| Updated: September 12, 2025Long-term factors driving the foreign exchange market: trade flows
This lesson will cover the following
- General thoughts on Forex drivers
- Trade flows
Capital and trade flows
Trade flows
The flow of trade is at the core of all international transactions. Trade flows reflect the net trade balance of a given country. Countries that are net exporters export more to international clients than they import from producers abroad. They usually have a net trade surplus. The currencies of these countries are more likely to appreciate, as they are purchased more than they are sold. International customers who wish to purchase the exported good or service must first buy the currency of the exporting country; therefore, demand for that currency increases.
Countries that are net importers export less to international clients than they import from international producers. They usually have a net trade deficit. The currencies of these countries are more likely to depreciate because they are sold more than they are bought. Importing companies must first sell their local currency and buy the currency of the producer of the good or service; therefore, demand for the importing country’s currency decreases.
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Let us consider an example. The Japanese economy is performing well and domestic stocks are surging. At the same time, the United States economy is not providing sufficient investment opportunities. In this situation, residents of the US will sell the local currency and purchase Japanese yen to take advantage of the booming Japanese economy. The result will be a capital outflow from the United States and a capital inflow for Japan. In foreign exchange market terms, this will lead to the devaluation of the US dollar and the appreciation of the Japanese yen because demand for the dollar diminishes and demand for the yen increases. In other words, USD/JPY will fall in value.
Conclusion
Any international transaction produces two offsetting entries – the capital flow balance (capital account) and the trade flow balance (current account). These two entries comprise the balance of payments of a given country. Theoretically, these entries should balance and sum to zero in order to maintain the status quo in a country’s economy and exchange rates. Countries may have positive or negative trade balances and positive or negative capital flow balances. If a country is to minimise the net effect of both on its exchange rates, it needs to find a balance between them.
Let us consider another example. The United States has experienced a considerable trade deficit in recent years, as imports have exceeded exports. The US trade balance is negative, and the country purchases more from foreign companies than it sells to them; thus, it needs to fund this deficit. The negative flow of trade may be neutralised by a positive flow of capital because foreign investors make either real or portfolio investments. The country will usually try to minimise the deficit on its trade balance and maximise its capital inflows until the two balance out. The net result of the difference between trade flows and capital flows will usually influence the direction in which a country’s currency will move. If the overall US trade and capital balance tends to show negative results, the national currency will likely depreciate. If the overall balance tends to be positive, this will likely have a positive effect on the dollar.
Any change in a country’s balance of payments has a direct impact on the exchange rate of its currency. Therefore, investors should pay close attention to economic reports related to the balance of payments and make their own interpretation of the likely outcome. An increase in a given country’s trade deficit, accompanied by a decrease in capital flows, will lead to a deficit in the balance of payments; therefore, an investor should expect the national currency to depreciate.