The next financial crisis is closer than most people think. We have already seen the warning signs, with the U.S. stock market plunge in February and, more recently, the Turkish lira crash in August. While these two events appear unrelated, they both involve a risky practice, known as “carry trade,” that could unravel and trigger the next crash.
Carry trading is a financial activity that involves borrowing at low-interest rates to finance higher-yield investments in markets assumed to be relatively stable. In the years following the global financial crisis, for example, Turkish businesses practiced a form of currency carry trade. They leveraged themselves heavily using low-interest U.S. dollars to finance investments in the high-interest lira in Turkey's rapidly-growing economy. This brought capital into Turkey, which supported the lira. But too much credit growth in Turkey and the consequently large trade deficit meant this practice became unsustainable; the lira crashed and Turkish businesses were left with dollar debt that they could not easily service.
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