Current Account Imbalances

In general, countries that run persistent current account deficits will see their currencies weaken over time. Countries that run persistent current account surpluses will tend to see their currencies appreciate over time.

Current account trends influence the path of exchange rates through several mechanisms.

1. The flow supply/demand channel.

If a country has a trade deficit, its reserves will decline and its currency will depreciate. Depreciation will then improve trade - now imports are more expensive and should decline, while exports are cheaper and should increase. A few factors will determine by how much exchange rates will need to adjust to restore current account balances:

• The initial gap between export and import.
• The response of import/export prices to changes in the exchange rate.
• The response of import and export demand to the change in import and export prices.

2. The portfolio balance channel.

Current account imbalances may shift global asset preferences and influence exchange rates indirectly.

3. The debt sustainability channel.

If a country's debt caused by large and persistent current account deficit rise to a level that is believed to be unsustainable, its currency must depreciate to correct the trade imbalance.

Capital Flows

Investment and financing decisions are usually the dominant factor in determining exchange rate movements, at least in the short to intermediate term.

• One model shows that movements in real interest rate and risk premia differentials between countries can cause real exchange rate movements.
• The practice of carry trades could put upward pressure on the value of high-yield currencies? value.
• There's no obvious correlation between equity market performance and exchange rates.