Question

Canada's current account deficit increased by CAD 5.4 billion in the fourth quarter of 2018 to CAD 15.5 billion from a downwardly revised 10.1 billion in the previous period and compared with market consensus of a CAD 13.5 billion shortfall. A higher deficit in goods and services was only moderated by a lower investment income gap.Canada recorded a capital and financial account deficit of 27 CAD Million in the fourth quarter of 2018.

Discuss the implications for Canada from the outflows of capital

Answer 1

• Unsustainable? If a current account deficit is financed through borrowing it is said to be more unsustainable. This is because borrowing is unsustainable in the long term and countries will be burdened with high-interest payments. E.g. Russia was unable to pay its foreign debt back in 1998. Other developing countries such as Brazil, African countries have experienced similar repayment problems. Countries with large interest payments have little left over to spend on investment.
• Risk of capital flight. A very high balance of payments deficit may, at some point, cause a loss of confidence by foreign investors. Therefore, there is always a risk, that investors will remove their investments causing a big fall in the value of your currency (devaluation). This can lead to a decline in living standards and lower confidence for investment.
  • A factor behind the Asian crisis of 1997 was that countries had run up large current account deficits by attracting capital flows (hot money) to finance the deficit. But, when confidence fell, these hot money flows dried up, leading to a rapid devaluation and crisis of confidence. When confidence fell and the exchange rate fell, there was a degree of capital flight as foreign investors sought to return assets.
• Foreign ownership of assets. If you run a current account deficit, it means you need to run a surplus on the financial/capital account. This means foreigners have an increasing claim on your assets, which they could desire to be returned at any time. For example, if you run a current account deficit, it could be financed by foreign multinationals investing in your country or the purchase of assets. There is a risk that your best assets could be bought by foreigners, reducing long-term income.

4. An indication of an unbalanced economy. A persistent current account deficit may imply that you are relying on consumer spending, and the economy is becoming unbalanced between different sectors and between short-term consumption and long-term investment.
   • For example, the UK has had a high share of GDP focused on consumer spending and relatively low levels of investment – especially in the manufacturing sector. This focus on domestic consumption can have adverse effects in the long-term with less investment in productivity. The UK experience might be contrasted with Germany which has a current account surplus and generally considered to have better levels of investment in the economy.
5. An indication of an uncompetitive economy. A current account deficit may imply the economy is becoming uncompetitive and the exchange rate relatively overvalued.
   • For countries with floating exchange rate – e.g. Pound Sterling, this is not so serious because market forces will cause a depreciation to restore competitiveness.
   • However, a current account deficit can be a real problem for countries in the Euro – who cannot devalue to restore competitiveness. For example, 2000-2007, a divergence in inflation rates caused very large current account deficits in southern Eurozone economies. This lack of competitiveness and low level of export demand was a factor behind the weak domestic demand 2008-13 of Greece, Portugal, Spain during the Eurozone recession of 2008-13.
6. Risk of depreciation. A country running large current account deficit is always at risk of seeing the value of the currency fall. If there is insufficient capital flows to finance the deficit, the exchange rate will fall to reflect the imbalance of foreign flows of funds. A depreciation in the exchange rate will cause imported inflation for consumers and firms who rely on imports of raw materials.