Short-Term Volatility and Long-term Trends of the Canadian Dollar
by
Mahmuda K. Siddiqua
B.A. (Honors in Economics), Mount Allison University, 1986
A Thesis Submitted in Partial Fulfillment of The Requirements for the Degree of
Master of Science in Applied Economics & Finance
Supervisor: Neil Ridler, PhD, Department of Economics
Examining Board: Saiful Huq, PhD, Faculty of Business Muhammad Rashid, PhD, Faculty of Business Administration
This thesis is accepted by the Dean of Graduate Studies
THE UNIVERSITY OF NEW BRUNSWICK
May 2009
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••1 Canada Abstract
Many factors affect the value of the Canadian dollar, such as expectations, commodity
prices, budget and current account deficits, debt ratios, interest rates, political stability, and
speculation. Since the Canadian economy heavily relies on foreign trade and investment,
fluctuations in the value of the Canadian dollar have far-reaching implications for the
nation's economic growth and stability. In this thesis, an attempt is made to understand the
complex nature of the foreign currency markets and how the Canadian dollar has performed
in the last three decades. The study has found that commodity prices, interest rate differentials, diverging inflation rates, and political events - all have significant influences on the value of the dollar. The relative impact of each in part depends on the time horizon analyzed.
Keywords: Exchange Rate Regime, Purchasing Power Parity, Hedging, World Trade Organization, Hard Currency.
n Acknowledgement
I would like to thank Dr. Neil Ridler for guidance and encouragement without which I would not have been able to finish this thesis. Every time I met him to discuss the thesis from its proposal stage to completion, Dr. Ridler made things appear easier than I thought.
This helped me to stay focused and complete the research work. I would also like to thank
Dr. Saiful Huq who read various drafts and provided valuable comments and suggestions that have improved the quality of the final version. I thank him for his interest in the topic and his help. Dr. Muhammad Rashid read the final version as an examiner, and pointed out some errors and made numerous suggestions for improvement, and that have been very helpful.
HI TABLE OF CONTENTS
Abstract ii Acknowledgement iii List of Tables vi List of Figures and Illustrations vii Chapter One: Introduction 1 Chapter Two: Exchange Rate Regimes, the Foreign Exchange Market and Performance of the Canadian Dollar 11 2.1. Introduction 11 2.2 Fixed versus Flexible Rates 13 2.2.1 Fixed Exchange Rates 14 2.2.2. Currency Boards 17 2.2.3. Flexible Exchange Rates 21 2.2.4. Advantages and Disadvantages of Fixed Exchange Rate 22 2.3. The Foreign Exchange Market 25 2.4. Historical Value of the Canadian Dollar 34 2.5. A Survey of Recent Research on the Value of the Canadian Dollar 40 2.6. Summary and Concluding Comments 44 Chapter Three: Theories of Exchange Rate Determination 47 3.1. Introduction 47 3.2. Various Theories of Foreign Exchange Rate 47 3.2.1. Purchasing Power Parity 48 3.2.2. The Asset Theory of Exchange Rate 56 3.3. Summary 62 Chapter Four: Factors Determining the Value of the Canadian Dollar on the Foreign Currency Market 63 4.1. Introduction 63 4.2. Sources and Nature of Data 64 4.3 Empirical Exercise 67
iv 4.3.1. OPEC Formation 70 4.3.2. Political Turmoil in Quebec (1976-1986) 72 4.3.4. Recent Commodity Boom (2003-2007) 75 4.4 Summary 75 Chapter Five: Summary, Policy Options and Concluding Comments 76 5.1. Summary of the Study 76 5.2. Policy Implications 79 5.3. Concluding Comments 82 References 85 Appendix A: A Sectoral Weights and Movements of Currencies 88 Curriculum Vitae
v List of Tables
2.1 Countries with Currency Boards or Currency Board-Like System 20
2.2 Hard Currencies and Symbols 27
3.1 Big Mac Exchange Rate 53
4.1 Regression Results 71
A.l Sectoral Weights in US and Canadian Stock Indexes 88
A.2 Movements in Major Currencies versus US$ from 2002-2008 89
VI List of Figures and Illustrations
1 Price of One C$ in US$ 65
2 Price ofOneCS in JPY 66
3 Energy Price Index 66
4 Commodity Price Index 67
VII Chapter One: Introduction
During the past two decades the process of globalization has accelerated and there has been increasing interest in studying the various aspects of this phenomenon. Although the term
"globalization" may mean different things to different people, for the most part it represents an ever increasing trend of a rising volume of trade and a freer flow of capital. The value and volume of world trade has increased more than twenty-fold since 1950 with the value increasing from US$320 billion to US$6.8 trillion in 2006.1
One of the fundamental reasons for international trade between nations is to enjoy consumption possibilities not restricted by the nation's own production possibilities.
Today, almost every nation participates in freer trade and enjoys a much better choice of goods in their markets. Labor migration has increased, but the number of people who are working for foreign companies while staying in their home countries has also grown in recent years. With the increase in merchandise trade and the mobility of labor, it is only natural to expect an increase in international financial market activity that encompasses the vast global foreign exchange market, the international money market, the international bond market, the international equity market, the rapidly growing global derivates market, and the gold market. In this environment, the discussion about the stability of currencies
See "Trade and Globalization" at http://www.globalization 101 .org.
1 has assumed a greater significance. The introduction of the Euro2 to replace 12 currencies in Europe was driven by the desire to eliminate price fluctuations of traded goods and services. The trend in economic globalization can be measured by examining the growth of the volume of trade, foreign direct investments and capital mobility. All these economic indicators have consistently risen for both the developed as well as developing countries during the last two decades.
Globalization is a mixed blessing and as such it has provided both opportunities and challenges. The nation states have become increasingly dependent on the rest of the world.
The markets have become more integrated and prices of freely traded goods and services now respond more readily to the global factors that can affect the market. Thus a war in an oil-producing country, an election in the USA, a strike in Nigerian oil fields, or an accounting scandal inside a multinational can affect asset prices in major international financial markets. A change in the interest rates in a country that has a hard currency, defined as a currency that can be easily converted into other currencies and is a popular international medium of exchange, can impact financial markets all over the world.
In Canada, the value of the Canadian dollar has recently been an important topic of discussion. Every day the press comments on changes in the value of the dollar. On a daily basis Canadians see or hear comments through radio, television, newspapers, and internet
2 The euro is the official currency of the European Union which currently consists of 15 states (Austria, Belgium, Cyprus, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Malta, Portugal, Slovenia, and Spain). It is the single currency for more than 320 million Europeans. Several other countries are going to gradually adopt the Euro. Euro as an accounting currency was introduced in 1999 and was replaced with physical currencies and coins on January 1, 2002.
2 about the exchange rate. In the border regions, posted signs on gas stations and gift shops
indicate the exchange rate.
The value of the Canadian dollar is always fluctuating, and like most goods, it is
influenced by the law of supply and demand. Many factors affect the dollar, for example
the economic situation, the budget deficit and debt, interest rates, political stability, and
speculation on the foreign exchange markets, just to name a few. In general, the Canadian
dollar is compared to the U.S. dollar mainly because the United States is Canada's most
important trading partner.3 Although there is no hard and fast rule of what is the best way
to define an exchange rate, in this study, we shall always define exchange rate as the
nominal value of the Canadian dollar in terms of foreign currencies, and since USA is our
most important trading partner, we shall express the exchange rate as the price of one
Canadian dollar in terms of one U.S. dollar.4 Thus, appreciation in the value of the
Canadian dollar means a higher price for the Canadian dollar and depreciation means a
lower price.
The value of the dollar has a significant impact on trade and cross-border
investments. When the Canadian dollar is strong compared to its U.S. counterpart, exports
from Canada tend to fall because businesses lose a part of their competitive edge. The cost
of all Canadian goods goes up. In contrast, when the value of the Canadian dollar is low;
3 About 77% of Canada's exports and 65% of the imports are between USA and Canada. Source: various Statistics Canada publications. A table summarizing bilateral trades between Canada and its three most important trading partners is available at http://www2.actden.com/WRIT_DEN/gl3/brief.htm.
4 It must be mentioned here that the other way of defining the exchange rate that is the price of a US$ in terms of Canadian dollar is as popular as the way we are defining the exchange rate in the present study. One rate is exactly the inverse of the other.
