Beware the carry trade?

If market turbulence continues this week, greater prominence will be given to the future of the so-called carry trade. 

The carry trade is the practice of borrowing money in a low-yielding, 'cheap' currency and using those funds to buy higher-yielding assets.  The most popular currency to use for these trades is the Japanese yen, although a fair bit of carry trade occurs using the Swiss franc.  According to the OECD, yen-financed carry trade could amount to as much as four trillion dollars, but this is a very rough estimate.  As market turmoil caused by credit fears makes investors more adverse to risk, they seek to offload their high yielding -- and thus also very risky -- assets.

One effect of the carry trade has been a steadily weakening yen. In order to buy high-yielding assets, investors must first convert their yen into other currencies -- by selling them. As more yen wash into the market, the Japanese currency becomes cheaper, particular in relation to the currencies in which the target assets are denominated.  When the carry traders decide to reverse their trades, it has the opposite effect.  A significant unwinding of the yen carry trade would take some external political pressure off Tokyo.  In the meantime, further complaints are likely that the weak yen gives an unfair advantage to Japanese exporters and causes unsustainable current account imbalances.