Should the Canadian Dollar be Fixed Against the Greenback?

Once again the Canadian dollar has spiralled upward against its US counterpart.  The Minister of Finance has  publicly stated that this is hurting Canada, and blames it on speculators.  One assumes he means buyers driving up futures prices by making uncovered forward purchases of Canadian dollars at what they see as cheap prices.  This most likely is the result of optimism about commodity prices.

One perspective on is that the real problem is that the dollar floats on world currency markets at prices set daily by demand and supply.  The alternative is to fix the value of  the dollar to the US dollar.  Supporters of this alternative view the floating dollar as harmful to the Canadian economy.

And they are right.  Since Janauary 1st, 2003  the Canadian dollar has ranged in value from over $1.1o (US) to under $0.65 (US).   Its mean value since January 2008 has been close to $0.90 (US).  This is an extreme amount of price volatility in any market, much less for something so central to the economy as the currency.

The harmful affects of this volatility are well known.  First, it creates uncertainty about the value of foreign investments in Canada, thus discouraging needed investment whether it be in real assets or stocks and bonds.  Second, when the dollar is high, it makes Canadian products more costly in in foreign markets, causing producers to reduce production, curtail investment, close plants and relocate to lower cost countries.  Third, when the dollar is low, it makes Canadian producers less atuned to the need to be competitive, leading to inefficiency and lower productivity.

Why is the Canadian dollar so volatile?  The simple answer is the heavy weighting of resource commodities in our international trade.   High international commodity prices drive the dollar up and low international commodity prices drive the dollar down.  This includes oil and gas, but also includes minerals and agricultural commodities.  International commodity prices are volatile and cyclical.  As is common with such products, price variability is much greater than variability in volumes traded.

For producers in  other parts of the Canadian economy, competitiveness internationally is in fact frequently driven by a factor completely beyond their control.  High commodity prices can undermine everything that is done in tourism, high tech, film, consulting, engineering, manufacturing, processing – indeed in virtually all other private sectors of the Canadian economy.  Valiant efforts to become competitive can be wiped out by a single unpredictable upward swing in commodities.  Some relief can be achieved through hedging, but this is often not as simple in practice as in theory.

In a sense this is hard to believe.  The commodity sectors account for about 6.5% of total Canadian private sector output.  Is it rational that these sectors should play a dominant role in determining the fate of all the others?

So why not fix the value of the Canadian dollar to the US dollar, and eliminate the problem?

An obvious consideration is that a floating dollar helps prevent unexpected and sometimes irrational (or speculative)  depletion of  foreign currency reserves   The amount of such reserves held by Canada at ony one time is finite.  If for whatever reasons Canadian dollars are  put up for sale in large amounts, and the demand is insufficient to match the sell-off, with a  fixed exchange rate the government must step in to meet the shortfall.  If the reserves run out, the country becomes insolvent so far as international exchange markets are concerned.  Other than to devalue, which is inconsistent with fixed exchange rates,  government must reduce imports and attract additional foreign capital.   In practice it must use fiscal and monetary policy to increase interest rates to attract foreign capital and to contract the economy, which will in turn drive down imports .  Since the economy could very well be free of any inflationary pressures and already be operating at less than full capacity and full employment, this is perverse.  Rational monetary and fiscal policy is impossible when maintaining currency reserves take precedent over other results of monetary and fiscal policy.  One need only think back to the 1960’s in the UK to be reminded how destructive this can be.

Not all agree that this constraint on monetary and fiscal policy is a bad thing.  If imports rise and/or exports fall and the foreign investment balance worsens, they say this is usually a signal that the domestic economy has developed underlying structural problems.  High wages, inflation, and falling productivity are the main culprits.  If this is the case, restrictive fiscal and monetary policy is exactly what is needed to force a shift of inputs to more productive sectors and firms and to reduce wages and prices.  This is the only way, it is claimed, to be competitive in world markets.  Flexible exchange rates hinder such adjustment since the government gets off the hook by avoiding the very monetary and fiscal measures that are needed.Flexible exchange rates hinder such adjustment since the government gets off the hook by avoiding the very monetary and fiscal measures that are needed.

In some types of economies, there can be longer term rolling cycles in the demand-supply balance for the home currency in international exchange markets.  This is particularly true in open economies when markets for some significant part of imports or exports are themselves cyclical.  Commodity markets of course come to mind.  In cases where commodities make up a significant portion of exports, long periods of low commodity prices will in all likelihood, under fixed exchange rates be accompanied by contractionary monetary and fiscal policy, even though rational considerations demand the opposite.  Again, however, some don’t agree for reasons similar to those already mentioned.

Some people believe that picking a fixed value for the dollar  is a huge obstacle to fixing the exchange rate.  In fact, it is not.  The rate can be set so as to approximate the continuing productivity differences between the two countries.  On this basis the rate should be about at about 85 cents, meaning a Canadian dollar will buy $0.85 US, and a US dollar will buy about $1.18 Canadian.  It does not matter much if this is not exactly right, since the Canadian economy will adjust through time to make this in fact the right number.

The largest obvious advantage of a fixed dollar is to stop the erosion of Canada’s industrial and processing base when the dollar is high, and to encourage more discipline in wages, prices and productivity when the dollar is low.  An improved investment climate is also likely.
The big disadvantage is that when resources prices and markets are strong, foreign buyers would get Canadian commodities at considerably less, in US dollars, than if the exchange rate is flexible.  A dampened Canadian dollar brings less foreign currency and thus real purchasing power to Canadian producers and the Canadian economy than one that can rise as commodity prices rise.   Since this would not be offset during periods of low commodity prices, a fixed exchange rate would lead to a net long term transfer of wealth from Canada to countries buying our commodities.

