Thursday, March 27, 2014

Exchange Rate and Trade Balance

The main trading partners of Canada are: the United States (US), the United Kingdom (UK), the rest of the European Union, and Japan. Exchange rate is one of the main factors influencing the amount of commodities we export, i.e., sell to these countries or import, i.e., purchase from them. By exchange rate, I mean how much US Dollar, Pound Sterling, Euro, or Yen you get in exchange for one Canadian Dollar.
   
When the Canadian Dollar, say, depreciates relative to the US Dollar viz., when the Canadian-US Dollar exchange rate falls, one should expect our exports to the US to increase because it has become cheaper for US residents to buy our commodities. At the same time, our imports are expected to decrease because it has become more expensive for Canadians to buy commodities made in the US. As a result, our trade balance with the US, i.e., our exports less our imports will increase.   

I have plotted below the trade balance and the Canadian Dollar rates with each of its main trading partners.

Trade Balance and Canadian Dollar Rates with its Main Trading Partners, US, UK, and Japan (1988:Q1-2013:Q4), UE Excluding the UK (1999:Q1-2013:Q4), Data Source: Statistics Canada
Figure 1: Trade Balance and Canadian Dollar Rates with its Main Trading Partners, US, UK, and Japan (1988:Q1-2013:Q4), UE Excluding the UK (1999:Q1-2013:Q4), Data Source: Statistics Canada
The data show, as expected, a negative correlation between trade balance and Canadian Dollar rates except the UK where the correlation coefficient is positive and very high.

Figure 2: Correlation between Trade Balance and Canadian Dollar Rates
Figure 2: Correlation between Trade Balance and Canadian Dollar Rates
Why this positive correlation between our trade balance and exchange rate with the UK? The answer may lies in the structure of our trade with this country. Canada essentially exports gold, uranium, nickel, and aircraft to the UK. Both the demand for Gold as a safe-haven and its price increased due to the volatility in the currency market. As for aircrafts, they are ordered years in advance and the amount of aircrafts delivered in the UK has nothing to do with current exchange rate.