Pound May Drop 18% Versus Yen on Carry Unwind, Citigroup Says

By Candice Zachariahs

Nov. 3 (Bloomberg) -- Investors should sell the pound against the yen as it may drop 18 percent against the Japanese currency because Britain's banks will have to ``drastically'' cut lending after short-term funding dried up, Citigroup Inc. said.

The U.K.'s gross external liabilities are nearly five times as large as the nation's gross domestic product, wrote a team of Citigroup analysts led by New York-based currency strategist Todd Elmer. Banks built up 50 to 60 percent of the obligations, using loans from countries with low interest rates to invest in the U.K.

``The massive foreign borrowing has driven an economy-wide carry trade which employed cheap foreign funds to finance domestic investment and consumption,'' wrote Elmer. Reduced capital inflow ``is set to exert a severe downward draft on the pound.''

The pound traded at 158.62 yen as of 8:19 a.m. in Tokyo from 158.28 yen on Oct. 31. The currency has lost 15 percent against the yen over the past month. It traded at $1.6107 per pound from 1.6076 late last week.

Investors should sell the pound and buy Japan's yen, wrote Citigroup, as Britain's currency could test its 1995 lows. The pound bought 129.37 yen in April 1995.

In carry trades, investors seek higher returns on funds from countries with low-borrowing costs such as the U.S. or Japan, where interest rates are 1 percent and 0.3 percent, respectively. The Bank of England cut its benchmark interest rate to 4.5 percent on Oct. 9. The risk in carry trades is that currency market moves will erase profits.

To contact the reporter on this story: Candice Zachariahs in Sydney at czachariahs2@bloomberg.net