CM Expectations - FX returns - Capital Flows and Portfolio Balance

[EG_KCM]

Hi, can someone explain to me this section from the the reading 11 “ Capital Market Expectations” regarding Fx returns, focus on capital flows (page 252, volum 2):

• In the long run, the relative size of each currency portfolio depends primarily on relative trend growth rates and current account balances. Rapid economic growth is almost certain to be accompanied by an expanding share of the global market portfolio being denominated in the associated currency. Thus, investors will have to be induced to increase their strategic allocations in that country/currency. All else the same, this would tend to weaken that currency…”

I believe that higher growth rates would make the country more attractive, therefore the currency should appreciate because investors are asking more of it.

Maybe i am not fully understanding the first part of the sentence.

Thank you!

[fino_abama]

Economic theory on exchange rate forecast

That part is true. So the more foreign capital flows into the domestic economy, the higher it would push the domestic currency upwards. But up to a certain point, the domestic currency becomes too expensive (overvalued) for foreign investors to enter (but they still want to get in). So how can an investor “be induced” to invest into that economy? That would be for the domestic currency to weaken, so it is “cheaper” for foreign investors to invest their funds. Take note of the “need to be ind…

See above link

[EG_KCM]

Thank you for the link. The “need to be induced” part seems very subtle to me, I wonder how something like this can be asked in the essay part.