London - Emerging economies may be on the cusp of a great unwinding of borrow-low invest-high carry trades, through which an estimated $2 trillion (R21.3 trillion) has flooded mainly into their debt markets in the past five years.
The latest cycle of carry trades is the third in little over two decades and its estimated size is roughly double that of its predecessor.
A reversal poses a specific risk to debt markets, especially in China, where investors who facilitated a corporate lending binge face both currency and credit losses.
With investors demanding higher compensation for growing political and economic risks, even aggressive interest rate hikes by emerging market central banks defending their currencies may not be enough to keep the carry party swinging.
Since the Federal Reserve started offering cheap money under its quantitative easing policy in late 2008, emerging banks and corporates have issued substantial volumes of foreign currency-denominated bonds and borrowed heavily from overseas banks.
According to Bank of America Merrill Lynch, external bond issuance from emerging markets more than doubled to $2 trillion in the five years to end-September 2013. Including bank loans, EM had attracted investment from abroad totalling $5 trillion by autumn 2013, nearly $2 trillion more than five years ago.
In return, investors enjoyed quick profits by borrowing in low-yielding currencies like the dollar and euro to invest in high-yielding emerging debt.
Some retail investors have begun unwinding these trades.
EPFR-tracked bond funds have lost over $11 billion this year, compared with outflows of $14 billion for the whole of 2013.
But institutional investors - which make up the bulk of EM carry trades - have yet to head to the exits.
“On a net basis it has not unwound, or in fact it may have increased further ... But as some people put it, carry is a rental profit. You have to give it back at some point,” said Salman Ahmed, strategist at Lombard Odier Investment Managers.
“This time, carry trades are more concentrated in the high-duration corporate bond market. Money went into the 10-year and seven-year debt. It's a much riskier situation because you have FX exposure and underlying credit and duration exposure.”
Duration is a commonly used measure of risk that indicates how price-sensitive a bond is to changes in interest rates.
Average interest rates in emerging economies have bounced off post-crisis lows after aggressive monetary tightening by the likes of Turkey and Russia.
But analysts said that was unlikely to kick off a new round of carry trades.
“EM carry is happening at a time when developed equities are doing well. There's competition between DM and EM,” Ahmed said.
“You are choosing 10 percent carry and political and FX risks, or a 15 percent gain without any risks. Carry may have to go further higher to bring people back.”
Emerging markets have seen carry trades fuel a boom-and-bust cycle before.
The first, driven by foreign banks, funded East Asian economic expansion before ending in 1997 with the Asian financial crisis.
The second was the gigantic yen carry trade that built up in the early 2000s, during which an estimated $1 trillion poured into big emerging economies before a rapid unravelling in 2008.
Some cash from carry trades which have been unwound this time may be making its way into high-yielding corporate debt in developed markets, according to Yves Bonzon, chief investment officer at Pictet Wealth Management.
“You borrow/short and leverage DM corporate debt with five-to-seven year duration risk, or maybe the euro zone periphery,” he said.
“As long as you have global capital flows and local regulations you will have carry trades, it is inevitable.”
CHINA RISKS
China could be one of the biggest victims if yuan carry trades unwind.
Years of stable appreciation in the yuan ended abruptly last week when the central bank let the currency make its biggest weekly decline since 1994.
BofA says Chinese banks and corporates issued $655 billion in foreign currency bonds in the five years to September 2013, five times more than the prior five-year period to 2008.
The volume of outstanding external bonds grew by five times, to $239.7 billion.
However, Chinese corporates have also borrowed in the shadow banking sector, which sold “trust” products to investors.
China's domestic bond market was worth 9.3 trillion yuan ($1.5 trillion) at the end of last year, but the real size of its private sector credit market is unknown.
Part of these funds were raised overseas. Net lending by Hong Kong-based banks - key participants in intermediating China carry trades - rose to 148 percent of Hong Kong's GDP in late 2013, from just 18 percent in 2007.
Yuan-denominated “dim sum” bonds designed to attract foreign investors have turned into a 600 billion yuan-plus market in a little over three years, mainly out of Hong Kong.
“The Trust sector in China could create rollover risks that reverse a gluttonous carry trade with China, but partly financed overseas,” BofA Merrill said in a client note.
Credit risk is also rising.
China recorded its first domestic bond default when loss-making solar equipment producer Chaori Solar missed an interest payment.
Any combination of higher US yields, tighter regulation on trust products, further yuan appreciation or volatile currency could trigger an unwind in China carry trades.
“There is speculation they are cleaning out speculators,” said Jeff Kalinowski, EM bond portfolio specialist at T Rowe Price.
“The general view is that liberalisation will bring greater volatility. It's less of a carry trade bet.” - Reuters