Carry Trade: Indian Institutional participation is still low

Carry trade has created a lot of noises across the bourses around the world. From web search and other readings available to me I have a feeling that allegedly Foreign Institutional Investors in Indian Capital Market are exploiting the opportunity in full swing. On the contrary, legal entities incorporated in India, which are without any Foreign Influence or Intervention in the management, are not that aggressive in exploiting this disparity of interest rates between Japanese Yen and other major currencies along with Indian Rupees.

I have worked in an Investment Bank in Tokyo and still am working in the same organization in Singapore. My employer made a record profit on Carry trades alone this year. Also George Soros, one of the wealthiest persons in the world, is investing in India to utilize this opportunity (source: http://www.rediff.com/money/2006/jun/14soros.htm and other Web sources). In the year 1999 when I first moved to Tokyo I borrowed a million yen naively and put the equivalent Rupees amount in my Non-Resident Ordinary account on a fixed deposit at 9% - I being a small individual did carry trade unknowingly that time. On the contrary, in the news I don't see much awareness for India rooted financial institutions in relation to this. Since 1999 I have been observing the foreign exchange rate between Indian Rupees and Japanese Yen varies between 2.5 to 3 per Indian Rupee - the variation itself is quite static. If variance i.e. volatility is measure of risk, accrued interest gain on loaned amount over a period of time will overshadow the risk.

Couple of points are worth noting in this context:

• United States claims Chinese Yuan should go up because it is undervalued as compared to its intrinsic value. It sounds like, US is extremely eager to get their malady of trade deficit fixed so as to curb their own inflation without disturbing interest rate hence the economy. Whereas, Japanese Yen "Interest Rate Parity" is conducive to cross-currency arbitrage promoting carry trades since when late 80's Japanese economic bubble has burst. In this case US do not interfere on exchange rate; because with raised interest rate, despite Interest Rate Parity would be brought back to balance, cost of capital would price Japanese product higher. The US is a great sucker of Japanese exports. Therefore, the silence of their Treasury Secretary (Ex-Goldman Sachs captain) makes sense (source- http://yahoo.reuters.com/news/articlehybrid.aspx?storyID=urn:newsml:reuters.com:20070210:MTFH86728_2007-02-10_17-11-05_L10748576&type=comktNews&rpc=44) by Swaha Pattanaik):Quote.While U.S. Treasury Secretary Henry Paulson declined public comment on carry trades, Bank of Canada Governor David Dodge was more forthright. "Clearly, we do want markets to be aware of the risks of taking one-way bets on anything and so it's there, quite clearly, to say that," Dodge told reporters, referring to the G7 statement. Unquote.
  
• Estimated potential GDP of Japan is still only a little ahead of real GDP which, in theory, says interest rate increase in Japan would not cause a large impact on Japanese Economy. Yet we saw that Bank Of Japan(BOJ), the central bank was hesitating in doing so. A Tokyo economist Takuji Aida (and others from other Investment Banks) expressed his anxiety about this hesitation before Nihon Keizai Shimbun number of times. The hesitation of Japanese Interest Rate rise to 0.5% from 0.25 was attributed to domestic political pressure. Can that be attributed partly to other international political hegemony as well?

Therefore, in all possibility a safe assumption would be: fluctuation of Japanese Yen won't be out of proportion. This state of affairs of low Japanese Yen interest rate will probably continue - reason is manifold: it boosts 1. Japanese export (and trade surplus) 2. First World consumptions of Japanese goods 3. Relatively low impact on slow market recovery rate in Japan (Nikkei fell from 40000 round about 10 years ago - an avalanche; it is still around 17000).

Let's do a simple math now. Let's hypothetically borrow 100 Japanese Yen and convert into INR @3yen per rupee (worst case exchange rate, based on 5 years historical exchange rate). In India we can safely invest it with @6% after tax return per annum for 3 years - over which volatility will be no more than 4%. After 3 years if we consider the worst case situation that we convert yield amount to Japanese Yen @2.6 Yen per rupee. The said Yen amount after 3 years will be (100/3)*power(1.06,3)*2.6 = 103 which implies 3% gain over a period of three years leveraged investment i.e. 1% gain for free.

I just wonder why India Inc or Individual Investors are not much allured out of this free "available" lunch. In my opinion, only Indian inflation could cause further volatility in exchange rate, in which case investors might be needed to rollover their investment horizon for 3 or more years to obtain the positive (though, a bit reduced) return.

To do this possibly we can pledge security or USD or do REPO and draw the loan from authorized trusts and the collateral could be strategically rated by Japanese Investment Trusts Evaluation companies e.g. Nomura Research Institute (A full list of such agencies is available on page 265, Securities Market In Japan 2001 from Japan Securities Research Institute) which would allow Indian Equities to be accepted as a Collateral for Japanese Yen loan. India needs to invite these trusts and rating organizations native of Japan to our country for their presence at any rate par with the presence of US based incorporations such as Merrill Lynch, Goldman Sachs, Citi or Morgan Stanley. Is our country's corporate or Financial Market's chieftains are sufficiently willing to coordinate such cross border interactions?

The New Zealand Dollar or Aussie Dollars pairing with Japanese Yen (or Swiss Franc) are of course would still be the first option in global market for Carry trades because of their currency rating and free trade-ability (fungibility in technical parlance) as compared to INR. However, given the Indian Reserve Bank's stringent regulations in place, I believe we could devise schemes to exploit more from Carry Trades opportunity, may be the greenback weakness itself could be beneficial to draw a market share of Carry Trades to INR. More volumes and openness of such trades would only further country's economic growth amidst recent surprises of Reserve Banks interest rate raise or any other unforeseen (and thus exacerbating) open market operation, because carry trade would even work as a hedge towards downfall of asset price.