THE CANADIAN DOLLAR: WHAT DETERMINES THE EXCHANGE RATE?

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1 THE CANADIAN DOLLAR: WHAT DETERMINES THE EXCHANGE RATE? Library of Parliament Topical Information for Parliamentarians TIPS-117E 20 December 2004 The Canadian Dollar The Canadian dollar operates under a floating exchange rate regime. That is to say that its value relative to foreign currencies the exchange rate is determined, like the value of any other openly traded good or service, by the forces of supply and demand. However, this was not always the case. From the beginning of World War II until A brief history of 1950, and again from 1962 to the Canadian 1970, the value of the Canadian dollar is featured dollar was fixed to the U.S. on the Bank of dollar. During those times, it Canada s Web was the responsibility of the site. Bank of Canada to intervene in the marketplace to maintain the fixed value of the currency. Today, the Bank of Canada does not intervene in foreign exchange markets for this purpose. It will intervene, however, to maintain order in the market and defend against large-scale sell-offs of Canadian dollars. The last time it did so was during the Asian Crisis. The Canadian dollar is almost always discussed in terms of its strength or weakness relative to the U.S. dollar. The reasons for this are self-evident. The United States is the largest and wealthiest economy in the world, and its currency acts as a benchmark Figure 1 shows the Canada-U.S. exchange rate since in international markets. The United States is also Canada s largest export destination, and economic linkages between the two countries have been strengthening for decades. Even so, the Canadian dollar is traded against most other currencies in the world. The Canadian dollar does not always move in the same direction with respect to all currencies. Frequently, it rises against one currency but falls against another. Since the Canadian dollar is traded freely on the open market, its value is affected by any and all factors that affect its supply and demand relative to other currencies. Factors that increase (or decrease) demand for the Canadian dollar, or that decrease (increase) demand for foreign currency, will place upward (downward) pressure on the exchange rate. Similarly, factors that increase (decrease) the relative supply of the Canadian dollar will push exchange rates lower (higher). Economic theory and empirical evidence have identified a number of exchange rate determinants that, in isolation from one another, have predictable effects on exchange rates. However, because so many factors come into play at the same time, predicting exchange rate movements is notoriously difficult. Often, the reasons underlying recent movements are evident only in hindsight. Factors Affecting the Value of the Canadian Dollar A few of the more significant factors known to influence the value of the Canadian dollar are described below. Interest rates: Relatively higher interest rates in Canada increase the foreign demand for the dollar as investors buy these Canadian securities earning higher returns. However, the rate of return to foreign investors is dependent on the expected future performance of the dollar. If foreign investors anticipate a decline in the value of the Canadian dollar, they would demand a higher interest rate on Canadian dollar securities. Commodity prices: The value of the Canadian dollar is correlated to the strength of world commodity prices. Commodities represent a larger share of exports in Canada compared to the United States and many other countries. As such, when commodity prices rise, Canada s terms of This is the paper version of a Web document that is available on-line at