3 exports rise since Canadian goods appear relatively inexpensive to our trading partners.
This leads to more demand for labor and employment rises.
Imports are not less important than exports and when our dollar is weak we pay
more for our imports, which builds inflationary pressure. Since businesses make long-term
investments and have to realize an attractive rate of return on their investments, it is
important for them to be able to predict costs and revenues for a number of years in the
future. Large fluctuations in the value of the dollar make these predictions not only
difficult, but at times unreliable. There are ways to hedge against future fluctuations, but hedging mechanisms are complex, costly, and provide insurance for a limited amount of time. Most small businesses do not have the capacity to fully understand the sophisticated insurance products such as futures, forwards, and options, and thus often carry out their business remaining wide open to the vagaries of fluctuating currencies.
In this new globally integrated economic environment, understanding the factors that drive the value of the Canadian dollar has assumed a greater significance. Another significance of such an exercise is the fact that Canada is a highly open economy with both export and import roughly being equal to 38% of the GDP.5 By contrast exports account for only ten percent of the US GDP and imports 15%. The significance of the study is enhanced by the fact that the Canadian dollar has gone through a turbulent ride in the last few years touching the all time low against the US$ in 2002 and then gaining more than
50% in the next five years.6 These wild fluctuations hurt the Canadian economy by making
5 Source: Pocket World in Figures, The Economist Newspapers Ltd., 2007.
6 In January 2002, the value of CAD was about US$0.62, and by November 2007 it reached US$1.09. 4 it difficult to predict the costs of imports and price our exports. When the Canadian dollar
was around US$0.62, our exports appeared to be on sale and foreign importers found
Canadian goods and services cheaper.7 The volume of exports rose and this appeared to be
helping the economy. However, with a weak Canadian dollar, costs of imported goods that
include finished products, raw materials, machineries and spare parts rose, and put upward
pressure on our price level. Too much fluctuations of the Canadian dollar make it
unattractive as an asset currency, and instead of making it an attractive investment or
reserve currency it draws attention of speculators whose actions only contribute to further
fluctuations. Thus, the current study of analyzing the factors that contribute to the long-
term influences on the Canadian dollar is timely, and hopefully will have useful policy
implications.
Since fluctuations in the value of a currency are unhelpful for trade, many
economists prefer a fixed exchange rate system to the floating rate regime. Mundel (1961) popularized the concept of an optimum currency area and he still remains a very strong supporter of adopting a common currency for North America. Mundel's idea inspired the adoption of the Euro by more than a dozen nations in Europe. Courchene (1999,2001),
Courchene and Harris (1999 and 2000), and Grubel (1999) have argued for fixed exchange rate or a common currency for USA and Canada, and perhaps including Mexico. Steil
(2007), among others, advocates for forming three currency areas for the entire world; the
Euro, the Dollar, and an Asian Currency.
7 The lowest value of the Canadian dollar in terms of the US dollar was reached on January 18, 2002 which was US$ 0.61918. Source: Pacific Exchange, Sauder School of Business, the University of British Columbia.
5 However, the collapse of the fixed-exchange rate system known as the Bretton
Woods8 system in 1973 has created serious setbacks for the proponents of fixed rates.
Many economists, including Friedman (1988) and Laidler (1999), and important
institutions including the International Monetary Fund (IMF) and the central banks in
Canada, USA, UK, Australia, Singapore, India, Indonesia, and many other countries,
follow a flexible rate. A flexible rate is compatible with the predominant thinking of our
time, namely promotion of free market economy. It is argued that a flexible rate strengthens
shock absorption capacity of an economy, and provides more autonomy for countries to
pursue their own monetary policy.
While short term fluctuations are unhelpful for businesses, persistent weakness or
strength are also not desirable. Persistent strength may not be a sign of a well-performing
economy, rather it can be just because of a high export earnings from one or two
commodities. This kind of strength can lead to a phenomenon known as 'Dutch Disease' a
term coined by The Economist magazine in 1977 to describe the decline of the
manufacturing sector in the Netherlands after the discovery of natural gas in the 1960s.9 In
the 'Dutch Disease' scenario, a country can rely on an easy export such as oil, gas or
minerals, causing its currency to strengthen thereby losing competitive advantage in its
manufacturing exports. Many economists are concerned that Canada is losing out to its
competitors in the manufacturing sector.
In 1944, a fixed exchange rate system was adopted by a large number of countries following a conference in Bretton Woods, New Jersey, USA. Currencies of the participating countries were pegged against the US$ which in turn was convertible to gold.
9 See the Wikipedia for a discussion on the 'Dutch Disease'.
6 Persistent weakness in the value of the currency, although it can help boost exports,
is also not an unmixed blessing. By selling manufactured goods abroad at fire-sale price the
manufacturing sector has no incentive to improve its productivity. Under normal
circumstances, with correctly valued exchange rate the primary source of competitive
advantage will be productivity gains.
A number of recent studies including Francis, Hasan and Lothian (2001) working
with nominal exchange rate data between US-Canada exchange rate have found evidence in
support of long-run purchasing power parity. Pino and Serlatis (2005) in an empirical
paper have found evidence in support of long swings in the value of the Canadian dollar
vis-a-vis US dollar. This is in line with what has been described by Dornbush (1976) as
'exchange rate overshooting' for foreign currencies in general. According to the
overshooting model, currencies move more readily than other variables. In a multi-sector
economy, disequilibrium in one sector may cause changes in another sector. Hence the exchange rate may overshoot to compensate for disequilibrium elsewhere in the economy.10
Antweiler (2002) investigates whether the Purchasing Power Parity holds, whether the volatility of the Canadian dollar has increased over the years, and whether the commodity price shocks and news events are responsible for short-run fluctuations in the value of the CAD. Using quarterly data for three decades (1972-2001), the author has found support for the PPP theory in the long-run; the exchange rate responds slowly to
10 If for example, prices should decline in response to a tight money policy but because of stickiness prices are dropping too slowly, exchange rate adjustment may compensate for it in the interim period and hence lead to overshooting.
7 differences in inflation rates. On an average, it takes four years for the exchange rate to
adjust to the PPP equilibrium.
Antweiler has considered two sources of volatility: (a) commodity price shocks and
(b) announcement effects. In his study, oil and gold prices have been used to examine
whether commodity prices affect the value of the CAD. Gold price has been used as a
proxy for non-oil commodities, and his findings support the hypothesis that the non-oil
commodity prices influence the value of the Canadian dollar in a positive way. In other
words, when the commodity prices go up, the Canadian dollar gains on the foreign
exchange market. However, the oil price did not have any clear positive impact on the
value of the CAD. The author attempts to explain the results by arguing that Canada is a vast country with long cold winters. It consumes a huge quantity of oil, and as a result, a rising oil price does not benefit Canada as much as other oil exporters. It is also generally argued that rising oil price does not always indicate rising demand for commodities driven by world-wide growth. Often, politics have played roles in suddenly raising oil price.
In his study, Antweiler has examined news shocks as a source of volatility. These shocks are felt on the foreign currency market as bad (depreciation) shocks and good
(appreciation) shocks. He argues that a bad news about the Canadian economy or politics create a more pronounced shock than a good news. An upward revision of the expected
GDP growth by Conference Board is an example of good economic news. Similarly, release of declining unemployment figures by Statistics Canada will have positive impact on the value of the Canadian currency.
8 Political news, such as referendum results in Quebec, will impact the dollar. There
is a perception on the financial markets that the Conservatives are better for the economy
than the Liberals. This perception is almost universal and applies to the USA, UK,
Australia and other developed countries. Conservatives by and large favor reduction of
debt and deficits, and favor businesses. Liberals, on the other hand, favor spending on
social programs, and have been reluctant to reduce debts and deficits. However, Antweiler
has not found any conclusive support for this hypothesis in his study.
Finally, Antweiler's findings suggest that the volatility has increased over the years,
which maybe a matter of concern. As it has already been mentioned earlier, the increased
level of volatility raises costs of doing cross-border business. If the direction of the value of
the dollar can be predicted with certain degree of reliability than it is easier to sort out who
will lose and who will gain. It is also possible to adopt hedging strategy which is like
buying insurance. However, in an unpredictable and volatile environment hedging becomes
costly and raises the costs of doing business. Small traders and investors often cannot
afford or understand hedging.
