Lonely near the bottom

The dollar is a currency in search of some friends

ROSS LAVER August 10 1998

Lonely near the bottom

The dollar is a currency in search of some friends

ROSS LAVER August 10 1998

Lonely near the bottom


The dollar is a currency in search of some friends


When times are tough, people lean on their friends for support. So it is with currencies. The hapless Canadian dollar has been looking for friends all this summer, without much luck. Prime Minister Jean Chrétien? Forget it—he actually sounds happy about the loonie’s eroding value against the U.S. greenback. How about Bank of Canada governor Gordon Thiessen? In the past, the bank could genreally be counted on to defend the currency against speculative attacks by raising interest rates or scooping up Canadian dollars on foreign exchange markets. Not this summer, however, which is why the boys in red suspenders have been having a field day betting against the buck.

So who’s left? Oddly enough, it was Monica Lewinsky who briefly rode to the loonie’s rescue last week. When the former White House intern struck an immunity deal to testily about her alleged sexual relationship with President Bill Clinton, the Canadian dollar rose 0.12 cents to close the day at 66.63 cents (U.S.)—the first increase in six trading sessions. On foreign exchange markets, investors were gambling that Lewinsky’s testimony would plunge Washington into a period of political instability, weakening the U.S. dollar against other currencies.

Alas, the Lewinsky Effect turned out to be the currency market’s equivalent of a White House quickie. The next morning, the loonie

resumed its downward spiral, much to the delight of U.S. tourists and the consternation of those Canadian commentators who believe the dollar’s decline is a crisis, and that it is high time somebody in charge did something.

Are they right? As always, economists offer differing responses to the dollar’s drop, but there is widespread agreement on two key points. The first is that it would be folly for Ottawa to try to bolster the currency with dramatically higher interest rates, since that would choke off economic growth. The second is that there are steps that can and should be taken to support the dollar over the longer term—steps such as cutting taxes and reducing the national debt that would strengthen the economy and make Canada less susceptible to exchange rate shocks.

To understand the rationale behind both of those positions, consider the causes of the dollar’s current predicament. By far the most important factor, experts agree, is the ongoing financial turmoil in Asia, which has triggered an exodus of capital from that region toward the United States and Europe. The search for a safe harbor inevitably leads many investors to the U.S. dollar, which helps to explain why the greenback has risen five per cent so far this year against its Canadian counterpart. Most major European currencies have also appreciated against the loonie, in part because interest rates in those countries are higher than in Canada.

In addition, Asia’s weakness has sliced deeply into demand for raw materials such as forest products, oil and gas, steel and other


Twenty-five years of decline

In May, 1974, Canada’s finances had rarely looked better.

The deficit stood at just $2.2 billion, and the dollar was towering over the greenback at 103.94 cents (U.S.)—a high watermark for the last 25 years. Commodity prices were expected to keep rising and analysts predicted the dollar would continue its ascent. But in the following decades, rising deficits and faltering raw material prices would slowly reduce the value of the loonie by 30 per cent. Some of the events that influenced the level of the Canadian dollar over the past 25 years:

October, 1973

The Organization of Petroleum Exporting Countries triggers a series of price hikes that push the cost of oil from $3 (U.S.) to $30 (U.S.) a barrel by 1980. The price shock ignites inflation, which reaches an average high of 12.4 per cent in 1982.

(Prime rate: 11 per cent)

Aug. 9,1974

U.S. president Richard Nixon resigns and is replaced by Gerald Ford.

Nov. 15, 1976

René Lévesque leads Parti

Québécois to power.

June 4,1979

Prime minister Joe Clark sworn in.

g|||l Dec. 13,1979

Conservative government falls when budget is defeated in the Commons.

Jan. 28,1980

Canada’s ambassador to Iran helps arrange the escape of six U.S. Embassy staff.

March 3, 1980

Prime minister Pierre Trudeau

sworn in.

May 22,1980

Quebec votes No in referendum on sovereignty-association.


Interest rates reach a record 21.75 per cent.

