May 29 (Bloomberg) -- In Mumbai in January, I asked India's No. 2 central bank official the same question I pose to every policy maker these days: What does Japan's revival mean for Asia?

Without a moment's hesitation, Rakesh Mohan replied: ``The yen-carry trade will make things interesting.''

It wasn't the response one expected. I assumed the man who may be the next governor of the Reserve Bank of India would talk about increased demand for Indian goods. Or that he'd mention that Japan's recovery may stabilize Asia's economic environment.

Mohan's focus on the yen now seems quite prescient in light of India's recent experience, and that of many Asian stock markets. The unwinding of yen-carry trades exacerbated sell-offs that started with a slide in the U.S. dollar and falling commodity prices. Last week, India's Sensitive Index briefly plunged below 10,000 for the first time in three months.

Over the last decade, the trade -- which exploits the gap between ultra-low Japanese interest rates and higher ones elsewhere -- has become a staple in markets. In many cases, anyone borrowing for next to nothing in yen and parking the funds in, say, higher-yielding U.S. Treasuries or higher-returning Indian stocks found it to be a sure bet.

That's about to change as Japan's recovery leads to higher rates in the world's second-biggest economy.

Japan's consumer prices rose for a sixth month in April, increasing the odds its central bank may soon raise borrowing costs for the first time since August 2000. Bonds fell on May 26 on news that core consumer prices, which exclude fresh food, increased 0.5 percent last month from a year earlier.

Yen-Carry Trade

Short-term rates and bond yields in Japan have been negligible for so long that investors take them for granted. Japanese recoveries tend to fizzle faster than they emerge. The Bank of Japan hasn't built much credibility in markets, having failed for some 15 years to stabilize growth and avoid deflation.

Yet Japan's long-awaited return to the economic plus column is here. And even if the country doesn't grow 5 percent a year, there can be little doubt that the BOJ will raise rates from zero percent. The central bank is keen to return some normalcy to Japan's monetary policy.

Global markets have been slow to grasp the specter of higher Japanese rates. In recent weeks, though, surprisingly large moves in markets from Iceland to Turkey to India have been partly attributed to the unwinding of yen trades. And where yen- volatility is concerned, we probably haven't seen anything yet.

Bad Intelligence

What makes the yen-carry trade so worrisome -- and easy to dismiss as a potential problem for markets -- is that no one really knows how big it is. It's not like the BOJ has credible intelligence on how many companies, hedge funds or mutual funds borrowed in yen -- or how much -- and put the money into assets elsewhere.

It would be more comforting if the Bank for International Settlements, the International Monetary Fund or the Federal Reserve Bank of New York had a better handle on all this. Who really knows how many purchases of Shanghai properties, Google Inc. shares, Zambian treasury bills, bars of gold or derivatives are related to yen borrowings?

All this may sound like a conspiracy theory, yet the world has seen before how carry trades can slam markets. There was no better example than in late 1998, when Russia's debt default accelerated the implosion of Long-Term Capital Management LP. The resulting panic caused the yen, which had been weakening for years, to soar 20 percent in less than two months.

Hedge Fund Uncertainty

Frantic efforts to unwind yen trades led to conference calls among officials in Frankfurt, Tokyo and Washington. Policy makers wondered how big the carry trade was, how much leverage was involved and what they could do, if anything, to avoid a crash in global markets.

Once things settled down and Japan's deflation worsened, the yen-carry trade was back in fashion. And with stock markets around the world returning to pre-1997 Asian crisis levels, investors sat back and watched their gains accumulate.

After all, the payoff from the trade is often twofold. Traders investing yen borrowings in 10-year U.S. Treasuries enjoyed a 3 or 4 percentage-point yield difference and then benefited from the dollar's strengthening. The latter dynamic boosts profit once it is converted back to yen.

Things are getting difficult again now that the yen is getting stronger, the dollar is sliding and the BOJ is itching to boost rates. On top of not knowing how big the yen-carry trade is, policy makers have the added challenge of figuring out if hedge funds will complicate things further.

Rates Headed Up

The number of hedge funds has increased sharply since the late 1990s. Worldwide, 8,661 hedge funds managed $1.1 trillion at the end of 2005, according to Chicago-based Hedge Fund Research Inc. The need to boost returns from quarter to quarter is driving many to take on ever more leverage. The question is what happens if oil prices continue rising, the dollar plunges, a major terrorist attack occurs, there's a bird-flu pandemic or the BOJ moves more aggressively than expected. Any sudden rush for the exits could shake up markets as rarely before.

The irony of all this is rich. The world has anxiously awaited Japan's recovery, and its arrival is good news for Asia. Yet there's a catch: As Japan raises its interest rates, it may export higher borrowing costs everywhere else.

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

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

Last Updated: May 28, 2006 13:14 EDT