Explained: How Unwinding of Yen Carry-Trades Will Impact Indian Equity Markets

Global asset markets have seen massive correction in the past two sessions. There have been significant moves in equity markets, cryptocurrency and currency markets globally. The key reason behind this trigger could be the unwinding of carry trade in the Japanese yen in the wake of its appreciation against the US dollar. The yen carry trade has been the focus of the last few trading sessions following the sell-off in shares of US technology giants.

On Monday, Japan’s yen touched mid-January highs around 145.28 extending its recent appreciation against the US dollar. The Japanese currency has appreciated by 10 per cent against the dollar in just over three weeks, partly due to the Bank of Japan’s 15 basis points rate hike to 0.25 per cent last week.

On March 19 this year, the BoJ first raised interest rates after 17 years to 0.10 per cent. In addition, the Japanese central bank also said it would halve its monthly bond purchases over the next couple of years in its bid to strengthen the currency and economic growth. However, the rate hike is expected to have an adverse impact on carry trade.

What is carry trade?

Carry trade refers to the trading strategy that involves borrowing money at a low-interest cost and investing the same in other assets like equities, bonds, commodities and currencies that provide higher returns. It is a popular strategy among forex traders wherein investors borrow from a country with low interest rates and a weaker currency and reinvest the money in another country for higher returns.

Due to the Bank of Japan’s (BoJ) ultra-loose policy for 17 long years, the Japanese yen is considered one of the most widely used currencies for this purpose.

The Japanese yen has surged by 10 per cent over the last three weeks from levels of 161 on July 11 to 145 now. As the yen appreciated against the US dollar, investors rushed to unwind their carry trade to cut losses.

Impact of yen carry trade unwinding on Indian markets:

The shock waves of the unwinding of the yen carry trade were felt on the markets globally. According to market experts, the severe sell-off in shares of US-based technology giants in the last few sessions could also be on account of the reversal of the yen carry trades. The sell-off in the US spilled over to Asian equities too, including India.

According to NSDL data, Japanese foreign portfolio investors hold equities worth Rs 2.05 lakh crore. A stronger yen could also be a reason to worry for some Indian companies, which have borrowed in yen but have not hedged against a sharp surge in the currency.

Recent data indicate that cross-border yen borrowing has risen by $742 billion since 2021 showing the ongoing influence of carry trades, according to a report by Anand Rathi.

Vinay Paharia, CIO of PGIM India Mutual Fund says Indian equities have had a stellar run in the last one year, mostly led by companies that have lower-than-average business quality and lower-than-average growth profile.

“We have been highlighting some of the micro bubbles in the market for quite some time now, which we think are brewing in low growth-low quality mid-cap and small-cap stocks, capital goods, defense and industrials sectors, stocks of newly listed IPO companies and real estate sector,” he said.

In the last one year, the mid-cap and small-cap indices have largely outperformed the benchmark indices of Indian stock markets. In the last one year, BSE mid-cap and small-cap indices surged over 50 per cent and 53 per cent, respectively, compared to 20 per cent rise in the BSE Sensex index.

Paharia added that companies in the micro bubbles segments of the markets are expected to underperform in the near to medium term. “We expect the market to rotate back into high growth–good quality companies. These companies have delivered strong returns over the last 5-Yr and 10-Yr basis. However, over the last 3-Yrs, 1-Yr and FYTD 25, we have seen such companies underperform significantly versus their low growth-low quality peers,” he added.

India has been one of the biggest beneficiaries of the near-zero interest rates that existed in Japan. The strategic and friendly relationship between both Asian economies saw cheap capital available to fund India’s infrastructure push in the past 10 years. In addition, Indian companies raised cheap funds to fuel their capital expenditure in the area of roads and highways, power and metals.

Moving ahead, the yen carry trade will lead to an increase in the debt-serving cost of Indian firms who have borrowed long-term yen loans in the last 10 years backed by near-zero interest rates.

Despite a $34 billion outflow over 12 months, from mid-July 2021 to mid-July 2022, the Nifty rose 2.6 per cent, buoyed by strong fundamentals and robust domestic flows into equity markets, with the latest monthly SIP inflows into mutual fund schemes at $2.6 billion.

According to Anand Rathi report, the domestic theme-related sector will continue to offer an oasis of safety. Therefore, even a complete unwinding of India’s carry trade exposure is unlikely to significantly impact the Indian equity market over the long term. “Any meaningful short-term fall in the Indian equity market should be seen as an opportunity to increase exposure to equity,” the report added.