Marketability: Exchange rates How they work and affect revenues

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1 Annex A Marketability: Exchange rates How they work and affect revenues 1. Overview The value of the Canadian lobster industry is determined by several factors: resource abundance; the capacity of the industry to harvest and generate supply; the ability of the industry to process and ship product to global markets; economic conditions that influence incomes and demand in these markets; the availability and price of lobster substitutes; and, exchange rates. Over much of the past decade it has been the shift in the exchange rate that has accounted for much of the change in industry revenues. The global recession is a more recent factor, and a factor that is likely to lose its negative impact on demand and prices over the next year or so as economies recover. The erosion of industry revenues caused by the rising value of the Canadian dollar is less likely to be reversed in the foreseeable future. And it could get worse before it gets better. This Annex examines what the exchange rate is, what factors cause it to shift up or down, and how it works to influence revenues. Also included is an estimate of the actual impact the exchange rate has had on the industry over the past decade. 2. The exchange rate is a price reflecting demand and supply In its simplest terms the exchange rate is a price the price of one currency in terms of another. For example, in 2002, you could buy one Canadian dollar with $0.65 in U.S. currency. Conversely, US$1.00 was worth CAN$1.55. So, every US$1.00 earned through the export of lobster (or any other product) was worth CAN$1.55 when the Canadian exporter converted the US dollar payment into Canadian dollars. By late 2007, the currencies were at par; CAN$1.00 = US$1.00, and have remained at close to par for most of the past 2-3 years. Understanding the factors behind the this shift is a matter of understanding the underlying changes in demand and supply for Canadian dollars in relation to the supply and demand for the US dollar. It is worth noting that we are using the US dollar to explain exchange rates because it is the most familiar to us, but the same kinds of factors determine the rate of exchange between the Canadian dollar and every other currency. Another point worth mentioning is that Canada has what is called a floating exchange rate. The value of the Canadian dollar is not fixed or controlled in terms of other currencies, but is left to find its own level based on market forces. This means that Canada does not use the exchange rate as an instrument to further economic policy the way some other countries do. For example, China controls the exchange rate of its currency with the U.S. dollar, and is accused of maintaining an artificially low value in order to makes its exports cheaper in global markets.

2 2 Annex A Marketability: Exchange rates How they work and affect revenues The exchange rate between two currencies is determined by supply and demand, the same factors that determine the price of any product. If the demand for Canadian dollars changes relative to supply, then the value of our dollar will shift relative to other currencies. Three forces are at work: Export demand Canada is a major exporter of commodities (oil and minerals, wheat, forest products and fish), and when the global economy is expanding (as it was during the early 2000s), the value of the Canadian dollar tends to rise in response to the increasing demand for dollars to pay for those exports. But as the price of the Canadian dollar rises, so too does the price of all the exports sold in Canadian dollar terms. This tends to have a negative impact on the demand for our exports, particularly in cases where there are ready substitutes from other countries. Canadian exporters then may be forced to cut prices to remain competitive, and/or look for other markets. And even in cases where the product is sold in U.S. dollars (as much international trade is), if the value of the U.S. dollar drops in relation to the Canadian dollar, it means that Canadian exporters receive less for each unit sold in U.S. dollar terms. It may be possible to push up prices to try to offset the currency loss, but there are obviously limits to what the market will bear. Interest rates The exchange rate is also sensitive to interest rates because differences in interest rates among countries cause investors to move their money around. For example, if the Bank of Canada increases the bank rate above the rate set in the U.S. by the Federal Reserve, then investors in the U.S. would have an incentive to move their investments to Canada to take advantage of higher returns. In order to make these investments (for example, in bonds or other securities), the investor would have to convert the foreign currency into Canadian dollars, increasing the demand for dollars. This rising demand would cause the value of the Canadian dollar to rise relative to other currencies. Of course, the opposite would occur if Canadian interest rates fell below those elsewhere. It is worth noting that interest rate is used as an instrument of policy to influence economic growth (by affecting the cost of borrowing), but also to moderate the rate of inflation. Expectations exchange rates are also influenced by what people think is going to happen to the value of a currency. There is a whole industry (currency trading) built on speculating about shifts in exchange rates. If traders believe an economic downturn is coming, then they will sell currencies of exporting nations (like Canada) because they know that the demand for those currencies will drop resulting in a decline in their value. Similarly, if traders think Canada is likely to raise its bank rate, then they will buy the Canadian dollar in expectation of an increase in its value once the rate actually goes up. Conversely, if they think a drop in the rate is likely, then they will sell Canadian dollars in anticipation of a drop in its value as investors pull investments out of Canada. What should be clear from this discussion is that the exchange rate in Canada is not the object of policy, but a residual. It floats in response to the demand and supply for the Canadian dollar, which in turn responds to conditions in the global economy and our ability to compete in this economy. The exchange rate is also sensitive to shifts in interest rates in Canada since rates affect the relative attractiveness of investments and hence the demand for dollars. So, as the Bank of Canada begins to raise interest rates because of a concern about inflationary pressures (as it did in July 2010), this action also leads to upward pressure on the exchange rate, resulting in an adverse impact on the competitiveness of price-sensitive exports. And while the Bank of Canada is not unconcerned about the broader economic effects of raising interest rates, its primary focus is inflation. It is up to export industries to maintain their competitiveness by cutting costs, improving productivity and improving the marketability of their products.

