With the removal of the benign conditions that underlie the profitability of this trading strategy, the future of the 'yen carry trade' and the continued weakness of the yen have come into question by market participants. [...] Table 1 reports the correlation between the interest rate differential (defined as the difference between the foreign interest rate and the Japanese interest rate) and the percentage rate depreciation of the yen, and confirms that the correlation has increased since 2002 for all four currency pairs considered.11. [...] While the yen's share of reserves has declined, the share allocated to the euro has increased over the same period, from 17.5 per cent in 2000 to 25.6 per cent in 2007Q2, and the share allocated to the pound has also moved ahead of the yen. [...] Further background on the forward premium puzzle and evidence that UIP fails in Japan is provided in Appendix A. Given that interest rates have been low in Japan relative to other countries since the early 1990s, another contributing factor to the profitability of carry trades, in addition to the failure of UIP, is the role of declining transactions costs and low volatility. [...] On 17 June 1998, the U. S. Treasury and the Japan Ministry of Finance agreed to a joint intervention in the foreign exchange market, to strengthen the yen to better reflect fundamentals; however, even after this intervention the yen continued to depreciate.

Yen carry trades have traditionally been viewed in narrow terms purely as a foreign exchange transaction. However, evidence from the waxing and waning of balance sheets of foreign banks operating in Japan points to a broader notion of the carry trade. Yen liabilities fund not only pure currency carry trades, but also fund the general increase in balance sheets of hedge funds and financial intermediaries. The difference in overnight rates across countries is a crucial determinant of balance sheet changes. Domestic monetary policy thus has a global dimension.--Author's description.

Carry trades are speculative activities which involve simultaneously going short a low-rate currency and long a high-rate currency. They are profitable as long as the gains from interest rate differentials are not offset by exchange rate movements. In this paper I investigate the dynamic relationships amongst exchange rate changes, interest rate spreads and carry trades by means of a Markov-switching vector autoregression model. I use regime-dependent impulse response functions to assess (1) how and to what extent shocks to the interest rate differential and the bilateral exchange rate affect the yen carry trade; (2) the consequences of the unwinding of the yen carry trade on the dollar-yen exchange rate. Empirical evidence indicates the presence of a so-called carry trade regime, whose timing is consistent with the yen carry trade episodes identified in the literature. Moreover, only when the system is in the carry trade regime a shock in the carry-to-risk ratio has a positive and significant effect on the net short positions in Japanese yen and the depreciation of the yen against the dollar is strong and persistent. Finally, a rising carry-to-risk ratio, which in turn reveals an increase in the attractiveness of carry trades, leads to a significant depreciation of the yen only when the system is in the carry-trade regime.

The role of the Japanese yen as an international currency is assessed. It is found that the determinants of international-currency use imply some increase for the yen’s use in international finance; however, the implications for the yen’s use in international trade are mixed. It is also shown that, despite Japan’s emergence as the world’s largest net creditor nation, Japan’s capital outflows have not significantly facilitated the yen’s internationalization. Data are presented showing that, although the yen’s use as an international currency has increased, it is still rather modest. Wider use of the yen as a regional currency in Asia has occurred, though a “yen-zone” does not appear to be emerging.

The process of globalisation has been ongoing for centuries, but few would doubt that it has accelerated and intensified in recent decades. This acceleration is evidenced as much by the strong synchronicity in the rapid transmission of financial crises starting in late 2007 as it is by the decade of almost unprecedented growth in international trade and financial market liberalisation that preceded it. This book shows how the international economy has become more connected via increased production, trade, capital flows and financial linkages. Using a variety of methodologies, including both panel econometrics and DSGE modelling, a team of experts from academia, central banks and the IMF examine how this increased globalisation has affected competitiveness, productivity, inflation and the labour market. This timely contribution to the globalisation literature provides a longer-term perspective while also evaluating some of the potential implications for policy makers, particularly from a European perspective.