The same author has attempted to link the increasing volatility to an ever-increasing
volume of capital flows. Financial investments across the borders and the activities of
speculators have contributed to the rising volatility that we are observing now.
Murray, Zelmer and Antia (2000) has examined the behavior of the Canadian dollar
from 1997 to 1999 and have found that movements in the world commodity prices and the
Canada-US interest rate differentials can account for most of the variations in the value of the Canadian dollar. These authors have not found any significant destabilizing role of the
9 speculators on the foreign currency market. The authors argue that exchange rate predictions are as reliable as the predictions of the commodity prices and the interest rates.
They also argue that periods of overshooting are characterized by heavy investment positions taken by investors rather than speculators. Investors are guided by market fundamentals. The authors view movements in the value of the currency as regular corrections and if the Bank of Canada intervenes it will only be counterproductive and undermine market efficiency.
The current study is about the equilibrium value of our currency on the foreign exchange market and will concentrate on the period 1970-2008. However, the 38-year period will be broken down into several shorter periods to examine the effects of specific economic and political issues such as the formation of the Organization of Petroleum
Exporting Countries (OPEC) and the rise of the separatist movement in Quebec.
The rest of the thesis is organized as described below. In chapter two, a discussion on how the foreign exchange market works and how exchange rate is managed by different countries is presented; a survey of the literature that have dealt with the fluctuating value of the Canadian dollar is included in this chapter. In chapter three, the various theories of exchange rate determination and how the various exchange rate regimes are implemented, are reviewed. In chapter four, an attempt has been made to analyze empirically the fluctuations of the Canadian dollar. The final chapter presents a summary of the thesis, concluding comments and future directions for research on this topic.
10 Chapter Two: Exchange Rate Regimes, the Foreign Exchange
Market and Performance of the Canadian Dollar
2.1. Introduction
Most industrialized countries, including Canada, manage their currencies using 'the
managed float' model. Under this model of management, the currency is allowed to freely
float with occasional intervention to smooth out extreme volatility. Thus, a managed float
refers to a flexible or floating exchange rate with a varying degree of intervention to
stabilize the value of the currency. Many developing countries are joining this regime to
manage their foreign exchange rates. Under floating or flexible exchange rates, the value
of a currency on the foreign currency market will move. Certain aspects of the short term
and medium term movements are naturally influenced by the guiding forces that will drive the long-term equilibrium.
Although there appears to be a strong trend towards managed float systems, maintaining exchange rate stability is such a complex task that many countries are reluctant to adopt a floating rate or are taking a very cautious approach to replacing the fixed exchange rate system with that of a floating one. Many developing countries have practiced exchange controls for decades and fear that a full-scale conversion will lead to capital flight. Thus many developing countries prefer to use some sort of exchange control whereby the buyer of foreign currencies needs to get clearance in order to convert local currencies into hard currencies. The importance of exchange rate stability is so great that
11 many countries adopt a fixed exchange rate or something similar to it; and use a set of
comprehensive controls to make sure that the domestic currency cannot be freely converted
into a hard currency. Through these control mechanisms, the conversion of domestic
currency into foreign currencies is allowed for productive purposes and restricted (or
prohibited) for wasteful consumption purposes. For example, India allowed its importers of
raw materials, equipment, and spare parts to buy foreign currencies and import these items
to increase domestic production. On the other hand, it discouraged imports of fashionable
goods and pleasure trips to foreign countries by limiting the amount of foreign currencies
that an individual was allowed for these purposes.11
Fixed exchange rates were the norm in many periods, the most recent being the
period between the end of the Second World War and up until 1973. Moving from the gold
standard regimes to fixed exchange rates and then moving on to flexible exchange rates,
indicates a trend that apparently favors the notion that market forces should determine the
exchange rate. At the urging of the International Monetary Fund (IMF) and the World
Bank, many developing countries have abandoned fixed exchange rates and are joining the
floating rate system, albeit a limited one.
There is so much news about exchange rate fluctuations such as headlines stressing the need for China to abandon its fixed rate and the value of the major currencies
continuously flashing through television screens that there is a general feeling that the concept of fixed exchange rates is an outdated concept and is irrelevant to the modern
11 Although the Reserve Bank of India (the Indian Central Bank) has relaxed exchange controls during the last decade, there is still a comprehensive exchange control mechanism in place. For details, see http://www.rbi.org.in.
12 global era. However, this is not the case: the performance of flexible rates has not always been satisfactory and the debate about which rate is better continues and has assumed enhanced significance since the introduction of Euro in Western Europe based on research of Robert Mundell (1961), a Nobel prize-winning Canadian-born economist. In fact,
Robert Mundell's view has not been totally discarded in Canada, and academics (such as
Thomas Courchene) and businesspersons alike, from time to time, raise the issue of going back to a fixed exchange rate or even adopting the USD as the domestic currency.
Thus, in the rest of this chapter we first present a brief review of the on-going debate about fixed versus flexible rates followed by a discussion of the workings of the foreign exchange market, and finally a review of a number of studies that have examined the behavior of the Canadian dollar on the foreign exchange market during the past several decades.
2.2 Fixed versus Flexible Rates
In this section, different types of fixed and flexible rate systems that are being followed by various countries will be discussed. It must be made clear at the outset that we are using the nominal exchange rate in our analysis and not the real exchange rate. The nominal exchange rate is what is commonly reported in the media and is the price of one currency in terms of another currency; in our study it is the price of one Canadian dollar in terms of
USD.
The real exchange rate is an index of a foreign exchange rate that is adjusted for the price level changes in the two relevant countries. So, if the nominal exchange rate for the
Canadian dollar rises by 10%, Canadian goods will be 10% more expensive for the rest of 13 the world. However, if the Canadian price level rises by another 10% while the prices in
our trading partner country remains constant then the real rate has gone up by 21%. Thus,
the real exchange rate (RER) is defined as following:
RER = Nominal Exchange Rate x (U.S. Price Index / Canadian Price Index)
Another definition of index rate that is encountered often is the effective exchange
rate, which is expressed as an index number by taking into account the weights of the value
of trade between a country and its trading partners. If a country carries out 100% of its trade
with just one trading partner then the exchange rate between the two currencies will have
100% of its weight in its effective exchange rate, and there will be no difference between the nominal and effective exchange rates. However, if a country trades with two different countries and the value of trades with each one of them is the same then the effective
exchange rate will be calculated by assigning equal weights to the exchange rates between the home country currency and each of the two trading-partner currencies.
2.2.1 Fixed Exchange Rates
Theoretically, under the fixed exchange rate system, the value of a currency is fixed against a hard currency and the central bank of the country that is fixing the rate remains ready to defend its currency by buying or selling the hard currency at the declared rate. Similarly, the flexible exchange rate refers to a system under which the value of the currency is changing continuously to reflect the changes in the foreign exchange market; in other words, it is the market equilibrium rate determined by the free play of market forces. As we shall see in the rest of the section neither the fixed nor the flexible rate found in real life follow the strict definition described above. 14 There are many variations to the theme of fixed exchange rates but in general under this system the value of a currency is pegged against a hard currency and the central bank stays ready to support that value. Once the value is fixed against one hard currency, the value of the currency against all other currencies is determined via this original peg. Of course at the time of setting the value, the central bank does its best to determine the equilibrium value, but with time this equilibrium changes and the balance of the payment equilibrium has to be restored by using official foreign currency reserves. If there is a chronic disequilibrium then the official reserves will not be able to sustain it. If the currency is over-valued then the reserves will dry up, and if it is undervalued then reserves will swell which often is favored by some countries. Currently, while China has been accumulating a massive build up of foreign reserves, poor countries in South Asia, the Far
East and South America are struggling to maintain their meager reserves at the current level.
In the past, overvaluation of developing country currencies has led to disastrous consequences, the latest being the Far Eastern economic crisis of the late-nineties.
