The FX carry trade (view post here) is probably the most popular strategy that has benefited from implicit subsidies. On its own, it is not a reliable estimate of expected returns. However, at times (particularly in the 2000s) positions in floating and convertible currencies with significant real carry reaped two types of implicit subsidies.
- Government support: central banks often set high real local short-term interest rates and engage in FX interventions to reduce inflation and attract capital flows. Such policies improve the risk-return trade-off of agents that lend locally and fund in foreign currency. Empirical research shows that official currency interventions can cause persistent external imbalances and over- or under-valuation of currencies (view post here) as a consequence of the portfolio balance effect. Moreover, central banks that lean against the wind of carry flows through sterilized currency interventions create an FX forward bias, i.e. a state where expected currency changes compound interest differentials rather than offset them (view post here). Suppressed valuation and forward bias imply subsidies to the market.
- Private insurance premia: when local currency depreciation is a clear and present concern corporates, banks and households often prefer holding funding currencies to protect their business and mere subsistence. For example, financial institutions hold precautionary positions in U.S. dollar assets as protection against funding pressure (view post here). This gives rise to a safety premium on the dollar. Also, in EM economies companies often buy dollars in crisis periods to secure liquidity for international transactions. Accepting negative expected returns in such situations is like paying insurance premia. Indeed, FX carry trades have historically been most profitable when fear of disaster triggered both high interest rates and undervaluation (view post here). Likewise, there is evidence that high-risk aversion as measured by volatility risk premia, differences between options-implied and actual volatility, leads to undershooting and subsequent outperformance of carry currencies (view post here).
FX carry opportunities depend on market structure and regulation. In emerging markets observed carry typically contains a combination of classic interest rate differential and an arbitrage premium that reflects the structure, regulation, and pressure points of on-shore and off-shore markets (view post here). This arbitrage premium is also called cross-currency basis. For example, a negative dollar cross-currency basis means that the FX forward implied carry of a currency against the USD is larger than the corresponding on-shore short-term interest rate differential. After the global financial crisis, 2008-09 periods of sizeable dollar cross-currency basis have also been observed in developed markets. They reflect arbitrage frictions due typically to a combination of regulatory restrictions and short-term funding pressure (view post here). In most cases, a negative dollar funding basis increases the implicit subsidy paid by the FX forward market.
FX carry trades also illustrate the inherent vulnerability of subsidy-based investment strategies. Positive carry typically encourages capital inflows into small and emerging markets. This helps to compress inflation but is also conducive to a domestic asset market boom. Because of the former, the central bank does not fight the latter. In this way, FX carry strategies can produce self-validating flows. Financial markets create their own momentum. Conversely, a reversal of such flows is self-destructing (view post here)
To bring trading signals closer to actual subsidies much can be done to enhance simple carry metrics. The most plausible additions are adjustments for inflation differentials, consideration of market correlation premia, and penalties for poor economic performance and external deficits. Enhanced carry strategies have historically produced much more consistent investor value (view post here).
Carry is the most popular but not the only indicator related to implicit subsidies in FX markets. Another approach is estimating the hedge value of currencies. Depending on the circumstances, some currencies tend to strengthen against the USD when global or U.S. equity prices fall. An expected negative correlation with the market portfolio means that investors pay a premium for holding such a currency in a diversified portfolio. This preference translates into an implicit subsidy for those willing to short it on its own. Analogously, the expected positive correlation of a currency with broader market benchmarks means that investors require a discount for holding that currency in a diversified portfolio. This translates into a subsidy for those willing to be long the currency. The hedge value of a currency, as priced by the market, can be inferred directly from “quanto index contracts” (view post here). “Quantos” are derivatives that settle in currencies different from the denomination of the underlying contract.