Title: The perils of a strong loonie

Sub-title: While a powerful currency makes Canadians richer, there are some disadvantages.

 

During the past couple of weeks, the Canadian dollar has shown remarkable resilience. Last week, the loonie approached the USD $1.00 level and some analysts think that there is more in store. “We look for the loonie to appreciate through parity (by mid-2011),” said Sal Guatieri, an economist at BMO Capital Markets.  Guatieri isn’t alone. UBS, the Swiss bank, recently predicted that the Canadian dollar would rise to US $1.05 by this time next year. Others have forecast ever higher numbers.

 

On paper, the loonie’s almost 25 percent rise against the greenback since the start of the year, is great news for Canadian consumers on a variety of fronts says Guatieri. A strong currency provides the Bank of Canada the ability to forego a policy interest rate increase at its next meeting and makes imports from the United States, - our largest trading partner –cheaper. Canadian travellers to US locations such as Florida and California also get a bigger bang for the buck as do those who buy US housing and properties, many of which are significantly undervalued in Canadian dollar terms, by historical standards.

 

Sharp downsides

That said, not all the news is good. That’s because a strong loonie makes Canada’s exports south of the border more expensive to US buyers, our biggest customers. And in an export dependent nation like Canada that can hurt. The strong loonie has already cost the country’s manufacturing sector hundreds of thousands of jobs, notably in Canada’s automotive sector. Further upwards movements could worsen the picture.

 

Canada is not alone in that respect. Other exporters, such as China, Japan and the European Union face similar challenges in their own export markets. As a result, despite the advantages that a strong currency brings, many finance officials around the world are actively working to weaken theirs. For example both China and Japan regularly buy huge amounts of US dollars in order to drive the yuan and the yen down. This “competitive devaluation,” trend has gotten so tense, that officials such as Brazil and Canada’s finance ministers have been warning that a currency war may be in the offing.

 

The loonie has so far escaped global competitive devaluations. One reason is that the Canadian dollar is largely regarded in foreign markets as a “petro-currency” which trades in large part based on movements in the price of oil. Politicians can talk all they want about Canada’s “knowledge economy,” however investors care more about what we have in the ground than what we have in our heads. And when oil prices hit close to $85 per barrel by the middle of last week, foreign exchange trades dove into the loonie.

 

A weak US economy

That said, according to Guatieri, the Canadian dollar has risen even faster than what would be expected from recent rises in the price of oil and other commodities. Much of the recent increase is due to the relative economic weakness in the United States, which according to Francois Trahan, an investment Strategist at Wolfe Trahan, is unlikely to perform as well as many experts think due to the county’s slumping housing sector, slow job creation record and the deleveraging process that many households there are undergoing.

 

“The Congressional Budget Office, the National Association for Business Economics and the Federal Reserve are all optimistically predicting growth rates of between 3.2 and 4.0 percent for the next two years,” Trahan noted to a recent meeting of the Board of Trade of Metropolitan Montreal. “However US banks are not lending, private investment remains week, and consumers are saving more of their income. In short today’s reality warrants unconventional growth models.”

 

The weakness that Trahan refers to, has major policy implications for the US dollar. The Federal Reserve has hinted that it will resort to Quantitative Easing, in the form of massive purchases of US obligations, to boost the money supply there. This in turn would likely send the greenback down even further relative to the loonie and other currencies.

 

In short says Guatieri, there is no easy answer as to whether a strong Canadian dollar is good or bad for the Canadian economy. “While it is true that consumers are big winners, at some points their gains get outweighed by losses elsewhere in the economy.”

 

In short, like so many other things in life, when it comes to currency issues, where you stand, depends in large part on where you sit.

 

 

Peter@peterdiekmeyer.com

 

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