In the vast global financial system, which connects local economies with the rest of the world, there are various ways of making investments. One of these is known as the carry trade, an investment strategy that is implemented through the capital markets. For a better understanding, it is important to address the relevance of the foreign exchange market, as well as interest rates and their role in the economy.
The foreign exchange market is the largest financial market in the world, where banks, commercial companies, central banks, investment management companies, hedge funds, brokers and investors buy, sell or exchange currencies. Currency trading has kept pace with both global growth and the increase in trade, which in the mid-2020s was more than seven times higher than the daily value of currencies traded at the start of the millennium. Currencies circulate between those who are trading, albeit with the support of brokers who provide the means to do so.
There is a substantial amount of interbank forex trading, which helps determine fluctuations in exchange rates and set the prices at which commercial transactions take place. Large banks trade currencies to protect themselves, adjust balance sheets and trade on behalf of clients, among other reasons, and the most traded currency pairs have been EUR/USD, USD/JPY and GBP/USD, among others, with these currencies having a share of transactions of 28%, 13% and 11% respectively by March 2024.
On the other hand, the variation in interest rates follows both economic and market logic. If, on the one hand, central banks use reference rates as an instrument of monetary policy, on the other, market players adjust their expectations and, through market transactions, bring about changes in the different interest rate maturities available. These behaviours make market rates dynamic, with their volatility being explained both by the different theories of expectations of financial agents and by the law of demand and supply. These movements in reference interest rates tend to have an impact on the capital markets, causing volatility in assets, including currency pairs.
Mozambique is one of the countries in the world with the most attractive real interest rate, making the metical a good option for carry trade investments
Carry trade strategies try to exploit the differences in the interest rates of different central banks on two different currencies. To implement these strategies, investors borrow funds in a currency with a low interest rate (the funding currency) and use those funds to invest in higher-yielding assets denominated in another currency (the target currency), with the aim of profiting from the interest rate differential and the potential appreciation of the target currency. Historically, the most popular carry trade pairs include borrowing in Japanese yen (JPY) or Swiss francs (CHF), historically low-interest currencies, to invest in higher-interest currencies. For example, an investor could borrow JPY at an interest rate of 0.1% to buy US Treasury Bonds yielding 4.0%. The investor profits from the 3.9 per cent difference if the exchange rates remain virtually the same.
Carry trader investments can entail exchange rate and interest rate risks
The risks
However, this type of investment strategy is subject to a variety of material risks that can lead the investor to incur losses in expected returns, and even capital losses. Among the main risks faced by carry traders are: changes in interest rates, as they can impact on the generation of income from the investment; exchange rate risk, as significant changes can cancel out any gains resulting from interest rate differences and cause losses in the capital invested; changes in future market expectations; the risk of devaluation of assets in the target currency; volatility, as increases in the volatility of the financial markets or capital outflows can generate excessive volatility in the foreign exchange markets; among others.
As an example, in August 2024, there was an unwind of the market’s main carry trade, where a considerable number of investors abandoned this strategy, which in other circumstances was profitable, because of changes in Japan’s monetary policy. The Bank of Japan, by raising interest rates at the same time as intervening in the foreign exchange market by selling USD and buying JPY, caused major changes in the USD/JPY exchange rate, which led to investors deciding to exit speculative positions in this carry trade. This unwinding of positions led to a sharp reversal in the exchange rate trend, with the JPY appreciating 19 per cent against the USD. This movement had a negative impact on financial markets worldwide.
Advantages for Mozambique
Mozambique is one of the countries in the world with the most attractive real interest rate, making the metical (MZN) a good option as a target currency for carry trade investments. The country’s capital market offers a variety of Treasury Bonds, as well as corporate bonds with very attractive yields for South African, European and American investors. In addition to the possibility of high yields from interest rates, the country’s currencies have been very stable in recent years as a result of the Bank of Mozambique’s monetary policies. Since 2021, the USD/MZN exchange rate has shown very little volatility.
