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.

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.

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?

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.

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.”

“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.

“… 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?