The Principles of Investment Flow
Investment flows represent the money that flows from one country to another as a result of the purchase or sale of assets in one country by an investor from another country. Investment flows are affected by three things:
- Foreign demand for domestic assets
- Domestic demand for foreign assets
- Repatriation of assets
Foreign Demand for Domestic Assets
Foreign demand for domestic assets increases the demand for the domestic currency and the supply of the foreign currency. This increase in demand for the domestic currency increases the value of that currency, while the increase in the supply of the foreign currency decreases the value of that currency. Here’s how it works.
Suppose an investor in Japan wants to buy a government bond in New Zealand. Naturally, the investor in Japan would like to pay for the product in Japanese yen, but the New Zealand government would like to be paid in New Zealand dollars. To facilitate this process, an exchange must be made. The investor in Japan must exchange his Japanese yen for New Zealand dollars to pay the bond issuer.
This exchange increases the supply of Japanese yen in the market and increases demand for New Zealand dollars, which means that the value of the Japanese yen should decline and the value of the New Zealand dollar should increase.
Domestic Demand for Foreign Assets
Domestic demand for foreign assets increases the demand for the foreign currency and the supply of the domestic currency. This increase in demand for the foreign currency increases the value of that currency, while the increase in the supply of the domestic currency decreases the value of that currency.
We could provide another illustration here, but once again, it would be exactly like the one between Japan and New Zealand that we just outlined, except that the roles would be reversed, so we won’t bore you with another one.
All you need to remember right now is that when buyers and sellers engage in international asset purchasing, the flow of money from the buyers to the sellers increases the value of the sellers currency and decreases the value of the buyers’ currency.
Repatriation of Assets
Repatriation of assets increases the demand for the domestic currency and the supply of the foreign currency. This increase in demand for the domestic currency increases the value of that currency, while the increase in the supply of the foreign currency decreases the value of that currency. Here’s how it works.
When a corporation makes money overseas, it has two choices as to what to do with that money: it can leave the money overseas, or it can repatriate the money by bringing it back home. There are advantages to both, but in most cases, you would imagine that the corporation would want to bring the money back home so that it can efficiently reallocate it throughout the rest of the corporation or distribute it to shareholders.
The process of repatriation requires the corporation to convert the profits from whatever currency they are denominated in to the local currency where the corporation is headquartered. For instance, if General Electric makes money in Japan but wants to bring those profits back home, it will have to sell Japanese yen and buy U.S. dollars.
One thing you can watch to gauge just how much money may be being repatriated is the earnings announcements of large multinational corporations. If a company like General Electric is making a lot of money overseas, the chances are good that some of that money is going to be brought home. Seeing an increase in overseas earnings can be an effective signal that repatriation activity is going to increase.
Changes in tax policy can also affect the level of repatriation. One shining example of this was the Homeland Investment Act of 2003 (H.R. 767).1 The Homeland Investment Act allowed corporations that earned foreign profits to repatriate those earnings at a tax rate of only 5.25 percent, instead of being taxed at their standard corporate rates, which could be as high as 35 percent. This decrease in tax rates prompted corporations that had left a large portion of their foreign earnings overseas to repatriate those funds. Some estimate that as much as $600 billion was repatriated thanks to this change in tax policy. As you can imagine, this had a bullish effect on the value of the U.S. dollar as all of that money flowed in, increasing demand for the U.S. dollar.
Monitoring Investment Flows
Unfortunately, monitoring investment flows isn’t as straightforward as monitoring trade flows. The information just isn’t as readily available from every country in a timely manner as the monthly trade balance numbers are. However, the United States, via the U.S. Department of the Treasury, does do a pretty good job of summarizing investment flow data in its monthly Treasury International Capital (TIC) Data reports.
If foreign investors are buying an increasing amount of U.S. securities, demand for the U.S. dollar will also be increasing. This should lead to a strengthening of the U.S. dollar compared to the foreign currency, all other things being equal.
If foreign investors are buying a decreasing amount of U.S. securities, demand for the U.S. dollar will also be decreasing. This should lead to a weakening of the U.S. dollar compared to the foreign currency, all other things being equal.
While it may not be easy to track the exact amount of investment flows between one country and another, you can get a general idea of whether investment demand is going to be increasing or decreasing by watching the performance of the asset markets—bond markets, stock markets, real estate markets, and so on—that foreign investors may be looking to put their money into.
For example, if the interest rates offered on government bonds in one country are much higher than the interest rates offered on government bonds in another country, you could reasonably conclude that investors from around the world are going to be interested in investing their money in the bonds with the higher interest rates. This would most likely lead to an increase in investment flows into that country, which should increase the value of that currency.
Interest-Rate Parity Theory
This concept of a currency getting stronger when the country it represents offers higher interest rates than other countries is the basic premise of another currency-pricing model called the interest-rate parity theory.
The interest-rate parity theory suggests that investors are always looking for the highest return on their money for the least amount of risk, and that countries that offer higher interest rates on their bonds without being extreme credit risks are going to attract more foreign investment than other countries. The thinking goes something like this:
- If a country offers high interest rates, demand for that country’s bonds will increase.
- Because you have to pay for bonds other assets in the currency of the issuing country, this increase in demand for local bonds will increase demand for the local currency.
- This increase in demand for the local currency will push the value of the currency higher
While this theory offers some basic guidance on the relationship between investment flows and currency values, it does have some flaws. Like the balance of payments theory, the interest-rate parity theory takes only one source of demand for a currency into account, and we know that this is a little too simplistic.
Why do we care about any of this? The interest-rate parity theory illustrates how international investing trends can drive currency prices. And as a current, or aspiring, Forex trader, you need to understand the impact that traders like you, when looked at as one cohesive group, can have on the markets.