Learning To Live With A Strong Canadian Dollar Conference Board Of Canada


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Learning to Live With a Strong Canadian Dollar: Four Options for Business and Government by Glen Hodgson.

This briefing examines the implications of a strong currency for Canadian businesses and the Canadian economy, and it provides options and strategies for adapting to a strong currency.
The Conference Board of Canada, 8 pages, April 2010.

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Learning To Live With A Strong Canadian Dollar Conference Board Of Canada

  1. 1. Briefing  April 2010 Learning to Live With a  Strong Canadian Dollar Four Options for Business   and Government T he loonie is flying high once again. With the  at a Glance economic recovery starting to take hold, the  TheCanadiandollarisatparitywithitsU.S. Canadian dollar has settled in comfortably at  counterpart,anditislikelytoremainstrong parity with the U.S. dollar, and it is getting ready to  foralongtimetocome. soar even higher on occasion, once the global recovery  becomes more widespread and sustained. Will a soaring  Firmsmusttakeactiontoadapttolifewitha loonie finally provide the boost to productivity that  strongloonie—the“donothing”approachis Canadian firms need? Or will Canadian firms become a  notaviableoption. victim of a strong currency and contract “Dutch disease”?  Afloatingexchangeratepolicyremainsthe bestpolicycourseforCanada. This briefing for The Conference Board of Canada’s  International Trade and Investment Centre examines the   Forfirmsthatareableandwillingtoadapt,a implications of a strong currency for Canadian businesses  strongCanadiandollarmaybejustthechal- and the Canadian economy, and it provides four options  lengethatunlocksaneweconomicpotential— and related strategies for adapting to a strong currency.  throughenhancedinnovation,fasterproductivity growth,andexpandedinternationalization. Trade, InvesTmenT PolIcy and InTernaTIonal cooPeraTIon
  2. 2. 2 | LearningtoLiveWithaStrongCanadianDollar—April2010 conTexT lIvInG WITh a sTronG canadIan dollar: The oPTIons avaIlable Over the past year, the Canadian dollar has moved  steadily higher, going from a floor of about 77 cents U.S.   So how might firms operating in Canada respond to the  a year ago during the worst of the global economic reces- structural repositioning of the loonie? There are a range of    sion to just below parity with the U.S. dollar today. In  available options, with wide variation in the implications.   fact, the loonie started to rise in value well ahead of  Here are the four most likely choices: the recovery in global and Canadian growth, propelled  by a rebound in commodity prices (particularly global  1. do noThInG oil prices) and by Canada’s relative attractiveness as an  The first option is both easy and extremely painful—do  investment destination.  nothing. If Canadian firms (and the entire economy  for that matter) fail to respond to the upward structural  realignment of the Canadian dollar, they will slowly lose  canada’s solid banking system, solid domestic economy, their international competitiveness and eventually contract  relatively healthy fiscal situation, and wealth in raw what is called “Dutch disease.” Dutch disease is the loss  materials will continue to support a strong loonie. of international competitiveness due to a stronger currency  that is pushed upward by higher prices for key commodity   exports. In the case of the Netherlands, the guilder was  The loonie’s rise is also the flip-side of the downward  pushed progressively higher during the 1960s and 1970s  slide in the value of other major currencies—the U.S.  by the revenues from the sale of natural gas from reserves  greenback, the British pound, and more recently, the  in the North Sea. A rising guilder gradually eroded the  euro. Global currency markets are highly volatile right  competitiveness of Dutch manufacturing, which did not  now due to the deep uncertainty that exists in many  adapt quickly enough to the new exchange rate reality— major economies. The U.S. economic recovery is still  hence the name “Dutch disease.”  