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12.1: The balance of payments

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    The balance of payments accounts provide the background to supply and demand in the foreign exchange market. They record transactions between residents of one country and the rest of the world that involve payments in different national currencies. Taking the Canadian economy as the domestic economy and the United States as the "rest of the world," all transactions that give rise to an inflow of US dollars to Canada are entered as credits in the Canadian balance of payments. Transactions requiring payments in US dollars are debits, entered with a minus sign.

    Table 12.1 shows the actual Canadian balance of payments accounts in 2016. Entries in the 'Exports' column represent supplies of foreign currency coming to the Canadian foreign exchange market, converted to Canadian dollars. Entries in the 'Imports' column represent the demand for foreign currency in the Canadian foreign exchange market, converted to Canadian dollars. Row 5 in the table shows that after adjustment for statistical error and changes in official reserves, the foreign exchange market is in equilibrium – supply equals demand.

    Balance of payments accounts: a record of trade and financial transactions between residents of one country and the rest of the world.

    Table 12.1 The Canadian Balance of Payments, 2016 (Billions of Canadian $)
    Receipts Payments Balance
    (Exports) (Imports)
    1. Current account
    521.4 547.2 –25.8
    107.2 129.3 –22.1
    Investment income
    91.5 106.3 –14.8
    Transfers, etc.
    13.6 18.6 –5.0
    Balance 67.7
    2. Financial account
    Foreign in Canada Canada in foreign
    Direct investment:
    41.8 85.1 –43.3
    Portfolio investment
    161.3 13.8 147.5
    Other investment
    59.3 91.0 –31.7
    Balance 72.5
    3. Statistical discrepancy 2.7
    4. Official reserves 7.4
    5. Balance of payments img793.png 0
    Source: Statistics Canada, CANSIM Tables 376-0101, 376-0102

    The Current Account of the balance of payments records international flows of goods, services, and transfer payments. The merchandise trade is exports and imports of goods; things like cars and car parts, steel, wheat, and electronic equipment. Non-merchandise trade measures exports and imports of services like travel, banking and financial services, transportation, and tourism. The total of merchandise and non-merchandise trade is the trade balance defined as net exports in our earlier study of planned expenditure and aggregate demand.

    Current Account: a record of trade in goods, services, and transfer payments.

    However, the trade balance is not the same thing as the current account of the balance of payments. There are also flows of investment income in the form of interest payments, dividends and reinvested earnings, and transfer payments between countries as a result of government programs like foreign aid, and private receipts and payments.

    But exports and imports of goods and services are the largest components of the current account. Trade in goods and services is based, in part on differences across countries in tastes, in the types of goods and services available, in economic structure, in national income levels and differences in the prices of domestic goods and services relative to foreign goods and services.

    Three factors determine the prices of foreign goods and services relative to prices of domestic goods, namely:

    1. The domestic price level (img794.png) for Canada;
    2. The foreign currency price of imports (img795.png) in the case of imports from the US; and
    3. The nominal exchange rate (er): the domestic currency price of foreign currency.

    International price competitiveness is measured by the real exchange rate, which combines these three factors. For example, the real exchange rate between Canada and the United States would be:

    img796.png (12.1)

    where the nominal exchange rate er is the Canadian dollar price of the US dollar and img797.png and img798.png are general price levels as measured, for example, by GDP deflators or consumer price indexes. The real exchange rate measures the price of United States goods and services in Canadian dollars relative to Canadian goods and services in Canadian dollars.

    The real exchange rate makes an important link in the transmission mechanism between the foreign exchange rate and the impact of domestic price levels and inflation rates on net exports, aggregate expenditure and aggregate demand.

    Nominal exchange rate (er): the domestic currency price of a unit of foreign currency.

    Real exchange rate: the relative price of goods and services from different countries measured in a common currency.

    Consider the following example:

    • The nominal exchange rate er=$1.25Cdn/$1US
    • The GDP deflator for Canada is 121.3, on the base year 2002.
    • The GDP deflator for the US is 110.4, on the base year 2002.

    Then the real exchange rate, which gives the price of US goods in Canadian dollars relative to the price of Canadian goods in Canadian dollars, is:

    img799.png (12.2)

    By this example, US goods and services are about 14 percent more expensive than Canadian goods and services, on average, when both are priced in Canadian dollars. At the same time, Canadian goods and services are less expensive than domestic goods in the US when both are priced in US dollars. These price differentials as are important to the flows of exports and imports of goods and services between countries.

    The Financial Account of the balance of payments makes a link between interest rates and the supply and demand for foreign exchange and the exchange rate.

    The financial account records the flows of funds for international purchases and sales of real and financial assets. Table 12.1 shows a net capital inflow of $72.5 billion in 2016. The payments by foreigners buying Canadian assets exceeded the payments made by Canadians buying foreign physical and financial assets. A financial account surplus was the result.

    Financial Account: the record of capital transfers and the purchases and sales of real and financial assets.

    Receipts and payments in the financial account reflect sales and purchases of foreign assets. These flows have become increasingly important. Computers and electronic communications make it as easy for a Canadian resident to buy and sell stocks and bonds in the financial markets of New York or London as in Toronto. Moreover, controls on international capital flows have gradually been dismantled with globalization and financial integration.

    The world's financial markets now have two crucial features. First, financial account restrictions on capital flows between advanced countries have been abolished. Funds can move freely from one country to another in search of the highest expected rate of return. Second, trillions of dollars are internationally footloose, capable of being switched between countries and currencies when assets with similar degrees of risk are expected to offer different rates of return in different countries and currencies.

