Canadian exporting companies face a stressful outlook, with rising interest rates and moderating sales growth. The one glimmer of hope is that the Canadian dollar will ease in coming months.
To some, this hope sounds like a pipe dream, with forecasts of a 90-cent dollar becoming increasingly common. Such forecasts have a valid premise they assume that the U.S. dollar will weaken due to the burgeoning U.S. trade deficit, and the Canadian dollar will rise in sympathy.
But forecasters have been calling for a lower U.S. dollar for a long time now, and it simply has not happened. In fact, the U.S. dollar has risen by upwards of 10-15% in the past 12 months against the Swiss franc, the euro, the British pound and the yen. This is because most of the U.S. trade deficit is a structural phenomenon, driven by the growth in intra-firm trade associated with the globalization of companies. When a U.S. multinational offshores some of its low-end production to its own affiliate in China, it sets up a trade route within the company. These trade routes are very busy. They generate higher productivity, lower costs, and higher profits. They also create a trade deficit with China, but one that is automatically financed within the company. Indeed, such trade deficits are not with China at all, but with another part of the now-expanded U.S. economy.
EDC Economics estimates that some two-thirds of the U.S. trade deficit is due to this phenomenon, and the remainder is too small to worry about. The U.S. dollar declined during 2002-04 as the world economy recovered but this simply reversed the rise in the dollar that took place during the crisis-ridden years of 1998-2001. Therefore, the U.S. dollar is done falling.
And what about the Canadian dollar? The world economy is moderating, which will mean lower non-energy commodity prices. It will also mean higher risks in global financial markets, which tend to boost the U.S. dollar. Interest rates are rising, true, but spreads won’t change much. This all should mean a lower Canadian dollar. But the fly in the ointment is oil. Recent research shows very clearly the extent to which the Canadian dollar has become a petro-currency. EDC’s statistical model shows that a rise in the price of oil of $10 results in an appreciation of the dollar of three cents. Accordingly, getting the dollar back below 80 cents means getting oil prices back to around $50. By the same token, higher oil prices will push the dollar higher into the 80s.
Hence, the recent history of the Canadian dollar can be summarized quite simply: the dollar rose from 62 cents to the mid-70s because the world economy recovered, commodity prices rose and the U.S. dollar fell back to normal. Then the Canadian dollar rose from the mid-70s to around 85 cents because the price of oil doubled to over $60. The immediate future, then, depends on oil.
The bottom line? Slower world economic growth should mean lower commodity and oil prices, and a firmer U.S. dollar. That spells a lower Canadian dollar for 2006 but it is likely to linger above 80 cents for the time being, unless oil prices suddenly correct downward.
Stephen Poloz is Senior Vice-President, Corporate Affairs and Chief Economist, Export Development Canada.
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