1 ECONOMICS 3150B Fall 2015 Professor Lazar Office: N205J, Schulich

2 Lecture 4: September 22 Ch. 10

3 US Current Account Deficit US largest debtor country in history – outstanding debt around US$4 T What if foreign investors no longer want to accumulate US$ denominated assets? –Collapse in asset prices – spillover effects –Plausible scenario? –What would happen to value of Yuan, asset prices elsewhere?

4 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

5 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

6 Foreign Exchange Markets Key financial centers: London, New York, Zurich, Tokyo –Frankfurt, Hong Kong, Singapore, Dubai, Mumbai and Shanghai Daily volume of transactions (April/13): US$5.3 T/day –1989: US 0.6 T/day –2000: US$1 T/day –41% in London; 19% in NY; 6% in Tokyo; 6% in Singapore –Currency trading in Canadian $: C$244 B/day US stock markets: about $150B/day US Treasury market: about $500B/day

7 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%

8 Exchange Rate Markets Large Number of exchange rates Most important for Canada: E = $US/$Can [E*=1/E] As of 14/08/15: E = [E*= 1.309] 01/21/02: [E*= 1.618] 11/07/07: [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, Yuan, etc. (See Table 11)

9 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 8/17/15) –1 month: –1 year: –5 years: –Spot rate: 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)

Exchange Rates (C$ vs. foreign currency) 2014, Table 12 Annual averages Australia $: Brazil Real: China Renminbi: India Rupee: Denmark Krone: Euro: Iceland Krona: Malaysia Ringgit: Mexico Peso: Japan Yen: Poland Zloty: Russia Ruble: Singapore $: UK pound: S. Korea Won: Taiwan $: Thai Baht: UAE Dirham:

Exchange Rates (C$ vs. foreign currency), 2005, Table 13 Annual Averages Australia $: Brazil Real: China Renminbi: India Rupee: Denmark Krone: Euro: 1,509 Iceland Krona: Malaysia Ringgit: Mexico Peso: Japan Yen: Poland Zloty: Russia Ruble: Singapore $: UK pound: S. Korea Won: Taiwan $: Thai Baht: UAE Dirham: NA 11

Canadian Dollar Exchange Rate Tables 12 and 13 C$ did not depreciate or appreciate against all other currencies in any year between 2001 and 2014 C$ appreciated every year against Ghana Cedi C$ appreciated most every year against India Rupee, Thai Baht, and Turkey Lira C$ effective exchange rate (Table 14) –Relatively unchanged July 2005 to June 2015 –C$ appreciated against US$ between 2005 and 2014; depreciated between 2005 and August

Effective Exchange Rate Table 14 July January July January July January July January July January July

Effective Exchange Rate Table 14 January July January July January July January July January June

Exchange Rate (Tables 12 and 13) Is the Canadian $ a petro currency? EWTI

Exchange Rates C$ peaked at 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% %∆E%∆E% ∆Light crude Jan. 1/01-0.8%-17.5% Jan. 1/ Jan. 1/ Jan. 1/ Jan. 1/ Jan. 1/ Jan. 1/ Jan. 1/ Jan. 1/ Jan. 1/ Dec. 9/ Nov. 22/

17 Export Demand Tables EX (exports of goods and services) –Determinants of D: real income, relative prices –Income of major trading partners – US in particular –US accounted for 76% of total exports of goods (56% of total services exports) ; 67% of total imports of goods (58% of total services imports) –Relative prices – prices of Canadian produced goods and services relative to price of competing foreign produced goods and services P C E/P US [E: exchange rate between C$ and US$ defined as US$/C$] –Non-price competitiveness of Canadian companies –Trade barriers – tariffs, transportation costs

18 Export Demand Exports of goods, Canada ($ B) 2007: $ : $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 2012: $547 (20.0%) 2013: $572 (4.5%) 2014: $624 (9.1%)

19 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

20 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 (0.764): Bombardier will receive C$ 41.9 M –If C$ depreciates by 5% (E = ), Bombardier will receive C$ 44.1M –If C$ appreciates by 5% (E = ), Bombardier will receive C$ 39.9M –Implications for profit margins, pricing?