that could be just me being overly sceptical.

    Comment by SatishT — February 18, 2007 @ 1:59 am

  20. [...] is all about, as well as in the significance of what is happening in Japan, about which I have previously posted something here, and about what Bretton Woods III might look like, and how quickly it might now have to arrive, I [...]

    Pingback by The Indian Economy Blog » The Rise and Rise of the Rupee, Or How to Screech A Galloping Elephant to a Halt Atop of A Dollar Bill — December 21, 2007 @ 2:45 am

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