Exact link between economic growth and value of a currency?

Hi, I wuold like to ask if anybody is able to provide a really good and clear causation/effect explanation of why a positive GDP development is generally deemed to lead to a strenghening of a specific currency, all else being equal.

On the calendar, you see this about GBP numbers:

Measures Change in the inflation-adjusted value of all goods and services produced by the economy; Usual Effect Actual > Forecast = Good for currency;

So, probably it should go something like this "Since country x is now producing more goods and services, the combined value of the assets of country X is now higher. This means that (.....)"

I would like to understand the direct link (or the most direct link that can be pointed out, at least, between higher (than expected) GDP numbers, and the value of the currency.

Maybe it's quite basic, but I can't see it right now!

(I am trying to get better at fundamental analysis, I think I have a decent understanding of monetary and fiscal policy, and also trade balance etc. ah - maybe this is the explanaton: if a country produces more goods and services, it will export more, which will lead to an increased demand for its currency, all else being equal - am I on the right track?)

This is very uncharacteristic of me because I'm purely a technical trader, but I've recently learned about this in a course, so I'll do my best to explain it.

The key is in the BOP (Balance of Payments).

(X - M) + (CI - CO) + (FI - FO) + FXB + NEO = 0

X = exports
M = imports
CI = capital inflows
CO = capital outflows
FI = financial inflows
FO = financial outflows
FXB = foreign reserves (including gold reserves)
NEO = net errors & omissions

I'm just going to cut to the chase here: The two largest components of the BOP are (X - M) and (FI - FO). Those two components dwarf the rest in size, so let's just ignore everything else (economists usually just focus on these anyway...)

(X - M) is net exports. It's the trade balance.

(FI - FO) is net financial imports. It's basically the amount of foreign capital flowing into the country, usually through investment. This can be investment in domestics stocks (e.g. Germans buying IBM stock) or direct investment in companies (e.g. a Japanese company buys an American company).

(By the way, there's a bit of a misnomer, the "financial account" should really be called the capital account, but for historical reasons, it's not.)

So the simplified BOP equation is:

(X - M) + (FI - FO) = 0

Which means that the trade balance and balanced/cancelled by net foreign investment. In other words, if imports exceed exports (citizens of the domestic country are consuming a lot so the trade balance is negative), then it must be financed by foreign capital investments.

Let me run through this part again in more detail because it's important: Suppose Americans are importing a LOT of foreign goods. People are buying Japanese cars, Korean electronics, Italian shoes, Chinese toys, etc. If America is also, simultaneously exporting a lot of goods and services then everything balances. Russians are buying American clothes, the French are purchasing American financial services, the British are buying American food, etc. But what happens if American are importing a LOT more than they are exporting? Well you can't spend more money than you earn (we're not talking about credit here), so that means that America must have some other source of cash inflows to finance all these net imports. That's what the Financial Account shows: net inflows from foreign countries (in the form of investment in American companies).

Ok finally we are in a position to talk about the logic you were asking for: Why does an increase in GDP generally lead to an appreciation of the currency?

Increased GDP
—> people are prospering
—> the people start to demand more imports
—> Trade Balance becomes negative[/b] (a.k.a. "Current Account Deficit")
—> the Financial Account must become positive to balance (a.k.a. "Financial Account Surplus")
—> foreign investors must exchange their money to USD so they can invest in American companies/stocks
—> demand for USD increases
—> USD appreciates

Now I know what you're thinking: If Americans are demanding more imports, won't they have to exchange USD for foreign currencies to purchase the foreign goods & services? Won't this depreciate the USD? This would seem to cancel the appreciation effect from foreign investment.

I was wondering the same thing. Now I must warn you that the following is my own opinion, and I'm not an expert:

I think the reason that the net effect is USD appreciation is because although Americans must convert USD to foreign currencies to buy the imports, these exchanges are spread out over multiple currencies. In other words, it's not like Americans are ONLY buying European goods & services. The downward pressure on the USD is diluted across EUR, JPY, GBP, CAD, etc. So there's a little demand for EUR, a little for JPY, etc. In contrast, on the Financial Account, ALL of the foreign investors are demanding USD. So the net effect is more demand for USD.

I hope I've helped a bit.