International Accounts

Why Should I Care?

Most of the things we buy nowadays come from abroad. If they become more expensive, it affects our purchasing power. All of a sudden, what happens in other countries, and how our exchange rate of the Canadian dollar reacts to that, really matters. 

This Lecture Has 2 Parts

• Balance of Payments
• Exchange Rates

What are International Accounts?

Money coming in and out of our country has a huge impact on how much investment goes on, but also how much our currency is worth to outsiders. This affects everyone by directly changing prices for all sorts of goods such as Korean flat-screen TV’s, Vermontan ice-cream, Italian shoes, or German cars. It also changes the price of Quebec-made regional jets, aluminum, and cheeses.

There is a set of aggregate measurements that help us understand how our economy relates to the rest of the world. This includes the sum of our imports, the sum of our exports, the sum of the foreign investments made by Canadians, and the sum of foreign investments made in Canada. All of these accounts are balanced by our floating exchange rate, which really helps us keep an open economy in Canada.

• Balance of Payments

Money flows between countries for two main reasons: A) the money is paying for products, or B) the money is being invested. There are also funds that are simply sent over for different reasons, such as gifts, or inheritances, but these amounts are marginal.

Diagram - Balance of International Payments

The Balance of Payments is a national economic accounting table that includes two main accounts. Flows entering the country are considered receipts. Flows leaving the country are considered payments.

A) The Current Account

The current account measures the country's net flow of income which is due to international transactions. There are two sub-categories of the current account.

The most commonly known is the trade balance, or net exports. This measures the exports leaving the country, the export income entering the country (receipts), as well as the imports entering the country, and the import income leaving the country (payments). The balance between exports and imports is measure by X - M. This is also called net exports.

The second, and most important category, is the income balance, or net foreign investments. This measures the sums entering and leaving the country for direct investment in new plants and equipment, and investments towards a country's stock exchange. Investments into Canada are receipts and the investments of Canadians abroad are counted as payments.

B) The Capital Account

The capital account measures the changes in national ownership of assets. It is not a flow value; it measures stocks of capital. The values are actually quite marginal in Canada and don't have an important effect on the overall balance of international payments.

Follow the money

Let's use an example. A Brazilian company, Vale, purchases a Canadian mining company. The asset valuation is accounted for in the capital account. However, when Vale then proceeds to invest 10 billion dollars in new machinery and equipment for its Northern Ontario nickel mines, it is registered as Direct Foreign Investment (receipt) in the current account, under the income balance. Later, we could expect to Canada to export more nickel as the investment will have improved capacity at the mines.

Bring Balance to the Force

In theory, all of the receipts (money coming into Canada) should balance with the payments (money leaving Canada). It may happen that the trade figures are in deficit, where exports are larger than imports (X > M). The overall accounts can still be in balance if the income figures are in an opposed surplus (Inv. Abroad > Foreign Inv.).

And vice-versa.

If the trade and income figures don’t BALANCE, the country is either accumulating foreign currency (double surplus), or accumulating its own currency (double deficit). Eventually, the accumulation needs to flow to the rest of the world.

The situation will force the exchange rate to change, encouraging markets to reallocate funds, and balance the international payments accounts. Briefly stated: the exchange rate does not vary only because of Net Exports. It also varies because of Net Income. The exchange rate varies because of changes in all of the accounts.

A floating, or variable, exchange rate acts as a negative feedback, a self-correcting feedback, to keep a country's international payments in balance.

A Double Deficit Will Boost the Loonie

Let's use an example. If - for some reason - Canada were running an Imbalance of its International Payments, in this case double deficit, this would mean it's trade balance would be in deficit, and its income balance would also be in deficit. According to the principle of International Payments, this is not sustainable. On the trade side, Canadian firms would be selling canadian currency (CAD) on the foreign exchange market to purchase foreign currency, and have foreign goods imported to Canada. The supply of CAD in Canada would decrease. On the income side, Canadian investors would be selling CAD to purchase foreign currency, and acquire stocks and bonds on financial markets outside Canada. Again, the supply of CAD would decrease in Canada.

Having this double imbalance would generate a shortage of CAD in Canada and a surplus of CAD on foreign exchange markets. The exchange rate would appreciate, which would decrease the price of exports, increase the cost of imports, and reverse the income balance. A variable exchange rate acts as a negative feedback, a self-correcting feedback, to keep a country's international payments in balance.

The following table shows the balance of international payments in Canada for 2021. Overall, the trade balance was positive, by 1.07 billion dollars. This means there was 930 billion CAD that came into Canada, and 929 that left the country. The difference is 1 billion CAD that came in (less than half a percent of the total current account), in favour of Canada. This would naturally have a rallying effect on the Canadian exchange rate, which has been appreciating moderately in the past year. Notice that Canada is running a trade surplus, so we are exporting more than we are importing. Inversely, we are running an investment deficit, which means that there are more funds invested by Canadians outside the country, than foreigners investing in Canada.

Table - Balance of International Payments, Canada, 2021

2021 annual (M$)	Receipts	Payments	Balance
Total current account	930,178	929,101	1,077
Goods and services	766,271	763,843	2,428
Income (Investment)	163,907	165,258	-1,351

• The Exchange Rate

This statistic is the value of a currency in terms of another country’s currency. In Canada, the Exchange Rate usually represents the value of the Canadian dollar in terms of US pennies. For example, you might hear on the news that the Canadian dollar is worth 92 cents US. In theory, that means that if a pair of shoes cost 100 dollars in Canada, the same shoes should cost 92 $ in Plattsburgh, USA.