Countries in that region had their currencies pegged against USD and the borrowers found it more attractive to borrow USD at a much lower interest rate rather than borrowing in local currencies at interest rates that were quite high to reflect the high domestic inflation rates. What happened next was quite predictable, and it was not the first time that the global economy witnessed something like this. At the first sign of concern foreign investors and lenders rushed to buy hard currencies to repatriate their capital and it did not take too long for the central banks in the region to admit that they could not continue to sell dollar at a
15 discount because they did not have adequate quantities of it.12 If a currency is overvalued under fixed exchange rate there will always be rising demand to convert that currency into hard currencies. Specifically, if the Thai Baht is pegged against USD at an exchange rate which implies overvaluation of the Baht then demand for the Baht will go down and demand for USD will go up. In other words, fixing the exchange rate between Bath and
USD at a rate that makes USD cheaper and Baht more expensive then it is only logical that the demand for USD will keep on growing. This may lead to a chronic shortage of foreign currencies in Thailand and the Thai central bank will eventually fail to supply enough USD to meet the ever rising demands for it.
When the relevant parties who need to convert Thai Baht into USD start to sense that the foreign reserves have started to decline they take this as an indication that the Baht will be eventually devalued. Speculators and currency traders start to pay special attention to this situation because a small change in the value of a currency can translate into a huge amount of capital gain on the currency markets. The behavior of the central bankers and the speculators can be best summarized by describing the process of how rising flood waters can wash away a dam. At the time of building a dam across a river the engineers estimate the danger mark. When water level rises near the danger mark the neighborhood is evacuated and people anxiously wait to see the consequences of the rising water level.
12 The Far Eastern Economic crisis began in July 1997 in Thailand and rapidly spread to the entire region. Thailand, Indonesia and South Korea, among other countries in the region had pegged their currencies against US dollar and the currencies were over-valued. Investors found it easier to borrow in US dollars and invest in that region where the interest rates were higher. But by the mid- nineties the foreign debts in many of these countries were much higher than their GDP and it was not sustainable. This led to the collapse of the fixed exchange rate. For more on this, see http://en.wikipedia.org/wiki/Asian_financial_crisis.
16 Although it cannot be precisely predicted when the dam is going to collapse, with each
centimeter of rising water, the breaking point comes closer.
Theoretically, the decision to devalue a currency under a fixed exchange rate should
be made by the central bank, but in reality the ministry of finance and the whole
administration in a developing country gets involved in the process. Obviously, it is not an
easy decision and it is perhaps the most disruptive financial decision that the authorities
dislike and almost always resist to make. Thus, often the decision to devalue is taken later than earlier, and there are instances where a series of devaluations take place, and each
successive round appears to be too little, too late. Devaluations have almost always been viewed as failure on the part of the government to manage the economy, and on more than one occasion, devaluations have been cited as the cause for the collapse of governments.
2.2.2. Currency Boards
Since not having adequate foreign reserves may lead to the devaluation of a currency, a special type of fixed exchange rate, a variant of a simple peg based on full reserve backing has been practiced by a number of countries (e.g. Hong Kong) with remarkable success.
Under this system, known as 'Currency Board,' there cannot be any inadequacy of reserves to back the currency. A currency board is a monetary authority that issues its own currency which is convertible into a hard currency, often called the reserve currency or the anchor currency at a fixed rate. A currency board normally operates as the central bank although it does not have the autonomy like a central bank to set policy targets with respect to inflation rates, exchange rates, or interest rates. A currency board is basically a strict form of a
17 fixed-exchange rate whereby unless the board has enough reserve currency it is unable to issue domestic currency.
Unlike a central bank, an orthodox currency board does not lend to the domestic government or to domestic banks. In a currency board system, the government can finance its spending by only taxing or borrowing, not by printing money and thereby creating inflation. In other words, as in the fixed exchange rate system, the fiscal policy is the only available policy to the government. The fixed exchange rate with the anchor currency tends to keep interest rates and inflation in the currency board country roughly the same as those in the anchor-currency country.
Some people have claimed that currency boards are only appropriate for small economies highly open to foreign trade. Historically, though, currency boards have worked well both in relatively large, closed economies and in small, open ones. Official dollarization (using a foreign currency as the predominant or exclusive legal tender) and an orthodox currency board are quite similar. The main advantage of dollarization over a currency board is that dollarization is likely to have somewhat greater credibility because it is harder - though not impossible - to reverse. The main advantage of a currency board over dollarization is that it retains seigniorage domestically.
The most prominent currency board today is that of Hong Kong where the Hong
Kong dollar is linked to the U.S. dollar at HK$7.80 = US$1. Bermuda, the Cayman Islands, the Falkland Islands, Gibraltar, and the Faroe Islands follow more or less orthodox currency boards. In Table 2.1, a list of countries that have a currency board or a currency board-like system is presented. Some economists have mistakenly characterized the monetary systems 18 of other countries - including Singapore and Latvia as currency boards. A central bank can try to act like a currency board, but experience indicates that without a formal commitment embodied in law, the central bank will quickly revert to an active, managed monetary policy that is the opposite of a currency board.
19 Table 2.1: Countries with Currency Board or Currency Board-Like Systems as of
June 2002
Country Population GDP (US$) Began Exchange rate / remarks Bermuda [UK] 63,000 $2 billion 1915 Bermuda $1 = US$1 / Loose capital controls Bosnia 3.8 million $6.2 billion 1997 1.95583 convertible marks = 1 euro / Currency board-like Brunei 336,000 $5.6 billion 1952 Brunei $1 = Singapore $1 / Currency board-like Bulgaria 7.8 million $35 billion 1997 1.95583 leva = 1 euro / Currency board-like Cayman Islands 35,000 $930 1972 Cayman $1 = US$1.20 [UK] million Djibouti 450,000 $550 1949 177.72 Djibouti francs = US$1 / million Currency board-like Estonia 1.4 million $7.9 billion 1992 8 kroons = 0.51129 euro / Currency board-like Falkland Islands 2,800 unavailable 1899 Falklands £1 = UK£1 [UK] Faroe Islands 45,000 $700 1940 1 Faroese krone = 1 Danish krone [Denmark] million Gibraltar [UK] 29,000 $500 1927 Gibraltar £1 = UK£1 million Hong Kong 7.1 million $158 billion 1983 Hong Kong $7.80 = US$1 / More [China] orthodox since 1998 Lithuania 3.6 million $17 billion 1994 3.4528 litai = 1 euro / Currency board like Source of population and GDP data: CIA World Factbook 2001.
20 2.2.3. Flexible Exchange Rates
Many different terms are used to refer to the flexible rate. Managed float or 'dirty' float is the most common form of flexible rate that is found in real life. The monetary authority of each country watches its exchange rate with interest and does not stand by to watch its currency fluctuate too much. Although under flexible rate the market is supposed to determine the exchange rate, the monetary authorities do not want too strong or too weak a currency for their country. The central bank monitors the value of its own currency constantly and it interferes regularly to stabilize the currency.
In the case of Canada, interventions take place in many different forms that range from statements from the Bank Governor, Finance Minister or even the Prime Minister to direct intervention in the market by buying or selling Canadian dollar. Short term interest rate changes are used from time to time to stabilize the dollar. As it has been mentioned already, and must be emphasized again, the goal of the Bank of Canada is not to see a stronger dollar but a stable dollar. This particular message is lost when at times we find the government takes credit for a strong dollar and comes out emphatically to support the value of the dollar when it declines sharply. As mentioned before, the declining value of currency in developing countries has often been interpreted as failure on the part of the government to manage the financial affairs of the country. Likewise, in Canada a weak value of the Canadian dollar has often been used by opposition politicians as an indicator of poor economic management by the government.
21 2.2.4. Advantages and Disadvantages of Fixed Exchange Rate
We shall present here the advantages and disadvantages of the fixed exchange rate regime. By doing so we are also presenting the disadvantages and advantages of the flexible exchange rate because the advantages for one regime are basically the disadvantages for the other.
Reduced risk in trade and investment
Under the fixed exchange rate, the exporters and importers of goods and services can predict their costs and revenues and they do not have to deal with the risk of an exchange rate change. Likewise, the foreign investors can clearly predict their costs of investment and the rates of return. The stability of fixed exchange rate promotes trade and investment.
