SPECIAL REPORT

Caught in the whirl

Interest rates rise to help shelter a battered dollar

BRUCE WALLACE September 7 1998
SPECIAL REPORT

Caught in the whirl

Interest rates rise to help shelter a battered dollar

BRUCE WALLACE September 7 1998

Caught in the whirl

SPECIAL REPORT

THE CURRENCY CRISIS

Interest rates rise to help shelter a battered dollar

BRUCE WALLACE

If anyone in Ottawa’s finance department should have seen a faint silver lining in last week’s black economic news it was Terrie O’Leary, Paul Martin’s trusted senior adviser. In the same week that the Canadian economy was being battered like the hurricane-whipped North Carolina coast, the 38-year-old O’Leary announced she was leaving the department’s trenches to become Canada’s top official at the World Bank in Washington. The post carries an annual

salary of $146,200 (U.S.)—the world’s currency of choice these days—or $231,000 (Cdn.) and rising in last week’s trading. Otherwise, no one in official Ottawa liked the numbers running across their computer screens: reams of dismal news from the sometimes scary new world that is the global economy. The economic data filtering into Martin’s airless downtown Ottawa offices were almost uniformly bad. The Canadian dollar kept setting new record lows against the American buck. It finished the week worth just 64.08 cents (U.S.). That was down almost a cent from the previous week but up about a penny from the depths it had plumbed before the Bank of Canada jacked interest rates up one full point on Aug. 27. The increase was followed by mortgage rate hikes at the chartered banks, with fixed rates climbing as much as three-quarters of a percentage point, the largest single-day rise in more than three years. Martin defended the bank’s intervention as necessary “to maintain order and calm to the best extent possible on currency markets.” But the rate increase may only have checked the pace of the dollar’s descent while raising worries that higher borrowing costs would hurt the Canadian economy. Mean-1 while, the near-panic selling that gripped world stock markets drove indexes down to levels that wiped out most of the year’s gains. The Toronto Stock Exchange 300 composite index was down 8.3 per cent over the week,

closing at 5,766 points, its lowest level this year.

There was nothing all-Canadian about the crisis, of course. Most other countries watched their currencies and stock markets endure beatings. European stock market losses almost paralleled Canada’s. The emerging markets of Latin America and Asia were pummelled even harder. Even the American economy felt the lash of the world turmoil at last, with the Dow Jones index falling precipitously from its giddy heights of earlier this year to hit 8,051 points.

There was no shortage of explanations for the world’s gyrations, everything from sinking prices for oil to the near-insolvency of some Japanese banks. But most observers settled on two main villains: the continuing inability of Japan’s political leaders to commit to cleaning up their banking system’s bad debts; and the unravelling of the Russian economy, where the ruble’s value was evaporating last week until government officials simply stopped trading it. The calamity in Russia threatened to topple President Boris Yeltsin and perhaps give Communists a foothold in running the country again (page 23).

This, then, was one of the world’s first serious tastes of the dark side of globalization, a glimpse of what can happen when national economies are connected like hot links on the Internet. The interlocking global system means political deadlock in Japan can effectively lead to higher mortgage costs for Canadians or more expensive sausages for Russians. In all but the biggest economies, once-powerful central bankers suddenly seemed no match for the market’s gusts. Who, after all, expected Russia would one day threaten the West, not by deploying nuclear weapons, but by inadvertently loosing an insidious virus in the global financial system?

Most experts have a concise, if complex, explanation for last week’s panic. The insolvency of so many Asian banks, from South Korea to Thailand and Indonesia, over the past year cut out the heart of economic growth in those countries. Slumping demand, in turn, triggered a fall in worldwide commodity prices. Last week, the commodity price index was at its lowest level

in 12 years, leading to an exodus from currencies whose economies were heavily dependent on such products as minerals, oil, gas and pulp and paper. That made big losers out of countries like Venezuela, Mexico, Australia, Norway and Canada. “Canada is getting hit by events largely outside Canada’s control,” says Youssef Nasr, president of the Hongkong Bank of Canada in Vancouver. “I thank God every day that our fiscal situation is better than five years ago. Imagine if we had this crisis on our hands when the government was in deficit.” Martin and Prime Minister Jean Chrétien kept pointing to that fundamental strength in Canada’s fiscal situation, hoping that currency dealers would recover some faith in the loonie. They also pumped out the message that Canada’s reputation as a commodity-driven economy is overstated and out-of-date. “The world has got to understand that Canada is much more of a manufacturing and service economy,” Martin told Maclean’s. He and and Chrétien seemed to hope that, if they repeated that line often enough, international markets would change their perception. Global traders weren’t buying it. “Canada’s high-tech and manufacturing exports haven’t registered with the international community,” says Nasr. “There is still a strong feeling that Canada is dependent on commodities.” Or, as a Canadian government official in Asia put it: “There is an incredible misunderstanding here that Canada is just another Australia.”

