Probing the Carry Trade

"The main problem in China is that their economy is overheating and posing serious concern to the authorities," says a research note issued by J.M. Finn in London. "Speculation is rife, bank lending often irresponsible and it is estimated that 90,000 stock dealing accounts are opened daily. These are not everyday Western economic conditions. In addition, China is facing a colossal level of fixed-asset investment, nearly 50% of GDP in 2006."

Others, such as Tony Crescenzi, chief bond market strategist at Miller Tabak and a RealMoney.com contributor, say it's not the actual carry trade itself that is the problem but the perceived effects of the unwinding. "Even with a full unwinding of the yen carry trade -- something that is very unlikely, given the large interest rate differential that exists between Japan and the rest of the world, the lasting impact of the unwinding is unlikely to be large," he writes.

"The bigger impact is psychological, with many fearing what might happen from the unwinding, because they do not have the figures needed to quantify what the impact might be. This is the stage of the unwinding that the markets are now in the midst of."

Still, Sean Darby of Nomura Bank in Hong Kong sees the carry trade as an almost inevitable cause of the heavy selling.

"The marginal financing from the carry trade had exaggerated the risk premium irrespective of the global economic outlook," he says. "Hence, any reversal in the borrowing of carry-trade currencies would have a profound effect on financial assets as sentiment reversed."

Unfortunately, both realities have very different solutions, for while one says that Japan's messy handling of its own economy and lending is the culprit, the other says it's about Chinese overconfidence in valuing its own assets. Needless to say, both arguments have different appeals, depending on where you find yourself in Asia.

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