April 9, 2013
A New Policy Approach to Canada’s Exchange Rate
In recent years, Canada’s exchange rate has been at historically high levels. There are differing views on the extent to which this high exchange rate, generated in part by a booming resource sector, has hurt other parts of the Canadian economy. This paper concludes that the evidence is overwhelming: the high dollar has hurt the Canadian economy and the Ontario economy in particular.
Ontario’s economy has experienced a significant loss of exports over the last several years, amounting to almost 10 percentage points of GDP. The evidence is clear that the substantial increase in the value of the Canadian dollar has been a direct contributor to Ontario’s trade deficit.
The high Canadian dollar has also made Ontario’s efforts to cope with global trends far more difficult. It has frustrated the major effort that Ontario has made to improve its competitiveness, including significant business tax reductions.
In the period since the dollar began surging, Canada has experienced an 11 percent decline overall in real manufacturing output, compared to a 23 percent increase in output in the US over the same period. The three largest provinces all suffered declines in manufacturing output, with Quebec and British Columbia not far behind Ontario.
Those who claim that the decline in manufacturing output has not resulted from the increase in the value of the Canadian dollar are misinterpreting the data. Canada’s largest loss has been to competition from the U.S. A high dollar has also caused declines in service sector exports and relatively low capital investment due to weak demand for Canadian goods and services, which has harmed productivity growth.
The Canadian dollar has been strongly correlated with movements in oil prices in the past few years. International speculators clearly believe that high oil prices imply a high Canadian dollar.
However, this correlation has the hallmarks of a market overreaction that is not supported by economic fundamentals. If the high value of the dollar were justified by rising oil exports, Canada would have a rising trade surplus. In fact, Canada now has a large trade deficit, in spite of the growth in oil exports. The money flowing into Canada does not come in the form of productive investments, but rather it is used to hold bonds and other money market instruments.
The fact that the Canadian dollar is already overvalued does not mean that it cannot rise even more. The volatility in exchange rate markets is so large that there is a risk of the dollar rising considerably farther above parity in a speculative binge. In an unstable world, Canada’s currency is understandably viewed as a safe haven. However, Canada’s economy is small relative to the investment funds available and its markets can easily become overwhelmed.
The Bank of Canada has acknowledged that commodity prices do not justify such a high dollar. Governor Mark Carney has warned that “over the medium term, [believing that commodity prices justify the high Canadian dollar] is going to be… a recipe for losing money.”
The Bank of Canada now has an opportunity to step in and take a more active role in countering this speculation. Severe under- and over-valuations of the currency are unhealthy for the economy, as they cause dislocations and inefficiency.
Allowing financial forces to dominate the currency, without regard to impacts on the real economy, is not a sound long-run policy. The federal government and the Bank of Canada have the tools to make Canada a less hospitable destination for speculative investment tied to the price of oil. Recent steps by the Swiss National Bank show that this is feasible. The Bank of Canada should consider taking similar steps. This would include asserting that it will not accept an unlimited range of deviation for the dollar. Publicly communicating that the Bank will intervene to mitigate speculative volatility tied to the price of oil would be beneficial for the long-term health of the real economy.