SPECIAL REPORT

What happened to the dollar?

JOHN SCHOFIELD November 10 1997
SPECIAL REPORT

What happened to the dollar?

JOHN SCHOFIELD November 10 1997

What happened to the dollar?

Despite predictions, Canada is struggling to keep the loonie aloft

Warren Jestin’s crystal ball must have been a little frosty. Last January, Jestin, the Bank of Nova Scotia’s chief economist, boldly predicted that Canada’s lacklustre loonie was finally about to take flight. After two years of wavering between 72 and 74 cents (U.S.), he announced, the dollar was set to climb and would

likely reach 75 cents by year’s end. Jestin was far from alone. Buoyed by forecasts of strong economic growth, continued low interest rates and declining government deficits, economists across the board were bullish on the buck. Some optimists even foresaw an exchange rate of 80 cents by late 1997.

Ten months later, the dollar has barely budged and the prognosticators are looking far from prescient. Still, like weather forecasters who have been wrong many times before, Jestin and his colleagues are thick-skinned and eternally hopeful. “I’m unrepentant,” he says. “Looking at the economic fundamentals, they’re all pointing to a return of the currency.”

Perhaps so, but last week’s chaos in financial markets dampened expectations in some quarters that the dollar’s long-predicted revival will occur anytime soon. As stocks plummeted, currency speculators chopped almost half a cent from the dollar, gambling correctly that the Bank of Canada would be loath to raise interest rates—its traditional means of propping up the currency— at a time of global market turmoil. As the loonie slid to a 2V2-year low of 70.6 cents, the central bank adopted another tactic, buying up hundreds of millions of dollars to bolster the currency’s value. By the close of trading on Friday, the

battered buck had risen only modestly to 71 cents.

The dollar’s thrashing in international money markets surprised some observers, given the apparent strength of the Canadian economy. But in some respects, that strength masks underlying problems, says Mario Angastiniotis, an economist with Standard and Poor’s MMS in Toronto. During the July-to-September quarter, he estimates, Canada’s current account—the sum total of all money flowing into and out of the country from trade, interest payments and other sources—was in the red by as much as $17 billion. That represents a sharp turnaround from 1996, when the current account was in surplus by $3.8 billion.

Angastiniotis says the deficit, caused largely by an increase in imports and a decline in exports, could keep the dollar under 71 cents. While a cheap dollar is a boon to exporters, it can be costly for consumers who buy imported goods and companies that rely on foreign-produced equipment or supplies. Moreover, another slide would almost certainly force Bank of Canada governor Gordon Thiessen to raise rates in a bid to attract money into the country.

It was a failure to accurately predict when Thiessen would push up interest rates that led economists to foresee a rapid increase in the dollar. Many analysts expected that rates would begin rising early this year in order to head off an expected increase in inflation. But as the year began, “the domestic economy was hardly growing at all and exports were generating all the growth,” says Jayson Myers, chief economist for the Alliance of Manufacturers and Exporters Canada. As a result,

Thiessen kept rates low. The strategy worked by kick starting consumer spending, but that led to an increase in demand for imported goods—one of the factors behind today’s current account deficit. Meanwhile, economic troubles in Germany and Japan lowered the value of those currencies against the Canadian dollar, so exports to those countries declined.

To bring the current account into balance, Angastiniotis says, the federal government must cut the national debt and reduce its interest costs. The flow of money out of the country has also been encouraged by more attractive interest rates in the United States—which are now roughly two percentage points higher than in Canada. But that spread is narrowing, says Jestin, because the Bank of Canada is moving more aggressively than the U.S. Federal Reserve to tighten monetary conditions. Encouraged by signs of stronger growth, Thiessen boosted the key lending rate by a quarter of a percentage point on June 25 and

the same amount on Oct. 1.

At least one more hike in rates is expected by the end of the year. But the timing of the central bank’s next move will be critical, observers say. Despite the weak dollar, the bank will risk more turbulence in Canadian stock markets—and further losses for the loonie—if it moves too quickly to increase rates. ‘The last thing it wants to do is look like it’s panicking to support the dollar because then the Bank of Canada will look like the Bank of Malaysia,” says Myers. In short, most economists still believe the dollar is due for an upward revaluation. The only question is when.

JOHN SCHOFIELD