3 Annex A Marketability: Exchange rates How they work and affect revenues 3 3. Recent exchange rate shifts have not been kind to export industries The Canada-U.S. exchange rate: The U.S. is Canada s major trading partner and so what happens to the exchange rate is of fundamental importance to Canadian exporters, as well as U.S. importers. Figure A-1 shows that from the mid-1990s to the early 2000s, the Canadian dollar traded in the range of U.S.$1.00 = CAN$ This was a period when Canada had begun to tackle the large deficits it had been running for many years. The lack of confidence the global financial community had in the Canadian dollar is reflected in the increasing weakness of the dollar between 1998 and 1999 as it dropped from U.S.$0.75 to U.S.$0.64. The benefits of deficit reduction and increasing economic strength after 1999 are reflected in the strengthening of the dollar to the U.S.$0.70 range by early The recession resulted a drop in demand for Canadian exports, causing the dollar to drop to U.S.$0.62 in early CAN$1.00=U.S.$ Figure A-1 Canada-U.S. exchange rate, Jan 1996 Jan 1997 Jan 1998 Jan 1999 Jan 2000 Jan 2001 Jan 2002 Jan 2003 Jan 2004 Jan 2005 Jan 2006 Jan-07 Jan-08 Jan-09 Jan-10 Source: Bank of Canada The recovery that began in 2003 gained strength over the next five years. This was a period of strong demand for Canadian commodities resulting in generally healthy economic growth. It was also a period of balanced budgets and low inflation. These factors, combined with renewed confidence in Canada s future economic strength, resulted in a steady rise in the value of the Canadian dollar vis a vis its U.S. counterpart. By 2008, the Canadian dollar was trading at par with the U.S. dollar. The global recession in 2009 led to a sharp drop in demand for commodities, resulting in an equally sharp drop in the value of the Canadian dollar. But the gradual recovery in late 2009 and early 2010 has contributed to the dollar s renewed strength (Fig. A-1). Of course, this sharp shift in the exchange rate was not all due to improvements in Canada s economic performance. Over this same period, the U.S. government was running huge deficits and the country was running a substantial trade deficit, providing the basis for a slide in value.

4 4 Annex A Marketability: Exchange rates How they work and affect revenues Fearing losses, currency traders sold U.S. dollars, adding to its decline in value against most other currencies. Exchange rates with Canada s other major trading partners The rising value of the Canadian dollar since the early 2000s has influenced exchange rates with all of our trading partners. In the case of the major seafood importing nations the European Union (EU), Japan, the United Kingdom (UK) and South Korea the exchange rate shift has generally worked against Canadian exporters. All these currencies are worth less in terms of the Canadian dollar than they were in 2000 (Fig. A-2). The net effect is to reduce Canadian revenues, though the path depends on the currency in which the goods are sold: If exports are sold in Canadian dollars it means that the import price would increase as the value of the local currency declines relative to the Canadian dollar (it takes more units of the local currency to buy the same quantity as before). This may mean reduced sales as local prices rise. Canadian exports would decline in value if priced in terms of the local currency because the local currency is worth less when converted to Canadian dollars (the same as the situation with the sales to the U.S.). Canadian exporters may try to push up their prices, but their ability to do so would depend on competition and the availability of substitute products (of course, Canadian exporters should always be trying to increase their prices). Figure A-2 Value of foreign currencies vs. Canadian dollar ( ) = US EU Japan UK S. Korea Source: Bank of Canada The immediate implication of exchange rate shifts is to make importing countries more or less attractive as export markets, depending on the direction of change in the exchange rate. If a foreign currency weakens against the Canadian dollar and cause revenues to decline, Canadian exporters would look for other markets. Conversely, if a foreign currency strengthens against the dollar, Canadian exporters would be attracted to that market because the returns would be higher. But since 2002, exchange rates have tended to work against Canadian exporters in several major markets. In these circumstances, switching to more attractive markets becomes problematic because there are few available. In the case of lobster, the five markets shown in Fig. A-2 account for most of the export sales from Atlantic Canada.

