Carry Trade Unwinding Hits Iceland and New Zealand

“Everything is connected to everything else,” said Vladimir Lenin. While he wasn’t talking about the world currency markets, he could have been. Because Japanese retailers, US hedge funds and European banks have been able to borrow cheaply in their currencies and invest those funds elsewhere, the smaller economies of the world now face declining currencies or higher-than-necessary interests rates. Two examples of this are at opposite ends of the world: Iceland and New Zealand.

The culprit is the “carry trade,” whereby investors borrow dollars, euros and yen at low rates and invest in places like Iceland and New Zealand where central banks have interest rates of 11.5% and 7.25% respectively. However, since the locals use the krona and kiwi dollar and not yen, euro or Yankee bucks, the investors have to buy the local stuff with the currencies in which they borrowed. This represents an increase in demand for local currencies, and when demand rises, so does the price. So, the Icelandic krona and New Zealand dollar had been rising until this year as foreigners bid them up to make their investments.

With the US Federal Reserve and European Central Bank continuing to raise interest rates, and with the Bank of Japan likely to start a tightening cycle soon, the interest rate differentials are shrinking. The carry trade is becoming less profitable. This means that a great many who hold krona- and kiwi dollar-denominated assets are ready to liquidate their positions and repatriate their profits. In other words, the supply of these currencies is now increasing as the capital flow changes direction, and the price they command is falling. Indeed, the krona is down 12% against the US currency in the first quarter of 2006, and the kiwi is off 10.7%, both two year lows (which corresponds to the beginning of the rise in carry trade profitability).

Dropping currency values makes imports more expensive, and as island nations off the beaten paths, imports are already expensive in both places. Rising import prices can set off a recession or worse. So keeping interest rates up will diminish the flight of currency, and therefore, imports will not get too expensive. However, that also means borrowing money in these countries will be more expensive, and that cuts down economic activity as well. It’s a marvelous case of “damned if they do, damned if they don’t.”

It is tempting to ignore these two economies due to their rather odd and small positions in the global economy. However, both of these nations have large current account deficits: Iceland’s is 16.5% of GDP, and New Zealand’s 8.9% of GDP. In the US, the figure was 6.4% last year, and the country is setting records every month in this category. Naturally, the US economy is more important than Iceland’s or New Zealand’s, the nation is more robust economically, and perhaps the comparison is unfair. That might be a pleasant thought the next time there’s a drop in the US dollar.

© Copyright 2006 by The Kensington Review, Jeff Myhre, PhD, Editor. No part of this publication may be reproduced without written consent. Produced using Fedora Linux.

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