Discipline in economic management
In order to sustain a fixed exchange rate, the governments have to follow responsible and credible economic management policies. Price stability is essential, but having no control over monetary and exchange rate policies, governments have to be extra careful with fiscal policy. An economy under fixed exchange rate cannot run current and capital accounts deficit because these will ultimately lead to the abandonment of the fixed exchange rate regime. Similarly, a rising unemployment rate must be fought with fiscal policy alone and too much of an expansionary fiscal policy will create inflationary pressure.
If the inflation rate in the domestic economy is higher than the inflation rates in its trading partners, then Purchasing Power Parity will eventually take effect and the currency has to
22 be devalued. Thus, to fight unemployment problems, the government should look for other tools in addition to fiscal policy. For example, retraining the unemployed can lower structural unemployment and dissemination of job market related information can reduce frictional unemployment.
In order to maintain fixed exchange rate, the government has to manage the economy in a credible and responsible way. If the international bankers, cross-border traders and investors, currency speculators, international financial agencies, governments in trading partner countries, and all other interested parties feel that the pegged currency does not reflect the true equilibrium value, then the fixed rate cannot be maintained and defended. There are several countries interested in joining the Euro area and the terms and conditions for joining include proof of responsible fiscal behavior on the part of the government. Joining Euro area is a form of adoption of fixed exchange rate and the requirements clearly state that fiscal discipline is essential to join.
Estimation of speculators
Speculators buy and sell foreign currencies to make money but their activities create instability in the value of the currency. It is not unusual on the part of the speculators to make large bets against a currency which can ultimately sink it on the foreign currency market. All these can happen only for a currency that is freely trading on the foreign exchange market. A currency, the value of which is fixed, does not attract speculator's attention unless there are sufficient grounds to believe that the currency will be devalued or revalued by the government.
23 Having considered the advantages of fixed exchange rate we are now in a position to review the disadvantages of adopting and maintaining a fixed rate. There are several disadvantages but here are the more important ones.
No automatic balance of payment adjustments
Under a floating exchange rate system, the external imbalances are automatically corrected through exchange rate adjustments. If there is a balance of trade deficit, the currency loses its value on the currency market thereby making imports more expensive and exports cheaper. The process continues until the deficit is corrected. Similarly, recurring surpluses in the Balance of Trade are not possible because the currency appreciates and necessary adjustments take place.
Under the fixed exchange rate system, there are no automatic mechanisms to correct trade deficits. The problem may be solved by reducing aggregate demand which in turn will reduce the price level and consequently export should rise and import falls. It is a round-about process which may take some time to yield the desired results.
Foreign reserve holdings
In order to defend a fixed rate, large quantities of foreign reserves have to be maintained by the central bank. These reserves obviously have opportunity costs.
Loss of freedom to conduct monetary policies
A country that pegs its currency against a hard currency virtually relinquishes its rights to conduct its monetary policy. Monetary policy is a powerful policy option for a
24 country and it is tied to the issue of national sovereignty. An independent monetary policy is seen as an essential policy tool to implement overall national economic policy. The
Bank of Canada is a well-run bank, and many economists feel that for it to give up its monetary policy functions will not be in the best interest of the country.
2.3. The Foreign Exchange Market
The foreign exchange market is a diverse and huge market. There are as many foreign currencies as there are sovereign nations with the rare exceptions of a very few countries that use another country's currency as their own or who have adopted a common currency such as Euro.13 With an average daily transaction of over $3 trillion the size of the market is enormous and is more than three times the total amount of the stocks and futures markets combined.14 The dominance of derivative instruments on this market makes it the most complex of all the financial markets. To top it all the market is virtually open round the clock and there is a saying in the financial sector that only the young and agile can withstand the stress and pressure of trading foreign currencies.
The Foreign Exchange Market (FOREX), unlike other financial markets, does not have a physical fixed address or a central exchange. The market is an electronic market and operates through a network of banks (central, commercial and investment), corporations and individuals trading one currency for another. Access to the FOREX markets by the internet has attracted individual traders with small amounts of capital to participate in this
For example Panama does not have its own currency but uses US dollar instead.
14 Triennial Central Bank Survey, Bank for International Settlements, (April 2007).
25 enormous market place. The lack of a physical exchange allows the market to operate round the clock spanning from one time zone to another as the sun rises from the East and moves towards the West.
The foreign exchange market performs several functions out of which the following three are the most important:
(1) It transfers purchasing power from one currency to another;
(2) It provides foreign currency loans that are essential to facilitate international
trade;
(3) It provides a mechanism to hedge foreign currency risks.
The transfer of purchasing power is the oldest and most important justification for the existence of foreign exchange markets. The other two functions are logical extension and development of the first function.
Spot Market and the Major Currencies
The spot market refers to present dealings where currencies are delivered immediately meaning within two days. The practical working of the market is useful to understand what happens in the short run. Currencies are traded through brokers and dealers and are executed in pairs such as the Canadian Dollar and Euro (CAD/EUR) or the Canadian Dollar and US Dollar (CAD/USD). In the following table the major currencies that are traded have been arranged in descending order of the volume traded. The currency symbols follow a three-letter system that clearly indicates of the country and its currency the only
26 exception being CHF for Switzerland where the name is derived from Confederation
Helvetica.
Table 2.2: Hard Currencies and Symbols
Symbol Country Currencies
USD United States Dollar
EUR Euro Members Euro
JPY Japan Yen
GBP Great Britain Pound
CHF Switzerland Franc
CAD Canada Dollar
AUD Australia Dollar
Who Trades Foreign Currencies?
It is important to understand who trades foreign currencies and why. The traders can be grouped into two groups. The first group includes the traders of goods and services across international boundaries. About five percent of daily volume is from governments and
27 businesses that buy or sell products or services in a foreign country and must subsequently
convert their profits into local currencies. It is just not the profit but payments for exports
and imports often are required in foreign currencies and hence the domestic currency has to
be converted into a foreign currency before the payment can be made, and the export
receipts have to be converted into domestic currencies so that the businesses can run their
local operations. Often, two nations trading between them use a third country currency, an
invoicing currency, to carry out the trade.
When Bombardier in Montreal sells planes to Chinese airlines, those airlines
convert their emnimbi (RMB) into US dollars to pay for these planes because most of the
high-price items such as locomotives and planes are priced in USD for the international market. Most of the world trade is conducted using just a few hard currencies where USD has its major share of it followed by Euro. More than 80% of US imports are priced in
USD but the comparable figures for Japan and Germany are 20% and 30% respectively.15
When a party enters into a foreign trade contract that will generate an amount of foreign currency, it may like to sell that foreign currency in the Futures market to make sure that in the intervening period there will not be a considerable change in the exchange rate that will reduce significantly the value of the amount when it is received.This is known as hedging. Going back to our example of Bombardier selling its planes to Chinese buyers it is only natural for Bombardier executives to be worried about their costs, revenues, and profits in Canadian dollar terms. Thus, when they contract a sale with Chinese airlines to
15 US dollar is the most popular invoicing currency in international trade.
28 sell planes they are receiving USD and any adverse change in the value of USD/CAD will affect its profit margin. The simplest of hedge will be to sell USD and at the same time buy
CAD so that the company knows their receipt in terms of CAD.
The second group who is responsible for the remaining 95% of the trading in currencies consists of investors and speculators who trade for profit. Speculators range from large banks trading $ 10m or more to individual home-based operators trading $10,000 or even less.
So, there is a large number of participants in the foreign exchange market and the list includes importers, exporters, international portfolio managers, multinational corporations, investors (long-term holders ), speculators (short-term traders), hedge funds, investment banks, commercial banks, central banks, and governments. These parties use the
FOREX market to pay for goods and services, to transact in financial assets, or to reduce the risk of their exposure in other markets.
Every foreign currency trade involves two currencies. For example, a speculator simultaneously buys a currency and sells another currency. He or she has no inherent liking for one currency or the other. The hedger, on the other hand, trades to protect his or her profit margin from a sale, as in the case of Bombardier, from adverse movement in the value of the invoicing currency. The hedger has an interest in one side of the market but the speculator does not.
29 Importance of the Foreign Exchange Market
It has already been mentioned how the importance of foreign exchange market has grown
in the last two decades. Globalization and the spread of internet technology both have
enormously contributed to the growth and development of the foreign currency market.
