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ECONOMICS 3150N

ECONOMICS 3150N. Winter 2013 Professor Lazar Office: N205J, Schulich flazar@yorku.ca 736-5068. Lecture 2: January 17 Ch. 14. Balance of Payments. Finance Account : transactions involving financial assets Direct investment Portfolio investments Other: loans, deposits

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ECONOMICS 3150N

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  1. ECONOMICS 3150N Winter 2013 Professor Lazar Office: N205J, Schulich flazar@yorku.ca 736-5068

  2. Lecture 2: January 17Ch. 14

  3. Balance of Payments • Finance Account: transactions involving financial assets • Direct investment • Portfolio investments • Other: loans, deposits • Capital inflow – credit in capital account [CNOOC acquires Nexen] • Capital outflow – debit in capital account [TD acquires US bank] • Official reserve transactions by central banks: official settlement balance • Unilateral transfers: repatriation of income; foreign aid • Sum of all accounts in each country = 0 (equilibrium in foreign exchange markets) • Debits  supply of Canadian $ • Credits  demand for Canadian $

  4. Canada’s Finance Account (C$ M)

  5. Bank of Canada, International Reserves • As of December 23, 2012, the Bank of Canada held a total of $68.5 billion in international reserves, consisting of the following:   • U.S. dollars: $35.6 billion: • Other foreign currencies: $19.6 billion; • Gold: $180 million; • Special drawing rights with the IMF: $8.8 billion; and • Reserves with the IMF: $4.4 billion • The Bank’s holdings of international reserves increased $15 billion between September 8, 2009 and December 23, 2012

  6. Top 25 Countries with Foreign Exchange Reserves, December 31, 2011(US$ B)

  7. National Income Accounts • Y – (C + I +G) = CU • Y < (C + I + G)  CU < 0 • Domestic demand > domestic production (case of US) • CU =  net foreign wealth = - FA (Finance account balance) • CU < 0,  US borrows from foreigners  FA > 0 • Net foreign debt  • CU > 0,  China lends (invests) to (in) foreigners  FA < 0 • Net foreign debt 

  8. Canada’s International Investment Position (C$ M)

  9. Globalization • Expanded economic interaction among countries • Anything that makes it easier to buy/sell goods across borders • Anything that makes it easier for an investor to invest in securities originating in another country • Anything that makes it easier for a worker in one country to travel and seek employment in another

  10. Globalization • Recycling from countries with current account surpluses to countries with current account deficits • Current account balance + capital account balance - change in official holdings of reserves = 0 • Countries with current account deficits (surpluses) must either generate capital account surpluses (deficits) or central banks must be selling (buying) foreign reserves or both

  11. Globalization • Recycling can take place smoothly as long as foreign investors have confidence in country with current account deficit • If confidence shaken, foreign investors will expect significant risk premium – loss of confidence will result in capital outflows, depreciation of currency and higher interest rates • Slippery slope: capital outflows worsen confidence, higher interest rates and possible liquidity squeeze reduce economic growth and reduce asset values – threaten viability of banking sector and major companies • IMF intervention may be necessary to restore confidence (IMF mandates economic policies of government in exchange for assistance) • IMF, World Bank and major central banks are lenders of last resort to countries

  12. Globalization • Trade and economic interdependence spills over and affects exchange rates, interest rates, rate of domestic economic growth, financial position of governments, profitability of domestic companies • If US economy slows down, decrease in demand for Canadian products (exports of goods and services to the US), so economic slowdown spills over into Canada • World trade declined in 2008 for first time in over 50 years because of global recession resulting from spillover form U.S.

  13. Changes in Net Foreign Wealth • Consider case of US – largest debtor country in history • Net international investment position of US, 2008: -$3,494 B • US owned assets abroad: $19,245 B • Foreign owned assets in US: $22,739 B • Net international investment position, 2009: -$2,738 B • US owned assets abroad: $18,379 B • Foreign owned assets in US: $21,117 B • Changes in 2008: • Financial flows: -$216 B • Price changes : $523 B • Exchange rate changes: $277

  14. US Current Account Deficit • US largest debtor country in history – outstanding debt around US$3 T • What if foreign investors no longer want to accumulate US$ denominated assets? • Collapse in asset prices – spillover effects • Plausible scenario? • What would happen to value of Yuan, asset prices elsewhere?

