Investors beware. The sharp rise in asset prices since March this year could well be the beginning of another crisis.

The massive rally in asset prices has come on the back of a steadily declining US dollar. The asset price bubble may eventually get pricked when the US monetary authority starts increasing interest rates.

When that happens, the greenback will be flown back to the US, leading to the crumbling of asset prices. Experts also foresee a currency crisis snowballing into a financial collapse.

Asset price bubble

In an article in Financial Times early this month, Nouriel Roubini, a professor of economics at the New York University’s Stern School of Business and the chairman of Roubini Global Economics, wrote: “Since March, there has been a massive rally in all sorts of risky assets — equities, oil, energy and commodity prices — and an even bigger rally in emerging market asset classes. The dollar has also weakened sharply, while government bond yields (the return that an investor will get holding on to the bond till maturity) increased but stayed low and stable.”

According to Roubini, risky asset prices have risen too much, too soon. An important factor fuelling this rise is the weakness of the dollar that has become a major funding currency of carry trades.

Carry trade

A carry trade is a speculation strategy of reaping the profit (called the carry) from the interest rate differentials available in two different countries/currencies. In a carry trade, a speculator borrows the currency of a country having a low interest rate (say, 1 per cent) and invests the money in currencies of other countries where interest rates are higher (say, 5 per cent) or in risky assets that are yielding higher returns. The interest differential (4 per cent in our example) accrues to the investor as profit or carry. This strategy works wonders if the funding currency (in which the money is borrowed) continues to depreciate against the investing currency.

Let’s suppose you have borrowed $100 from the US at an interest rate of 1 per cent and invested the money in equities here yielding an annual return of 20 per cent. Let us assume that the exchange value was Rs 50 a dollar at the time of borrowing. Your interest liability is $1 and your investment in Indian equities is Rs 5,000. Your investment from equities after one year is Rs 6,000 (= 120 per cent of Rs 5,000).

Had the exchange rate remained the same, your profit from the carry trade would have been the difference of the profit from equity investment (Rs 1,000) minus interest liability (Rs 50), or $19 (= Rs 950).

Now suppose the dollar depreciates 10 per cent against the Indian currency. The new exchange rate is 45 a dollar. In this case, your profit will be $21.22 (= $22.22—$1). A depreciating funding currency of the carry trade is like a double treat to speculators.

For over a decade till 2007, the yen has been the preferred currency for carry trade because the Japanese government kept the interest rate in the country close to zero along with monetary expansion to combat economic stagnation in the country.

During this period, the yen continually depreciated against the dollar as speculators invested in US assets, including sub-prime mortgage papers, on a highly leveraged (in yen) basis.

In 2007, when the sub-prime and credit crisis surfaced, the yen started appreciating sharply against the dollar as speculators had to book their losses and repatriate yen back to Japan.

Weak dollar

The dollar has now taken the place of the yen in carry trade.

“With investors taking advantage of low US interest rates to fund high-yield currencies with borrowed dollars, emerging markets may be set for a jolt when the Federal Reserve eventually tightens the monetary policy,” the Bank of Korea said in one of its recent research reports.

“Any Fed move to raise rates will trigger liquidation of such transactions (investments in emerging markets), resulting in heavy fund outflows from the emerging markets,” Wall Street Journal reported.

Massive inflows

In India, foreign institutional investors made a net investment of $15.68 billion ($14.23 billion in equities and $1.45 billion in debt) in the current calendar year till November 6. In contrast, they repatriated investments worth $11.97 billion in equities in 2008. Thus, net investment in equities by FIIs in the current calendar year has already exceeded more than what they took away last year. This explains the spurt in equity prices in domestic bourses.

The same dollar carry trade is working behind the steep spike in gold and silver prices in world markets. Gold price in the international markets rose to an all time high of $1,095 from a low of $737 in October last year.

“I do expect (a) currency crisis or semi-crisis in the next year or two because there are so many imbalances in the world. Normally what happens is that you have small countries you don’t think about. Then something goes wrong and it starts snowballing and people say: how did it happen? That’s going to happen again before too much longer,” Jim Rogers, chairman of Rogers Holdings and an investment expert, told Financial Times.

Countries such as Brazil have started imposing caps on foreign capital inflows. China and India have also started diversifying into gold and other currencies such as euro and yen. Some countries have been forced to keep their short-term rates low to prevent their currencies from appreciating against the dollar.

Roubini says the perfectly correlated bubble across all global asset classes is getting bigger by the day and once they burst, it will be the biggest co-ordinated asset bust ever. Only time will tell whether this will be true.

"If the dollar continues to depreciate against other currencies without any government intervention, it will only make dollar carry trade more attractive. If governments try to control currency appreciation through open market interventions, the domestic monetary easing created via stimulus and bail-out packages will continue to blow up the asset price bubble," Roubini noted.