Traditional explanations for currency movements – including the analysis of growth and interest rate differentials and purchasing power parity – have become increasingly inadequate over the years. This is largely because traditional valuation models have failed to keep up with the rapid growth in global capital markets and the associated rise in cross-border investment, particularly over the past decade.
As the importance of global investment has grown, it has now reached the point where it drives a significant proportion of all daily foreign exchange transactions. Meanwhile, international trade has also expanded over this period due to a globalisation phenomenon that has underpinned strong global growth.
However, due to the rise in cross- border investment flows, it is estimated that trade-related deals now account for less than 1 per cent of all currency transactions.
The major custodian banks are now coming to the fore as providers of data on these critical cross-border investment flows, based on their advantage in processing millions of transactions daily from large institutional investors.
A further advantage of using global custody data is that it does not suffer from long reporting lags, as is the case for data released by finance ministries and central banks. Consequently, custodian bank clients have access to extremely timely data that reflect the aggregate behaviour of institutional investors globally on a daily basis.
As one of the largest global providers of investor services, The Bank of New York (BNY) is uniquely positioned to follow a significant proportion of the world’s major cross-border investment flows. To this end, BNY has developed the world’s first internet-based interactive portfolio tool, the interactive Portfolio Flow Monitor (iPFM), based on the daily netcross-border activity within its global custody system.
The iPFM gives BNY customers the ability to chart net portfolio flows for a particular country or currency zone from one to 24 months, compare these aggregated flows with a selection of major currency pairs, fixed income and equity indices, and analyse the statistical relationships between them.
It would be wrong to suppose that simply having a clear picture of international investment flows allows an investor to predict currency movements with any degree of precision. Too many other factors come into play over time (central bank activity, mergers and acquisition flows, derivatives and model-related trading, changes in liquidity and so on) to make this a practicable proposition.
Nevertheless, portfolio flows do play a significant role in currency markets. By understanding how they have influenced currency prices in the recent past, and how in turn differing currency regimes have influenced them, investors can gain a greater insight into what may drive currency prices in the future.
Asian equity market flows
Since early June, one of the principal factors behind the upward pressure on the yen has been foreign investor interest in Japanese equities. This was apparent not only from our own iPFM data, but also from the data released by the Japanese Ministry of Finance (MOF).
According to MOF data, overseas investors went on an aggressive buying spree from May onwards. Between May and the week ending September 12, they purchased a net ¥6012.3bn (E46.5bn) in equities. This compared to net purchases of ¥327.1bn during the first four months of 2003 and ¥775.5bn for all of 2002.
A number of factors contributed to this strong interest in Japanese equities. The initial trigger was the decision by the Federal Open Market committee to keep interest rates low for as long as needed to ensure a recovery in the US economy.
This initiated an interest in global equities as investors came to believe that this would be the catalyst for a recovery of the global economy.
However, equity investors showed a particular interest in the equity market of the export-oriented economy of Japan. There were three main reasons:
- First, they appeared to be substantially underweight Japan (hardly surprising, given the 13-year-old bear market).
- Second, exporters had a competitive advantage due to the FX policy being pursued by the government to keep the yen at an artificially cheap level.
- Third, the same currency policy ensured that the equities themselves looked artificially cheap when viewed from an overseas investor’s perspective.
Japan was not alone in seeing a significant pick-up in foreign demand for equities this year – South Korea has also seen notable inflows since May. According to our own data, around 85 per cent of the net stock purchases over the past year took place between the start of June and the end of August. Again, it is notsurprising that outflows from South Korean equities started to appear following the September G7 announcement.
The question that must be asked is whether a potential decline in foreign investor interest in Japanese and Korean equities will necessarily spill over into other Asian equity markets.
We believe this is unlikely. If foreign investors became interested in Japanese equities because they saw the MOF fighting to peg the yen at a fixed level against the dollar (which they perceived to be artificially cheap), then the same argument can be made for Chinese and Hong Kong equities.
It is reasonable to assume that investors will show a greater interest in Chinese and Hong Kong equities now that the MOF appears to have subtly altered its currency policy to better reflect the latest G7 statement while the currency policies in China and Hong Kong remain unchanged.
This is exactly what was observed in the week following the G7 meeting. The iPFM indicates that Hong Kong equities experienced a significant pick-up in foreign demand recently.
US equity market flows
Asian equity markets are not the only markets affected by the recent G7 statement. US equity markets also saw a significant shift in interest in the immediate aftermath of the announcement.
On the Friday before the G7 meeting, the S&P 500 stood at its highest level since June 2002, having staged a 31 per cent rally from the March lows. However, the following week saw a 3.8 per cent decline.
The numbers for the Nasdaq composite were even more dramatic, with the index losing 5.9 per cent of its value. In other words, technology stocks shed around about 18 per cent of the gains made since March 12 over the course of just one week.
What has happened to change investor sentiment so dramatically? It would appear that investors feared that a decline in the dollar would prompt a pullback in US stocks.
Our own data show that investor interest peaked in late August, though overseas holdings of US equities remained close to two-year highs. There was ample opportunity for funds to reallocate capital into other markets if they became concerned about a decline in the dollar.
Conclusion
It is clear that cross-border investment flows cannot be ignored when attempting to explain the price behaviour of freely floating currencies (as well as underlying asset markets), and that The Bank of New York – as one of the world’s largest providers of investor services – is well positioned to provide this information.
With uncertainty still surrounding the pace of recovery in the world economy and interest continuing to grow in Asian currency markets, the iPFM will remain an indispensable tool for understanding market behaviour.
Simon Derrick is vice-president, global markets, at The Bank of New York.
Tel +44 (0) 20 7570 0892
sderrick@bankofny.com