The exchange rate is

E_USA     = 92 USD / 100 CAD  = $ 0.92 US/CA 

We can use this statistic, the exchange rate, to calculate how much a foreign product costs in Canadian dollars.

To calculate the Canadian price of a foreign good, you divide the foreign price by the foreign exchange rate. If a bicycle costs 500 US dollars, and the exchange rate is 0.92, then the Canadian price of that bicycle is

Canadian Price = 500 USD / 0.92 USD/CAD  = 543 CAD.

NOTE – The Canadian media prefer to use this version of the exchange rate, because at a glance it is easier to understand. Regular people want to know how much 1 $CA can buy in the US. This is actually called the US Exchange Rate with Canada.

Canadian economists would use something else. The CA Exchange Rate measures how much 1 USD can buy in Canadian currency. It is the exact inverse of what the media uses. It comes out to the same interpretation, but it is sometimes confusing if things are inverted.

When an economist says the CAD exchange rate is 1.087, he is saying the same thing as the news anchor on TV (1 CAD = 0.92 USD).

1 / 0.92 = 1.087

1 / 1.087 = 0.92

Some people are professional brokers of foreign exchange, and they do these kinds of transactions daily. They buy and sell from anyone, so the exchange rates are made public, and published in the news. Banks also offer this service, they keep a cut of the transaction to cover their costs. To increase the stability of the foreign sector, some countries such as China fix their exchange rates. Most countries do not, they prefer to let markets decide the rates. This is called a floating exchange rate.

Aldo Shoes Are Everywhere

You want to buy shoes at Aldo. But you are not sure if you should buy them in Montreal, or in Plattsburgh, USA, because you heard they are much cheaper there. The exchange rate is now 0.88 USD/CAD. Economists are predicting demand for the US currency will drop as the Fed unleashes a third round of expansionary monetary policy to prop up their economy. The Exchange Rate could rise to 0.98 in six months.

Location	Price of shoes	Exchange rate	CAD price
Montreal	CAD 85.00	-
Plattsburgh today	USD 75.00	0.88	CAD 85.23
Plattsburgh in 6 months	USD 75.00	0.98	CAD 76.53

As you can see from the table, the shoes will be much cheaper in 6 months, when the exchange rate is basically at par with the US dollar.

Aerospace: From Mirabel to Mexico

You are the CEO of a Mirabel, Qc, manufacturer. Your final product is exported to Europe. Parts are made in Canada, USA, Mexico, and Spain. All things being equal, the Mexican Peso has dropped in value tremendously over the past decade. It seems to be a permanent slide.

In 2009, 1 CAD bought 9.5 Pesos. In 2018, 15.9 Pesos.

https://www.xe.com/fr/currencycharts/?from=CAD&to=MXN&view=10Y

It helps to calculate the price of the part, depending on the location. Because wages are lower in Mexico, the part costs a lot less to produce there.

Part Cost of Production
In Canada	In Mexico
	@10P:1CAD	@16P:1CAD
1,000 $CA	5,000 P	5,000 P
Import Cost	500 $CA	312.50 $CA

You are considering the following:

• Buying more/less parts from Mexico. More
• Opening/Closing a manufacturing plant in Mexico. Open

Assuming the exchange rate is constant at 1 : 16, and assuming other manufacturers will act the same as you, what is the effect on

• Canada’s Trade Balance? X < M = Deficit
• Canada’s Income Balance? Inflows < Outflows
• Canada’s Balance of Payments? Negative Imbalance
  
  
• Mexico’s Trade Balance? X > M = Surplus
• Mexico’s Income Balance? Inflows > Outflows
• Mexico’s Balance of Payments? Positive Imbalance

Given the Balance of Payments situation of both countries, how would the exchange rate react? 

Both Canadian importers, and investors are demanding Pesos, but Mexicans are not demanding the loonie. At 15, Pesos were cheap. They will be more expensive, so maybe 12. This would decrease Canada’s imports from Mexico, and decrease the outflow of investments from Canada to Mexico. Both effects would help to balance the payments between the two countries.

Wrap-Up

Money leaves and enters our country daily, for two reasons: as payment for goods, or as a “pure” transfer of money. If the money leaving the country does not balance the money entering, the exchange rate will be forced to change.

When the exchange rate changes, it may help or hurt producers and buyers, as well as exporters and importers, of different goods. It may change our industrial structure. Understanding the exchange rate helps consumers decide where and when to buy specific goods, especially if they live close to a border.

Cheat Sheet

Balance of Payments:
National economic account of money flows associated to payment for goods, income, or pure transfers.

Current Account:
The current account measures the country's net income either from net exports, or from net investments.

Capital Account:
The capital account measures the changes in national ownership of assets.

Trade Balance:
Net Exports, where Exports minus Imports

Income Balance:
Net investment income, including foreign direct investment and into stocks and bonds.

Exchange Rate:
Ratio value of one currency vs. another currency.

References and Further Reading

Investopedia. (2022). Capital Account Definition. https://www.investopedia.com/terms/c/capitalaccount.asp

Statistics Canada. (2022). Table 36-10-0014-01  Balance of international payments, current account and capital account, annual (x 1,000,000)