The internet has enabled all the participants to share and disseminate relevant information
about the currency market. In addition internet has made it easier and less costly to
participate in the FOREX market, and a s a result a large number of small traders, who
were previously locked out, have been attracted to the market.
In today's market, the US dollar constantly fluctuates against other currencies and the updates on exchange rates are regularly broadcast as weather forecasts. A lower yield
on the bond market, lower borrowing costs that have prevailed for the much of the current
decade, easy access to foreign currency market, a more educated class of investors who
invest in the financial markets today, all of these have helped the foreign exchange market to grow. The globalization has increased trade and commerce as well as investments in all types of financial instruments. This phenomenon and the resulting fluctuations in the values of hard currencies have created a huge international FOREX market. For many investors, the FOREX market has created new opportunities and profit potentials.
The FOREX market is quite different than stock or bond markets and for traders it offers different kind of opportunities that are not available in other financial markets. The
FOREX market offers profit potential in any market condition or in any stage of the business cycle. The following is a list of distinguishing factors of the FOREX market.
30 • No Commissions: There are no commissions, clearing fees, exchange fees,
brokerage fees, or government fees to trade foreign currencies. The bid/ask spread
provides enough compensation for the banks and other intermediaries who
participate in market making. For retail customers the bid/ask spread is typically
less than 0.1 percent. By way of comparison the commission for trading stocks
generally ranges from $10 with discount brokers to $100 or more with full-service
brokers just to buy a board lot of 100 shares of any company. So, depending on the
price of the stock the commission can often be one percent or higher of the
transaction value.
• No Middleman: Clients on the spot market trade directly with one another and the
market maker is responsible for pricing of the relevant pair of currencies.
• No Fixed Lot Size: Unlike the stock market there are no fixed lot sizes of trades.
There are no board lots or standard contract size as in the stock and commodity
markets. On the spot currency market the trader determines the lot size and this is
why a trader can participate in the foreign exchange market with a very small
amount of capital, say as little as $1,000.
• High Liquidity: With an average trading volume of about $2.0 trillion daily the
FOREX market is the most liquid market in the world. Because of this high
liquidity a trader can execute a trade instantaneously in any of the major currencies
(USD, EUR, JPY, GBP, CHF, CAD and AUD) and the most frequently traded
minor currencies such as New Zealand dollar (NZD), the South African rand (ZAR)
and Singapore dollar (SGD). Another aspect of this liquidity is a very tiny
31 fractional change in the value of the currency. While in stock markets the price of
stocks changes by a cent in the Forex market price of a currency, say USD, changes
by one-hundredth of a cent called a 'Pip'.
The bid and ask prices are expressed using up to four decimal points. For example
in the quote USD/CHF 1.4527, the bid price is CHF 1.4527 to buy one USD.
The buyer is willing to pay this much for one USD.
• A 24-hour market: There is no opening or closing bell for the FOREX market. It is
open round the clock.
• High Leverage: The margin requirement for FOREX trading is very low and as a
result a trader can engage in highly leveraged trade that magnifies profit and loss
both. The margin requirements vary from brokers to brokers and can be as low as
1% of the investment. In other words, an investor with only $1,000 in the account
can buy a foreign currency worth $100,000.
• Interbank Market: The backbone of the FOREX market is the global network of
major commercial banks that act as dealers in foreign exchange. They communicate
with one another and their clients through electronic networks and by phone. There
is no organized market similar to New York or London stock exchanges that work
as central locations to facilitate transactions in stocks. The Forex market is more
similar to NASDAQ market which is basically an electronic network of dealers. 16
NASDAQ is the acronym for National Association of Securities Dealers Automated Quotations system.
32 • Relationship with the Stock Markets: The Forex market is not linked with the
business cycle or the stock market cycle. Stock markets move through bullish and
bearish phases, and move up when the economy is expanding and often perform
poorly during recessions. Moreover, most major stock markets move up or down
together.17 Unlike the stock market, for the Forex market there is no bull or bear
market for the currency market as a whole; if there is bullishness about one currency
then there will be bearishness about another. When USD is losing grounds, other
currencies such as EURO, CAD or JPY, are gaining grounds. One can short USD
or go long with Euro, JPY and CAD.
• No one can corner the market. The Forex market is too huge and it is difficult to
corner the market, although at times multi-billion dollar hedge funds such as George
Soros' Quantum Fund has been blamed for inflicting damage to some ailing
currencies but most of them are developing country currencies. In general, for the
four the four most important currencies (USD, Euro, GBP and JPY), it is difficult to
unduly influence the value on the Forex market.
• Insider trading: Given the vast size of the Forex market, there is not much scope for
using inside information to make gains. Possibilities of committing fraud are much
less here than in the stock market.
A large number of studies have found a high degree of correlation between market indices for USA, Canada, Western Europe, Hong Kong and so on.
33 • Limited regulations: There are not much government regulations in the Forex
market primarily because there are no centralized trading exchanges. In contrast
stock exchanges are quite heavily regulated.
• Forex versus Stocks: There are approximately 4,000 stocks listed on New York
Stock Exchange and another 2,800 on NASDAQ. If we add the number of stocks
listed on TSE, London, and other major stock exchanges then we are looking at tens
of thousands of stocks that are available to a stock trader. However, for Forex
trader there are only eight major currencies and seven possible major USD pairs to
consider. Researching just seven major USD pairs instead a much larger set of
stocks makes it much easier to trade Forex rather than stocks.
• Futures: Forex futures or forward contracts are not used much and almost all
activity is in the spot market where rollover contracts are used to buy time.
All these above factors have contributed to growth in the Forex market with an ever increasing volume of trade carried out by an increasing number of participants who are trading for commercial and investment purposes. The above discussion gives a good idea about the size of the foreign exchange market and its workings and we now turn to a brief discussion of the historical value of the Canadian dollar.
2.4. Historical Value of the Canadian Dollar
A comprehensive historical review of US-Canada exchange rate is available in Powell
(1999), which goes back to the beginning of the last century, but in this section we decided to limit our coverage to the post Second World War period. As it can be seen from this
34 review the Canadian dollar has been fairly volatile. This section heavily draws from two sources Powell (1999) and Huq (2005).
In 1949, Canada established with International Monetary Fund (IMF) under Bretton
Woods System a par value of US$0.9091, with a fluctuationban d of one percent (snake in the tunnel). In 1950 Canada decided to float its currency. Such floating regime was unpopular with business circles, but favored by academic economists as a means to insulate the domestic economy from external shocks, either inflationary or deflationary.
After a quick rise to US$0.95, CAD appreciated more slowly, and by 1952 had a
2% per cent premium. Between 1952 and 1960, CAD traded between USD 1.02 and 1.06, reaching a peak of USD 1.0614 in August 1957. Foreign exchange intervention was limited to smoothing the short-run fluctuations. Substantial capital inflows attracted by high interest rates contributed to a very high value of the CAD. However, concerns arose about the decline in Canadian competitiveness on the export market because of strong dollar. As a result economic activities slowed down, with unemployment rising from 3.4% in 1956 to
7.2% in 1961.
A policy dispute between the government, which wanted an easy money policy, and the central bank, which did not, became a serious one. The Finance Minister, Donald
Fleming, wanted to lower the value of CAD, by buying USD and selling CAD, a policy with inflationary potential. The finance minister also wanted an easy money policy which would have lowered the interest rate and helped fight unemployment, but lower rate would also put a downward pressure on the Canadian dollar. The central bank governor, James
Coyne, resisted these policies and he was forced to resign; the dispute between the
35 governor and the minister is known as 'Coyne Affair".18 CAD fell to USD 0.96 by
October 1961.
What followed was a "managed" float system, under which the government would intervene to keep CAD at a significant discount to USD. No par value, as was required under Bretton Wood System, was established right away. Later, in May 1962, the par value of CAD was fixed at USD 0.9050. Lack of confidence in CAD led to continuing pressure on the currency requiring heavy foreign market intervention. A major economic and financial program involving tight fiscal/monetarypolicy , temporary import surcharge, and
USD 1,050 million in international financial support was implemented. This program restored confidence in CAD. Barring some occasional pressures (due to US interest equalization tax in 1963 and US controls on capital outflows in 1968), the arrangement worked reasonably well. However, due to higher commodity prices, strong demand for
Canadian exports turned a sizable current account deficit into a large surplus. Attractive
Canadian interest rates also produced sizable capital inflows. Both of these created upward pressure on the exchange rate. The market intervention to keep external value of Canadian dollars led to a rise in international reserves.
