Foundations for Forex - Balance of Payments, Foreign Exchange Reserves, Politics and Speculation [part 3]

Balance of payments, currency reserves, policy and speculation

This is the third and final part of the series on fundamentals on the Forex market, which contains a large dose of knowledge in the field of currency response to economic and political factors. Their observation plays an important role in their analysis. It will not be a big surprise if I find that not every currency reacts with a similar level of volatility when publishing, e.g. inflation data. On the other hand, the search for positive or negative correlations between individual currency pairs does not make much sense, as their degree gradually changes depending on market conditions. Of course, correlations on the market are not a constant factor occurring always, to the same extent between pairs.

Read absolutely

Foundations on Forex - Fundamental Factors Affecting Odds [Part 1]

Foundations on Forex - Unemployment and Inflation [part 2]

Balance of payments

First, let's see exactly what the publication of the balance of payments is about. It provides a statistical picture of all flows of a given country's foreign trade over a specific period of time (most often we are talking about an annual basis). We divide it into two groups - the current balance sheet and the capital balance. Consider the first of these.

Current balance we divide into a trade balance and an invisible account (it includes service traffic, transfers, income from term deposits). The trade balance is definitely more "influential" on the market, which illustrates the flows of goods exchange, in other words, export / import. If between export (e) and import (i) there is such a relationship: e  > and, we are talking about a positive trade balance. Then exporters receive foreign currency for the goods sold. Then they exchange it for PLN, selling more foreign currency than is needed for import. Naturally, it works favorably (strengthening) on ​​the national currency.

In a negative balance of payments situation (i> e), importers pay with foreign currencies for goods purchased abroad. The demand for a foreign currency bought domestically (in this example) for PLN is greater than the sale of this currency from exports. This has a negative effect on the zloty.

Let's take the second type for the workshop - capital balance. It concerns, as the name says, streams of capital exchange. Purchase of foreign assets by Poles causes outflow of funds from the country. The opposite situation causes the inflow of foreign means of payment to Poland. When the balance does not coincide (does not go to 0 / is not equal), we are dealing with a deficit or a positive balance. In Poland, there has been a trade deficit for many years. What is this caused? As usual, many factors contribute to this state of affairs. Taking them all into account, a simple relationship can be derived:

• positive balance of payments -> domestic currency increase
• balance of payments negative -> decline in the national currency

Gross foreign exchange reserves

The currency reserves in Poland include: monetary gold, special drwawning rights (SDR - international non-cash settlement unit) and other currency assets that can be exchanged at the central bank. In general, the larger the reserves, the lower the risk of destabilization of the domestic currency in the event of turbulence in the markets, the greater the guarantee of convertibility of the zloty and the repayment of foreign debt.

In general, the level of foreign exchange reserves is of an illustrative nature. We should not, on the basis of readings from it, make long-term speculations about the potential rise or fall of the national currency. Foreign exchange reserves are helpful in the event of exchanging large amounts of cash for another currency. Especially intensely the level of the country's foreign exchange reserve is observed by non-residents.

Portfolio and direct investment

For a large proportion of currency market analysts and researchers, portfolio and direct investment are considered the most important factor on the Polish market. What is really in them? Among other things, it is a calendar of acquisitions, privatizations and buyouts of Polish enterprises, e.g. by foreign investors. Good knowledge of the above transactions allows you to join the flow of significant cash flows. Often aware investors, in order not to cause a significant reduction in the national currency, conclude currency swap transactions on the money market, thus indirectly lending PLN, thus postponing the sale of the currency in the future (second swap leg).

Political stability and speculation

It will not be a big surprise here to derive the dependence on the statement that the more politically stable the country, the stronger the national currency. Hot periods for currencies are all anti-government demonstrations, political party activities (as an indicator of further development), government stability or elections.

In the case of political events such as wars, upheavals, important speeches by political leaders or scandals, they have a psychological character. Thanks to this, people build ideas based on a given country, whether it is stable, what is its strength in the international arena or the economic situation. It is worth mentioning the so-called escape currencies. We are talking about the US dollar and the Swiss franc, which gain in situations of uncertainty. This is due to some historical conviction about the military power of the United States and the policy of neutrality in Switzerland.

Speculation is a more interesting factor. Given the increasing liberalization of financial markets, the volume of foreign trade plays an increasingly smaller role in shaping the prices of individual currency pairs. Considering the fact that large cash flows play the most important role, it is above all flows (speculative fund streams) will build short-term courses. In Poland, only Polish and foreign banks deal with short-term speculation.

Central bank exchange rate policy

One of the main goals of central banks is to maintain a stable price level. The strategy used by the MPC is based on the principles of a direct inflation target. It assumes focusing on all information that supports or threatens the achievement of the assumed inflation target. It is difficult to directly classify a given exchange rate system in the theoretical framework and general relationships. The current exchange rate system is called liquid regulated, due to the determination of the level of intervention by NBP.

Summation 

When examining fundamental factors, we should first of all observe their impact on the currency (historically) and take into account the current environment and trade and political connections. Not every currency pair will behave similarly to news of falling inflation in the country, and often (as recent world events show) it will completely ignore it. Our investment horizon plays a big role. If we really intend to assess the economic situation of a given country, bearing in mind that we will want to invest our money for longer, then the most fundamental analysis makes sense. However, for purely speculative plays, such analysis is overwhelming to us. Information on data publications can only signal periods of increased volatility.