Carry Trades and Financial Crisis: An Analytical Perspective

This paper develops an analytical framework to explain how a liquidity shock or a shock to the aggregate haircut on collateralized assets amplifies financial crisis in a carry trade recipient country. The model allows roles for shocks to the size of a haircut, strategic behaviour across currency carry traders and the feed-back effect between asset prices and exchange rates. The paper finds that there is a threshold level of the aggregate haircut at the equilibrium. After introducing small exogenous noise, the model shows that a liquidity shock leads asset prices and the exchange rate to depart from the steady state level, triggering a financial crisis. Further, a negative shock to the interest rate differential also has the potential to trigger a liquidity crisis in the domestic market and amplify a financial crisis in the carry trade recipient country. A possible policy implication suggests that keeping policy rates low entails risks for financial systems. Therefore, instead of low inter- est rates and foreign exchange intervention policies, monetary authorities should focus on introducing macro-prudential regulations and establishing a sustainable and effective financial architecture to prevent future financial crisis.