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Currency Conundrums

The 2008 financial crisis has prompted many analysts to speculate about the decline of major developed economies like the United States and Japan as hubs for global capital. Currency flows, however, tell a different story. As markets worldwide stumbled, foreign governments have poured money into dollar- and yen-denominated holdings, sharply reversing a trend that saw steep declines in both currencies over the past few years. In late October, the dollar jumped to a two-year high against the euro (FT); it has also risen sharply against the British pound, the Swiss franc, the Canadian and Australian dollars, and several other major currencies. The Japanese yen has risen even more sharply--even against the dollar--prompting G7 officials to indicate they may move to intervene (WSJ) in currency markets to dampen the yen's volatility. It may be comforting for some analysts to see renewed confidence in formerly maligned currencies, but the trend also poses major economic concerns.

The yen's rise is the most imminent threat. The run-up could undermine exports and growth of one of the world's largest economies, but the more immediate concern for the finance sector stems from bets many investors had made through an obscure practice called the "carry trade." Investors would take out loans in low-interest rate currencies (like the yen), exchange the money to higher-interest-rate currencies (like the dollar or euro), and reloan it out. In so doing, they stood to make more interest on the second loan than they paid on the first one--free money, so long as interest rates and currency valuations remained steady. The past year has seen these rates change rapidly, however, as the U.S. Federal Reserve and European Central Bank have been forced to cut their benchmark interest rates to boost their struggling economies. Carry traders,...

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