Capital flows are made up of all of the money moving between countries as a consequence of investment flows into and out of countries around the world. In this case rather than money flowing between countries to purchase each other’s goods and services, we are referring to money flowing into and out of the stock and bond markets of countries around the world, as well as factors such as real estate and cross border mergers and acquisitions.
In the same way that imports and exports of goods shift the supply/demand balance for a particular country, so do the flows of money coming into and out of the country due to capital flows. As the barriers to investment in foreign countries have reduced, as a result of many factors including the introduction of the internet, it is much easier for investors, such as fund managers, to take advantage of opportunities not only in their domestic markets, but anywhere in the world.
Therefore, when a market in a particular country is displaying above average returns, foreign investors will often enter the market with capital, purchasing the assets of that country that are also looking to earn above average returns. When this occurs it not only affects the markets of that country, but it also affects the value of its currency, due to the fact that foreign capital must be exchanged into local currency to be able to participate in the markets there.
While in general people are most familiar with the equities markets, it should be noted that the bond markets in most countries are much larger than the equities markets, and can therefore have a greater affect on the currency. When the interest rates on bonds in a particular country are high, this will normally attract capital to that country from foreign investors seeking to take advantage of that higher yield, which also has the effect of creating a demand for the local currency as well.
Finally, cross border mergers and acquisitions are also part of the capital flows category, and when they happen on a large scale, they can move the market as well. For example, if Citibank (a large US bank) were to buy Royal Bank of Scotland, this would create a large demand for pounds and increase the supply of dollars on the market as Citibank sold dollars for pounds in order to complete the transaction.
There are a plethora of factors that can affect both trade and capital flows for a particular country, and therefore its currency. As currency traders it is up to us to know what to expect in terms of a reaction in the FX market when various things occur, so always think of things in terms of how something affects the supply demand relationship. Once you understand this it is next important to understand whether that effect fits into the trade flow or capital flow category since, as we will discuss later, some countries are more susceptible to trade flows than capital flows and vice versa.
The basic formula for calculating the capital account is:
Increase in Foreign Ownership of Domestic Assets (e.g. real estate, cross boarder M&A, and Investments by Foreign Companies in local operations)
– Increase in Domestic Ownership of Foreign Assets
+ Portfolio Investment (e.g. stocks and bonds)
+ Other Investment (e.g. loans and bank accounts).
In the same way as the current account, it is not important to understand all the intricate details of the capital account, but simply to understand that where the current account measures money flowing in and out of a country as a result of trade flows, the capital account measures money flowing in and out of the country as a result of capital flows.
As we discussed in the previous lesson on capital flows, when a country’s market is performing better than the markets in other countries of the world, money will flow into the country from foreign investors seeking to participate in those inflated returns. The country’s capital account reflects these flows. This is the case whether we are talking about a country’s bond market, stock market, real estate market or any other market.
For example, let’s assume that a fund manager located in Great Britain invests $1 Million Dollars in the Canadian Stock Market, and a Canadian real estate firm buys the equivalent amount of real estate in Great Britain. For the purposes of simplicity, if these were the only transactions that took place between these two countries and any other country, the Capital Account for both Great Britain and Canada would show a balance of zero, as the two transactions would have offset themselves to the penny.
In the same manner with the current account when a country has strong inflows or outflows of capital, this will have a direct impact on its currency. When there are considerable inflows this creates demand for the currency, pushing the value of the currency up, all else being equal. On the other hand, when there are considerable outflows, this creates a market supply of the currency, pushing its value down all else being equal.
It should be noted that it is the interaction of both the current account and the capital account that fundamental traders focus their attention on, as it is the disparities here that theoretically trigger the value of a currency to rise and fall over the long term.