(EDC Economics)
IThe Canadian dollar is the talk of the town once again. There are multiple reasons being given for its recent strength, and a tendency to extrapolate them into the future -- an unlikely outlook.
Argument number
one: The Canadian dollar is rising because Canada is an exporter of base metals, the prices of which are increasing due to strong global demand. This story helps explain the rise in the Canadian dollar from its historic
lows in 2001-02 back up into the mid-70 cent range.
However, it is risky to extrapolate this trend into the future -- the world economy is showing multiple signs of deceleration, and base metal prices are forming
a plateau as a consequence.
Argument number two: Canada's interest rates will rise faster than U.S. rates, boosting the Canadian dollar. Again, this is a short-term story that probably has run its course and
should not be extrapolated. Most forecasters expect the two economies to see similar growth in 2005, at just over 3 per cent, which suggests that the two central banks will be on a similar path, not a divergent one.
Argument number three: The Canadian dollar has been boosted by high oil prices, which are set to continue higher due to Chinese demand. But China has been growing rapidly for at least 10 years, during which time we
have seen oil prices of $10, $55 and everything in between. Today, China uses less than half as much oil to produce the same amount of GDP as 20 years ago; the world uses one-third less, and this trend will continue. As
oil supply tensions ease, expect prices to drift back down into the $30-35 range, which should shave 4-5 cents off the Canadian dollar.
Argument number four: Purchasing power parity (PPP) calculations indicate
that the natural level for the Canadian dollar is around 82-83 U.S. cents.
But Canada's PPP has been above 80 cents since the mid-1990s, including when the dollar was worth 62 cents and forecasters were
predicting a drop to 50 cents. PPP benchmarks have their uses, but forecasting exchange rates is not one of them. They are based on the notion that production costs should be equal between countries, but such
comparisons are very difficult when economic structures are so different.
Argument number five: The U.S. dollar must fall to reduce America's huge trade deficit. The reasoning is that the U.S. cannot keep
borrowing $500-600 billion per year from the rest of the world to finance its deficit. Yet, U.S. bond yields remain very low, at just over 4 per cent on 10-year money. Why? Because the U.S. trade deficit is being
financed for the most part internally by U.S. companies. Globalization of supply chains by American companies means that about 70 per cent of the U.S. trade deficit represents trade within companies -- imports from
American-owned affiliates operating abroad and exports to these same affiliates. These arrangements are profitable for all concerned, and no financing strains are produced by them -- American companies owe these funds
to themselves, an internal matter.
The bottom line? Assuming oil prices continue their retreat, the U.S. dollar should recover and the Canadian dollar should ease back, to average around U.S. 75-78 cents next
year. But global conditions remain ripe for currency volatility, so we should be prepared for more overshoots.
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