Capital is flowing into Canada. Is that a bad thing?

flovestock

STEPHEN GORDON
Globe and Mail Blog
Posted on Tuesday, May 17, 2011 7:13AM EDT

Bank of Canada Governor Mark Carney’s speech yesterday included the following passage:

“Unlike Canada, which imported on average 8 per cent of GDP per year in the three decades before World War I, emerging markets are currently net capital exporters... In effect, there is a massive recycling operation under way: private capital flows from advanced to emerging economies are being more than offset by official outflows in the opposite direction.”

There’s a saying in international finance: ‘water wants to go downhill’. The normal direction for the flow of capital is from advanced countries that have high levels of savings to emerging countries that have difficulty generating the savings required to finance their own investment needs. By the accounting rules of the balance of payments, this implies that emerging countries would run trade deficits while advanced countries run trade surpluses. As Governor Carney notes, this story characterises the economic development of pre-1914 Canada. Large capital inflows from the U.S. and the U.K. were accompanied by correspondingly large Canadian trade deficits.

In the current context, capital wants to flow to emerging countries. But after the Asian crises of the 1990s, countries such as China are unwilling to accept the trade deficits that would be an integral part of this flow. Quite the opposite, in fact: China has been running important trade surpluses. This has the perverse result of forcing water to run uphill: developing countries are sending their savings to advanced countries.

Canada is one of the countries on the receiving end, and these capital flows are contributing to the appreciation of the Canadian dollar and to our current account deficit. But as I noted here, it’s not clear to what extent running a current account deficit is a problem. If those capital flows are channelled to finance viable investment projects, then the effects are beneficial, or at least benign. But if they end up financing what turns out to be an asset bubble in housing and/or stocks, then they are a cause for concern.

This situation reminds me of Moncton’s Magnetic Hill and the stream that seems to go the wrong way. We can see the direction of the flow, but it’s not clear if what we’re seeing is natural or if someone is pointing a hose uphill.