As usual, in Canada there is a regional dimension to this.  The benefit from more stability for industrial producers would predominantly accrue to central Canada.  The transfer of wealth to other countries would be predominantly at the expense of western Canada.

With complex policy problems there are always winners and losers from either option.  In this case it comes down to a choice about whether Canada wants to cushion the damage done by a high dollar to the industrial sector or whether it wants the resources sector to get the maximum advantage from strong markets and high prices.  And whether we want to lose flexibility over fiscal and monetary possible as tools of employment policy.

My bet is that regardless of the concerns expressed by Mr. Flaherty about the high dollar, the status quo will prevail.  It is not clear that this is the right course.  With a fixed value of the dollar, the west will invariably argue that it is a loser once again in order to accommodate central Canada’s problems.  But the damage to the 93.5% of the economy that doesn’t share in these gains cannot be ignored.

Fiscal and monetary policy issues can be accommodated with a far sighted currency reserves policy.  Reserves must be allowed to accumulate to substantial levels during commodity booms to accommodate cumulative depletions of reserves during long cycles of commoditiesweakness.  This will act as a preventative against the need for irrational contractionary stabilization policy during these times. And in more serious cases of long term imbalance, it is correct that contractionary is needed to force adjustments in the internal economy.

Doug McArthur

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The above was written in part in response to the following from the National Post (Saturday, July 25, 2009).

Markets and newspapers alike have recently been abuzz with speculation that the Bank of Canada might begin intervening in the currency market, after a long hiatus. Inaction at the Bank of Canada’s most recent rate decision poured a teaspoon of cold water onto the notion, but the speculation continues.

We do not believe it would be wise or fruitful for the Bank of Canada to intervene on behalf of the Canadian dollar in an effort to temper its recent strength. There are seven main reasons why.

It is not possible for any country to have perfect control over its currency and interest rates simultaneously. One most float or the whole enterprise is doomed as investors will elect to arbitrage interest rate opportunities between countries, and the resulting tsunami of capital flows overwhelms either the fixed exchange rate or a central bank’s monetary policy independence, if not both.

The Bank of Canada is too small to have the desired effect on the FX market via intervention. Canada’s currency reserve ranks only 33rd in the world, and there are 20 times more Canadian dollars transacted over the foreign exchange market each month than the value of the reserves. To have a substantial influence, Canada would have to either print tens of billions of dollars in money or issue tens of billions of dollars in bonds to finance the operation. In the present context, both are equally unpalatable. And to truly achieve traction, the effort would have to be paired with further rate cuts (mathematically impossible) or quantitative easing (seemingly not in the cards).

The Bank of Canada was unsuccessful in its last effort in 1998 to corral the Canadian dollar over a decade ago. Despite deploying roughly $18B, the Canadian dollar continued to fall and the effort was eventually halted due to its “ineffectiveness.” This experience left such a sour taste in the bank’s mouth that the intervention policy was subsequently changed for use “only in the most exceptional of circumstances.”

While the Canadian dollar is likely a tad overvalued by conventional measures, it is hardly egregiously so. Purchasing power parity argues that the loonie is about 10¢ too rich, while TD Bank models suggest overvaluation in the range of 1¢ to 7¢. In the grand scheme, these differentials are not especially large, and in the case of purchasing power parity, the Canadian dollar has actually spent two-thirds of the past decade at least 10¢ off “fair value.” It is thus not clear why the Bank of Canada’s appetite would be sufficiently ravenous as to warrant a rare currency intervention.

The Canadian dollar has managed to avoid significant overvaluation because a fair portion of its recent appreciation reflects fundamentals. The bank itself notes that commodity prices have increased, while we observe that Canada’s housing market is stabilizing, retail sales have grown in four of the last five months and the latest Business Outlook Survey reveals remarkable optimism and nary a mention of pain from the loonie. From a structural perspective, investors remain attracted to Canada given its intact housing market, sound banks, and firm commitment to inflation targeting.

A certain portion of the appreciation in the Canadian dollar is due to speculative flows. This is the sort of thing that Bank of Canada is likely hoping to oppose, but we believe it would be folly to fight these forces. The speculative portion of the appreciation has little to do with Canada specifically, and far more to do with U. S. weakness. Other major currencies have risen by just as much, and it would be very difficult for Canada to extricate itself from the shift. Moreover, we postulate that some of the recent speculative flows could eventually transform into fundamental flows if the Canadian dollar proves to be a leading indicator for commodity appreciation and the global recovery.

The Canadian economy has already proven itself impressively adaptive to foreign exchange shocks in the past. It survived at Canadian dollar levels that have varied by as much as 80% in recent years.

The timing is not right for the Bank of Canada to intervene in the currency market. The loonie is not sufficiently far from fair value for market participants to take the bank seriously. Speculators are not particularly long the Canadian dollar, nor are markets frothy enough for the bank to achieve the outsized influence that it needs.

The bottom line is that while the risk of currency intervention in Canada appears as elevated as it has been in a decade, it remains ill-advised. In turn, we continue to believe that the Canadian dollar’s recent appreciation may have some further life left in it. – Eric Lascelles is chief economics and rates strategist and Shaun Osborne is chief FX strategist for TD Securities.