The Dollar, Capital Flows, and U.S. Trade Deficit

February 15, 2012

Released data on the the U.S. trade balance each month and current account each quarter seldom evoke an immediate currency market response.  The balance of payments, a summary compilation of all transactions with foreigners must net to zero because of the double entry accounting convention that records each item twice but with opposite signs.  Portions of some transactions go unreported, and the zero bottom line is made possible by the inclusion of "errors and omissions" (also known as the statistical discrepancy).  Conceptually, some analysts think of the current account as a residual after tabulating the net inflow of all private and officials capital movements, since gross capital flows dwarf the gross flows of exports, imports, investment earnings and payments, and transfers. 

Likewise, it is tempting but ultimately frustrating to a  currency forecaster with a fundamentalist predisposition to seek guidance from capital flow data.  The frustration derives from two broad respects.  First, reported data in this area tend to be incomplete, incompatible, and dated.  Second, capital flow data do not correlate with dollar movement as well as as does change in the trade deficit.  Such a mismatch is illustrated in the table below of the last three calendar years.  The table presents the calendar year average of the trade-weighted dollar against a broad subset of other freely convertible currencies.  Also shown and expressed as a monthly average are 1) the goods and services trade deficit and three definitions of net private capital flows as provided in the Treasury  International Capital (TIC) statistics reported monthly.  Definition number one is the narrowest capital aggregate, while definition #3 is the broadest of the three.

$ bln per mth 2011 2010 2009
Trade-Wted $ -6.2% -2.7% +4.5%
Trade Deficit -$45.5 bln -$41.7 bln -$31.8 bln
Definition #1 +$26.3 bln +$66.1 bln +$37.7 bln
Definition #2 -$14.5 bln -$19.6 bln -$17.1 bln
Definition #3 +$33.7 bln +$24.7 bln -$26.4 bln

The dollar on a calendar year average basis strengthened in 2009 when the U.S. trade deficit shrunk around 45%, but it depreciated in both 2010 and 2011 as the trade imbalance re-widened.  The broadest measure of capital flows, including short-term ones, lines up inversely with the order from best to worst of how the dollar performed. 

It’s really not surprising that net capital flows and the dollar would fail to tell a more consistent story.  Movements in interest rates, currency values, and capital stocks are determined simultaneously in the marketplace.  One should not think of change in one variable determining change in a second but rather change in all three (interest rates, exchange rates, and capital flow) reacting to other independent variables.  Furthermore, although the size of capital flows far exceeds gross current account flows, the current account has special significance because it constitutes an important element of real gross domestic product. When the current account strengthens, economic activity also improves assuming no change in other components of GDP.  When GDP is performing better, market participants become more upbeat about a currency’s outlook.

Copyright 2011, Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.

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