Trade Flows and Capital Flows

Forex Trading | by Dailyfx.com | Saturday, 20 February 2010 15:03 UTC
Trade Balance

The Trade Balance figure is a measure of net exports minus net imports. This has tended to be negative in the US in recent years as the US has primarily been a "consuming" nation. A growing imbalance in the Trade Balance can suggest much about the current account and whether or not the U.S. is "overspending" on foreign goods and services. Traders will see a decreasing Trade Balance number to implicate dollar bullishness, whereas a growing imbalance will generally lead to dollar bearishness.

The balance of trade is one of the most misunderstood indicators of the U.S. economy. For example, many people believe that a trade deficit is a bad thing. However, whether a trade deficit is bad thing or not is relative to the business cycle and economy. In a recession, countries like to export more, creating jobs and demand. In a strong expansion, countries like to import more, providing price competition, which limits inflation and, without increasing prices, provides goods beyond the economy's domestic ability to meet supply. Thus, a trade deficit is not a good thing during a recession but may help during an economic expansion.

The US Trade Balance refers to the difference between exports of goods and services out of the US, and imports to the US. The trade balance is one of the biggest components of the US's Balance of Payments, which gives valuable insight and exerts heavy pressure on the value of the dollar.

The reason why the Balance of Trade is important to a currency trader is that export demand and currency demand are inextricably linked. Foreigners must buy the domestic currency to pay for the exports of a nation. So, the stronger the exports in a given month, the greater that demand will be for the currency of that country. Export demand also impacts production and prices at domestic manufacturers as they strive to meet the increasing demand by increasing production.

Also coming into play in the Balance of Payment are investments reflected in the TIC (Treasury International Capital) data. This is generated each month by the Treasury Department.
TIC data shows the difference in value between the amount of foreign long-term securities purchased by US citizens and the amount of US long-term securities purchased by foreigners during the reporting period. The result shows the balance of domestic and foreign investment. For example, if foreigners purchased $60 billion of US stocks and bonds, and the US bought $30 in foreign stocks and bonds the resultant number (reading) would be $30.0B.

This data is significant to traders in much that same way as the Trade Balance is significant: when foreigners buy domestic securities, they must pay in domestic currency and, therefore the greater demand causes the domestic currency to appreciate.

Connected with both of the above is the concept of Trade Flows and Capital flows.

Trade Flows

Trade flows are the buying and selling of goods and services between countries.

Trade flows measure the balance of trade (exports – imports). This is the amount of goods that one country sells to other countries minus the amount of goods that a country buys from other countries. This calculation includes all international goods transactions and represents a country's trade balance.

Countries that are net exporters export more to international clients than they import from international producers.

Net exporters run a trade surplus. This is due to the fact that they sell more goods to the international market than they purchase from the international market. Demand for that country's currency then increases because international clients must buy the country’s currency in order to buy these goods. This causes the value of the currency to rise.

Countries that are net importers import more from international producers than they export to international clients.

Net importers run a trade deficit. This is due to the fact that they purchase more foreign goods than they sell to the international market. In order to purchase these international goods, importers must sell their domestic currency and buy a foreign currency. This causes the value of the domestic currency to fall.

As an example, let us look at Japan, which is an export-driven economy which usually runs a trade surplus. Japan exports more goods to international clients than they import from international producers.

Japan's trade surplus is the major reason why the JPY has not depreciated sharply despite severe economic weakness.

Japan is a net exporter with a current account surplus of about 3% of GDP.

This creates international demand to buy the JPY in order for international clients to purchase Japanese products.

Clearly a change in the balance of payments from one country to another has a direct effect on currency levels. Therefore, it is important for traders to keep abreast of economic data relating to this balance and understand the implications of changes in the balance of payments.

JPY has appreciated despite economic weakness. From 8/2003 – 12/2003 USD/JPY went from 121.00 to 107.00.

Capital Flows

Capital flows represent money sent from overseas in order to invest in foreign markets.

Capital flows measure the net amount of a currency that is purchased or sold for capital investments. The key concept behind capital flows is balance. For instance, a country can have either a positive or negative capital flow.

A positive capital flow balance implies that investments coming into a country from foreign sources exceed the investments that are leaving that country for foreign sources.

As inflows exceed outflows for any given country, there is a natural demand for more of that country's currency. This demand causes the value of that currency to increase because a foreign investor must change his currency into the domestic currency where he is depositing his money.

A negative capital flow balance indicates that investments leaving a country for foreign sources exceed investments coming into a country from foreign sources.

When there is a negative capital flow, there is less demand for that country's currency, which causes it to lose value. This is because the investor must sell his local currency to buy the domestic currency where he is depositing his money.

Countries that offer the highest return on investment through high interest rates, economic growth, and growth in domestic financial markets tend to attract the most foreign capital. These countries maintain a positive capital flow. If a country's stock market is doing well, and they offer a high interest rate, foreign sources are likely to send capital to that country. This increases the demand for this currency, and causes its value to appreciate.

As an example, let us take a booming economy in the United Kingdom and a sluggish economy in the United States. In the UK, the stock market is performing very well, while in the United States there is a shortage of investment opportunities.

In this scenario:

US residents sell their US dollars and buy British Pounds to take advantage of a booming British economy.

Capital flows out of the United States into the United Kingdom.

Demand for GBP increases and demand for USD decreases.

The value of USD decreases in relation to the value of the GBP.

With this overview of Trade Balance, TIC data and Trade Flows/Capital Flows, you can see how these pieces of information function in tandem and why a trader of currency would do well to follow these releases.

The dates of economic releases such as these can be accessed through the Daily FX Global Economic Calendar at http://www.dailyfx.com/calendar/.

Written by Dailyfx.com


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