Japan is in a zero interest rate regime today. This could change in the month of July if the Central Bank of Japan decides to increase the interest rate.

According to legendary global investor George Soros, funds of close to $200 billion have been borrowed from the Japanese banks under the 'yen carry trade' structure. These funds have essentially been invested in the emerging markets, like India. As of today, approximately $4.5 to $5.0 billion have been invested by various funds and investors from Japan into the Indian markets.

If these funds have been raised through a yen carry trade structure and if the Japanese central bank does increase its interest rate to 1% or even 0.5%, we could witness an outflow of 10% to 20% of those funds invested by the Japanese funds into India. This could adversely affect the Indian capital markets, especially considering the already bearish trend witnessed by our markets over the last month or so.

Yen carry trade, in simple words, means borrowing funds in yen at a very low or negligible interest rate and using this loan to buy higher yielding assets in other markets.

Let me illustrate this with an example: Say a trader/fund/investor borrows 100,000 yen from Japanese banks. The borrower then converts these yen into US dollars.

Them the borrower invests these funds into a bond with a yield of, say, 5%. The profit for the borrower, thus, would be 5% (as Japanese lending rates are 0%). This would stand good if the exchange rates of both the currencies remain constant and also the lending rates of the Japanese bank remains unchanged.

A savvy borrower normally leverages his position to maximise profits. A normal leverage ratio around the world would be 10:1. Thereby he would stand to gain close to 50% annually. But this is not always true, as -- because of the high leverage on the borrowing -- even the slightest change in the exchange rates could completely negate the profits unless the borrower has taken a forward cover on the currencies.

Similarly, if the Japanese bank raises its interest rate by even half a per cent (0.5%), the borrower's return would diminish. The borrower would then start converting his investments into dollar positions and subsequently back to Japanese yen and repay the bank.

This increase could start a pullout of Japanese funds from various markets around the world and brought back to Japan.

According to a recent article in the Forbes magazine, a sudden strengthening of the yen against various currencies was witnessed in the foreign exchange markets around the world.

What you should do

Indian investors should not get carried away by short-term buoyancy in the capital markets but take this optimism with a pinch of caution and skepticism.

However, if the funds invested in India by large investors are not through the yen carry trade structure, then the impact of the hike in Japanese interest rates could be negligible and only the other macro and micro factors like the rains, June-end quarter corporate results, global markets, oil rates, et cetera could affect the Indian stock markets.

The author is Director, Jitendra Harjivandas Securities (P) Ltd and an expert on stock market issues.