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Irs And The Carry Trade

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It's only recently that I've become aware of the carry trade and the way that increasing IRs sucks even more money into the economy. As far as I can make out:

If the Bank cuts rates, people borrow more (this bit's obvious)

If the Bank raises rates, foreigners deposit more money in sterling, which must then be lent out to earn the required interest. So people borrow more (to me, this bit is less obvious)

That must is the scary bit, because the banks are forced to turn to ever dodgier deals, i.e. what is now being characterised as 'sub-prime'. We call it irresponsible lending, but if they're obliged to take deposits, and obliged to pay interest on them, then it's an irresponsibility that seems built into the system.

Here are a few things that puzzle me about the whole business. If anyone has any insights to share, I'd be grateful!

When somebody borrows yen to buy pounds, what happens to those yen, and where do the pounds come from? My guess is that the yen are deposited as reserves with the Bank of England, which creates a corresponding number of new pounds; is this correct?

Could an individual bank say, "given current IRs and UK indebtedness, we have no promising loans to make--so we're not taking any more sterling deposits"?

Why does the UK not reduce interest rates to deter the carry trade, and use fiscal means to cool the economy instead? I'm thinking of something along the lines of an interest tax.

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It's actually the level of foreign investment via treasury bonds which helped to push down interests rates originally. The problem is the Chinese seem to withdrawing their money, thereby causing the yields on bonds to rise, which has a knock on effect on all IRs.

http://www.tutor2u.net/newsmanager/templates/?a=949&z=1

A glut in global savings and a build up of foreign exchange reserves: The second explanation for falling bond yields is that there has been a huge rise in the demand for bonds brought about by a glut in global savings. Here is the story. In countries such as China, Japan and the rich oil-producing nations, the huge current account surpluses in their balance of payments accounts have led to a super-fast rise in savings (reserves) of foreign currency. These savings look for a home that offers the highest expected return and according to some commentators, what we have seen is a tremendous surge in demand for bonds in global capital markets. Chinese savers have invested in US government debt, overseas investors and UK pensions funds have been happy to buy into UK government debt. The result has been a large rise in bond prices and a commensurate reduction in bond yields (since there is an inverse relationship between the price of a bond and the yield on it). High levels of domestic savings cause an outward shift in the supply curve for loanable funds which, other things remaining equal, causes a fall in average interest rates. In the diagram below the supply of loanable funds has shifted out by more than the increase in demand for such funds, causing a fall in the equilibrium rate of interest.
Edited by Sinking Feeling

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When somebody borrows yen to buy pounds, what happens to those yen, and where do the pounds come from? My guess is that the yen are deposited as reserves with the Bank of England, which creates a corresponding number of new pounds; is this correct?

Could an individual bank say, "given current IRs and UK indebtedness, we have no promising loans to make--so we're not taking any more sterling deposits"?

Why does the UK not reduce interest rates to deter the carry trade, and use fiscal means to cool the economy instead? I'm thinking of something along the lines of an interest tax.

Could do worse than top start here

http://en.wikipedia.org/wiki/Foreign_exchange_market

http://en.wikipedia.org/wiki/Carry_(investment)

It does not necessarily follow that the BOE has to create GBP for every Yen received. It can just decide to let the value of the currency appreciate. This is is pretty much what has happened to Sterling over the past few years.

You are not alone in wondering why the BOE insists on the one club policy of interest rates to control the economy. Professor Wynne Godley at Cambridge University argued for many years that this was one of the main causes of the boom and bust cycle that has plagued the UK. Before the 1980s governments used exchange and credit controls in an attempt to control capital flows and to prevent reckless lending. These were all abolished by the first Thatcher administration. Because the City of London is now pretty much dependent on the unfettered movement international money for its existence I can not see any British government proposing the reintroduction of exchange controls. Some of our colleagues in the rest of the EU, particularly the French, are rather keener on the idea. Given the new EU Treaty negotiations it will be interesting to see what they try to do in this area over the next few years.

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It's actually the level of foreign investment via treasury bonds which helped to push down interests rates originally. The problem is the Chinese seem to withdrawing their money, thereby causing the yields on bonds to rise, which has a knock on effect on all IRs.

http://www.tutor2u.net/newsmanager/templates/?a=949&z=1

That's a brilliant article - thanks.

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You are not alone in wondering why the BOE insists on the one club policy of interest rates to control the economy. Professor Wynne Godley at Cambridge University argued for many years that this was one of the main causes of the boom and bust cycle that has plagued the UK. Before the 1980s governments used exchange and credit controls in an attempt to control capital flows and to prevent reckless lending. These were all abolished by the first Thatcher administration. Because the City of London is now pretty much dependent on the unfettered movement international money for its existence I can not see any British government proposing the reintroduction of exchange controls. Some of our colleagues in the rest of the EU, particularly the French, are rather keener on the idea. Given the new EU Treaty negotiations it will be interesting to see what they try to do in this area over the next few years.

nice post, thanks. And props to the OP for pointing out the salient fact. You might find Elaine Supkis' work interesting. for example or...

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You are not alone in wondering why the BOE insists on the one club policy of interest rates to control the economy. Professor Wynne Godley at Cambridge University argued for many years that this was one of the main causes of the boom and bust cycle that has plagued the UK. Before the 1980s governments used exchange and credit controls in an attempt to control capital flows and to prevent reckless lending. These were all abolished by the first Thatcher administration. Because the City of London is now pretty much dependent on the unfettered movement international money for its existence I can not see any British government proposing the reintroduction of exchange controls. Some of our colleagues in the rest of the EU, particularly the French, are rather keener on the idea. Given the new EU Treaty negotiations it will be interesting to see what they try to do in this area over the next few years.

Thanks. I found this article on Professor Godley, from 2003 -- a distance that perhaps gives us a worthwhile perspective.

Professor Godley traces the origin of the UK debt bubble back to the early 1980s, when a range of consumer credit controls and restrictions on mortgage lending were removed.

"That should never have happened," he says. "We are now at a point where the problem doesn't have a clear solution."

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Guest vicmac64
Could do worse than top start here

http://en.wikipedia.org/wiki/Foreign_exchange_market

http://en.wikipedia.org/wiki/Carry_(investment)

It does not necessarily follow that the BOE has to create GBP for every Yen received. It can just decide to let the value of the currency appreciate. This is is pretty much what has happened to Sterling over the past few years.

You are not alone in wondering why the BOE insists on the one club policy of interest rates to control the economy. Professor Wynne Godley at Cambridge University argued for many years that this was one of the main causes of the boom and bust cycle that has plagued the UK. Before the 1980s governments used exchange and credit controls in an attempt to control capital flows and to prevent reckless lending. These were all abolished by the first Thatcher administration. Because the City of London is now pretty much dependent on the unfettered movement international money for its existence I can not see any British government proposing the reintroduction of exchange controls. Some of our colleagues in the rest of the EU, particularly the French, are rather keener on the idea. Given the new EU Treaty negotiations it will be interesting to see what they try to do in this area over the next few years.

I was not aware of this - the more I read the more I see the hand of TREASON involved!!! - this is not right!!! this is undemocratic!!!!!!!!!!!!!!!!!!!

But I'm glad The British are a BAND OF BROTHERS in the face of adversity wherever it comes from - Welsh, English and Scottish and Northern Irish along with anyone that backs us from anywhere - we are all family and we look after one another!!!!!

So we'll sort it out

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