However, is this trade relationship stable? In an economy, periods of high volatility follow periods of low volatility and so on. Are those country-specific factors always advantageous in all scenarios? How does the instability of the economy—the instability of the relative prices between the two countries—affect international trade flows between US and Canada?
Relying on the theoretical and empirical heritage of the literature on consumer behaviour under risk, we may know that individuals are risk-averse, and so traders are. Indeed, as individuals care a lot about changes in their wealth, negative changes on the latter tend to impact more significantly upon their decisions than those positive. The rationale behind this can be understood as losses lead individuals to be worse-off if they are compared with a reference point they come from, while not achieving a potential gain does not move them from that point—which is Tversky and Kahneman’s (1979, 1991) proposed ‘risk aversion’ and ‘endowment effect’. In effect, under these theoretical predictions, almost twice painful might be the profit loss for a trader—making a trader to move from her reference point—than those from gaining additional profits in light of attractive business opportunities of the trade activity (Fig. 1). Subsequently, US and Canadian traders might rise their expected utility of profits from trading every time that the volatility of the US/Canada relative price rises, leading them to trade more in order to escape from losing profits by investing more in the tradable sector and escaping from profit loss as they care more about the worst scenario than potential gains.
Source (Tversky & Kahneman, 1979, p.279)
Under risk aversion, theoretical predictions and empirical literature point to a positive impact of relative price instability on trade flows; however, why does this impact in the case of Canada and the US seem to be robustly negative in the empirics?
The key point relies on the fact that exporters who do not invoice their exports in their own currency have to absorb appreciations by reducing profit margins (Mckinnon, 1979). As a consequence, this might force (1) Canadian importers to pass the appreciation onto their final consumers—likely Canadian citizens—resulting in a price increase and subsequent reduce in the final consumers’ demand, and (2) Canadian exporters to cut down on their export activity to the US as they might also be forced to absorb an appreciation in view of the impossibility of passing it onto US importers.
When an increased volatility of the relative price results in such profit loss for Canadian traders, led by such invoicing ‘advantage’ of US traders over the former, Canadian traders might cut down on their trade flows with the US as the magnitude of this economic loss likely makes it too costly to be afforded. Consequently, this ‘augmented’ profit loss might come from either (1) a reduction on their final consumers’ demand (for importers), as a consequence of increasing prices in light of absorbing the appreciation, or (2) cutting down Canadian exports supply to the US because of the high cost of absorbing such appreciation, as a consequence of the impossibility to pass it onto US traders (Muñoz-Salido, 2016).
This augmented dimension might reduce Canadian imports of goods from the US and Canadian export supply of goods to the US as it would be too costly to be afforded by Canadian traders and too strong to fight against, leading them to consider another allocation for their products abler to cut down on their profit loss. This fact wouldn’t give Canadian traders a chance to invest more in the tradable sector (as predicts De Grauwe, 1988) with the US as the invoicing feature would always impede them to recover from losses.
Then here, my proposed ‘bilateral factor’ might work as follows. The resulting cut down on the reduction on the Canadian demand for goods from the US and Canadian supply of goods for the US would decrease US exports to Canada and US imports from Canada, which is quite consistent with the aforesaid features. Finally, the unilateral reduction on trade by Canada would impede the risk-aversion factor explained above to work for US traders as they wouldn’t have the chance to trade with Canada as the used to, in view of the cut-down on trading of the Canadian traders (leading US traders to also reduce their trade flows with the latter), which would be a consequence of the invoicing feature that might impede the aforementioned theoretical predictions to hold.