Balance of payments theory

In general, the balance of payments indicates that prices must be at their equilibrium level, which is the price generated by a stable current account. Countries that have a trade deficit, like the United States, for example, are experiencing leakage from their foreign exchange reserves because those who export to these countries have to sell the local currency in order to receive their payments. The fact that the currency is cheaper makes the country's exports cheaper abroad, which boosts exports and brings the price of the currency to a point of equilibrium.

What is the balance of payments?

The balance of payments account is split into two parts:

  • The current account
  • The capital account

The current account balance measures trade in tangible and visible goods, such as manufactured goods. The difference between exports and imports, whether they are surpluses or deficits, is referred to as the balance of payments. The capital account measures cash flows to and from a country, such as investments in bonds or equities.

Commercial flows

The trade balance is an indicator that measures the difference over a given period between a country's exports and imports. When a country exports more than it imports, its trade balance is positive (or has a surplus). On the other hand, when it imports more than it exports, the trade balance is negative (or, it has a deficit).

In this sense, the trade balance shows the redistribution of wealth across countries and is an important means by which the economic policies of one country can affect those of another. For example, in the case of the United States, if trade data indicates that imports are greater than exports, it means that there is an exit of dollars from that country that could result in a decline in the value of that currency. On the contrary, a positive trade balance could affect the dollar in the other direction, increasing its value versus other currencies.

Capital flows

There are also capital flows between countries in addition to trade flows. Capital flows show investments within and outside of a country, such as payments for entire businesses or parts of businesses, bonds, stocks, bank accounts, factories and real estate. Capital flows are often influenced by a multitude of factors, such as economic and financial conditions in other countries, and may take the form of physical investments or portfolios.

Bank loans and foreign direct investment tend to dominate the makeup of capital flows from developing countries. In the case of the first world countries, strong equity and fixed income markets ensure that stocks and bonds are more relevant than bank loans and foreign direct investments.

Securities Markets

Without a doubt, the stock markets have a significant influence on the evolution of currency prices, mainly because they are an important setting for transactions involving large volumes of foreign currencies. These markets are of great importance in the case of currencies of countries that have developed capital markets where capital inflows and outflows are significant and where foreign investors have become major players. In these stock markets, the volume of foreign investment depends primarily on the state and growth of the market, reflecting the strength of companies and specific economic sectors.

Currency movements occur when foreign investors bring their money to a specific stock market. As a result, they convert their money into the local currency and increase the demand for this local currency, which increases its value. However, when there are recessions in the stock markets, foreign investors tend to withdraw their money and convert currencies back to their original currency, which results in lower local currency values ​​in the stock market in which they invested.

Fixed income markets - Bonds

Fixed income markets, such as bonds, have a currency effect that is similar to that of equity markets. This effect is a product of capital movements. Investor interest in the fixed income markets depends largely on the overall strength of the economy, the country's interest rates, and the specific characteristics of companies and their credit ratings.

Movements of capital to and from a country's fixed income markets result in a change in the supply and demand of currencies, which decisively affects their prices.

The limits of the balance of payments model

The balance of payments model focuses on goods and services purchased and sold by a country, but it doesn't take into account international capital flows. Towards the end of the 1990s, these capital flows tended to reduce the trade flows within the currency markets, which often contributed to an equilibrium of the current accounts of debtor countries with large trade deficits, such as the United States.

In fact, in 1999, 2000 and 2001, the United States experienced a large current account deficit, while Japan recorded a surplus. Despite this, and during this period, the US dollar appreciated against the yen, even though trade flows opposed it. This situation is explained by the fact that capital flows tended to balance the trade flows, which even contradicted what was provided for in the balance of payments model for this period. The increase in capital flows has led to what is known as the asset market model.

Since capital flows are playing an increasingly important role in the world economy, it can be said that the balance of trade is no longer the largest part of the balance of payments in most countries, as was the case until the 1990s.

Summary

Determining and understanding a country's balance of payments can be one of the most useful tools for traders interested in fundamental market analysis. All international transactions give rise to two counterparts: the balance of trade flows (current account) and the balance of capital flows (capital account).

When the trade balance has a negative value, it means that the country buys more and sells less abroad, or, exports are lower than imports. When the trade balance is positive, the country sells more and buys less, or, exports are greater than imports.

As for the balance of a country's capital flows, it has a positive value when financial flows from abroad to invest in physical or portfolio investments are greater than the capital flows leaving the country to make the same types of investments abroad. Conversely, a negative capital flow occurs when a country acquires more physical investments or portfolios abroad than it sells at home.

When added together, capital flows and trade flows constitute a country's balance of payments. In theory, both should be balanced and zeroed to ensure both the status quo and the exchange rate of a country's currency. In general, countries can have a positive or negative trade balance as well as positive or negative capital flows. In order to minimise their effect on the price of its currency, a nation must maintain a balance between the two.

In the case of the United States, the trade deficit is high because the United States imports much more than it exports. When a country has a negative trade balance, it means that the country must finance its deficit. This negative balance can be offset by a positive flow of capital into the country, via foreign investors who invest in both physical and portfolio investments. As such, the United States seeks to reduce its growing trade deficit by increasing its capital inflows until they are balanced.

When there is a change in this balance, the consequences for a country's economic policy and the exchange rate of its currency can be significant. The result of the difference between trade flows and capital flows, whether positive or negative, has an effect on the direction in which the prices of the national currency change. If the balance of trade and capital are both negative, there will be a decline in the price of the currency, but if it is positive, there will be an increase in its value.

Without a doubt, any change in the balance of payments directly affects the price of the national currency. As a result, investors and traders must monitor and interpret the results of this indicator. In particular, traders need to pay attention to data on trade flows and capital flows. For example, if there is an increase in a country's trade deficit as well as a decrease in capital flows, this can lead to a balance of payments deficit and consequently to a decline in the country's currency.

Summary - Interest rate forecasts according to economists

  • Balance of payments theory (BOP)
  • Purchasing power parity model (PPP) (coming soon!)
  • Interest rate parity (IRP) (coming soon!)
  • Monetary exchange rate model (coming soon!)
  • Interest rate differential model (coming soon!)
  • Asset market model (coming soon!)
  • Currency substitution model (coming soon!)
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