Introduction
As a petro-currency, the Canadian dollar has fallen from parity with the USD by as much as 30% in the space of less than two years. In 2009, Canada`s current account turned negative, after a long period of supporting economic growth ( Chart 1). We have sustained deficits ever since, exacerbated by the collapse of the oil prices and the failure of the non-energy sectors to pick up the slack in exports. The current account deficit has ranged between 2-3% of GDP, a significant loss in terms of incomes, output and jobs.
As the deficits persist, Canada needs to import capital to finance the trade deficit and to stabilize its currency. The influence of the capital account is often over-looked in determining the fluctuations in a country`s currency, yet its role in the balance of payments can be just as significant as that of trade balances.
The Importance of Capital Inflows
A various times in Canada's history, foreign investment has contributed to :
* an appreciation in the Canadian dollar;
* the lowering of domestic interest rates;
* the bidding up of Canadian assets in natural resources, financial, and in real estate sectors;
* the long term financing of our external public and private debt.
In short, the capital inflows are central to the shaping of the economy. Now that the current account is in deficit, future capital flows are going to play a vital role in the mapping the path of future economic growth.
Canada has and continues to be both a supplier ( assets) and receiver (liabilities) of capital with the rest of the world. However, we continue to be in a net liability position and hence rely upon capital inflows to support our economy. Chart 2 compares flows of capital in and out of the country.
What makes up the Capital Account
There are three basic components of the capital account.
* Portfolio investment. This investment is usually traded in the secondary markets, such as stocks and bonds, It has expanded enormously in recent years with advancements in technology and de-regulations, allowing for more cross-border trade and a much wider choice of financial instruments ( e.g ETFs, derivatives, etc).
* Direct Investment. This form of cross -border investment results in a significant degree of control though equity ownership in the management of a Canadian company by non-residents. The importance of direct investment has diminished as fewer Canadian companies have given up control to foreign entities .
* Other investments. This category includes short-term bank loans and deposits and responds to fluctuations in interest rates and domestic currency.
Recent Developments in Capital Flows
Canada has been the beneficiary of huge inflow of portfolio capital since the 2008 crisis. The boom in commodity prices worldwide encouraged foreign investors to seek out resource development projects in oil, gas , and other minerals. Financing for mergers and acquisitions was plentiful as Canada was viewed as a safe economic and political environment with a well- established infrastructure . Chart 3 illustrates the dominance of portfolio investment , dwarfing other forms of capital inflows.
The influx of capital , however, had an adverse impact on our trade balance. The loonie appreciated by 15% between 2009 and 2012, at one point trading above par against the USD. However, the Canadian economy continued to grow, albeit modestly, as the resource sector expanded and the benefits were felt throughout the economy.
Of special note , the rise in the value of the loonie occurred all the while Canadian mid- to long-term interest rates were below those of the US; normally, this interest rate spread would have discouraged money to flow into Canada. Over this same period, for every $1 dollar of equity investment, foreigners purchased $3 in bonds. The overweight in debt financing is reflective of the worldwide reduction in borrowing costs as corporate bond spreads narrowed in Europe and North America.
Another way to view the capital account inflow is to consider the book value of foreign investment in Canada (Chart 4). Over the period 2009-2013, the book value of direct investment grew at 20% in total; the value of portfolio investments by 51% and other investments by 31%. The preferred instrument for financing the current account was and continues to be through debt instruments.
Nevertheless, capital inflows into Canada are trending down. International investors in energy are more attracted to opportunities in the US where costs are lower. In addition, investors have a wide choice of resource developments in emerging markets. In a word, Canadian assets are losing some of their prior allure, as international competition is stepped up.
Concluding Observations
1. Now that the super cycle in commodities has ended with a hard landing, our trade balances will continue to be under pressure and that means the loonie will be down for the long count. Furthermore, worldwide trade is slowing significantly, and Canada is a price-taker and will have adjust to lower export values and likely lower terms of trade; both working against a reversal in the value of the loonie.
2. It is no longer apparent that Canada can expect portfolio investment to support the balance of payments as it has in the past .Indeed, the trend in portfolio investment has been declining over the last five years, all the while the current account deficit has widened. Canada will face competition for overseas capital from emerging markets offering similar natural resources.
3. To attract international capital, Canadian interest rates across the board would have to increase; however, any increase in domestic interest rates will have an adverse affect on the economy and will be counter productive in trying to eliminate our trade imbalances. ; it is unlikely the Bank of Canada would counsel such a policy move .
4. To the extent that it will be harder to attract new overseas investment, the loonie is unlikely to move far from its current range (USD=1.25-1.35). Any appreciation in the currency must come from improvements in the overall balance of payments, current and capital accounts.
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