Dollar closes at 66.120 (U.S.) on

July 31,1998.

April 2, 1982 Argentina invades the Falkland Islands, triggering a war with Britain.

June 30,1984

John Turner succeeds Trudeau as prime minister.

Sept. 17, 1984

Prime minister Brian Mulroney

sworn in.

Feb. 1,1987

John Crow replaces Bank of Canada governor Gerald Bouey.

Jan. 1,1989

Free Trade Agreement with the United States takes effect. (Prime rate: 13.2 per cent)

June, 1990

Meech Lake constitutional accord dies.

November, 1990 With the prime rate at 14.11 per cent, Crow begins cutting interest rates.

Jan. 15,1991 Gulf War begins.

Oct. 26,1992 Voters reject the Charlottetown accord. (Prime rate: 7.54 per cent)

Feb. 1,1993 Gordon Thiessen becomes governor of the Bank of Canada.

Nov. 4,1993

Prime Minister Jean Chrétien sworn in. The federal deficit for the fiscal year 1993-1994 hits a record $42 billion.

(Prime rate: 5.98 per cent)

Oct. 30,1995

The No side wins a slim victory in the Quebec referendum.

Nov. 8,1996

Interest rates hit bottom at 4.75 per cent.

June 2,1997

Prime Minister Chrétien re-elected.

July, 1997

Asian currency meltdown begins. Frightened investors move into the U.S. greenback as a safe-haven security, adding to the downward pressure on the loonie.

May 13, 1998

Bank of Canada says it has no immediate plans to raise interest rates.

July 12,1998

Japanese voters reject prime minister Ryutaro Hashimoto at the polls, casting further doubts on Japan’s ability to fix its economy. The potential loss of further commodities exports to the region only adds to the dollar’s woes.

commodities. Canada’s reliance on resource-based exports has declined steadily over the past quarter-century, but the category still accounts for about 40 per cent of the country’s total exports. A recent Royal Bank study found that every 10-per-cent drop in commodity prices translates into a decline of between three and five per cent in the value of the Canadian dollar. On average, commodity prices have fallen about 13 per cent in U.S. dollar terms over the past year. If the Canadian dollar had not declined in response to that weakness, thousands of jobs in the mining, oil and gas, and forestry sectors would now be on the line. (Contrast that with the situation in Britain, where the strong pound—up 16 per cent against the loonie in the past two years—is squeezing exporters and raising fears of a recession.)

In the short run, then, the falling Canadian dollar softens the blow of lower commodity prices and protects jobs. In theory, it also leads to higher prices for imported goods, which contribute to inflation. But with the annual rate of increase in consumer prices now running about one per cent, few analysts are worried that inflation is about to get out of control. The fact that neither Chrétien nor Finance Minister Paul Martin has expressed concern about the declining dollar is a good indication that they feel a devaluation was necessary to help the country ride out the Asian storm.

On the other hand, a weak dollar can do serious damage if it is allowed to persist. As economist Sherry Cooper of Toronto-based Nesbitt Burns Inc. has pointed out, a fall in the currency has the effect of a national pay cut because it reduces the value of imported goods and services that Canadians can afford to buy. It also discourages foreigners from holding Canadian dollars and creates an incentive for people to send money out of the country. There are signs that is already happening. In the first four months of this year, Canadian purchases of foreign stocks and bonds were running at a record annualized rate of $22 billion, more than double the level in 1997.

Perhaps most important, a low dollar lulls Canadians into believing that the country is more competitive internationally than it really is. “If we learn to live with a dollar at 66 cents, beware the day that it actually starts to go up again because that would cause massive dislocation,” warns Tom d’Aquino, president of the Ottawa-based Business Council on National Issues, which represents 150 of the country’s largest corporations. “A 78cent dollar would clearly be a huge wake-up call for a lot of companies.”