    This is the age of perfect capital mobility when small differences in expected returns trigger very large flows of funds from country to country. Indeed, the stock of international funds is now so huge that capital flows could swamp the typical current account flows from exports and imports.

    Perfect capital mobility: when very small differences in expected returns cause very large international flows of funds.

    In international asset markets, capital gains or losses arise not merely from changes in the domestic price of an asset, but also from interest rate differentials and changes in exchange rates while temporarily holding foreign assets. Table 12.2 provides an example.

    Table 12.2 Returns from lending $1,000 for a year
    Interest Rate Exchange rate Final
    $1,000 (%) ($Cdn/$US) asset value
    Lent in Initial Final $Cdn $US
    1. Canada 4.0 1,040.00
    2. United States 5.0 1.03 1.009 1,028.50 1,019.41

    Suppose you can invest $1,000 Canadian for a year. Canadian one-year interest rates are 4 percent. In the United States one-year rates are 5 percent. The higher United States rates look attractive. If you keep your funds in Canadian dollars, Row 1 shows that you will have $1,040 at the end of the year. Can you do better by buying a United States asset?

    Row 2 shows what happens if you convert $1,000Cdn into US dollars at an initial exchange rate of $1.03Cdn/$1US you have $970.87US to invest at the United States interest rate of 5 percent. You get $1,019.41US. You would be ahead if the exchange rate remained constant. $1,019.41US is $1,050Cdn, a return of 5 percent, as you would expect.

    Suppose, however, the exchange rate changes while your funds are out of the country. Let's say the Canadian dollar appreciates by 2 percent during the year, lowering the exchange rate to $1.009Cdn/$1US When converted back to Canadian dollars your $1,019.41US now buys $1,028.50 Cdn. You get 1 percent more interest income from holding the United States asset instead of the Canadian asset, but you suffer a capital loss of 2 percent by temporarily holding US dollars, whose value relative to Canadian dollars fell by 2 percent in that year.

    In this example, you end up with about $1,028.50Cdn if you lend in US dollars. The Canadian dollar appreciated by more than 1 percent, the difference between Canadian and United States interest rates. As a result, the capital loss from the exchange rate while holding US dollars outweighed the gain on interest. This was the experience of many portfolios in 2008 as the Canadian dollar appreciated strongly and the exchange rate fell. The total return on lending in US dollars was lower than the return in Canadian dollars.

    Conversely, if the Canadian dollar depreciated against the US dollar while you were holding your United States asset, your total return would be higher than the 1 percent interest rate differential. You would get a gain on the exchange rate when you converted back to Canadian dollars. This was the experience of portfolios holding assets denominated in US dollars as the Canadian dollar depreciated over the period from May 2008 to March 2009, raising the nominal exchange rate from er=0.9994 to er=1.2645. The exchange rate movement provided a 26.5% annual return, in terms of Canadian dollars, to portfolios holding US dollar assets. The depreciation of the Canadian dollar in 2014-15 had the same effect.

    Equation 12.3 summarizes this important result. The total return on temporarily lending in a foreign currency is the interest paid on assets in that currency plus any capital gain (or minus any capital loss) arising from the depreciation (appreciation) of the domestic currency during the period.

    Return on holding = Interest rate on img800.png % increase/ % decrease in
    foreign asset foreign asset nominal exchange rate (er)
    img801.png (12.3)

    As a result, the net capital flow in the balance of payments depends positively on the differential between domestic and foreign nominal interest rates (iif). A rise in domestic rates relative to foreign rates would attract a flow of funds into the domestic financial market. A fall in domestic rates would push the flow toward foreign financial markets, assuming in both cases that the exchange rate is not expected to change in an offsetting direction.

    Alternatively, assuming the interest rate differential is constant, the net capital flow depends negatively on the expected rate of depreciation of the domestic currency suggested by img802.png. An expectation that the domestic currency will depreciate (a rise in ere) will increase the returns from holding foreign assets and lead to a net capital outflow. An expected appreciation would reduce expected returns on foreign assets with the opposite effect. These capital flows are important parts of the supply and demand for foreign exchange on the foreign exchange market.

    The change in official international reserves in Table 12.1 records the increase or decrease in the Government of Canada's holdings of foreign currency balances. A government's holdings of foreign currencies are in its official international reserves account. These balances are like investments in foreign countries because they are the government's holdings of foreign assets. An increase in the official reserves is like a payment item in the financial account of the balance of payments. Because Canada maintains a flexible exchange rate, annual changes in international reserves are small. When it comes to discussing different exchange rate policies, countries that adopt fixed exchange rates often experience large changes in their foreign currency reserves in defense of the exchange rate they have set.

    Change in official international reserves: the change in the Government of Canada's foreign currency balances.

    The balance of payments is the sum of the balances in current and financial accounts minus the change in the official international reserves account. In Table 12.1, this balance is shown as the sum of accounts (1+2+3–4) namely img803.png. If all items in the accounts were measured correctly, the balance would be zero. To recognize this, a statistical discrepancy adjustment is made, as shown in the table, to account for any errors in the measurement of other items.

    Balance of payments: the sum of the balances in current accounts and financial accounts, minus the change in the holdings of official reserves.

    The record of the change in official reserves is always of equal magnitude to the sum of the balances on the current and financial accounts, if there is no statistical discrepancy in the measurements. As a result, the balance of payments always balances, but the state of the individual accounts underlying that overall balance need not be in balance. Indeed, changes in the foreign exchange rate in the foreign exchange market reconcile the different account balances to produce overall balance.

    This page titled 12.1: The balance of payments is shared under a CC BY-NC-SA license and was authored, remixed, and/or curated by Douglas Curtis and Ian Irvine (Lyryx) .

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