Carry Trade and You

Interest on the shekel is much lower than on the dollar. Many ask: Why shouldn't I take a cheap loan from the bank in shekels and invest the whole amount in dollar deposits, at the very same bank? With an interest rate gap of 1.75%, isn't that profit in the bank?

That dead-simple strategy is actually an enormously popular gambit among pros, and in some countries, among regular investors too.

Take the Japanese. Interest in the Land of the Rising Sun is less than 0.5%. Millions of Japanese borrow locally in yen and invest it in New Zealand banks, where interest is presently 8%, the highest among the developed nations. But does this strategy make the Japanese money?

The strategy of borrowing in a low-rate currency to invest in a high-rate one is called Carry Trade. Among pros, mainly hedge funds, it's a tried and true method. For years foreign investors borrowed dollars to invest in the shekel because interest on the shekel was high.

In Israel ten years ago there was a wave of builders and the like borrowing in yen to finance construction projects in Israel, just because interest on the yen was practically zero while interest on the shekel was sky-high.

Is it that easy to make money? There are no free lunches in economics: a currency cuddled in a high interest rate is riskier.  High interest is usually a tool to curb inflation, and if a currency is subject to inflation then its price should drop. And for a foreign investor (like you in New Zealand), that tends to offset any extra returns you might be making.

However, in recent years reality has been ignoring the basic laws of economics; even in countries with high interest rates, the currencies have been appreciating rather than the opposite.

New Zealand is an amazing example. Desperate to tame inflation, and cool the real estate market, the central bank raised interest three times this year to 8%. What happened? The New Zealand dollar soared by 20% against other currencies inside 12 months to a 22-year high.

Just yesterday the New Zealand central bank tried again to rein back the currency by selling in the free market. It worked, too, for a few minutes, then the NZ$ started climbing again. The Japanese investors in the New Zealand dollar have done beautifully from the high interest rates and capital gains, too.

Then there is the annual rate on three-month deposits in the Brazilian real: 12.4%, and what has the real done? Based on the laws of economics, it should drop. Actually, it's risen by 9% against the dollar this year.

Similar things have happened in Turkey, Russia and elsewhere. Almost all the emerging markets where interest rates are higher than on the U.S. dollar have seen a huge influx of investments, the local currency has soared and investors have raked in vast profit. Carry trade has been working like a Swiss clock and not a few Israelis have made a pretty shekel on it too.

How do you do it?

To do it too, you have to instruct your bank to invest your money in a deposit in New Zealand, Turkey or Russia, and wait for interest payments to flow in. If you're really the daring type, borrow money in shekels to deposit. Generally, it works.

But - not always. That's the snag in carry trade. Developing countries with high interest rates tend to be subject to sudden crashes. Their currency can implode in a matter of hours. It happened in Russia nine years ago, happens in Brazil every few years and happened in Turkey last summer. Even the New Zealand dollar has known its ups and downs. And the cheap currency, that you borrowed, can suddenly soar, costing you a mint.

The yen just jumped like a wallaby against the dollar, ruining the strategy for any number of players. Since then, the yen has retreated again and Japan's carry-traders are back in business. But this explains why the cynics call carry-trade the art of picking up pennies in front of a moving steam-roller. And it also explains why it's mainly a strategy for pros, who can make quick decisions - and accept the pain of losses.