Finance Minister Jim Flaherty's Feb. 11 budget projected that as early as next year, Canada will become the first G7 country to achieve a balanced budget since the onset of the financial crisis. It can be argued that Canada has among the most well-managed public finances in the world, earning it the highly coveted triple-A rating from every major credit-rating agency, a crown held by only a dozen countries. Even the United States cannot claim membership in this elite group.
Yet despite Canadian bonds being rated as among the safest securities on the planet, Statistics Canada's international transactions data show that foreign interest in Canadian bonds is waning. This decline appears to coincide with the loonie's fall from parity with the U.S. dollar, to current levels of about 90 cents (U.S.). But what actually has happened, and what are the implications?
Shift in risk appetite
As we discussed in our previous column, the important shift in the Bank of Canada's monetary policy (from a tightening bias to a quasi-tightening bias on its overnight rate), at the same moment as the U.S. Federal Reserve started getting serious about tapering its quantitative easing (QE) program, has contributed to reducing the attractiveness of Canadian bonds. The yield differential between five-year Canadian and U.S. government bonds went from an average 62 basis points in 2012 to 46 basis points in 2013, and even briefly went into negative territory in early 2014. (A basis point is one-hundredth of a percentage point.)
This had a direct impact on foreign purchases of Canadian bonds, which fell to $26-billion (Canadian) in 2013 from $69-billion in 2012. Cumulative net bond purchases by foreigners entered negative territory in the second half of 2013. (Chart 1)
As far as Canadian equities are concerned, this asset class is now rebounding from its plunge in popularity with foreign buyers earlier in 2013. The Canadian stock market, being largely weighted in energy and materials, is in fact correlated with emerging markets;(Chart 2) when expectations for the Fed's tapering started to surface last May and money started fleeing emerging countries, inflows into Canadian stocks went down as well.
In addition, uncertainty regarding the final outcome of TransCanada Corp.'s Keystone XL pipeline project in the United States has probably induced many foreigners to adopt a "wait-and-see" approach regarding Canadian energy stocks.
But now that the Fed's tapering is in progress, foreign investors are making up for lost time, with $22-billion in net investments in Canadian stocks in the past six months of 2013 (versus a measly $968-million in 2012 and a $3-billion net outflow in the first half of 2013).
Now, all of this is interesting, but what does it mean for the Canadian economy and the loonie?
A lower appetite for Canadian bonds surely does not mean that the federal government or any of the provinces will have a hard time borrowing money, nor that the international community is losing confidence in Canada's ability to repay its debts.
The direct impact lies in the prospects for the Canadian dollar, because the current pace of Canadian securities purchases (stocks, bonds and money market instruments) by foreigners is not large enough to compensate for the deficit in Canada's current account (net revenue on exports minus payments for imports).
In 2013, the Canadian current account deficit clocked in at $62-billion, while Canadians bought $27-billion in foreign securities and foreigners invested $43-billion in Canadian securities. This means that net international securities transactions showed a $16-billion surplus – well short of financing the current account deficit. More money is going out of the country from the trade of goods than that coming in from the trade of securities – an unsustainable imbalance unless we tap official foreign reserves, or foreign domestic investments (FDI) step up to fill the void.
Fortunately, this is exactly what started happening in 2013: Net FDI turning positive for the first time since 2007. The devaluation of the Canadian dollar made Canadian assets more affordable for foreign investors and, conversely, foreign acquisitions more expensive to Canadian companies.
Looking ahead, if our prediction that the Canadian dollar is headed for its purchasing-power-parity (PPP) level, as we argued in our previous column, then net positive FDI could be here to stay for the next few years. This could actually play a role in sustaining the dollar and keeping it from dropping even further.
Clément Gignac is senior vice-president and chief economist at Industrial Alliance Insurance and Financial Services Inc., vice-chairman of the World Economic Forum Council on Competitiveness and a former cabinet minister in the Quebec government.