not fully assured. The financial crisis and recession has  taken a heavy toll on the British economy and on the  pound. And recent events within the euro zone, such as  “doing nothing” is not a desirable or realistic scenario the fiscal tragedies in Greece and Portugal, are raising  for canadian businesses or the economy as a whole. questions about the credibility of the euro. As a conse- quence, investments in the Canadian dollar look awfully  good compared with investments denominated in many  The conditions for Dutch disease are already occurring in  other currencies. Canada. The issue is whether firms will adapt, or contract  the disease and potentially expire. If firms do nothing,   For the foreseeable future, Canada’s solid banking system,  there is much greater risk of contracting a serious case  solid domestic economy, relatively healthy fiscal situation,  of Dutch disease. Therefore, doing nothing is not a  and wealth in raw materials (especially oil) will continue  desirable or realistic scenario for Canadian businesses  to support a strong loonie. These fundamentals suggest  or the economy as a whole, and it should be set aside   that the Canadian dollar will remain roughly at parity with  as a credible option.  the greenback over the near term. Moreover, the loonie  could be pushed beyond par by factors such as a sharp  2. adoPT a FIxed exchanGe raTe rise in oil prices or a period of positive interest rate   A second option would be to consider a fundamental  differentials. In short, the signs point to continued  change in Canada’s exchange rate policy, specifically by   strength in the Canadian dollar for some time to come.  adopting a fixed exchange rate policy through pegging  the loonie to the U.S. dollar. In recent years, the idea of  FindthisbriefingandotherConferenceBoardresearchatwww.e-library.ca
  3. 3. TheConferenceBoardofCanada | 3 fixing the loonie to the U.S. dollar has been raised with  reached in 2002 when the Canadian dollar fell to 62 cents?  the Conference Board by numerous people in business,   Presumably it isn’t the top of the trading range for the  and by a few in public policy. Some Canadian economists  loonie, which briefly traded at US$1.10 in 2008. Or should  and media commentators have argued that Canadians  a fixed rate fall somewhere in between, such as the point  would be better off if the country adopted a fixed  where analysts think that purchasing power in the U.S. and  exchange rate policy.1 Canada is equalized—which is probably around 85 cents?  Under this line of argument, the Canadian dollar would  The level at which the exchange rate is fixed would be  be pegged against its U.S. counterpart, thus effectively  critical. There are economic winners and losers at any  removing currency fluctuations from decision making by   exchange rate level, and the gains or losses would be  businesses and consumers. Alternative ideas, such as a   long-lasting under a fixed exchange rate system. For  target exchange rate within a trading band, have also been  example, exporters with high Canadian costs and a low  raised. A more extreme arrangement would see the loonie  level of imports in their production process might prefer  disappear and the U.S. greenback adopted as Canada’s  a pegged rate below 70 cents. Firms with a high import  currency, either unilaterally or under a full monetary  content in their production process would favour a  union, similar to what has occurred under the euro zone. stronger currency, as would heavy consumers of imported  goods. At the extreme, Canadians on vacation in Florida  or Arizona, not to mention professional sports franchises  some economists have argued that canadians would be based in Canada with revenues in Canadian dollars and  better off if a fixed exchange rate policy was adopted. U.S. dollar salaries for players, would love a pegged  rate above US$1.00.  Advocates of a fixed exchange rate policy emphasize the  potential benefits of exchange rate stability. It is argued  advocates of a fixed exchange rate policy emphasize the that a fixed exchange rate with our dominant trade and  potential benefits of exchange rate stability. investment partner—the United States—would help to  maintain our international competitiveness. Stable prices  would be established for the majority of Canada’s traded  The second critical issue is the impact of a fixed exchange  goods and services, and for much of our international  rate on Canadian monetary policy. If we decided to peg  investment. However, the advocates of such a system  the loonie to the U.S. dollar, we essentially would be  seldom give sufficient weight to the thorny economic  eliminating the Bank of Canada’s latitude to establish an  policy and political decisions that would arise if we  independent monetary policy for Canada. The Bank would  were to implement, and then try to maintain, a fixed  have to follow the interest rate path determined by the U.S.  exchange rate policy. Federal Reserve Board in order to maintain the pegged   exchange rate. Tight controls on international capital flows  