That said, d’Aquino is far from panicked about the state of the currency. He continues to keep most of his own savings in Canada, in part because he, like many analysts, believes that the loonie is now significantly undervalued. For proof, he points to studies by

agencies such as the Organization for Economic Co-operation and Development, which regularly surveys price levels and exchange rates in various countries. In April, the OECD found that a representative basket of goods and services that cost an American $100 (U.S.) could be purchased in Canada for the equivalent of only $87 (U.S.). By that measure, the loonie was 13 per cent undervalued, and that was before this summer’s steep slide. Based on the OECD’s numbers, the Canadian dollar should actually be trading somewhere around 75 cents (U.S.)—which, in fact, is the level many economists were predicting it would hit this year, before the crisis in Asia knocked the stuffing out of their forecasts.

Unfortunately, the markets have a way of defying economic theory. In the case of the dollar, the Asian-induced sell-off appears to have been exacerbated by at least two homegrown factors, both of

Asia's financial crisis has decreased demand for the raw materials that Canada exports

which are within Ottawa’s control. By focusing on those issues, economists say, the federal government can lessen Canada’s vulnerability to sudden swings in international exchange rates.

The first such area is taxation. Currently, taxes of all types claim an average of 49 per cent of Canadians’ incomes, compared with 35 per cent in the United States. Moreover, Canada now has one of the highest marginal rates of personal income tax in the developed world. Although it varies from province to province, the top average rate is 51 per cent for taxable income over $62,300. In contrast, the top average U.S. rate is 43 per cent, for income over $382,670. Normally, d’Aquino says, differences in taxation levels have little impact on exchange rates, but in times of instability foreign investors tend to focus on the negatives. The fact that taxes in Canada are well above the average for industrialized countries discourages investment, which in turn weakens the value of the Canadian dollar.

Another obvious negative for the loonie is Canada’s high level of public debt. After peaking at 98 per cent of the country’s gross domestic product in 1995, the combined total of federal and provin-

cial government debt fell to 94 per cent in 1997 and is projected to hit 89 per cent this year, thanks to the growing economy and the elimination of the federal and most provincial deficits. But that still leaves Canada’s level of indebtedness far above the average for major industrialized countries. The United States, Germany, France and Britain all boast public debt levels of between 60 and 65 per cent of GDP.

It might seem contradictory to suggest that governments should reduce their debt levels at the same time that they are under pressure to cut taxes. But Cooper and several other economists note that Ottawa has entered a period of rising budgetary surpluses, giving it the ability to address both problems at once. Her prescription is for a 15-per-cent cut in personal income taxes over the next three years; some other analysts are pushing for a series of smaller tax cuts, combined with an accelerated program of debt reduction. Either approach would underpin the dollar by sending a favorable message to foreign investors. Martin himself said last week that such measures are on the way, although perhaps not soon enough for some. “We would expect to see in every budget reductions in debt and in every budget reductions in taxes, but we’ll do it basically on the schedule that we have set out,” he said.

Granted, tax cuts and debt reduction are longterm fixes for Canada’s currency woes. What, if anything, can Ottawa do right now to arrest the loonie’s slide? Some economists want the Bank of Canada to raise interest rates by about a modest quarter of a percentage point. That would eliminate the differential between Canadian and U.S. rates without greatly affecting consumer and business borrowers. Beyond that, Ottawa could “talk up” the dollar by reminding currency traders of the economy’s fundamental strengths. The World Economic Forum, for example, recently ranked Canada fifth in terms of competitiveness, behind (in descending order) Singapore, Hong Kong, the United States and Britain, but well ahead of Japan and Germany. And while productivity in Canada is only about three-quarters as high as in the United States, the gap is narrowing. In 1997, the production of goods and services for each hour worked rose 2.9 per cent in Canada, compared with a 1.8-per-cent improvement south of the border.

Assuming those measures worked, there would still be one other major domestic obstacle confronting the dollar: the uncertain future of Confederation. Right now, Canada’s national unity question hardly shows up on the radar screens of currency traders in London and Tokyo, but that could change in the run-up to the next Quebec election, expected next spring. And if a majority of Quebecers ever do cast their votes for separation, the impact on the dollar could make this summer’s currency slide seem like a picnic.