Higher reserves also raised the expectations of a revaluation (upward valuation) which encouraged speculative short-term inflows into Canada. All these had a strong
18 James Coyne affair is a classic case that is studied by central bankers everywhere. The crux of the controversy lies in the debate about how much freedom the bank governor should have so that politics of the ruling party cannot influence the bank activities. In order for the public and the rest of the world to have confidence in the financial system of a country the central bank must be very much autonomous. It must be mentioned here that the Federal Government has not interfered in the affairs of Bank of Canada ever since the Coyne Affair took place.
36 expansionary impact on money supply and inflationary expectations. A higher par value was not fixed in the fear that it could have been interpreted as the first in a sequence, which would have encouraged further speculative inflows. In May 1970, CAD was floated again.
Throughout the 1970s, CAD appreciated reaching a high of USD 1.0443 in April
1974. Such strength was largely due to the higher prices of raw materials and also the perception that the Balance of Payment position of Canada was not likely to be as much affected by the tripling of oil prices as other major industrial countries. General weakness of the US dollar was also a factor.
The strong CAD with its impact on export sector was a cause for concern. Banks with government approval introduced interest rate ceiling on large, short-term (less than one year) deposits that narrowed positive interest differentials vis-a-vis US. This was intended to moderate such short-term inflows. CAD weakened somewhat, but later, when monetary policy was tightened to address rising inflationary pressure, the exchange rate went up again to U$1.04 in summer 1976.
Reversal was to follow soon. Political situation in Quebec, softening prices of non- energy commodities, rising cost and wage pressures in Canada, substantial current account deficits, all encouraged heavy sell-off of the dollar. It fell to US$0.84, but recovered to
U$0.87bytheendofl970s.
The CAD weakened sharply during the first part of 1980s, as a result of continuing weakness in commodity prices, concerns about policy commitment to fight inflation and significant strengthening of USD against most other major currencies. A record low of
USD 0.6913 was reached in February 1986. The second half of the decade however saw 37 CAD rebound following an aggressive intervention in the foreign exchange market, sharply higher interest rates and large foreign borrowings by the federal government. The CAD closed the 1980's at USD0.8632.
The CAD continued to climb till 1991 when it reached USD0.8934, but fell sharply to USD0.7868 in 1992. Lower interest rates were part of the explanation. Other factors were persistent budgetary problems, softening commodity prices, and large current account deficits. The CAD became relatively stable in 1995 and 1996 as a result of higher interest rates, improvement in the fiscal situations, improvement in the Balance of Payment and a diminished focus on constitutional issues. It traded in a narrow range close to USD 0.73.
Since 1997, there has again been a weakening of the CAD despite strong economic fundamentals: very low inflation, moderate economic growth, and solid government finances. This weakening can be attributed to: lower commodity prices, negative interest rate differentials between Canadian and US financial instruments, and the US dollar's role as a safe-haven currency. The CAD reached an all-time low of USD0.6311 in August
1998. Since then the Canadian dollar gained slowly and in 2003 fluctuated between
USD0.64 and 0.76. During the last five years the dollar has further gained with the support of high commodity prices, current account surpluses, low inflation rates, and declining budget deficits. However, it must be stressed here that a significant portion of the gain against USD is not due to anything made in Canada but because of a weakening USD
38 against all major currencies. While currently the dollar is trading around USD 0.82, it
traded at parity or at times even stronger than parity in 2007. 19
As CAD gained against USD in 2007 the same old question of a strong Canadian
dollar hurting exports became important. The issues of fixed versus floating rate and
market intervention by bank of Canada resurfaced. On May 5, 2007, David Dodge,
Governor of Bank of Canada, reiterated the bank's policy and spoke about the benefits of a
floating exchange rate regime.
"Let me say that the greatest benefit Canada has found with a floating currency is
the way in which it helps the economy deal with economic shocks. It has allowed the Bank
of Canada to keep inflation rate near the two percent target."20 Thus, Canada is committed
to a floating exchange rate system and the value of the Canadian dollar in terms of USD is
the main indicator of the strength and weakness of our currency. Unfortunately, USD as
our benchmark currency is not exactly as stable as we would have liked it to be. In order to
appreciate whether the change in the value of CAD is more dramatic than other currencies,
it must be mentioned here that the exchange rate used here is the price of a CAD in terms of
USD. However, in recent years USD has lost grounds against many other hard currencies.
For example, between January 200 and December 2007, the USD has lost about 30%
against both the CAD and Euro.21
On July 11, 2007 the Canadian dollar traded for USD 1.09. Source: Pacific Exchange, UBC.
20 David Dodge, Governor of the Bank of Canada quoted in The Globe and Mail, May 5,2007.
21 The monthly average of CAD/USD for January 2000 was 1.45 and for December 2007 it was 1.00. During the same period EUR/USD dropped from 0.99 to 0.69. Both the currencies gained against USD as the price of USD in terms of CAD dropped 31% and in terms of Euro it dropped 30%. 39 2.5. A Survey of Recent Research on the Value of the Canadian Dollar
Choosing an appropriate exchange rate regime for Canada has been a subject of
long standing debate and a number of studies have attempted to address the issue of the
fluctuating value of the Canadian dollar and what is the best way to manage the external
value of the currency.
Several economists have advocated for a North American Monetary Union where
USA, Canada and Mexico will adopt a common currency following the example of the
European Union. Grubel (1999) argued that a new currency should replace the existing
currencies of the three NAFTA countries and the currency should be called Amero which
definitely sounds like Euro. Courchene and Harris (1999, 2000) and Courchene (1999,
2001) have argued that a monetary union will benefit all the three countries that form
NAFTA and offered interesting ideas about how to maintain separate currencies for the
three countries while in effect a strict form of fixed exchange rate will replace the
independent monetary systems. They suggest that USA should continue to use its dollar but
Canada and Mexico should introduce new currencies to replace the old ones and the value
of the new currencies will be strictly pegged. The new currencies should be issued by a
newly formed North American central bank.
Courchene (2001) argues that the world economy will be dominated by two major currency zones: the European and American. In this context, Courchene concludes that
Canada will not have a choice between having a flexible exchange rate versus a fixed exchange rate. The choice will be between "dollarization" and North American Monetary
40 Union (NAMU). Courchene then goes on to argue that NAMU is a superior option compared with dollarization.
The idea of a single currency for North America is not a new one and the discussion has surfaced from time to time. There are some Latin American countries that have adopted the US dollar as their own currency. Ecuador unilaterally dollarized in September
2000 and Panama has used the US dollar as its own currency since 1904. Thus, the question of adopting the US dollar as the currency for both Canada and Mexico will never disappear from serious discussions. At this point it must be stressed that adoption of US dollar versus creation of a new monetary unit for North America has some important differences.
Creation of a monetary union with a single central bank responsible for the monetary policy for all the countries in the union is different than simple dollarization. Creation of a monetary union requires active cooperation between the countries involved. A new currency regime is built with a central bank for the entire expanded region. All national monetary policies have to be abandoned in favor of a shared monetary policy.
A Canadian Noble prize-winning economist, Robert Mundell, has been the most ardent advocate of fixed exchange rate. Mundell (1961) explained how a common currency for an optimal currency area can benefit all the participating countries. Mundell's logic has been used by Benn Steil (2007), among others, to advocate for reduction in the number of currencies in the current global world. There are more than one hundred and fifty fluctuating fiat currencies in the world today. There is no denying of the fact that fluctuating currencies hurt trade and eventually affect production and incomes.
41 Steil (2007) makes a very interesting suggestion. He argues in favor of reducing the number of currencies from more than one hundred and fifty to only three. According to him Euro is performing remarkably well and more and more countries will be anxious to join the European Union. The U.S. dollar is used by several countries and a number of countries including Malaysia, the UAE, Saudi Arabia, and to a lesser extent China are using fixed exchange rate against the dollar. These economies are performing well. Another example that is often cited by the proponents of monetary unions is the smooth trade and capital flows between provinces and states, such as New York and California, two of the world's twelve largest economies. Similar argument applies when we compare Ontario and
Quebec.
