Lecture 2: Canadas Balance of Payments:

When Canadians want to buy foreign goods, services or financial assets, Canadian dollars must
be sold in order to buy foreign currency for those transactions. Likewise, Canadian dollars must
be purchased by foreigners in order to buy the Canadian currency to buy Canadian goods,
services or financial assets.
Canadas international transactions are grouped into 3 accounts that make up the Balance of
Payments:
o Current account
o Capital & Financial account
o Reserve account
Current Account:
o Flows of exports, imports, investment income and international financial transfers
o Foreign purchases of Canadian dollars = Credits
o Purchases of foreign currencies = Debits
Capital & Financial Accounts:
o Flows of capital that move into or out of Canada for that period
o American buys a bond issued by Canadian government = Credit
Reserve Account:
o Changes in the amount of official foreign exchange reserves held by the Bank of
Canada
Balance of payments must balance
o BCA + BKA + BRA = 0
o Balance on reserves account tends to serve as a foreign exchange buffer managed by
the government or the central bank.
o For all practical purposes, the key balance of payments relationship is that the balance
on current account equals the balance on capital and financial account
Current Account:
o Favorable balance of merchandise trade: The total value of Canadian exports of such
tangible items as forest products, minerals, energy, agricultural products, airplanes
exceed the value of the imported merchandise
o Canada generally runs a small deficit on services
o Largest gap between debits and credits on Current Account involves investment income
receipts and investment income payments. The outflow of financial payments far
exceeds the inflow of receipts from abroad. This imbalance reflects Canadas heritage
as a small country that over the years has imported vast amounts of capital to build the
nation and its industry.
o Deficit on current account means that Canada generated fewer receipts through exports
and income on foreign investments that it paid out for imports and capital service
payments to foreign investors
o The positive balance on current account can be interpreted as Canada and Canadians
earning more foreign exchange than Canadians needed in order to purchase things with
those US dollars, Euros, etc. The excess foreign exchange on current account must be
spent somehow and so it is used to purchase foreign financial assets. As a result, the
overall balance of payments balances, which means that the surplus (or deficit) on
current account corresponds to the deficit (or surplus) on capital and financial account.
o The current account balance, especially the trade balance, tends to be sensitive to
changes in the exchange rate. When the Canadian dollar appreciates relative to the US
dollar, Canadian produced goods become more expensive in the export market.
Conversely, the stronger Canadian dollar makes imports cheaper. As Canadian exports
fall and imports rise, the trade balance deteriorates.
o One would predict that the trade balance, exports minus imports, would improve if a
countrys currency depreciated against the currency of its major trading partners.
Indeed so, but adjustment generally require time to work themselves through. The
length of time required to adjust production plans and contracts with foreign customers
results in lags that result in a predictable pattern in the trade balance following a change
in the exchange rate.
o The classic reaction pattern of the trade balance to currency depreciation is referred to
as the J curve effect. It is an initial deterioration and eventual improvement of the trade
balance following currency depreciation. The reason lies in the difficulty and costliness
of adjustment in production and marketing in international trade. One observes short
term inelasticity or lack of price responsiveness of exports and imports to the change in
the exchange rate.
Capital and Financial Account:
o Capital account records a nations capital transfer and transaction in non-produced,
non-financial assets.
o Financial account records a nations international transactions in financial assets such as
bonds, loans or equities. There is generally much more activity in the financial account
as opposed to the capital account.
Two main categories: Direct investment and portfolio investment
FDI is what multinational enterprises do
The distinguishing features of FDI are ownership and control in a corporate
context.
Directly involved in the ownership, control and management of their operations
abroad.
Canadian companies assign their corporate names and they transfer technology,
trademarks, marketing and strategy to their subsidiaries abroad.
In the capital account, McCains contribution to outbound FDI would consistent
of the new direct investment, in the form of corporate quality, made in that
year. So when McCains sets up the food processing plant in France with equity
injections of $10 million per year for 2 years, $10 million is recorded each year
as a debit in the Capital Account in each of those years. Reinvested earnings
and non-arms length (intra-firm) debt are also recorded in the financial
account.
While FDI is recorded in the Capital and Financial account, the subsequent flow
of earnings on that capital is recorded as investment income in the current
account
If McCain foods earns $1 million dollars on its operations in France and then
immediately reinvests those earnings in the French subsidiary, the Current
Account would record $1 million of foreign investment income (credit) while the
Capital and Financial account would record $1 million of FDI (debit)
Firms go abroad to expand their markets or take advantage of more profitable
sites of production
o Portfolio investment refers to changes in Canadian holdings of non-controlling equity in
foreign companies, changes in foreign holdings of non-controlling equity in Canadian
companies, changes in Canadian holdings of debt issued by foreigners and changes in
foreign holdings of debt issued by Canadians.
Portfolio capital seeks out attractive bond interest, non-controlling equity
returns, diversification and tax advantages
External Balance and the Exchange Rate
o Current account deficit indicates that a nation has spent more than it has earned. In
that case other nations lend money to the nation in current account deficit to finance
the difference between its income and spending. The nation as a whole borrows money
from the rest of the world by means of the net sale of financial assets. Of course, the
net sale of financial assets to the rest of the world is that nations capital account
surplus. Again, we see that a deficit on current account is mirrored by a surplus on
capital account such that the balance of payments balances
o Surpluses or deficits in either account are not necessarily problematic
o Helps to view the surplus on capital account as essentially loans from financiers in the
rest of the world to the country in current account deficit. Such loans are attracted to
capital importing nations by interest rates. The interest rate is an important mechanism
for balancing the capital account and current account.
o The fact that these current account deficits were financed through capital account
surpluses reflects on the enormous capacity of the US to borrow from the rest of the
world (the capacity of the US to sell financial assets to foreigners)
o If the rest of the world becomes uncomfortable with mounting loans to the US and if
they reduce the flow of capital to the US (they reduce the capital account surplus), then
one of two things (or a combination of the two) will occur. Either US interest rates must
rise to attract new capital inflows, or the US dollar will fall against other currencies as
foreign financiers willingness to buy US dollars (to buy US financial assets) subsides. In
either case, the US current account will shrink to match the reduced capital inflows. For
example, if the US dollar falls, imports become more costly for Americans and US
exports become cheaper on world markets and hence the US trade balance improves.
On the other hand, if US interest rates rise, the US economy is negatively affected and
imports fall, likewise improving the US trade balance and reducing the overall need for
capital imports.
o With respect to shorter term movements in the exchange rate, it is generally that case
that any news of an unexpected boost to a macroeconomic factor news that points to
greater economic strength or higher interest rates, for example is likely to trigger a
strengthening of that countrys currency.
o In the very short term at least, the movement of the exchange rate is random.
Consequently, the best estimate of tomorrows exchange rate is todays exchange rate.