Capital Flows and Forex

Imagine the world as if every country were one 5-gallon bucket, and capital (money) was water. We could pour money from one bucket to another, and some would overflow, while others would dry up.

Money makes the business world (and forex) go round. In looking at capital flows, fundamental analysts can get a sense of where the “hot” places are for their money, and also understand why certain currencies perform better or worse than others.

When Money is Mobile

In the 21st century, it’s pretty safe to say that nothing travels as fast as money. Thanks to the advancement in computers, international trade, and a general improvement in the global economy, businesses, investors, and consumers can move money at the speed of light from one country to the next.

Being able to move money quickly is a good thing; new factories can open quicker, businesses can expand into new markets, and investors can literally shop the world for investment opportunities.

When money moves, it’s flowing. Thus, we have capital flows. Capital flows are the measure of all money that moves in between borders and currencies. If we know how much money is moving from the US to England, for example, we can know how many dollars are being sold to buy pounds—how many long GBPUSD positions are being opened.

Here are some examples of capital flows:

• Financial Market Movements – Capital flows between different financial markets. We can look at international capital flows between stocks, bonds, and cash currencies to determine where money is moving.
• Direct Investment – A direct investment is one that is made without the financial markets. Whereas individuals and companies can go buy investment products on Wall Street, direct investment is direct investment in a business. A great example of direct investment is building a new factory. If a foreign company builds a new factory in a different country other than its home country, it is recognized as a foreign direct investment.
• Acquisitions – Sometimes companies want to buy up others. In an acquisition, a company might affect capital flows by delivering payment for a piece of a business. A recent example is XXXX, which acquired the XX-based company XXX for $XXX. This would register in capital flows, since money is flowing from one country to another.

On Capital Flows

Capital flows confirm that a trend is happening, and may lead us to new trends. To use a recent example, the Brazilian economy grew quickly after its central bank decided to raise interest rates on the Brazilian Real.

Higher interest rates on the Real were intended to curb inflation. Investors, however, had a different plan. They started borrowing money in their home currency to buy Reals for investments in Brazil. In borrowing inexpensively, they could earn money on the interest rate differential, a strategy known as carry trading.

All this new money meant that Brazilian businesses could find new money to put to work in their businesses. Brazilian firms combined with foreign companies have invested tens of billions of dollars in new factories, more employees, and new business ventures. All is well in Brazil.

Since 2009, this interest rate differential combined with a booming economy sent the Real soaring! The Real has gained more than 50% against the dollar, and with leverage, made many investors rich from all the interest payments. Smart investors realized that high interest rates plus a growing economy and strong capital flows meant that the Real would gain ground against a slower-growing United States’ Dollar. They were right.