Exchange Rates: Balance of Payments

This valuation strategy highlight currency cycles that are ultimately self-correcting owing to lagged effects on the balance of payments. It is designed to show the risk to the exchange rate based on the trade deficit on Current Account as a proportion of GDP. For comparability, exchange rates have been rebased to set year-end 1994 at 100.
 
The exchange rate is shown as the thick white line on the right hand axis. The explanatory variable, the Balance of Payments, shown as the thin yellow line, uses the left hand axis. A Best Guess as to the future developments of the valuation ratio is also shown on the left hand axis, as the thin orange line. Best Guesses reflect Consensus Forecasts, which generally assume constant exchange rates.
 
See also Real Effective Exchange Rates to study in greater depth the cyclical patterns that frequently arise through the J-curve effect on the balance of payments, whereby initial price effects may "justify" and serve to exaggerate movements in the real effective exchange rate before countervailing volume effects create offsetting movements up to two years later.
 
Owing to the conversion of legacy currencies into Euros, analysis is provided on the common currency, rather than for individual countries. Historical data is provided by creating synthetic GDP-weighted time-series for the component currencies, expressed in the European Currency Unit.
 
Please note this is a lagging indicator, where forecasts of the balance of payments are likely to be self-defeating, through pre-emptive changes in exchange rates. Owing to its lagging nature, this indicator is not a component of the currency forecasting model. Comparisons between countries are of limited usefulness, owing to differing long-term trends in capital flows.