Forex: Balance of Payments

Buy when the coloured lines are at the low end of their range, sell when they are high

This is a "what-if" tool that is intended to 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 payments deficit on current account, including a Best Guess as to future developments. For comparability, exchange rates have been rebased to set year-end 1994 at 100.

In each chart the currency index is shown as the thick white line on the right hand axis. The main explanatory variable, the balance of payments on current account, shown as the thin yellow line, uses the left hand axis. A Best Guess as to the future development of the valuation ratio is also shown on the left hand axis, as the thin orange line.

Best Guesses suggest what is widely expected to happen to the ratio of the balance of payments on current account to GDP, assuming constant exchange rates. Forecasts are based on consensus estimates the current account and GDP.

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. Such "what-if" analysis should be interpreted for its usefulness in predicting the likelihood of currency movements. Owing to its lagging nature, this indicator is not a component of the econometric forecasting model. Comparisons between countries are of limited usefulness, owing to differing long-term trends in capital flows.

See also the relevant Valuation chart 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.

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