It is the interaction of flows of money relating to international trade and investment that ultimately decide the value of a currency in the long term. When the demand for the exports of a particular country increases and/or investments by foreigners into that country rise, then, all else being equal a currency should strengthen. On the other hand, when demand declines for the exports of a particular country and/or investment by foreigners in that country falls, then, all else being equal a currency should weaken.
It is the interaction of the current account and the capital account that measures this, and the combination of these make up the balance of payments of a country. Simply put, the balance of payments is the total transactions of a country with all other countries in the world, or in other words the combination of both trade flows and capital flows into one report. Forex traders can gain a great insight into the potential direction of a country’s currency through monitoring a country’s balance of payments and its related indicators.
To make this clearer, it is useful to look at the example of the US Dollar. As previously mentioned, the United States has had a very large current account deficit for quite some time now, which means that the country has imported more goods and services than it has exported. However, if you look at the below chart of the US Dollar Index, it is clear that the US Dollar has continued to strengthen for some time, in spite of this large current account deficit.
Despite the fact that this is starting to change, for many years there has been a high demand for US Dollars because the US Dollar is the reserve currency of choice for many major central banks, with Japan and China in particular being the countries you will hear most about in this regard. This generates a demand for dollars on the capital flows side of the equation that helped to offset the persistent current account deficit going into 2000.
The NASDAQ top which occurred in March of 2000 was preceded by a major bull market in the United States, a market where foreign investors were active participants. As previously discussed in our lesson on capital flows, this also created a large demand for dollars, further helping to offset the large current account deficit.
However, following the sell-off of the NASDAQ, foreign investors fled the US Stock market along with a lot of other traders and investors. The US Dollar began to weaken therefore, due to the fact that there was no longer as much foreign capital flowing in to offset the large current account deficit. This created a chain reaction with the central banks as the dollar began to weaken, and these central banks began to diversify into the EURO and other currencies, further intensifying the sell-off of the dollar.
This led to a situation whereby the current account deficit in the United States remained large (therefore creating a market surplus of US Dollars from an international trade standpoint) and the inflows of capital into the US stock and bond markets began to fall, lowering the demand for dollars which was offsetting the current account deficit.
While it is not necessary to go into this in too much detail, it is important to understand that to be able to obtain a feel for the long term fundamentals of a currency, it is key to have a general understanding of what is happening from both a trade flows and a capital flows point of view, and how these two things interact with one another.