^*Masazumi Hattori is director and senior economist, deputy head of economics section, Institute for Monetary and Economic Studies, Bank of Japan. Hyun Song Shin is professor of economics at Princeton University. The authors are grateful to Tam Bayoumi, Bob Flood, Kazuo Fukuda, Dick Herring, Isao Hishikawa, Wataru Takahashi and a referee for their suggestions, and to Tobias Adrian for encouragement and support.

Abstract

Yen carry trades have traditionally been viewed in narrow terms purely as a foreign exchange transaction. This paper argues that the carry trade should instead be viewed in the broader context of global credit conditions. We show that the volume of yen funding that is channeled for use outside Japan is mirrored by fluctuations in the size of U.S. broker-dealer balance sheets. Differences in short-term interest rates across currencies help to explain the incidence of the carry trade, as does the measure of implied equity risk given by the VIX index. The conjunction of deteriorating credit conditions in the United States and the weakness of the dollar against the yen in the early stages of the credit crisis of 2007–08 can thus be seen as two sides of the same coin. Both can be seen as consequences of financial sector deleveraging in the United States.