2 LIBRARY OF PARLIAMENT BIBLIOTHÈQUE DU PARLEMENT 2 trade improve because its goods have become relatively more valuable. Since Canada s effective purchasing power is higher, this movement is usually reflected in a higher exchange rate. The opposite also holds: weaker commodity prices can translate into a weaker Canadian dollar. Inflation rates: Inflation is the rate at which general price levels rise over time. If inflation in Canada were to exceed foreign inflation rates, then in the long run this would erode the purchasing power of the Canadian dollar relative to foreign currencies. That erosion would be reflected in a decline in the value of the Canadian dollar. The opposite is also true. Sustained, relatively low inflation in Canada has a positive influence on the exchange rate. International trade of goods and services: When a country is running a trade surplus, the overall value of exports exceeds the value of imports, putting upward pressure on the exchange rate (the demand or receipts for the currency exceed the supply or payments). When a country is running a trade deficit, the overall value of imports exceeds the value of exports, putting downward pressure on the exchange rate (the supply or payments for the currency exceed the demand or receipts). Foreign investment and debt payments: Inflows of foreign investment in Canada (e.g., the purchase of bonds and stocks by foreigners) increase the foreign demand for Canadian dollars, and thus push the exchange rate up. Direct investment made by Canadians abroad has the opposite effect. Debt payments made to foreigners also push the exchange rate down. Productivity: As with commodity prices, a country s productivity loosely defined as the amount of output that There is a debate over can be produced with a whether or not the given level of inputs value of the Canadian can be a factor in the dollar affects national productivity. See the determination of the Library of Parliament exchange rate through publication entitled Will its effect on relative the Higher Dollar Make prices and international Canadians More competitiveness. For Productive? example, if productivity in Canada were to grow faster than in the United States, then the prices of Canadian goods would become more competitive and, over time, Canadian output and exports would increase, leading to greater demand for Canadian dollars. What Explains the Recent Performance of the Canadian Dollar? In the late 1980s and early 1990s, the Canadian dollar was relatively strong, largely because Canadian interest rates were significantly higher than U.S. rates as part of Canada s low-inflation policy at that time. When those rates began to fall, however, the combination of lower yields in Canada, stronger economic growth in the United States, and a growing perception of Canada as a risky investment (because of high public debt levels and a declining credit rating) contributed to a steep decline in the exchange rate, which took effect in the early 1990s. In the mid-1990s, Canada s fiscal situation improved and inflation rates were low; but these positive influences were offset by weakening commodity prices in the second half of the decade and interest rates that remained, for the most part, below U.S. levels. The dollar stabilized, temporarily, in the low- 70 cent range. In the late 1990s and early in the present decade, expectations began to mount that the Canadian dollar was due to rise. Not only had Canada s fiscal situation improved, but its trade balance and current account were showing a surplus, its net investment position with the world was improving, commodity prices were stable, and economic growth was strong. However, the Canadian dollar did not begin to rise until late in Global economic uncertainty, beginning with the Asian Crisis of , continuing with the bursting of the tech stock bubble in 2000 and followed by the terrorist attacks in the United States a year later, all led skittish investors to flock to safe U.S.-dollar denominated assets. This movement kept the U.S. currency high, even though evidence was beginning to mount that economic fundamentals in that country were weakening.

3 LIBRARY OF PARLIAMENT BIBLIOTHÈQUE DU PARLEMENT 3 Eventually, however, the U.S. dollar did begin to depreciate against most major world currencies, including the Canadian dollar. In addition, growth in the Canadian and U.S. economies began to diverge in the early 2000s. While the U.S. economy weakened, Canada s remained strong. Accordingly, the United States began to lower interest rates in an effort to stimulate economic growth. In Canada, such stimulus was not necessary and interest rates remained higher. As a result, the Canadian dollar rose from 63.6 cents U.S. in January 2003 to 77.1 cents U.S. by the end of the year. The dollar initially gave back some of its gains in early 2004, but then resumed its upward course later in the year. In part this was because of stronger-thanexpected Canadian exports. Exports to the United States had been expected to fall because of the higher dollar, but instead showed solid gains in 2004, thanks in part to a recovering U.S. economy. However, the main contributor to the rising Canadian dollar in 2004 was domestic economic conditions in the United States. Specifically, U.S. trade (and budget) deficits persisted in 2004, despite a weaker currency. As a result, the U.S. dollar has continued to lose ground against other currencies, including the Canadian dollar. prepared by Michael Holden Parliamentary Information and Research Service For more information Please see the bibliography as well as the internal and external links of the Web version of this document at: or dial (613)

4 APPENDIX Figure 1 The Canada-U.S. Exchange Rate, $ 1.1 $US per $CAN End-of-month rates Note: 2004 data for January July. Source: Bank of Canada. 1.6 Index, 1990 = 1.0 Figure 2 Real Commodity Prices and the Canadian Dollar $US per $CAN Non-Energy Real Commodity Prices (left axis) Real Energy Prices (left axis) Exchange Rate (right axis) Source: Bank of Canada; Library of Parliament.

5 Figure 3 U.S. Current Account and Merchandise Trade Balances $billions Merchandise Trade Current Account Source: OECD; Library of Parliament. Figure 4 World Currencies Gains Against the U.S. Dollar 150 Exchange Rate Index, January 2001 = Euro Yen British Pound Canadian Dollar Australian Dollar Apr-01 Aug-01 Dec-01 Apr-02 Aug-02 Dec-02 Apr-03 Aug-03 Dec-03 Apr-04 Source: U.S. Federal Reserve Board; Library of Parliament.

6 Figure 5 The Value of the U.S. Dollar, Trade-Weighted Exchange Rate Index, March 1973 = Note: 2004 data for January July. Source: U.S. Federal Reserve. Figure 6 Interest Rate Spreads and the Canadian Dollar, Canadian Rate less U.S. Rate (%) $US Interest Rate Spread (left axis) Exchange Rate (right axis) Notes: 1) 2004 data for January July. 2) Interest rate spread refers to the difference between the Bank of Canada s target for the overnight rate less the target for the federal funds rate in the United States. Source: Bank of Canada; Library of Parliament.