The potential unwinding of the yen carry trade poses a significant threat to Indian markets, especially as yen-denominated investments in the country have surged 251% since January 2023, reaching $21 billion. This rapid increase in yen-driven inflows highlights the vulnerability of various sectors, particularly those with high levels of such investments.
With the recent appreciation of the yen following the Bank of Japan’s tightening of monetary policy, there is growing concern that investors may begin to unwind their yen carry trades to safeguard their profits. This shift could be particularly impactful for Indian markets, given the substantial yen-denominated inflows into mid-cap and large-cap funds.
Indian assets tied to the yen have seen substantial growth, with banks, software and services, and capital goods sectors attracting the most inflows. Additionally, sectors like automobiles and components, energy, and materials have each garnered over $1 billion in yen-denominated investments. While these investments have provided strong returns, particularly in the capital goods sector with a 107% gain, the potential for a sharp or accelerated unwinding could lead to significant market disruptions.
Sectors impacted
Sectors with the highest returns, such as capital goods, automobiles and components, and energy, would be the most exposed in the event of an unwinding. Conversely, sectors like consumer durables, insurance, food-and-beverages, tobacco, and household products, which have lower yen exposure, may experience less impact.
Historical patterns indicate that a previous phase of the yen carry trade, from 2016 to 2018, also led to a substantial increase in yen-denominated investments in India, followed by a prolonged unwinding period. This phase resulted in a notable contraction in the mid- and small-cap segments, despite continued positive domestic mutual fund flows.
The report suggests that monitoring the rupee-yen exchange rate could offer insights into the direction of the trade, with a continued appreciation of the yen potentially signaling a larger unwind. While the current phase of the yen carry trade has driven significant inflows into Indian equities, particularly mid-cap funds, the risk of a rapid unwinding remains a looming concern for market stability.
