Outlook for the Canadian Dollar — Flirting with U.S. Dollar Parity

Alex Carrick -- August 29, 2007

Six Leading Factors Determine Currency Value
The value of the Canadian dollar currently stands around $0.95 U.S. This is an increase of 50% versus its low point in the $0.62 to $0.64 range at the beginning of 2003. CanaData expects the Canadian dollar to stay at about $0.95 U.S. to the end of this year, then to climb close to parity during much of next year.

The value of one currency relative to another is determined by a wide range of factors including:

• relative Gross Domestic Product (GDP) growth;
• relative inflation rates (Consumer Price Index, all items and “core”);
• relative levels of interest rates;
• trade performance in each country (surplus or deficit);
• federal and provincial/state finances (surplus or deficit);
• trade dependency (e.g., Canada is viewed by financial markets as “commodity-driven”).

Perception of Canada as Resource-dependent
As for the perception of Canada as a resource nation, this goes back to the days when the country was known as a “hewer of wood and drawer of water” (a phrase taken from Deuteronomy in the Bible). The modern equivalent has centred on net exports of forestry products and motor vehicles and parts. Canada’s lumber exports have been set back by the collapse in the U.S. housing market, but this will recover in 2008. In the auto sector, Canada is well-positioned due to restructurings and new investments being undertaken by the former Big Three and the fact that Japanese carmakers have a long history of profitable and highly efficient operations in Canada, with significant expansions to capacity underway.

In the last several years, however, net energy exports have taken over as the major source of Canada’s resource trade surplus with the United States. As a result, the Canadian dollar has often moved in tandem with the international price of oil. As long as the world economy continues to grow strongly, there will be upward pressure on the Canadian dollar. Commodity prices in general are receiving a particular boost from exceptional (and unsustainable) expansion in China. The most likely timing for a reckoning over China’s breakneck economic surge is after the Summer Olympics in 2008.

Six Reasons for U.S. Dollar Weakness
Beyond inherent strength in the value of the Canadian dollar, however, lies the fact that the U.S. dollar has been weakening versus most other major currencies. Similar to the Canadian dollar, the Euro has gained about 50% in value over the last several years.

The U.S. dollar is slipping in world financial markets due to several factors.

1. The huge U.S. trade deficit, which is particularly apparent in terms of U.S. dollars spent on “goods” from China.
2. The fact that the U.S. is dependent on China returning those dollars to the U.S. in the form of capital investments in order to maintain Balance of Payments equilibrium without undue pressure on interest rates. U.S. debt obligations to foreigners render the economy vulnerable to sudden capital withdrawals.
3. Unease over the uncertain extent, both in terms of total dollars and a termination date, of continuing U.S. military spending in Iraq and Afghanistan.
4. While the U.S. economy remains the most dynamic economic force in the world, the chief showcase for this is stock market activity and this is entering the late stages of the investment cycle.
5. U.S. dependency on foreign oil holds the economy hostage to volatility in world pricing and availability.
6. Particular to the moment, U.S. monetary authorities face a dilemma over interest rate policy. As a result of the subprime mortgage crisis, pumping money into the economy and lowering the discount rate have been warranted to restore liquidity and spark continuing economic growth. The world economy, however, is at a somewhat different juncture, with many nations growing strongly. The thrust of monetary policy elsewhere is to raise interest rates to slow overheating growth. The potential “U.S. vs. Rest of World” interest rate discrepancy is another depressant for the value of the U.S. dollar. Further out, U.S. efforts to safeguard liquidity have introduced further inflationary bias into the economy, which must eventually be answered by higher interest rates.

Long-term Investments in Energy will bolster the Canadian Dollar
Returning specifically to the Canada-U.S. dollar question, there are some other interesting considerations. Major investments are taking place to ensure that Canada will increase its energy production long into the future. There are mega construction projects underway in oil and gas production and delivery systems (i.e., pipelines) in western Canada (Saskatchewan, Alberta and B.C.) and off the East Coast. Canada is also about to embark on a new era of mega electric power projects in almost every region of the country. These projects, in both oil and gas and electric power, are geared towards export potential as well as domestic demand.

If the Canadian dollar moves beyond parity with the U.S. dollar, this will present a whole new set of economic challenges. Most major commodities trading in world markets are priced in terms of U.S. dollars. For much of recent history, this has provided Canada with an advantage. Commodity price increases in U.S. dollars have provided windfall revenue gains to Canada’s resource producers. It has also made investment in Canada by foreign entities relatively cheaper than in the U.S. As a result, much of Canadian industry has now passed into foreign ownership.

If parity is exceeded, these advantages will turn to disadvantages. Profits being reported back to U.S. head offices will shrink (in U.S. dollars) and it will cost more to invest in Canada than in the U.S. Investment in Canada will suffer. This will set in motion factors to restore what economies like best, equilibrium.

Summary
There are few forecasts riskier than currency forecasts. They can be altered so readily by changed external and internal circumstances. In the absence of extraordinary shocks from geopolitical factors (i.e., conflict-zones), energy markets, currency or stock market collapses elsewhere and the weather, CanaData is expecting the Canadian dollar to stay around $0.95 U.S. to the end of this year and to reach parity during much of next year.