The Loonie and Oil Exports
Like other disciplines, economics tends to organize material into narratives. It is worth scrutinizing the “stylized facts” that underlie these narratives, as page B15 of Saturday’s Globe endeavoured to do.
One piece of conventional wisdom is that the Canadian dollar’s value is driven by the skyrocketing price of oil. David Wolf argued, and Heather Scoffield reported, that the loonie is probably overvalued because crude oil accounts for a relatively modest share of Canada’s global trade surplus (much less than natural gas, forest products or metals). Currency traders are using the “petrocurrency” theory to rationalize their speculative purchases of Canadian dollars.
This analysis reflects three important points. First, “oil and gas” are typically bracketed together into a single economic sector. However, while world oil prices have taken off, North American gas prices remain grounded partly due to the prospect of large-scale imports of liquified natural gas from overseas.
Modest natural gas prices explain why return on equity in “oil and gas” does not dramatically exceed the economy-wide average and buttressed the industry’s opposition to higher royalties in Alberta. These prices do not support the loonie’s petrocurrency status.
Second, while western Canada is a huge oil exporter, central and eastern Canada remain significant oil importers. This dynamic limits the country’s trade surplus in oil.
Third, since almost all of Canada’s oil and gas exports go to the US and most of Canada’s oil imports come from overseas, fossil fuels contribute far more to our trade surplus with the US than to our total international trade surplus. However, the Canadian dollar has mainly been appreciating against the American dollar. To contend that the role of oil in our global trade surplus does not support this appreciation may be an apples-and-oranges comparison.
The piece of the puzzle that Wolf and Scoffield leave out is refined petroleum products. Canada ran a $6-billion trade surplus in this area from January through August 2007, according to Industry Canada’s Strategis database. Adding refined oil to crude oil makes it as significant as forest products or metals in our worldwide trade surplus. In this case, the conventional wisdom may not be as far off as Wolf and Scoffield suggest.
Also, whatever oil’s current role in our trade surplus, it is likely to increase as the oil sands and offshore oil are developed. Higher provincial royalties could slow this development, but last week’s federal corporate-tax cuts fully offset Alberta’s modest royalty hike. Foreigners may be buying Canadian dollars expecting that they will soon need them to pay for future Canadian oil exports. This approach may be “speculative,” but it is not entirely unfounded.
Good post Erin. My main problem with the whole “Dutch disease” argument is that the Canadian dollar is only strong with respect to the American dollar (and the currencies pegged to the latter, of course). If one looks at the evolution of the value of the dollar with respect to the Euro since January 1st 2000 with the currency converter of the Bank of Canada, for example, the highest value of the dollar is reached in September 2000, at 0.80 Euro, while it has been fluctuating between 0.68 and 0.73 in the last year (and over 0.6 and 0.8 in the whole period).
So it is mostly the US dollar that is tumbling down, not the Canadian dollar that has taken off. Now, given that most of our trade is with the US, this distinction is somewhat besides the point for most practical purposes (like the ailing manufacturing sector). Still, though, I think that oil is not the main culprit for the recent upward movement in the Can/US exchange rate.
In fact, I would venture another hypothesis: The US is letting its currency tumble both in a way to curb its external deficit and to renege on some of its external debt. Can’t prove the second one yet (if it is at all intended, rather than only a side-effect), though some of the Fed’s behaviour since Bernanke came in is more than suspicious (like the fact that they stopped publishing some monetary aggregates – M3, for example).
And it looks like I am not the only one to be suspicious: The Chinese have also started to move away from holding US currency. Mind you, talk about a reinforcing spiral…
I believe Jim Stanford touched on some of these issues in a post some weeks ago. Just a couple of comments adding onto Mathieu’s idea. There are a wide ranging set of ideas of why the US would want to depreciate their dollar. It is a quite complicated subject matter as there are so many issues to consider. From the notion of being used as the international currency, to the breakdown of Bretton Woods, to supporting trade flows, to the enormous debt levels the US has incurred, to slowing of the economy and a host of others. It is quit a gordian knot to unravel. However you do touch on some interesting ideas with the debt reduction strategy. Another that I would through in to the depreciating US dollar is the Bush regimes desparate attempt at some “begger thy neighbour” fix to there economy. Let it fall and watch the domestic economy heat up. Quite simple really and a solution for a simplistic type regime that rules down south could bring about. With some consideration to the US, it’s dollar has been pushed into many areas that I am sure usurped it function as a domestic currency, and placed the US economy within that fold.
A short comment of should I say showing my sympathy for Erin, I am not too sure that looking for some kind of logic within the nexus of collective action of currency traders is a an easy or fruitful task. Similar to Jim’s queries some time ago, it is not an easy task to deliver legitimate causality within that space. Is it just the herd mentality of greed or is their some logic underneath it all that guides this behaviour.
I am a bit of a Polanyi camper and the commodification process of that market is detrimental to its function. Unlike some Polanyi type notion however, I see no double movement forming up within the speculators and the day traders that would approach some notion of regulating these oil and currency markets. Until some kind of Bretton Woods type solution is sought we will see such behavior continue to wreak havoc on our dollar.
The U.S. dollar is being driven down by speculators making a one-way bet. Borrow U.S. dollars, exchange for Can.$, hold for equivalent or better interest rates on T-bills; sell Can. $, payback the loan, cover your exchange expenses, the interest rate spread, and pocket your surfire profit on the falling greenback. Our $ was up 3 percent this week.
I believe this is called the carry trade. U.S. financial institutions are working overtime to recover their sub-prime losses.
The Bank of Canada is asleep. Their silly idea of adopting six pre-announced dates for rate changes means they cannot lower rates until Dec. By then the Can $. will be above 1.10.In the meantime the U.S. federal reserve has lowered its rate by 50 basis points so that we are both at 4.5%. To moderate the rise in the dollar we should be under the U.S. rate.
Crow set the precedent for this in the 89-90 when he unexpectedly pushed up Canadian rates, and did his zero inflation number, encouraging the cross border inflow. Banker/speculators make a fortune, while jobs and manufacturing tanked.
Of course the FX trades are reversed and cancel. But the U.S. current account ouflow is so huge it ensures the U.S. dollar is weak overall.
Count on the Bank of Canada to continue to fight the class war from above with their garbage about the unprecedented rise in real wages.
Of course, in reference to Duncan’s comments, we must also have a long gaze towards the Canadian side of the equation. There are measures that a strong government can do to counteract the rise of the dollar. I did want to make this clear. It would have to take a determined effort to break this oil to dollar relationship but as Mr. Cameron points out the current party is too busy with a class war from above.
There is no doubt that Dodge and Flaherty could put the fear into the markets with an interventionist stance. Just enough to spook the leaders of the herd as they gather at the watering hole of the BOC, enough of a scare to get at least a few of the herd to think about running now rather than following would probably be enough. But it takes a concerted commitment.
Good point about speculation, but given the size of the Canadian currency market, I am dubious that speculative activity here would have any important effect whatsoever on the US dollar.
Moreover, the Canadian currency is mostly appreciating with respect to the dollar, so it seems that we have to search for downward pressures on the US dollar, not upward pressures on the Canadian currency.