Three policy issues are of critical importance. First, we  would be required in order to manage the movement of  would have to select the “right” exchange rate for pegging  investment funds in and out of the country, since these  ourselves to the U.S. dollar. Is the “right” exchange rate  movements influence the exchange rate. Of course, inter- at the bottom of the historical trading range, which we  national capital controls would cause other problems— such as creating a barrier to increased investment, both  within Canada and offshore, by Canadian firms seeking  1 SeeThomasCourchene,“Canada’sFloatingRateNeedsFixing,” Policy Options(February2008),pp.24–28;orNeilReynolds, to globalize their business. “DollarWoes:AMonetaryUnionSolution,”The Globe and Mail (November16,2007),p.B2. FindthisbriefingandotherConferenceBoardresearchatwww.e-library.ca
  4. 4. 4 | LearningtoLiveWithaStrongCanadianDollar—April2010 U.S. monetary policy is determined by U.S. economic  shock—which could make for very difficult politics.  conditions, not by conditions here in Canada. Without  And the political elephant in the room would be the  the establishment of a common currency area, it is highly  potential—some might say the inevitable—erosion of  improbable that Canada would have a direct role in the  Canadian political sovereignty if we were to peg the  Fed’s decision making; and the Canadian tail would   Canadian dollar to the greenback. be unable to wag the American dog when it came to   a common monetary policy.  The bottom line on exchange rate policy is that Canada  has chosen to allow the exchange rate to float and adjust   Third, and perhaps most importantly, under a pegged  to global forces. When global growth has weakened and    exchange rate, any external shocks or imbalances would  commodity prices have fallen, the exchange rate has acted    need to be addressed by purely domestic adjustments in  as a shock absorber—falling and thereby cushioning the    fiscal policy and in wages. The exchange rate could no  impact on revenues and income. When commodity prices    longer be used to offset external shocks.  and economic growth have been strong, the Canadian  dollar has risen in value—as is the case today. The cur- rent system has served Canada well for many decades,  When commodity prices and economic growth have been notwithstanding the need to adapt to sharp exchange rate  strong, the canadian dollar has risen in value. movements and structural shifts—also the case today.  A floating exchange rate policy remains the best policy  course for Canada, and the fixed exchange rate option  A recent sharp external shock illustrates the point.  should also be set aside. Like the “do nothing” option, a  Commodity prices collapsed in the fall of 2008 as a  fixed exchange rate is not a desirable or realistic scenario  result of the financial crisis. If Canada had been under  for Canadian businesses or the economy. a fixed exchange rate regime at that time, it would have  had to cut wages and public spending in order to adjust  to the external shock and rebalance the country’s exter- Under a pegged exchange rate, any external shocks or nal accounts. But under the existing floating currency  balances would need to be addressed by purely domestic system, the exchange rate took the hit from a collapse  adjustments in fiscal policy and in wages. in commodity prices, and the Canadian dollar drifted  down to around 80 cents. 3. boosT ProdUcTIvITy GroWTh The natural reluctance of business leaders and ordinary   The third and fourth options are challenging for businesses,    citizens to be required to adjust domestic wages and  but also create the potential for significant rewards over  government spending in order to re-stabilize the external   the long term.  accounts is one key reason why most countries have  moved away from a fixed exchange rate policy over  The third option calls for Canadian firms to respond to the  the past 30 years. Recent events within the euro zone,  structural shift upward in the loonie by becoming more  for example, provide more real-time illustrations of the  productive and efficient. They would seek out ways to re- challenges of implementing domestic economic policy  invent themselves, re-structure their operations globally,  within a fixed exchange rate system.  and create an internal culture of innovation that feeds  stronger productivity growth. Firms would no longer be  Then there are the politics of a fixed exchange rate  able to rely on a cheap dollar for their competitiveness;  system. As noted, increases or decreases in public  they would have to increase their productivity through  spending would be required to adjust to an external  improved innovation, or risk contraction—even extinction.  FindthisbriefingandotherConferenceBoardresearchatwww.e-library.ca
