This concept of a currency getting stronger when the country has trade surplus and getting weaker when it has a trade deficit is he basic premise of a currency-pricing model called the balance of payments theory.
The balance of payments theory suggests that currency markets are self-regulating and will always bring the import and export levels of individual countries back into balance. The thinking goes something like this:
- If a country has a trade deficit, the value of its currency will start to decline because the supply of the currency is so high.
- As the value of the currency starts to decline, the goods and services offered by that country will become less expensive for (and thus more attractive to) foreign consumers.
- The less expensive the goods and services become, the more foreign consumers will buy.
- The more foreign consumers buy, the smaller the trade deficit becomes until trade ultimately comes back into balance . . . in theory, anyway.
Conversely:
- If a country has a trade surplus, the value of its currency will start to increase because demand for the currency is so high.
- As the value of the currency starts to increase, the goods and services offered by that country will become more expensive for (and thus less attractive to) foreign consumers.
- The more expensive the goods and services become, the less foreign consumers will buy.
- The less foreign consumers buy, the smaller and smaller the trade surplus becomes until trade ultimately comes back into balance . . . in theory, anyway.
While this theory offers some basic guidance on the relationship between trade flows and currency values, and how either one can eventually drive the other, it does have some flaws. Most glaringly, it accounts only for trade-based demand when looking at what drives currency prices. But as you will see as we continue to move through this chapter, currency prices are driven by many other factors, such as investment flows, money supply, interventions, and investor fear. These other factors can wreak havoc on the balance of payments theory by keeping the value of a currency from a country with a trade deficit high or by keeping the value of a currency from a country with a trade surplus low, effectively preventing a move back toward balanced trade.
Why is any of this important? The balance of payments theory illustrates how international trade can drive currency prices, which it is important for you to understand if you want to make money in this market. The flaws in the theory also illustrate how dangerous it is to try to oversimplify your analysis as you look at what is driving currency prices. This is also crucial for you to understand if you want to make money in this market. You have to look for nuances.
