Trade Flows

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Forex education and moreover forex fundamental analysis start with first of all understanding the basics, investors related to the forex market should start their forex education by first of all reminding themselves that when a market for something can operate in an unrestricted way, price will be decided by the law of supply and demand. Therefore should there be more demand than supply for something then price will rise. On the other hand should there be more supply than demand for something, then price will fall. Should supply and demand are equal then price will remain the same.

The forex market is no exception to this basic economic concept. In essence, the value for a free floating currency is determined by the demand for a particular currency in relation to its supply. While this is a basic concept, to determine the situation for the supply and demand for a particular currency, and to attempt to forecast changes in that equation, is a little more difficult proposition, and is what fundamentals focused currency traders try to ascertain.

Bearing this in mind as a first step in your forex education and more over to your forex fundamental analysis, whenever events occur such as a geopolitical event, an increase or decrease in the amount of goods and services imported or exported by a country or an economic news release, a currency trader will always consider how this affects the supply demand situation, and therefore the value of the currency which they are trading.

To make this as clear as possible it is best to think of matters that can affect the supply/demand equation as fitting into one of two categories. The first of these, which we will discuss in this lesson, is what is known as trade flows. Trade flows are anything that involves money moving in and out of a country due to global commerce. Simply put, this means money flowing out of countries due to goods and services being imported from other countries, and money flowing into countries due to countries exporting goods and services to other countries.

When a country imports goods this will add currency of the importing country to the market and will create demand for the currency of the exporting country. This is due to the fact that the goods are normally purchased in the currency of the producing country, so the entity that imports the goods must exchange their currency for the currency of the entity that is exporting the goods.

For example, if a UK based Corporation is importing 1 Million Great British Pounds (GBP) worth of steel from a Canadian steel producer. To be able to purchase this steel, the UK based corporation has to pay the Canadian corporation in Canadian dollars. Because the UK Corporation most likely does not hold reserves of Canadian Dollars, they must go out to the market and sell Pounds and buy Canadian dollars.

Therefore, the buying and selling of currencies which takes place as a necessary part of this transaction, creates an increase in demand for Canadian Dollars while at the same time adding supply to the market for GB Pounds. While a transaction of this size would not have much, if any, affect on the market, should this type of transaction be multiplied many times over, it is clear that the two currencies of the countries involved in the transactions would be affected.

Generally countries which have a heavy reliance on imports will see their currency weaken in value as a result of this, all else being equal, and countries with economies that are more export focused will see their currency strengthen.

Measuring Trade Flows – The Current Account

Despite being a relatively complex concept, it is important to at least have a general understanding of how the money flows of a country are measured in order to comprehend how these flows can affect the value of a currency and start your forex education in forex fundamental analysis the right way. Now that you have an understanding of trade and capital flows, we will cover how these are measured beginning with the current account.

The basic formula used to calculate the current account for a country is:

Balance of Trade (exports – imports of goods and services)

+ Net Factor Income from Abroad (interest and dividends)
+ Net Transfer Payments (e.g. aid provided to foreign countries)

Generally, with the countries whose currencies we are concentrating on, the balance of trade portion of the formula is the main part that we are focusing on.

When considering a country’s balance of trade (exports and imports), you will most commonly hear a country referred to as having either a current account surplus or a current account deficit. In basic terms, a current account surplus translates as a country exporting more than they are importing which, as discussed above, should strengthen the value of the currency all else being equal. A current account deficit basically means that a country is importing more than it is exporting which should weaken the value of its currency all else being equal.

Consider the example discussed in the previous lesson of a UK company needing to import 1 Million Pounds worth of steel from a Canadian steel producer. For the sake of simplicity, let’s assume that this was the only transaction that both Great Britain and Canada did with foreign countries. If this were the case then Great Britain would have a current account deficit of 1 Million Pounds and Canada would have a current account surplus of 1 Million dollars.

Clearly there are millions of transactions just like this one which go on between countries all over the world. The current account serves the purpose of measuring these transactions so traders can have an idea of where the value of a countries currency is going based on the trade flows of that country, all else being equal.

At the time of writing and for the purposes of this lesson, China has the largest current account surplus at $363 Billion and the United States has the largest current account deficit at $747 Billion. It is for this reason that many argue China’s currency is too weak and the US Dollar is too strong, imbalances which have began to correct over the last year.

Below is a table of the current accounts of some of the major countries on whose currencies we will be concentrating, so you can have an idea of whether those countries are more import or export oriented.

Japan A Surplus of $201 Billion
Germany A Surplus of $185 Billion
Switzerland A Surplus of $67 Billion
Canada A Surplus of $28 Billion
New Zealand A deficit of $10 Billion
France A deficit of $35 Billion
Australia A Deficit of $50 Billion
Italy A Deficit of $58 Billion
United Kingdom A Deficit of $111 Billion