by Kathy Lien

Capital flows and trade flows constitute a country’s balance of payments, which quantifies the amount of demand for a currency over a given period of time.  Theoretically, a balance of payments equal to zero is required for a currency to maintain its current valuation.  A negative balance of payments number indicates that capital is leaving the economy at a more rapid rate than its entering, and hence theoretically the currency should fall in value.

This was particularly important in 2006 when the United States was running a consistently large trade deficit without sufficient foreign inflow to fund that deficit.  As a result of this very problem, the trade-weighted dollar index fell 22 percent in value between 2003 and 2005.  The Japanese yen is another good example.  As one of the world’s largest exporters, Japan runs a very high trade surplus.  Therefore, despite a zero interest rate policy that prevents capital flows from increasing, the yen has a natural tendency to trade higher based on trade flows, which is the other side of the equation.

Capital Flows: Measuring Currency Bought and Sold

Capital flows measure the net amount of a currency that is being purchased or sold due to capital investments.  A positive capital flow balance implies that foreign inflows of physical or portfolio investments into a country exceed outflows.  A negative capital flow balance indicates that there are more physical or portfolio investments bought by domestic investors than foreign investors.  Let’s look at these two types of capital flows – physical flows and portfolio flows.

Physical Flows

The physical flows encompass actual foreign direct investments by corporations such as investments in real estate, manufacturing, and local acquisitions.  All of these require that a foreign corporation sell the local currency and buy the foreign currency, which leads to movements in the FX market.  This is particularly important for global corporate acquisitions that involve more cash than stock.

Physical flows are important to watch, as they represent the underlying changes in actual physical investment activity.  These flows shift in response to changes to each country’s financial health and growth opportunities.  Changes in local laws that encourage foreign investment also serve to promote physical flows.  For example, due to China’s entry into the World Trade Organization (WTO), its foreign investment laws have been relaxed.  As a result of its cheap labor and attractive revenue opportunities (population of over 1 billion), corporations globally have flooded China with investments.  From an FX perspective, in order to fund investments in China, foreign corporations need to sell their local currency and buy Chinese renminbi (RMB).

Portfolio Flows

Portfolio flows involve measuring capital inflows and outflows in equity markets and fixed income markets.

Equity Markets

As technology has enabled greater ease with respect to transportation of capital, investing in global equity markets has become far more feasible.  Accordingly, a rallying stock market in any part of the world serves as in ideal opportunity for all, regardless of geographic location.  The result of this has become a strong correlation between a country’s equity markets and its currency: if the equity market is rising, investment dollars generally come in to seize the opportunity.  Alternatively, falling equity markets could prompt domestic investors to sell their shares of local publicly traded firms to capture investment opportunities abroad.

The attraction of equity markets compared to fixed income markets has increased across the years.  Since the early 1990’s, the ratio of foreign transactions in US government bonds over US equities has declined from 10 to 1 to 2 to 1.  The Dow Jones Industrial Average had a high correlation (of approximately 81 percent) with the US Dollar (against the deutsche mark) between 1994 and 1999.  In addition, from 1991 to 1999 the Dow increased 300 percent, while the US dollar index appreciated nearly 30 percent for the same time period.  As a result, currency traders closely followed the global equity markets in an effort to predict short-term and intermediate-term equity-based capital flows.  However, this relationship has since shifted since the tech bubble burst in the United States, as foreign investors remain relatively risk-averse, causing a lower correlation between the performance of the US equity market and the US dollar.  Nevertheless, a relationship does still exist, making it important for all traders to keep an eye on global market performances in search of inter-market opportunities.

Fixed Income Markets

Just as the equity market is correlated to exchange rate movement, so too is the fixed income market.  In times of global uncertainty, fixed income investments can become appealing, due to the inherent safety they posses.  As a result, economies boasting the most valuable fixed income opportunities will be capable of attracting foreign investment – which will naturally first require the purchasing of the country’s respective currency.

A good gauge of fixed income capital flows are the short- and long-term yields of international government bonds.  It is useful to monitor the spread differentials between the yield on the 10-year US Treasury note and the yields on foreign bonds.  The reason is that international investors tend to place their funds in countries with the highest-yielding assets.  If US assets have one of the highest yields, this would encourage more investments in US financial instruments, hence benefiting the US dollar.  Investors can also use short-term yields such as the spreads on two-year government notes to gauge short-term flow of international funds.  Aside from government bond yields, federal funds futures can also be used to estimate movement of US funds, as they price in the expectation of future Fed interest rate policy.  Euribor futures, or futures on the Euro Inter-bank Offered Rate, are a barometer for the euro region’s expected future interest rates and can give an indication of euro region future policy movements.

Trade Flows: Measuring Exports versus Imports

Trade flows are the basis of all international transactions.  Just as the investment environment of a given economy is a prime determinant of its currency valuation, trade flows represent a country’s net trade balance.  Countries that are net exporters – meaning they export more to international clients than they import from international producers – will experience a net trade surplus.  Countries that are net exporters are more likely to have their currency rise in value, since from the perspective of international trade, their currency is being bought more that it is sold.  International clients interested in buying the exported product/service must first buy the appropriate currency, thus creating demand for the currency of the exporter.

Countries that are net importers – meaning they make more international purchases than international sales – experience what is known as a trade deficit, which in turn has the potential to drive the value of the currency down.  In order to engage in international purchases, importers must sell their currency to purchase that of the retailer of the good or service; accordingly, on a large scale this could have the effect of driving the currency down.  This concept is important because it is a primary reason why many economists say that the dollar needs to continue to fall in order to stop the United States from repeatedly hitting record high trade deficits.

To clarify this further, suppose for example, that the UK economy is booming, and that its stock market is rallying well.  Meanwhile, in the US, a lackluster economy is creating a shortage of investment opportunities.  In such a scenario, the natural result would be for the US residents to sell their dollars and buy British pounds to take advantage of the rallying UK economy.  This would result in capital outflow from the US and capital inflow for the UK.  From an exchange rate perspective, this would induce a fall in the USD coupled with a rise in the GBP as demand for the USD declines and demand for GBP increases; in other words, the GBP/USD would rise.