  5. 5. TheConferenceBoardofCanada | 5 Most economists would agree that a strong Canadian  dollar should act as a catalyst for stronger productivity  chart 1 growth. A strong loonie makes imported goods—includ- LabourProductivityGrowth (percent) ing imported technology that can help firms become more  efficient—cheaper. But things are seldom that simple or  Canada U.S. linear in the real world. As but one example of this, the  2.0 Canadian national accounts data for the fourth quarter of  1.8 2009 indicated that investment in machinery and equip- 1.6 1.4 ment, much of which is imported, actually fell by 2.4 per  1.2 cent even as the dollar was rising in value. We suspect  1.0 that this was an aberration that will be corrected over  0.8 0.6 the coming quarters, but it does suggest that a strong  0.4 currency and the resulting lower import prices may  1970s 1980s 1990s 2000s not be sufficient on their own to produce a sustained  improvement in Canada’s productivity performance.  Source:TheConferenceBoardofCanada. most economists would agree that a strong canadian dollar   re-energizing free trade and investment within north should act as a catalyst for stronger productivity growth. america and globally. (The recent Conference Board  report Re-Energizing Canada’s International Trade: Strategies for Post-Recession Success2 provides  For many years now, The Conference Board of Canada  detailed analysis and guidance on how to strengthen  has advised firms and governments to develop and imple- trade policy and strategy.)  ment a strategic plan to improve Canada’s dismal track  record on productivity growth. (See Chart 1.) There is  Action on all these fronts should be supported by   no silver bullet for “fixing” productivity, but action on a  adopting a culture of innovation within Canadian  number of fronts should contribute to better performance  organizations—one in which new ideas and measured  by firms and by the entire economy. These include:  risk-taking are encouraged. There are many competing    Fostering stronger investment in physical capital. Recent  definitions for innovation, but in the simplest terms,  tax reform—such as the elimination of federal and  innovation is making changes—both big and small— some provincial capital taxes, and lower corporate  that create value. These changes can lead to increased  income tax rates—should create better incentives   productivity, improved efficiency, or the launching of  for capital investment.  new initiatives, thereby creating value by increasing    deepening canada’s human capital through increased profits for firms or strengthening the financial capacity   investment in people. Renewed public investment in  of public sector organizations. In an ever-more integrated  education by governments, but also enhanced training  and competitive global economy, innovation will be  and development by private firms, would contribute  the factor that separates mediocre from good, and good  to human capital development in Canada.  from great.   reducing barriers across the economy and improving the alignment of regulations. Some progress has been  Implementing a strategic plan to improve productivity  made on this front in recent years—such as the Trade,  growth (see Exhibit 1) will be a critical part of adapting  Investment, and Labour Mobility Agreement (TILMA)  to a strong loonie. between Alberta and British Columbia, and improved  regulatory alignment between different levels of gov- ernment on environmental assessments of projects— 2 TheConferenceBoardofCanada,Re-Energizing Canada’s International Trade: Strategies for Post-Recession Success but this remains an unfinished agenda.  (Ottawa:Author,2010). FindthisbriefingandotherConferenceBoardresearchatwww.e-library.ca
