Wednesday, November 18, 2009

Why China Hates The Carry Trade

I had a student ask about this...

Why China Hates The Carry Trade:
"A carry trade is when you borrow from a currency with a low interest rate, and then invest in a currency with a higher interest rate. Say the US interest rate is 3%, and the Chinese interest rate is 5%. Borrow at 3%, invest at 5%, make 2%, because the Chinese yuan is pegged to the dollar at a fixed rate. "
In international finance one learns that as this happens, what should happen is that the currencies and interest rates adjust to end this opportunity. But in this case the Yuan is pegged (more or less) to the Dollar. So that does not happen.

However, the student asked why don't the interest rates adjust?

The question was why don't US rates go up? The best answer I could give was that they will but currently "under priced" because the US Fed would like to stimulate the economy. In a global world you can not stimulate one part of the world's economy without it having effects elsewhere (and similarly, let's suppose the US Fed decides to raise rates. If other countries do not raise, then this carry trade can work in reverse which is exactly whatis happening to China right now:

"The chairman of the China Banking Regulatory Commission complained to Obama that the carry trade was destabilizing the Chinese economy, but this really means the capital inflows are making it hard to keep the currency peg at its low current level. China has a higher interest rate than the US, and though the US dollar is falling worldwide, the yuan remains at its old peg against the greenback. China could float it, and let the market decide, but like most politicians, he does not trust the market. More importantly, there are worried it will hurt exports because a stronger yuan would increase the price of their exports to the rest of the world."

Thoughts? A better answer? I have not given it a great deal of thought and did no research on it and it is definitely not my specialty.

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