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Dampening the Global Risk Appetite Cycle
International capital flows come in only two modes: feast or famine. The policy response to both situations has been primarily via exchange and capital controls--both have their consequences. Macro-prudential tools may represent a more flexible, less discriminatory alternative to capital controls. These tools of macroeconomic policy, though already in place, are not used as they should be, that is, to directly address the risk-appetite cycle of international capital.
Market participants and readers of the financial press will be familiar with the “carry trade” in global foreign exchange markets. This is where, in the absence of exchange controls, a speculator borrows a currency with a low interest rate and deposits it in the currency with a high interest rate. The speculator benefits if the currency with the high interest rate does not depreciate by the same percentage of the interest rate differential or what is referred to as “the carry.” The weight of many traders pursuing the carry often lifts the high-yielding currency and so the speculator gets the benefit of being paid for holding on to an appreciating asset. Part of the appeal of the carry trade for traders is that it is both self-fulfilling and it appears to resonate with international macroeconomic theory, where tighter monetary policy leads to a currency appreciation.
Speculation and Carry Trade
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