  6. 6. 6 | LearningtoLiveWithaStrongCanadianDollar—April2010 against currency fluctuations within their overall oper- exhibit 1 ations. The reason is that firms that are highly “internation- Productivity:AConceptualPolicyFramework alized” are likely to have more flexibility in their operating  structures. In general, manufacturing industries, as well as  mining and oil and gas extraction industries, are the most  broadly internationalized—and firms in these industries  are therefore likely to have an operational hedging strategy  built into their business model. Skills/Human Innovation capital In contrast, service industries may be more exposed to cur- rency volatility since they have fewer means within their  Investment tio operations of hedging against dollar volatility. Industries  me nt Na n al o p e r a ti n g e n v i r o n that are highly reliant on foreign markets and suppliers,  in cl u d i n g i n fr a s tr u c t u r e as well as those with limited strategies for doing business   N ort h A m e ri c a n i n t e g r a ti o n in international markets, are not as well positioned to  Inter respond to fluctuations in the exchange rate.  n a ti o n a l ent tr a d e a n d in v e st m Dollar Volatility: Who Should Care? used four indica- Source:TheConferenceBoardofCanada. tors to identify the degree to which 27 industries rely on  international transactions to conduct business, and the  nature of that internationalization. The four indicators  4. exPand The InTernaTIonalIzaTIon were: export intensity, import intensity of inputs, import  oF canadIan bUsInesses intensity of machinery and equipment investment, and  Option four is closely interlinked with option three,   the extent of Canadian direct investment abroad. High  and would see more Canadian firms embrace various  rankings on multiple indicators indicated a high level of  forms of engagement in international business in order  internationalization for the manufacturing, mining, and  to be competitive. oil and gas extraction industries. (The report provides the  industry sector analysis in detail.)  Rapid movements in the exchange rate have made it  increasingly difficult for some businesses to develop a  workable cost structure. A recent 2010 Conference Board  service industries may be more exposed to currency report Dollar Volatility: Who Should Care?3  identified  volatility because they have fewer means within their the industries that are most and least exposed to rapid  operation of hedging against dollar volatility. changes in the value of the currency, such as we have  seen the past two years. The report provided some   surprising insights.  The implication of this research is that Canadian  industries must continue to internationalize in order to  The conventional view is that manufacturers were more  remain competitive. A firm that uses various approaches  highly exposed to currency fluctuation, since they rely  to globalization simultaneously will be better positioned  more on exports than do other industrial sectors. But  to reduce the financial risks associated with changes in  the Conference Board’s finding was that manufacturing   the value of the Canadian dollar, and with the strong  industries, along with the mining and oil and gas extrac- dollar we see today.  tion industries, are the most able to weather a volatile  Canadian dollar because they have more ways to hedge  Businesses, particularly small and medium-sized enter- prises, need to examine where they fit into global supply   3 ValériePoulinandLouisThériault,Dollar Volatility: Who Should chains and to identify risks and opportunities in the  Care?(Ottawa:TheConferenceBoardofCanada,2010). international marketplace. Internationalizing also means   FindthisbriefingandotherConferenceBoardresearchatwww.e-library.ca
  7. 7. TheConferenceBoardofCanada | 7 forming strategic partnerships with other firms and indus- Canadian businesses will have to come to grips with this  tries to share resources, risk, expertise, and capital in  new reality. Ignoring the problem, or implementing quick  foreign markets. Policy makers can undertake indirect  fixes, won’t work. While we have set out four options for  measures to prepare for and mitigate exchange rate effects  adjusting to a strong loonie, in truth only two interrelated  on Canadian industries. These measures include increasing  strategies will work—boosting productivity within firms  trade liberalization and renewing policies that encourage  and across the economy, and expanding the international- both inward and outbound foreign direct investment.  ization of Canadian businesses. Canadian firms are now being exposed to the Dutch   Policy makers can undertake indirect measures to mitigate disease virus. Some firms will not be able to adapt  exchange rate effects on canadian industries. quickly enough to the upward shift in the loonie, just  as some firms were unable to adapt to earlier structural  changes (such as the Free Trade Agreement, or much  higher energy and commodity prices). These firms will  conclUsIon fall prey and could well succumb to Dutch disease.  Driven higher by the still modest economic recovery,  But for firms that are able and willing to adapt, a strong  the Canadian dollar is now at par with the U.S. dollar, and  Canadian dollar may be just the challenge that unlocks  it could soar further once the global recovery becomes  a new economic potential—through enhanced innovation,  more widespread and sustained. Our view is that the  faster productivity growth, and expanded international- Canadian dollar will remain a strong currency for some  ization of their business strategy and operations. time to come. FindthisbriefingandotherConferenceBoardresearchatwww.e-library.ca
