The forex market is the largest financial market in the world, with an average global turnover of 5 to 6 trillion US dollars on a daily basis. The commodity being sold and bought in this market is currency pairs i.e. one currency is sold while the other one is being bought simultaneously. Currency movements in the forex market are influenced, just like any other market in the world, by supply and demand. When the value of a particular currency increases, the demand will be greater than the supply, and when the value of a currency decreases, its supply is greater than the demand. What then influences the supply and demand of a currency?
There are two main factors that influence the movement of currency in the market. They are capital flows and trade flows. These two flows determine what economics terms ‘balance of payments’. The main reason why balance of payments is used is to quantify the demand and supply for a currency of one country over a certain period of time. The balance of payments can be expressed mathematically as the sum of the capital flows and trade flows.
Balance Of Payments = Trade Flows + Capital Flows
The positive and negative sign associated with the balance of payments gives us an idea about the demand and supply of the currency. If the balance of payments is positive, that means that the capital entering the economy is greater than the capital leaving the economy indicating an increasing demand for the domestic currency. If the balance of payments is negative, it shows that the capital entering the economy is lesser than the capital leaving the economy, signifying a fall in demand for the currency. Theoretically, the balance of payments should be zero so that the right value of the currency is maintained.
The net quantity of currency bought or sold through capital investment is called capital flows. Capital flows can be divided into 2:
- Physical Flows– Happens when foreign entities sell their local currency and buy foreign currency to make direct foreign investments. The health and good shape of an economy can be seen reflected when the volume of this kind of investment increases.
- Portfolio Investment– Global market investments like T-bills, forex, stocks etc.
The net export and imports of a given country can be measured using trade flows. The current account is what is constituted by the imports and exports. If the current account of a country is positive then it is more likely that the value of the currency recedes, and when the current account of the country is negative, the value of the currency is bound to appreciate or increase.