Slumping U.S. dollar boosts loonie

The importance of a strong national currency has changed during the past 50 years or so.

Once upon a time, governments would crow about having a dollar or franc or quetzal that was worth more than competing currencies. Indeed, the strength of the national money was a source of gratification, certainly for citizens who derived some psychic pride from the strength of their monetary medium of exchange.

Thus, as the loonie approaches equity with the American currency in 2009, you would think that Canadians would be pleased.

However, in past decades, trade between countries was only a minor contributor to a nation's gross domestic product (GDP) and people really did not cross borders that much for pleasure.

In the 21st century, many analysts see a strong currency not as a source of pride, but as an economic millstone that, in Canada's case, must be carried by Ottawa and the country's central bank.

"[A] persistently strong Canadian dollar would reduce real growth and delay the return of inflation to target," Mark Carney, governor of the Bank of Canada, said in a speech to the Victoria Chamber of Commerce in September.

Ironically, the federal government has only a modicum of control over the worth of the Canadian dollar which is measured against the value of another currency, usually the U.S. greenback.

Experts say the recent run-up in the dollar's worth was because of a loss of confidence in the American recovery rather than anything Ottawa did "a result of a more generalized weakening of the U.S. dollar," Carney said in the same Victoria speech.

Worse still, the American economy faces persistent twin financial deficits: a trillion-dollar budgetary shortfall and a 33-year-old merchandise trade deficit factors likely to remain part of the U.S. financial landscape for the foreseeable future.

Thus, the U.S. fiscal mess combined with the perilous state of the country's recovery might make international investors and foreign companies ultra-reluctant to hold American dollars. That situation, in turn, almost guarantees that the Canadian dollar will stay strong in the coming months or years.

"Breaking through parity with the U.S. dollar is a distinct possibility sometime in the next two or three years," said Helmut Pastrick, chief economist for Central 1 Credit Union, the Vancouver-based umbrella organization for the credit union systems in British Columbia and Ontario.

Loonie launch

After strong jobs data for September, the Canadian dollar hit a one-year peak in October at almost 97.5 cents US, according to the Bank of Canada.

Measured against the currency's 2009 trough 76.98 cents on March 9 the Canuck buck has gained almost 27 per cent in value against the U.S. dollar. In October alone, the dollar has improved 5.7 per cent, or more than five cents.

To be fair, the loonie, driven by the perception of the country's economic strength along with its oil resources, has gained against most of the world's major currencies recently.

Compared with its 2009 lows, the Canadian dollar has risen almost 11 per cent against the euro, 26 per cent compared with the Japanese yen, nearly 12 per cent against the Swiss franc and 16.5 per cent matched up against the British pound sterling.

U.S.comparison

However, since the United States is Canada's largest trading partner and main foreign investment destination, any gain Canada will receive from a stronger currency must be measured in relation to the U.S. dollar.

Unfortunately, as the Canadian currency approaches parity with its U.S. counterpart, the benefits usually associated with a gaining greenback could be of marginal significance this time around.

For instance, a stronger domestic currency often means the Bank of Canada gets some latitude to drop interest rates.

However, Carney's crowd is holding the Bank of Canada's overnight rate at a miniscule 0.25 per cent, mainly to stimulate the domestic economy. Thus, Canada's central bank appears to have little room to cut rates regardless of the strengthening domestic dollar.

A rising loonie also can help keep a lid on prices by reducing import costs.

However, Canada's inflation rate in August stood at a negative 0.8 per cent, compared with the same month a year earlier. Even when drastically lower oil prices were subtracted, the country's core consumer price index (CPI) was still at a mild 1.6 per cent in August compared with a year earlier, the midpoint in the Bank of Canada's target range of one to three per cent.

That means any inflationary gain stemming from a higher Canadian currency also would be tiny at best.

And finally, the rising loonie, combined with the plunge of household net worth in the United States due to the miserable American employment situation and the precipitous plunge in housing prices, means Canada's tourism industry is going to take a hit.

With their incomes on life support, Americans are probably more interested in conserving cash rather than seeking out vacation spots north of the border.

Looking for relief

With little to gain from a higher dollar, many analysts are now fixated on the damage the currency could do to the country's ability to sell its products and services in foreign markets.

"Fair value for our currency, based on purchasing power, is in the low-80s [US]. So Canadian-made products are already artificially overpriced by 20 per cent; that will get worse in the months ahead," Jim Stanford, chief economist for the Canadian Auto Workers, wrote recently.

In fact, Canadian exports to the United States were down almost 32 per cent in August 2009 versus the same month a year earlier. That compared with a drop in sales of American goods coming to Canada, which slipped by 17.4 per cent in the same time period.

And those declines were even prior to the most recent rise in the value of the Canadian dollar, a situation that will make goods heading into the United States even more expensive.

Answers that really aren't

Canada's trade problems stemming from a higher currency are easy to see; the solutions aren't.

To chop a currency's value, central banks often cut domestic interest rates or increase the amount of money sloshing around in the economy. Either situation reduces the incentive for foreigners to hold loonies and thus shrinks the dollar's worth on international markets.

But, the Bank of Canada has already set its overnight target rate at .25 of a percentage point, essentially eliminating the central bank's ability to reduce borrowing costs any further.

In addition, Ottawa has already poured billions of dollars into infrastructure projects while the Bank of Canada has engaged in various types of monetary stimulus, a situation that does not allow Carney much ability to expand the country's money supply further.

"There's not a whole bunch the government can do about the high dollar," said Peter Drake, vice-president of retirement and economic research with Fidelity Investments Canada, the northern arm of the huge U.S. investment company.

A weakened America

Worse still, the U.S. economy is in rougher shape than Canada's without an obvious improvement in sight.

In fact, the deepening U.S. budget deficit and the continuation of that country's persistent merchandise trade shortfall reduce the incentive foreigners have to hold American dollars.

Right now, the Congressional Budget Office an arm of the U.S. government charged with providing legislators with objective, non-partisan and timely analyses to aid in economic and budgetary decisions estimates that Washington's budgetary shortfall will reach $1.6 trillion US in 2009 and will shrink to $722 billion by 2019.

By way of comparison, if the estimate is correct, the 2019 deficit would be almost 60 per cent higher than the U.S. government's 2008 deficit of $459 billion.

The American trade picture appears even bleaker.

Between 2005 and 2008, Americans bought $827 billion US more in goods annually from foreign countries than they were able to sell overseas. That four-year average merchandise deficit was more than 50 per cent higher than the $533 billion sales shortfall for the previous four years.

Both deficits but especially the trade shortfall have ominous implications for the U.S. currency.

"Economic experts are concerned about the dollar's health for a number of reasons. Most importantly, the scale of the current trade and spending imbalances puts heavy downward pressure on the dollar's value over the long term," said an online article published in September by the Wharton School at the University of Pennsylvania in Philadelphia.

As the U.S. currency weakens, the Canadian dollar gains strength. And, with the American fiscal and trade situations strained, loonie parity, once a dream of Canadian economists, might just turn into an economic nightmare for the country.

"Current account fundamentals suggest there's still a further 20 per cent devaluation ahead [for the U.S. currency]," Canadian Imperial Bank of Commerce economist Avery Shenfeld said in a recent analysis of the Canadian dollar.

Thus, the answer to Canada's dollar drag might lie, not in Ottawa, but Washington.

If the Obama administration can outline a credible five-year plan to put "a big dent" in the U.S. budgetary deficit, currency traders will begin to regain confidence in the American economy, Fidelity's Drake said.

Along with some decent U.S. growth, the improved monetary picture would boost the worth of the American greenback, he said.