  8. 8. acknowledgements author Internal reviewers external reviewer Glen Hodgson  Louis Thériault and Danielle Goldfarb  Christopher Ragan The Conference Board of Canada would like to thank external reviewer Christopher Ragan of the federal Department of Finance and McGill  University, for his comments and suggestions, which were offered in his personal capacity and do not necessarily represent the views of his  organization. Any errors of fact or interpretation are solely the responsibility of the author and The Conference Board of Canada. InTernaTIonal Trade and InvesTmenT cenTre members The Conference Board of Canada is also grateful to the champion and lead members of the International Trade and Investment Centre  who, through their membership, support the Centre’s research program.1 aboUT The InTernaTIonal Trade and InvesTmenT cenTre The International Trade and Investment Centre aims to help Canadian leaders better understand what global economic dynamics—such as  global and regional supply chains—mean for public policies and business strategies. The Centre brings together business and government  leaders in an off-the-record forum to discuss successful trade and investment strategies. The Centre’s independent, evidence-based reports  propose effective policy and business solutions for improving Canada’s trade and investment performance. champion members Business Development Bank of Canada Natural Resources Canada Export Development Canada  Canada Economic Development Ontario Ministry of Economic  Foreign Affairs and International   Canada Mortgage and Housing Corporation   Development and Trade   Trade Canada Farm Credit Canada RBC Financial Group Forest Products Association of Canada Sun Life Financial Inc. lead members Industry Canada Alberta International and   Ministère du Développement     Intergovernmental Relations   économique, de l’Innovation     et de l’Exportation du Québec For more InFormaTIon Please visit www.conferenceboard.ca/ITIC. 1 Theseorganizationsdonotnecessarilyendorsetheresearchconclusionsofthispaper.
  9. 9. Learning to Live With a Strong Canadian Dollar: Four Options for Business and Government by Glen Hodgson about The conference board of canada We are: •  The foremost independent, not-for-profit,  •  Experts in running conferences but also at  •  Not a government department or agency,  applied research organization in Canada. conducting, publishing, and disseminat- although we are often hired to provide   •  Objective and non-partisan. We do not  ing research; helping people network;  services for all levels of government. lobby for specific interests. developing individual leadership skills; and  •  Independent from, but affiliated with,   •  Funded exclusively through the fees we  building organizational capacity. The Conference Board, Inc. of New York,  charge for services to the private and   •  Specialists in economic trends, as well   which serves nearly 2,000 companies in   public sectors. as organizational performance and public   60 nations and has offices in Brussels and  policy issues. Hong Kong. Publication10-250 E-copy:Complimentary 255 Smyth Road, Ottawa ON  K1H 8M7  Canada    Tel. 613-526-3280  •  Fax 613-526-4857  •  Inquiries 1-866-711-2262 The conference board, Inc.  845 Third Avenue, New York NY  10022-6679  USA  Tel. 212-759-0900  •  Fax 212-980-7014  •  www.conference-board.org The conference board europe  Chaussée de La Hulpe 130, Box 11, B-1000  Brussels, Belgium  Tel. +32 2 675 54 05  •  Fax +32 2 675 03 95 The conference board asia-Pacific  2802 Admiralty Centre, Tower 1, 18 Harcourt Road, Admiralty  Hong Kong  SAR  Tel. +852 2511 1630  •  Fax +852 2869 1403 ©2010The conference board of canada* For more information,pleasecontactusat Forecastsandresearchofteninvolvenumerous PublishedinCanada • Allrightsreserved thenumberslistedaboveore-mail assumptionsanddatasources,andaresubject AgreementNo.40063028 contactcboc@conferenceboard.ca. toinherentrisksanduncertainties.This *IncorporatedasAERICInc. This publication is availableon informationisnotintendedasspecific theInternetatwww.e-library.ca. investment,accounting,legal,ortaxadvice. www.conferenceboard.ca