All of That Dollar Borrowing in Emerging Markets Looks Like It's Been One Giant Carry Trade


Source: BIS. NFC = non-financial corporates.

Since the 2008 financial crisis, companies across emerging markets have been borrowing dollars and converting them into local currencies as part of a massive carry trade. This practice has helped U.S. dollar shadow banking go global as the effects of near-zero U.S. interest rates seep into all corners of the world economy.

That's the main finding of a new report released Thursday by the Bank for International Settlements, an institution in Basel, Switzerland, known as the central bank for central banks.

The paper, co-authored by Valentina Bruno, a finance professor at American University, and BIS Economic Adviser and Head of Research Hyun Song Shin, serves as a follow-up to a report released by the bank in January that found firms outside the U.S. have borrowed $9 trillion in U.S. dollars, up from $6 trillion before the global financial crisis.

The new study aims to get to the bottom of what those companies have been using the money for. Perhaps surprisingly, the evidence shows that firms which tend to borrow in dollars are not cash-strapped and are actually in better financial shape than those that don't, suggesting that the motivation for the borrowing has less to do with funding actual investment projects or other types of spending.

Instead, it looks like they've been using the cash at least in part for "carry trades," a term used to describe a popular investment strategy in which traders borrow in one currency at a low interest rate and buy something denominated in another currency with a higher interest rate, profiting on the spread between the two rates and any depreciation in the currency that is being borrowed.

"Irrespective of the motivation of the firms concerned, our evidence therefore points to the greater incidence of financial decisions that bear an outward resemblance to carry trades," Bruno and Shin wrote.

"Since corporate cash holdings could be in the form of claims on banks, shadow banks or other financial intermediaries, the evidence points to non-financial firms playing the role of surrogate intermediaries, channeling external financial conditions into the domestic financial system."

The unwinding of this activity over the next several years, as the Federal Reserve raises rates and the U.S. dollar appreciates, will present another headwind for emerging markets, many of which are already in turmoil, as it sucks cash out of those countries.