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 19971998 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 Figure 1 shows self-evident. The United States the Canada-U.S. is the largest and wealthiest exchange rate economy in the world, and its since 1951. currency acts as a benchmark 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
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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 low70 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 2002. Global economic uncertainty, beginning with the Asian Crisis of 1997-1998, 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.
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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
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APPENDIX Figure 1 – The Canada-U.S. Exchange Rate, 1951-2004 $
1.1
$US per $CAN – End-of-month rates
1.05 1 0.95 0.9 0.85 0.8 0.75 0.7 0.65 0.6 1951
1958
1965
1972
1979
1986
1993
2000
Note: 2004 data for January–July. Source: Bank of Canada.
Figure 2 – Real Commodity Prices and the Canadian Dollar 1.6
$US per $CAN
Index, 1990 = 1.0
0.9
1.4
0.85
1.2
0.8 0.75
1 0.8
0.7
0.6
0.65
0.4
0.6
1988
1991
1994
1997
2000
Non-Energy Real Commodity Prices (left axis) Real Energy Prices (left axis) Exchange Rate (right axis)
Source: Bank of Canada; Library of Parliament.
2003
Figure 3 – U.S. Current Account and Merchandise Trade Balances 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 100
$billions
0 -100 -200 Merchandise Trade -300
Current Account
-400 -500 -600
Source: OECD; Library of Parliament.
Figure 4 – World Currencies’ Gains Against the U.S. Dollar 150 140 130 120
Exchange Rate Index, January 2001 = 100
Euro Yen British Pound Canadian Dollar Australian Dollar
110 100 90 80 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.
Figure 5 – The Value of the U.S. Dollar, 1988-2004 120
Trade-Weighted Exchange Rate Index,
115 March 1973 = 100 110 105 100 95 90 85 80 1988
1990
1992
1994
1996
1998
2000
2002
2004
Note: 2004 data for January–July. Source: U.S. Federal Reserve.
Figure 6 – Interest Rate Spreads and the Canadian Dollar, 1993-2004 Canadian Rate less U.S. Rate (%) 5
$US
4
Interest Rate Spread (left axis) Exchange Rate (right axis)
3 2
0.85
0.8
0.75
1 0.7
0 1993 -1
1995
1997
1999
2001
2003 0.65
-2 -3
Notes:
0.6
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.