  15. US Current Account Deficit • Options for reducing US current account deficit • Reduction in US current account deficit requires reduction in aggregate current account surpluses of all other countries • No reason to expect “ equitable sharing” by all other countries • Decline in value of US$ against most currencies • Improves price competitiveness of US-based companies • Canada and EU bearing disproportionate share of currency and trade adjustments • Recession in US • Protectionist trade policies in US • More rapid rates of growth in all other countries

  16. Exchange Rate Markets • Large Number of exchange rates • Most important for Canada: E = $US/$Can [E*=1/E] • As of 12/28/12: E = 1.0048 [E*= 0.9952] • Low @ 01/21/02: 0.618 [E*= 1.618] • High @ 11/07/07: 1.103 [E* = 0.907] • Depreciation (appreciation):  E ( E ) • Exchange rates between Canadian dollar and other currencies – e.g. Euro, pound, yen, peso, rupee, ruble, HK dollar, renminbi, etc.

  17. Exchange Rates (C$) 12/23/12 v 12/28/12 Australia $: 0.9653/0.9677 Brazil Real: 1.822/2.055 China Renminbi: 6.207/6.262 India Rupee: 51.71/55.04 Indonesia Rupiah: 8,850/9,709 Israel Shekel: 3.709/3.751 Jamaica $: 84.46/92.85 Malaysia Ringgit: 3.093/3.077 Mexico Peso: 13.54/13.05 Philippines Peso: 42.61/41.27 Poland Zloty: 3.336/3.102 Russia Rouble: 30.55/30.52 Singapore $: 1.267/1.229 South Africa Rand: 7.981/8.518 S. Korea Won: 1,126/1,073 Taiwan $: 29.66/29.19 Thai Baht: 30.66/30.72 UAE Dirham: 3.598/3.619

  18. Exchange Rates • Is the Canadian $ a petro currency? • E vs. Light crude (Brent spot) • C$ peaked at 1.0905 on Nov. 7/07 • Crude oil prices peaked in July/08 • Between Nov/07 and July/08, C$ depreciated 11%, crude oil prices increased 55%

  19. Foreign Exchange Markets • Participants: • Commercial banks • Corporations • Non-bank financial institutions • Hedge funds • Foreign exchange dealers • Central banks • Exchange rates – spot, forward • Rates move together • Futures, options (call and put) • Foreign exchange swaps – spot sale of a currency combined with forward repurchase of same currency

  20. Foreign Exchange Markets • Key financial centers: London, New York, Zurich, Tokyo • Frankfurt, Hong Kong, Singapore, Dubai, Mumbai and Shanghai • Daily volume of transactions: US$4 T/day • 1989: US 0.6 T/day • 2000: US$1 T/day • 46% in London; 22% in NY; 8% in Tokyo • Currency trading in Canadian $: C$95 B/day • US stock markets: about $150B/day • US Treasury market: about $500B/day

  21. Foreign Exchange Markets • Each transaction involves two currencies, so market shares calculated out of 200% • US$: 86% (vehicle currency – widely used to denominate int’l contracts) • Euro-$ trades: 27% • Yen-$ trades: 13% • Pound-$: 12% • Emerging market currencies-$: 19% • Emerging market currencies-Euro: 4%

  22. Foreign Exchange Markets • Forward exchange rate: • Over-the-counter transactions between bank and customers whereby bank agrees to buy or sell specified amount of currency at an agreed rate (forward rate) for delivery at specified future date (as of December 31/12) • Spot rate: 1.0146 • 1 month: 1.0139 • 1 year: 1.0060 • 5 years: 0.9756 • Futures: Transactions on an exchange • Closing dates for contracts, usually end of each quarter • Fixed value for each contract • Options: Transactions on an exchange • Rights to buy/sell currencies at pre-specified exchange rate at future point in time (usually available with monthly closing dates)

  23. Export Demand • EX (exports of goods and services) • Determinants of D: real income, relative prices • Income of major trading partners – US in particular • US accounted for 72% of total exports of goods (55% of total services exports) ; 62% of total imports of goods (57% of total services imports) • Relative prices – prices of Canadian produced goods and services relative to price of competing foreign produced goods and services • PC E/PUS [E: exchange rate between C$ and US$ defined as US$/C$] • Non-price competitiveness of Canadian companies • Trade barriers – tariffs, transportation costs

  24. Export Demand • Exports of goods, Canada ($ B) • 2007: $461.4 • 2008: $487.3 (5.6%) • 2009: $367.4 (-24.6%) • 2010: $403.1 (9.7%) • 2011: $456.5 (13.2%) • Exports in 2011 still 6.3% below 2008 levels

