Jan. 19 (Bloomberg) -- There has been another delay in the great yen rally that investors have been waiting for, and Bank of Japan policies are to blame.

By leaving its benchmark interest rate at 0.25 percent yesterday, the BOJ appeased politicians arguing the economy is too fragile to withstand higher borrowing costs. It also mollified investors who have borrowed cheaply in yen and parked those funds in higher-yielding assets overseas.

The upshot is that the BOJ may have provoked a new wave of so-called yen-carry trades that will add to distortions in the Japanese economy, as well as the global one.

In a recent report to clients, analysts at Bridgewater Associates Inc., a money-management firm in Westport, Connecticut, said they were ``getting queasy about the amount of money that's going into carry trades, driving down spreads and making these positions more risky.''

What worries observers is that declining market volatility and increased liquidity are encouraging investors to take on more leverage. ``Low yields and credit spreads have also created much lower expected returns and much higher price risk, further increasing the markets' riskiness,'' Bridgewater argued.

One wonders whether the BOJ's decision to leave interest rates alone will compound the risk by keeping the yen low.

``The BOJ's easy monetary policy will increase the volatility of the currency and, accordingly, the economy through the yen-carry trade,'' says Masaaki Kanno, chief economist at JPMorgan Securities Japan Co. ``This is deja-vu from the late 1980s. The carry trade is creating a currency bubble this time.''

A New Bubble?

It has been a while since the word ``bubble'' has been used to describe Japan, and respected economists such as Kanno don't utter it flippantly. While it's rarely thought of in the context of BOJ rate decisions, the yen-carry trade is a growing risk to policy makers' control over the world's No. 2 economy.

Debates about the carry trade tend to focus on overseas markets. In recent years, yen borrowings have made their way into Shanghai and Mumbai real estate, Google Inc. shares, Zambian treasury bills, the Thai baht, bars of gold, you name it. If the yen suddenly shot higher and investors unwound their carry trades, the world economy would feel the pain.

Yen-carry trades have paid off handsomely for many investors. Borrowing for next to nothing in yen and parking the funds in, say, 10-year U.S. Treasuries can provide a twofold payoff through a yield difference of 3 percentage points or more and through the dollar's rise versus the yen. The latter dynamic boosts profits by the time they are converted back to yen.

Risks Abound

The trade can also go wrong -- very wrong. In late 1998, for example, Russia's debt default accelerated the implosion of Long- Term Capital Management LP and caused a panic in markets. Investors scaling back their positions drove the yen up 20 percent in less than two months.

While a replay might seem unlikely, a plunge in the dollar, major terrorist attacks or a bird-flu pandemic are but a few of the events that could blow up the yen-carry trade. And this time, the amount of yen-related leverage could be much greater than in 1998. There also are many more hedge funds now; some no doubt are highly leveraged and vulnerable to a yen rally.

It's all hard to quantify. If officials at the International Monetary Fund, U.S. Federal Reserve or Bank for International Settlements have a handle on the magnitude of the carry trade, they're not saying much. JPMorgan estimates the size to be about 40 trillion yen ($331 billion), which is bigger than Austria's economy. The trade may be much larger than that, and far more powerful when you factor in leveraging.

Yen Liquidity

A week ago, the BOJ was widely expected to raise short-term rates to 0.50 percent. While the pressure to tighten is mounting -- yesterday's was a six-to-three decision -- the BOJ bowed to government pressure to move slowly. Politicians are concerned about the weakness of consumer spending and the absence of clear inflationary signs.

Yet Fukui has said borrowing costs should be raised gradually to avoid excessive business investment and asset-price bubbles. The carry trade may be such a bubble.

The question is whether an undervalued yen will lead to imbalances in Japan's stock and property markets. Raising the stakes, the BOJ has shown it's not immune to government pressure, encouraging investors to increase yen borrowings while the Japanese currency remains weak.

As central banks around the globe take money out of their economies, yen borrowings are doing the opposite. ``The yen-carry trade is providing a significant amount of liquidity to global financial markets, and is likely a major force behind the run-up in global asset prices,'' Benjamin Reitzes, a Toronto-based analyst at BMO Capital Markets, wrote in a recent report.

It's a classic be-careful-what-you-wish-for situation. The world has been waiting for years for Japan to defeat deflation. As that occurs, and the BOJ raises rates, it may only increase risks around the globe.

(William Pesek is a Bloomberg News columnist. The opinions expressed are his own.)

To contact the writer of this column: William Pesek in Tokyo at wpesek@bloomberg.net

Last Updated: January 18, 2007 14:02 EST