US and India largest recipients of Yen carry flows since Jan 2023: Elara Capital

Global stock markets experienced a rollercoaster ride last week, driven by fears of the US economy slipping into recession and heightened tensions in the Middle East. However, another key factor that impacted the market sentiment was the unwinding of the Yen carry trade.

To briefly recap, the Bank of Japan unexpectedly raised its interest rate target to 0.25%, the highest level in 15 years. This move caught investors off guard, leading to a withdrawal of funds from Japanese equity markets. The reason lies in a strategy known as the 'Yen carry trade,' which has been popular among investors for years.

The Yen carry trade involves borrowing money in Yen at Japan’s historically low interest rates and investing it in higher-yielding assets like bonds or stocks in other countries. However, the recent rate hike by the BoJ has caused the Yen to strengthen significantly, forcing investors to sell stocks to repay those loans.

This led Japan's Nikkei index to plummet 12.4% on August 05 in its largest single-day decline since the 1987 Black Monday sell-offs. Additionally, concerns about a stronger Yen have cast a shadow over the profit outlook for export-dependent firms in Japan.

Analysts estimate that around $200–250 billion of the carry trade has been unwound in recent weeks, with some suggesting that the total size of the carry trade could be as high as $500 billion.

In this context, domestic brokerage firm Elara Capital has analysed the impact of the Yen carry trade on global equities, with a focus on identifying potential vulnerabilities in certain markets that could be exposed if the trade unwinds rapidly.

Yen-denominated assets in global equity funds surge $150 billion in 18 months

Elara Capital's analysis shows a significant surge in Yen-denominated assets within global equity funds, with an increase of $150 billion over the past 18 months, driven by the accelerating Yen carry trade since January 2023. During this period, the brokerage noted that the JPY/USD exchange rate depreciated from 127 to 162 levels, contributing to the growth.

Yen-denominated assets in global equity funds (excluding Japan) expanded from $200 billion in January 2023 to $350 billion. This growth included $45 billion in inflows, with 33% ($15 billion) directed to U.S. funds, 23% ($10.3 billion) to Indian funds, and the remaining 45% ($20 billion) into global funds, primarily comprising U.S. stocks.

The increase in JPY assets was fueled by 30% inflows and 70% price appreciation. The brokerage analysis showed that, 25% of the Yen flows to India were directed to mid-cap funds, while in the U.S. and global funds, the focus was on large-cap funds. Most of the Yen inflows have been allocated to long-only funds, with minimal ETF participation.

For India specifically, 80% of the Yen flows ($8.6 billion) originated from Japan-domiciled funds, while the remaining 20% ($1.7 billion) came from Luxembourg-domiciled funds, the brokerage noted. 

Mid-cap index surges 42% between April and September 2023, driven by Yen inflows

According to the Elara Capital, India's Yen-denominated assets have surged from $6 billion in January 2023 to nearly $21 billion by the end of June. This represents about 2.2% of the total Foreign Institutional Investor (FII) holdings in India, which stand at $945 billion.

The brokerage highlights that India is unique in attracting a substantial portion of Yen inflows specifically towards mid-cap funds. These inflows started in April 2023 and surged rapidly until September 2023, contributing to a remarkable 42% rally in the Indian mid-cap index, with no significant corrections during this period. However, the brokerage notes that since then, yen flows in India have gradually shifted towards large-cap funds.

Yen carry trade unwinding is a real threat to India

Elara Capital stated that the potential unwinding of the Yen carry trade presents a significant risk for India. The brokerage referenced the last major phase of the Yen carry trade in India, which took place between March 2016 and January 2018, during which the Yen depreciated by approximately 16% against the Indian rupee.

This period saw substantial Yen inflows into India, leading to a broad market expansion, particularly in mid-cap funds, which received 10% of the total inflows. However, when the Yen unwind began in January 2018, the market breadth suffered significantly, and the Yen appreciated by nearly 30% over the following two years. Despite this, domestic mutual fund flows remained positive, albeit with slowed momentum.

It noted that in the current cycle, which began in March 2023, mid-cap flows have increased significantly, now accounting for 25% of total Yen inflows. The brokerage also observed that domestic mutual fund inflows into mid-cap and small-cap schemes have accelerated, with average monthly small-cap flows since March 2023 being 1.5 times higher than the previous two-year average.

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