The Canadian economy has, in fact, curbed some of its dependence on commodity exports. The percentage of total Canadian exports coming from the commodities sector has fallen from 80 per cent in the early 1970s to under 40 per cent now. Still, that is high by international standards, says a recent Royal Bank of Canada analysis, explaining why the dollar’s drop over the last 25 years has shadowed the fall in real commodity prices.

But not even tumbling commodity prices could fully explain last week’s chaotic world markets and the dumping of so many foreign currencies for the American dollar. ‘There is a sense here that things are happening that people don’t fully comprehend,” said an official at the International Monetary Fund in Washington. “Each crisis is playing into the other, and we have a market psychology that leads to a flight to quality.” Things changed last week when the Russian crisis hit, agreed Mark Chandler, an economist with Goldman Sachs Canada in Toronto. “Before that, you could explain the weakening dollar by the drop in commodity prices, but now it has become a confidence issue for us,” he says. The world thought it was going to scrape by the Asian crisis, notes Chandler, but the Russian mess raised the spectre of global collapse. “So

most investors are asking: What's the safest place?’ ” The international nature of the crisis did not stop Ottawa’s critics from demanding something be done. There was a clamor for Bank of Canada governor Gordon Thiessen’s resignation last week, forcing Martin to publicly declare confidence in the governor. And the Reform party, among others, continued to call on Ottawa to cut taxes on the premise that lower U.S. tax rates are a prime reason for the robust U.S. dollar. Martin rose to the bait slightly last week, promising income tax cuts in next February’s federal budget. But other economists argue that tax cuts are an expensive way of driving the dollar higher—and will only work in conjunction with higher interest rates. University of Toronto economist Peter Dungan has run computer models suggesting the cost of raising the dollar by a penny against the U.S. buck could require

up to $10 billion in tax cuts and a one-per-cent rise in interest rates. Even if Dungan’s projections are high, Martin is hardly about to embrace anything that would take such a huge whack out of the government’s revenues. “While the idea had merits,” says Dungan, “the numbers are such that it becomes very, very expensive.” That leaves Ottawa with two choices, both in the hands of the Bank of Canada. The central bank can continue to intervene in currency markets by buying Canadian dollars with its U.S. dollar reserves in the hope of driving the loonie up. It has done so on selective occasions over the last few weeks without stopping the descent for long. Or it can continue to hike interest rates. Neither Martin nor Chrétien have any enthusiasm for the latter path. The dollar’s decline has become a political problem in recent days. But Liberal thinking remains wedded to the belief that the dollar headache is nothing compared to what would be unleashed if high interest rates lead to recession. Even economists within the finance department are divided on the merits of raising rates. The advice filtering up through his department essentially told Martin there is little Ottawa can do on its own. “We’re getting side-

swiped in this,” said one senior official. ‘We are a very small boat in very rough seas,” said another. The preponderance of advice to Martin called for restraint, patience and crossed fingers that Japan and Russia can sort out their problems. “Whither Japan is still very much whither Asia,” said a Canadian government official in Asia. “If Japan can be a supporting anchor out there, you may see an Asian recovery faster than you think.” That certainly falls into the optimistic category. Asian economic news remains bad, so much so that private sector economists have already declared British Columbia’s Asian-oriented economy to be in recession. Whether that bad news spreads east of the Rockies is now an open question. All Martin knew for sure on the day last week when uneasiness threatened to become panic was that he should make a public statement. His short address, delivered outside his regional office in Montreal, urged calm. “While these are turbulent times—and we have no choice but to deal with them—we must not lose sight of the fact that Canada is strongly positioned to weather the storm,” he said. Beyond that, he could not pretend to know how rough things may get. □