‘Of zero value and potentially destabilising’: how should we regulate the carry trade?

The carry trade, where profits can be made in currency markets using price information alone, has been a persistent anomaly in financial markets since the collapse of Bretton Woods. This thesis outlines how, under free floating currencies, there have been waves of financial crises, financial sector growth has decoupled from GDP, and currency market activity has become increasingly concentrated in a few centres. The thesis uses the stock-flow consistent or accounting approach to explain the carry trade. Problems with the quality, coverage and timeliness of the SNA and BOP are discussed, with recommendations to improve the data for research into foreign exchange risks. The persistence of high and low interest rate economies is explained with hedge, speculative and Ponzi models of a simple economy. Disaggregating a typical carry trade strategy shows scant evidence for currency market efficiency or a constant risk premium. Rather, there is the impression that international liquidity is a co-ordination problem, and that foreign exchange losses are absorbed by the balance sheets of central banks and exporters. The key features of low interest rate economies are summarised as a Financial Consensus underpinned by a liquidity put from central banks during crises. These findings are consistent with the literature on endogenous money. Carry trade indices are suggested as a measure of the success of expansionary and contractionary monetary policy. In parallel, deficit countries would need tough fiscal and regulatory policies to tackle stubborn trade deficits, the risks posed by unsustainable external positions, the risks from leveraged offshore finance, profit accumulation and speculative capital flows. The thesis also outlines strategies for countries to resist losses to financial speculators: to move away from inflation targeting, to put in place mechanisms to recycle your own trade receipts, and to settle foreign exchange and derivative trades in domestic currency.