For any party who assumes net exchange positions, an assessment of future prices of currencies is imperative. However, this assessment is hard to make. It can take the form of only a forecast, and forecasting remains more of an art than a science. Nevertheless, these limitations do not excuse the funds manager who must operate in these markets from making an educated estimate of the future movements of the values of relevant currencies. In this chapter, we shall examine the major fundamental forces which shape the destiny of exchange rates.
The underlying force which determines changes in exchange rates (as well as any other price) is the relationship between the amounts of currency supplied and demanded at a given price. If, at a certain price, the amount supplied exceeds the amount demanded, that price will show a tendency to decline. If, at a certain price, the amount demanded exceeds the amount supplied, that price will tend to increase. As discussed in Chapter 2, the price of a currency is expressed in terms of other currencies- the exchange rates.
What are the forces which determine the amounts of Money demanded and supplied at a given exchange rate? To answer this question, it is best to introduce the report required to measure the various sources of supply of and demand for a given currency; that report is the so-called balance of payments.
The balance of payments
Despite the implications of its name, the balance of payments does not measure the levels of anything. The balance of payments measures changes, flows . If we have to compare the balance of payments with one of the traditional statements used to report the financial condition of a company, the balance of payments is most similar to a statement of sources and uses of funds. The balance of payments measures the sources and uses of forex trading during the period indicated by the statement. Of course, the only transactions reflected in the balance of payments are those between the citizens of the given country and the residents of other countries. Transactions among citizens of the same country do not enter the balance of payments. They are not a source or a use of foreign exchange for the country as a whole.
In the balance of payments, the sources of foreign exchange, or the supply of foreign exchange, are indicated by positive numbers. The uses of foreign exchange, or the demand for foreign exchange, are indicated by a minus sign. shows a summary of the balance of payments for the United States in 1975. In this exhibit, we can see that the figure for merchandise exports has a positive sign. (In many presentations the positive sign is not printed.) When a country exports merchandise, foreigners make payments in their currency.
Foreigners' currency is a source of supply of foreign exchange to the country for which the balance of payments is being prepared. In Exhibit 6.1 the figure for merchandise imports is accompanied by a minus sign. As a country purchases merchandise, it offers its own currency, that is, it demands foreign exchange, to be able to pay for the imported merchandise.
Most of the accounts in the balance of payments can be classified into two major groups: trade accounts and capital accounts. For each group of accounts it is possible to compute a "balance." Thus, the net between exports and imports in goods and services is called the trade balance. In Exhibit 6.1 the trade balance is + $16,270 million. Here, the trade balance is a surplus; exports exceed imports. This surplus indicates that the supply of foreign currency exceeds the demand for foreign currency used to trade goods and services in the United States. In the absence of any other transaction in the balance of payments, this balance will tend to put downward pressure on the price of foreign currency against the domestic currency. In other words, there will be pressure for a devaluation of foreign currencies relative to the domestic currency, which is the same as an up valuation of the local currency against the foreign currency.
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