5 Annex A Marketability: Exchange rates How they work and affect revenues 5 4. Exchange rate shifts have reduced Canadian lobster industry revenues The impact on lobster prices from exchange rate shifts is most clearly illustrated using the recent U.S. market experience. Fig. A-3 shows how the average price of lobster exported to the U.S. changed between January 2002 and May The U.S. dollar price is the price paid by U.S. importers and reflects conditions in the U.S. market. The Canadian dollar price is the price received by Canadian exporters after adjustment for the exchange rate. Fig. A-3 also includes trend lines that smooth out the seasonal fluctuations. Figure A-3 Export price of live lobster from Canada to U.S $/lb CAN$/lb US$/lb The U.S. dollar price increased from 2002 to 2006, reflecting generally good market conditions. Prices increased despite a 20% increase in lobster supply (in both Canada and the U.S.) during these years. U.S. dollar prices leveled off in 2007 and began to decline. This decline continued into 2010 reflecting weak markets due to the recession. The price trend looks quite different when expressed in Canadian dollars. Though there were some seasonal upswings, the general trend was one of price decline. This is due to the rising value of the Canadian dollar (or, conversely, the declining value of the U.S. dollar). In 2002, lobster sold to U.S. importers for US$4.85/lb was worth CAN$7.75/lb to Canadian exporters. By 2007, that exchange rate premium had disappeared. The impact on revenues of the exchange rate shift is illustrated in Fig. A-4, which shows that the value of a dollar of U.S. sales revenue in Canadian dollars in 2010 is 65% of what it was in The steady slide had been interrupted by the turmoil caused by the recession in 2009 when the Canadian dollar lost ground, but that weakness was temporary. The exchange rate is back to its pre-recession level.

6 6 Annex A Marketability: Exchange rates How they work and affect revenues Figure A-4 Change in the value of U.S. $ sales in Canadian $ January 2000= Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan Looking ahead exchange rate profits are likely history While it may be foolhardy to try to predict exchange rates too far into the future, there are good reasons to believe that it is more likely that the current trading range of the Canadian and U.S. dollars is going to persist than it is that the exchange rate will return to the level of the early 2000s. Indeed, it probably more likely that the Canadian dollar will trade at a premium as the global economy emerges from recession. Canada is heading into the next decade with its fiscal house in relatively good order and poised to take advantage of the commodity boom that is likely to occur as industrial economies return to economic growth. With this rising demand will come a stronger Canadian currency. This is not good news for seafood exporters. The prevailing view within the industry is that it became complacent during the years when favourable exchange rates produced easy profits. The lobster industry alone is operating on about $200 million less revenue than it earned in 2002 (Fig. A-5). Part of this is due to exchange rates, but part is also due to weaker markets, particularly in Indeed, were it not for the weaker Canadian dollar in 2009, total revenues would have been some 20% lower (because most of what is produced is exported to the U.S. The message for the industry is that it has to become more competitive; that it cannot rely on the exchange rate for a bailout. It has to find ways of reducing costs (perhaps by reducing redundant harvesting and shipping/processing capacity) and of improving the marketability of its products. Also, it seems that the industry needs to find a way of gaining strength in the market to increase its share of final product prices. The issues underlying marketability and industry structure are discussed elsewhere in this report.

7 Annex A Marketability: Exchange rates How they work and affect revenues 7 Figure A-5 Atlantic Canada lobster industry exports: ,200,000,000 1,000,000, ,000,000 CAN$ 600,000,000 Total Live Processed 400,000, ,000, Source: Statistics Canada

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