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Probing the Carry Trade

Did a yen rally cause the China selloff or vice versa?

Asia's downward spiral continued Monday amid fresh debate in the region over the cause of the recent selloff. It's a classic chicken-and-egg debate: Did the rising cost of the yen carry trade set off the panic-selling in China, or did the Chinese meltdown set off the unwinding of the yen carry trade?

Which came first is important, market-watchers say, because finding the catalyst may be the answer to stemming the red-digit bloodbath affecting world markets.

In what some are seeing as a new "Asian contagion," investors in Asian ETFs fared the worst of all last week. The

iShares FTSE/Xinhua China 25 Index

(FXI) - Get iShares China Large-Cap ETF Report

plunged nearly 10%, while the

iShares Singapore Index

(EWS) - Get iShares MSCI Singapore ETF Report

, the

iShares Malaysia Index

(EWM) - Get iShares MSCI Malaysia ETF Report

and the

iShares MSCI Emerging Market Index

(EEM) - Get iShares MSCI Emerging Markets ETF Report

-- which gained 22% last year -- all suffered similarly. (In recent trading Monday, the ETFs were down between 0.9% and 5.7%.)

Many hoped that the region would reverse last week's losses. But overnight Monday, the Nikkei 225 lost 3.34%, while Hong Kong's Hang Seng plummeted 4% and the Shanghai Composite Index lost 1.6%. But it was the Shanghai market's B-share index that set off another round of panic selling, after it plunged 6.9%. So-called B-shares are denominated in foreign currencies and are thus more relevant to the carry-trade conversation than shares on the mainland, which trade only in the local currency.

The start of the week in Asia has been notable for the lack of commentary. Many asset managers, such as the usually outspoken Alex Wong of Ample Financial Group in Hong Kong, are not making official statements. After being downright chatty last week, other gregarious analysts held back on issuing research at the end of trading Monday.

As a knock-on effect, European markets were hit hard by selling early Monday. After hitting its lowest level in three months earlier in the day, London's FTSE was recently off 0.8%, as was the Paris CAC 40. The German DAX was recently off 1.2%, although up from its intraday lows as major U.S. markets attempted to rebound from early selling.

Some say the cause of the recent selloff is simply that Chinese assets were at inflated prices, and that this is an inevitable correction, given the overall lack of productivity vs. growth in the country. Others see the Chinese economy as perfectly healthy and as suffering from a credit squeeze caused by the soaring yen, which rallied sharply last week and hit multimonth highs vs. the dollar and euro intraday Monday.

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This latter theory points to idea that market growth in the region was increasingly dependant upon a continuing "yen carry trade," where foreign banks were borrowing in yen and short-term exchange-traded contracts to finance rising investments in Asia and elsewhere.

When the Bank of Japan signaled its intention to raise interest rates two weeks ago amid attempts to normalize monetary policy, the theory goes that the potential of the yen's ascent against the dollar suddenly made this borrowing much more expensive. When banks and hedge funds cut back on their borrowing as a result, they had to sell some of the shares they owned with the borrowed capital, causing the downward spiral.

But it's unclear whether an unwinding of the yen carry trade is responsible for setting off this latest round of selling, says Cazenove's economist Paul Schymyck in Malaysia.

"It is still very uncertain as to whether an unwinding of the yen carry trade is occurring," he said in a research note published Friday. "Japanese interest rates remain very low, and Japanese data remains unconvincing -- flat CPI, weak retail sales and wage growth. The BOJ may not raise rates again until the third or fourth quarter, which should keep the yen attractive as a funding vehicle."

To further complicate the argument, some analysts say it happened the other way around: that the unwinding of the yen carry trade is a


of last week's selloff in China rather than the cause. After last Tuesday's nearly 9% decline on the Shanghai Stock Exchange, investors realized that prices were inflated, and the Japanese reacted by unwinding many of the yen carry trades, in turn sending markets plummeting further.

"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

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.

At the time of publication, Daniel M. Harrison had no positions in the ETFs mentioned.

Harrison is a business journalist specialising in European and emerging markets, in particular Asia. He has an MBA from BI, Norway and a blog at

. He lives in New York.