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Dollar carry trade i.e. borrowing short term loans from US and investing in long term assets in markets with better yielding interest. The three conditions to ensure profitability are stable dollar, interest rate differential and appreciating target currency. One of the strong evidence is the global capital flow into countries like BRIC, Africa etc in form of FIIs. For example: Foreign institutional investors (FII) have increased their stakes in Indian companies by 100 basis points to 15.8% in the first quarter of 2009.According to Deutche Bank, this is the dollar carry coming in form of FII. So how did dollar carry trade get started? The reasons are obvious-the low interest in US (0.5%), inflation is -0.2% and the high interest rate prevailing in Emerging markets.
Implications: The carry trade provides liquidity in the target currency country, thus reducing the cost of capital. The dollar carry has provided the required capital flow in countries like Sudan, Congo, India. But it can have tsunami effect on the global capital market and economies, when the investors of carry trade start unwinding i.e. selling off the target currency.
What can lead to unwinding?
1. Rise in Interest rate in US: The rise in interest rate in US will affect the carry trade returns in two ways. It will decrease the interest rate differential premium and forward premium. The Forward premium is decreased as the rise in interest rate will appreciate Dollar. So what are the chances that interest rate will rise? Firstly, the most awaited revival of economy has been there around for some time, with soaring stock indices and improved GDP growth in 2nd quarter of FY09.This will have two positive effects on the Dollar. With so much liquidity in the system and America being the consumerist economy, the inflation fears cannot be ignored. Fed can raise the interest rate, once the economy recovers from inflation. Secondly it can also raise interest rate to appreciate the Dollar to control the huge current and capital account deficit. Thirdly, America is a consumerist economy, the personal consumption to GDP is 70 %.If we assume that Americans hold foreign currencies as investment, then the depreciating dollar will enhance the wealth of the American, in terms of dollar. (Portfolio Balance theory). This can enhance the real money demand and thus trigger more consumption. The increase in real money demand will lead to rise in interest rate, and thus appreciating dollar. (By IRP).
2. Depreciation of target currency: The short term selling off Dollar will depreciate dollar. Depreciating dollar can led to the decrease in export revenue of the emerging markets .Further, the debt will be widened in terms of Dollar. This will be led to the depreciation of the emerging market currencies with respect to Dollar. Thus this will lead to sell of dollars for covering their returns. Thus the major sell off will further crash the markets worldwide and give rise to major crisis.

Effects of unwinding on:
US: The unwinding can affect US through financial crisis, as many hedge funds and bank have invested in carry trade. The trigger of decreasing interest rate differential and appreciation of Dollar will lead to selling off target currencies. The high leverage ratio can drive these investment funds to bankruptcy.
Emerging Market: The target markets can be severely hit. The FIIs selling can lead to sharp fall in market. This will further depreciate their currency and worsen their Balance of Payment position and debt. Also the sell off in one country can spill over to other economies and crippling the financial market worldwide.