  25. Import Demand • IM (imports of goods and services) • GDP in Canada • Relative prices – prices of Canadian produced goods and services relative to price of competing foreign produced goods and services • Non-price competitiveness of Canadian companies • Trade barriers

  26. Revaluations of Exchange Rates and Impacts on Relative Prices • Prices of comparable Canadian and US goods expressed in same currency • P[C]*E; P[US] •  = P[C]*E/P[US] • Depreciation (appreciation):   (  ) • Example: Bombardier selling Q400 to Horizon Air • Price set in $C or $US? • Set in $US (US$ 32 M) – no foreign exchange risk for Horizon Air • Delivery in 6 months • @ current E: Bombardier will receive C$ 31.8 M • If C$ depreciates by 5% (E = 0.9548), Bombardier will receive C$ 33/5M • If C$ appreciates by 5% (E = 1.0554), Bombardier will receive C$ 30.3M • Implications for profit margins, pricing?

  27. Revaluations of Exchange Rates and Impacts on Relative Prices • Depreciation of spot rate of C$ increases C$ price of foreign goods and services, unless foreign prices reduced • US$ price of US good/service: US$100 (PUS), with E=1.0051, C$ price of this good/service = PUS / E = C$99.49 • Depreciation of C$: i.e. E decreases to 0.9548 (5% depreciation in the value of the C$ relative to the US$), C$ price of this US good/service (US$ price unchanged at US$100) at new exchange rate is C$104.73

  28. Revaluations of Exchange Rates and Impacts on Relative Prices • Depreciation of the spot rate for the C$ also reduces foreign currency price of Canadian goods and services, unless C$ price increased • C$ price of Canadian good/service: C$100 (PC), with E=1.0051, US$ price of this good/service = PC * E = US$100.51 • Depreciation of C$: E decreases to 0.9548, US$ price of this Canadian good/service (C$ price unchanged at C$100) at new exchange rate is US$95.48 • Leakage of air travel at US border airports

  29. Revaluations of Exchange Rates and Impacts on Relative Prices • Ceteris paribus, competitive position of Canadian-based companies improves vis a vis foreign competitors when C$ depreciates and deteriorates when C$ appreciates as long as Canadian companies do not use many US or foreign produced/priced parts, components, services • Depreciation may lead to higher rate of inflation (prices of imported goods and services), and increase in wage demands • Foreign suppliers may improve quality, productivity to maintain competitive position • Foreign suppliers may reduce profit margins to maintain prices in C$ • Canadian suppliers may become lax (X-inefficient) and less innovative

  30. Demand for Financial Assets • Relative expected rates of return – returns on financial assets denominated in different currencies must be compared in the same currency • Forward-looking decisions • Risk – variability of expected return, default risk and expected losses in case of default • Comparison of expected return for same degree of risk • Diversification of portfolio to reduce overall risk for portfolio • Measurement of risk • Risk preference • Liquidity: cost/speed of converting asset into cash • Precautionary motive for holding liquid assets • Consider case of ABCP market in Canada

  31. Links between Spot and Forward Rates • Covered interest rate parity: • Invest C$1 for one year in Government of Canada bond at interest rate of R(1,C): $1 [1+R(1,C)]  C$ • Invest C$1 for one year in US Government bond at interest rate of R(1, US): $1*E[1+R(1,US)]  US$  convert into C$ at end of year at spot exchange rate at that time (speculate) or enter into forward contract at beginning of year at forward rate of F • For investor to be indifferent between two investments and not speculate: [1+R(1,C)] = E[1+R(1,US)] /F • F = E{[1+R(1,US)]/[1+R(1,C)]} • R(1,C) = {E[1+R(1,US)] – F}/F  R(1,US) + (E-F)/F  R(1,US) + (F*-E*)/E*

  32. Financial Markets • Financial intermediaries and financial intermediation • Goldman Sachs: “Doing God’s work” • Banks, credit unions, insurance companies, pension funds • Matching savers/lenders and investors/borrowers • Disintermediation • Getting between savers and investors • Mutual funds, hedge funds, venture capital, private equity

  33. Derivatives • Derivatives: financial instruments whose value depends upon other financial instruments or assets (commodities) • Forward contracts (provided by banks) • Futures contracts (traded on exchanges) • Options on futures – examples for interest rates, currencies, commodities • Securitized financial instruments; e.g. mortgage-backed bonds • Swaps: interest rates, currency, credit default • Derivatives offer insurance against various forms of financial risks (interest rates, currencies, commodity prices, etc.) • Also enable gambling: e.g. credit default swaps

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