Unwinding the Carry Trade

Few places look more vulnerable than the countries of Eastern Europe.


The Crash of October 1929 didn’t mark the onset of the Great Depression. The collapse of the Bank of United States, a New York bank, in December 1930 had a far greater impact on the stability of the financial system. At the time, many still considered the developing crisis to be a purely American affair, a due reckoning for the excesses of the Roaring ’20s. This delusion didn’t last long. In May 1931 the Credit Anstalt closed its doors. The failure of Austria’s biggest bank brought panic to the Continent. Now, as the U.S.’s current financial wildfire spreads across the globe, Eastern Europe looks like it may once again take center stage.

After years of credit excesses, few places look more vulnerable to an unwinding of the global carry trade than the swath of countries running from the Baltics to the Black Sea. The currency carry trade involves borrowing in countries with low interest rates and investing the proceeds in higher-yielding currencies. But it’s not exactly a free lunch, since carry traders face a currency mismatch between their assets and liabilities. When currencies blow up, this risk becomes painfully manifest.

The carry trade also has a harmful influence on the wider economy: Large capital inflows generate domestic credit booms, fueling asset price bubbles and stimulating inflation in the recipient economies. They also support current-account deficits, allowing recipients to consume more than they produce. As domestic prices become inflated during the boom, recipients become less competitive. Eventually, a point is reached when the markets lose faith in the ability of countries receiving capital inflows to repay foreign loans. The currency comes under pressure and eventually cracks, bringing with it a wave of defaults and bankruptcies. This is what happened during the Asian crisis in the 1990s. The lessons of that debacle are still keenly remembered in the Far East.

Eastern Europe, on the other hand, has not suffered such an experience within living memory. Perhaps this explains why a number of former Soviet countries have sought cheap foreign funding in recent years. Eastern Europe has been the largest recipient of emerging-markets cross-border bank loans over the past five years, reports the Bank for International Settlements. Capital inflows have climbed roughly fivefold since 2003, approaching nearly $1 trillion last year.

Over the same period, current-account deficits have exploded. Latvia boasted a trade deficit equivalent to 25 percent of GDP by the end of 2006. The International Monetary Fund reckons Bulgaria’s current account will reach 22 percent of GDP this year. The ratios of external debt to GDP of several Eastern European countries are now larger than those of most Asian countries a decade ago, says Ian Harnett of Absolute Strategy Research, a London-based research outfit. For instance, Hungary’s ratio of foreign debt to GDP exceeds that of Russia before the latter’s default in 1998. Many of these loans are short term and need to be rolled over. The short-term foreign bank borrowing of Hungary and Bulgaria amounts to roughly 20 percent of GDP, according to BCA Research, a Montreal-based research firm.

The currency carry trade might have been a boon had foreign capital been used to finance industrial development in emerging Europe. However, much of this money found its way into local real estate markets and domestic services. As Eastern Europe played a game of financial catch-up with its Continental neighbors, it was only natural that consumer borrowing should expand rapidly. Nevertheless, the rate of credit growth in this region has been awesome. In recent years the Baltics, Bulgaria and Romania have experienced annual rates of household credit growth in excess of 50 percent. Hungarian and Polish homeowners also availed themselves of easy money during boom times.

From 2000 to 2006, housing loans in emerging Europe grew at an average annual rate of 43 percent, according to ASR’s Harnett. By early last year foreign currency loans averaged about 40 percent of total mortgages in Hungary, Poland and Slovenia. In Croatia and Estonia about three quarters of mortgage loans are foreign-denominated.

Companies have played the same game. Hungarian firms have increasingly funded their operations with U.S. dollar, Swiss franc and euro liabilities. Turkish businesses have also borrowed heavily abroad. Tim Lee of Pi Economics reckons that Turkish corporate foreign liabilities have climbed to $120 billion, or about 17 percent of GDP.

There are few places in which to hide from the credit crunch. Eastern Europe must now face the consequences of its credit binge. The position of countries such as Hungary, for example, is not enviable. It needs to attract capital flows to cover a current-account deficit equivalent to 5.5 percent of GDP, according to a recent IMF projection. Short-term interest rates were raised a percentage point earlier this year, to 8.5 percent. However, high interest rates have depressed consumer confidence as economic growth has slowed.

Despite access to cheap foreign loans, Hungarian households currently expend nearly 15 percent of their income on servicing their mortgages, which isn’t much below what American homeowners stump up. However, nearly half these loans are in foreign currencies, so the outstanding debt will increase if the forint declines. Policymakers in Budapest are caught between a rock and a hard place. Continued high rates could depress economic activity, hurting household income over time. But low rates might weaken the currency, creating balance-sheet problems for foreign currency mortgage borrowers.

The unwinding of emerging Europe’s carry trade may not be far away. U.S. investment banks have been important intermediaries for global capital flows. September’s events have further weakened the surviving Wall Street firms, which are no longer in a position to fund the currency carry trades on their own balance sheets. Japanese banks have been another major source of foreign currency loans, but several of them were badly burnt by the fall of Lehman Brothers. EU banks have been the largest providers of loans to Eastern Europe. But the euro zone has its own problems, and its banks have recently been shrinking their stock of foreign assets.

The credit crisis is set to shrink Asia’s trade surpluses. Global liquidity — as measured by the growth of central bank reserves — has already started to turn down. This means there will be fewer resources to fund carry trades. Eastern Europe could be hurt by any further weakness in the oil market. After oil prices collapsed in the early 1980s, the supply of petrodollars dried up, which left many Latin American borrowers unable to roll over their debts. A recent IMF working paper warns that history could repeat itself. “An unwinding of global imbalances — including through a drop in oil prices,” writes IMF researcher Johannes Wiegand, “could entail substantial risks for some emerging markets, by drying up sources of funding . . . In contrast to the 1970s and ’80s, the bulk of vulnerable countries is not in Latin America but in emerging Europe.”

If currency turbulence comes to the region, then the Western banks that provided foreign currency loans would be on the hook. Sweden’s Riksbank has warned that the country’s banks face “significant losses” from their exposure to the Baltic states. As far as the rest of Eastern Europe is concerned, one country’s banking system looks most vulnerable. Austrian banks have dominated the surge of foreign currency loans to former regions of the Habsburg Empire. Credit Anstalt brought the Great Depression’s financial crisis to Central Europe. Viennese banks may find themselves playing a similar role as the current disaster unfolds.

Edward Chancellor is the author of Devil Take the Hindmost and a senior member of GMO’s asset allocation team.