Flashback: When yen carry trade unwinding worsened the 2008 global market meltdown

Japan’s roaring 80s lead to a huge bubble in the stock markets and real estate sector. As bubbles are prone to, this one also burst. In 1991, Japan was facing a major recession and the central bank decided to keep interest rates at lows, in an attempt to encourage consumption and borrowing.

While the move was aimed as a shot in the arm of a weakening economy, cheap credit lured traders from around the world to Japanese shores. By 2007, the yen had weakened to 125 to the US dollar, and with the ultra low interest rates made it the most preferred currency for carry trades.

There is no data on how much money was tied up in Yen carry trades in the run to the 2008 global financial crisis, but some estimates put it in the region of hundreds of billions of dollars.

The onset of the financial crisis led to a significant increase in risk aversion among investors. As uncertainty and volatility in financial markets surged, investors sought to reduce exposure to risky assets, including those financed through carry trades.

This triggered a chain reaction and eventually a vicious cycle. As global markets tumbled, investors fled risky assets and repatriated funds to safer currencies, including the yen. The result was that the yen appreciated significantly, hitting a high of 871.3 to the dollar by late December 2008.

This made many of the carry trades unprofitable, leading to more liquidation of such trades, roiling equity, bond and commodity markets across the globe.

The strong yen posed problems for Japan as well. The economy was extremely reliant on exports, but Japanese products were now pricier compared to competitors. Also, as a result of the global recession, consumption had sunk. During the crisis, Japan saw the worst economic performance in the G7.

2007 versus 2024

While both periods are marked by sharp global risk aversion, leading to a flight to safety, there are some key differences. Currently, risks are compelling investors to unwind their carry transactions, selling higher yielding currencies while simultaneously buying back Japanese Yen. This has resulted in a quick rise in the Yen in both periods.

However, the unwinding in 2007-08 was more dramatic and anticipated, substantially adding to the global financial crisis. “While the 2007-08 crisis was caused by the systematic collapse of the financial system, the current situation, marked by uncertainty and geopolitical tensions, does not appear to be as dire,” said Aamir Makda, Commodity & Currency Analyst, Choice Broking.

He added that since then, central banks have become more engaged in intervening in currency markets in recent years, which could mitigate the impact of carry trade unwinding.

In 2008, the USDJPY had dropped from 125 to 87, nearly 30 percent. However, over the past one month USDJPY is down 12.5 percent.

"This time, carry trades are notably elevated, as Japan's prolonged ultra-dovish stance has created a stark divergence in monetary policy. However, this doesn't necessarily mean we'll see a comparable appreciation in the JPY. In 2007/08, the price movement was significant due to the Global Financial Crisis,” said Anindya Banerjee, SVP: Head of Research, Kotak Securities.

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