The proponents of reduction in the number of currencies present a scenario where
China with its more than a trillion dollar foreign reserves should liberalize its financial and capital markets. Other Asian economies should cooperate with china to come up with a
Pan-Asian currency. Countries outside the monetary unions should adopt one of the three international currencies: dollar, euro and Pan-Asian currency.
Obviously, not everybody agrees that a highly simplified world with three currencies will solve all the complex problems of trade and finance that we are facing now.
Milton Friedman (1988), as the leading monetary economist, is the most vocal advocate of the power and effectiveness of monetary policy. By abandoning the use of the monetary policy, a country will severely restrict its ability to manage its economy. Monetarists have successfully convinced the central bankers in many countries including the USA and
Canada to follow a flexible exchange rate regime. The International Monetary Fund (IMF),
42 the central bank of central banks, has been steadfast in promoting flexible exchange rate to
all its member countries. Adoption of fixed exchange rate of any kind amounts to passively
following the interest rate policy of the anchor currency against which the domestic
currency is pegged. For example, countries that have pegged their currencies against the
U.S dollar are now experiencing inflationary pressure as the U.S dollar has lost in the last two years against all major currencies.
By pegging against the U.S dollar, Hong Kong, China, Bangladesh, UAE, Saudi
Arabia and many other countries have indirectly devalued their currencies in recent years.
These countries are paying more for their imports and receiving less for exports. China, which is slowly and reluctantly moving away from a strict peg against U.S dollar, is finally feeling the inflationary pressure that is seeping through higher import costs.
Although the discussion of adopting a fixed exchange rate or even a common currency with USA or outright dollarization surfaces from time to time, the support for a flexible exchange rate regime has grown over the years in Canada. The Bank of Canada claims that it is getting better at predicting the value of the dollar, the dollar is responding well to Purchasing Power Parity and Covered Interest Parity theories, and a flexible dollar is protecting the country from undue inflationary pressures in times like now. 22 It further argues that the monetary management is an important tool and it is serving well for our economy. The Canadian dollar is a hard currency and it is gaining in popularity in
Mark Carney, Governor of the Bank of Canada, argued against pegging loonie to greenback. See the Globe and Mail Update, December 5,2007. www.theglobeandmail.com/servlet/RTGAM.20071205.wcarneyl205/
43 international trade. A number of recent studies carried out by the economists working at the
Bank of Canada and other economists have found support for many of the above claims.23
David Laidler (1999) has considered the pros and cons of alternative exchange rate
regimes including adjustable pegs, currency board and the current monetary order of
Canada based on inflation targets and a flexible exchange rate. He concluded that all the
variants of fixed-exchange rate regimes were inferior to the current arrangements. Given
the fact that cross-border labor mobility was limited and prices and wages were sticky in
both the countries, a flexible exchange rate regime was better in that environment. Since nothing has changed since then, Laidler's conclusions will remain unchanged.
2.6. Summary and Concluding Comments
In this chapter, we have first discussed the difference between the fixed and the flexible exchange rates, and when a country adopts one or the other exchange rate regime how it is managed. If a country wants to adopt fixed exchange rate policy then it has to fix the rate as close as possible to the market equilibrium rate. The next important task is to defend that rate. Historically, it has been a problem for almost every country to maintain a fixed rate for a considerable length of time. Some countries have gone to the extreme of considering using a hard currency as their domestic currency, while some other countries have formed currency boards, which mean issuance of domestic currency against foreign currency reserves.
See Francis, Bill, Iftekhar Hasan and James Lothian (2001) and Bailliu, Jeannine (2005)
44 The flexible rate is also not one hundred percent market determined rate. Almost all
the countries with flexible rate manage the value of their currencies on the foreign
exchange market. Thus, the flexible exchange rate is better described as managed float.
There is an on-going debate over which regime is better and the recent formation of
the Euro area and adoption of a common currency by 13 European countries has provided
new incentive to those who argue about forming other currency areas including one in
North America that will see US dollar or a newly introduced currency as the common
currency for USA and Canada and perhaps for Mexico also.
Many central banks including the Bank of Canada favor the flexible exchange rate
because it allows the central banks to use the monetary policy as a tool to manage the
economy. Many economists who are strong adherents of the free-market economy model
support the flexible exchange rate regime; the International Monetary Fund strongly
supports the flexible rate.
After discussing the advantages and disadvantages of the two dominant exchange rate regimes, the chapter presents a brief review of the existing work on the Canadian experience. Canada has gone through periods of fixed rate followed by flexible rate. Since,
1973, Canada has been following the managed float system which is basically the flexible rate with interventions by the Bank of Canada from time to time. Although during this period, the Canadian dollar has fluctuated and at times has overshot the equilibrium values but the currency has ultimately settled down to its fair value.
Although short term fluctuations introduce uncertainty in cost and revenue forecasting and are costly for businesses, most economists feel that maintaining the flexible exchange rate is in the best interest of the Canadian economy. Given the dominant size of
45 the US economy which is about 12 times the size of the Canadian economy, it is not practical to form a common currency area with USA.24
The value of the Canadian dollar is closely linked with the commodity prices and the rising volatility in the commodity prices has caused similar volatility in the value of the currency. As the Canadian economy diversifies itself and the service and the manufacturing sectors grow that will lower the volatility.
24 GDP figures are from the Pocket World in Figures, 2007 published by The Economist, London, England.
46 Chapter Three: Theories of Exchange Rate Determination
3.1. Introduction
In this chapter, a review of the theories of exchange rate determination is presented. The
theories of exchange rate try to explain the factors that determine the equilibrium exchange
rates and why exchange rates fluctuate. It must be emphasized at the beginning that much
of what is presented as theories of exchange rate determination is relevant only for flexible
exchange rate system and have indirect relevance to fixed exchange rate system. In other
words, under fixed exchange rate system, the monetary authorities do examine the
economic fundamentals before determining the appropriate fixed rate and the fundamentals
remain relevant as the fixed rate has to be revised from time to time.
The theories of exchange rate determination may be divided into two types - the traditional theory and the modern theory. The traditional theory is based on international trade considerations. The foundation of the modern theory is anchored in asset markets.
The traditional theory which is based mostly on commodity market is called the Purchasing
Power Parity (PPP) theory and the modern theory which is based on asset market is called the Interest Rate Parity theory. Monetary approach and Portfolio balance approach are
included in the asset theory.
3.2. Various Theories of Foreign Exchange Rate
In this section Purchasing Power Parity (PPP) theory is presented first followed by the
Modern Theory. The PPP theory emphasizes the role of trade as the main determinant of
47 exchange rate whereas the modem theory considers demand and supply of financial assets
and the consequent demand for the currency in which the assets are denominated. Another
difference between the two approaches is that the PPP theory is a long-run theory and the
asset theory attempts at explaining the short term fluctuations.
3.2.1. Purchasing Power Parity
Purchasing power parity is one of the main theories of exchange rate determination. This is
also called the inflation theory of exchange rate. This theory was developed by Swedish
economist Gustav Cassel. He called the PPP as the "inflation theory of exchange rate". It
is based on the law of one price. The law of one price states that when measured in a
common currency, freely traded commodities should cost the same everywhere excluding
the transaction costs. In other words, freely tradable goods should cost the same across
borders adjusted for shipment costs. It must be emphasized here that the phrase 'freely
traded' refers to an environment where there are no trade barriers in the form of taxes and
quotas.
There are some good examples for PPP in real life where we find that gold, silver,
oil and foreign currencies sell for the same price in every market adjusted for local taxes
and subsidies. If USD price of Yen is higher in Tokyo and lower in London, immediately
arbitragers will buy where it is cheaper and sell where it is dearer to make a quick profit.
The same thing applies to gold price which converted into USD sells at more or less the
same price in Shanghai and Toronto. Similarly we expect, and the PPP theory supports, that the price of tractors, automobiles or sheet steel to be related across geographically different
48 markets. However, there are sound economic reasons that explain why prices of some goods are more similar across countries than others.
The tendency for similar goods to sell for similar prices across international boundaries is the principal foundation of the purchasing power parity theory. If prices in one country rise more rapidly than in its trading partners then the exchange rates must adjust so that similar goods cost more or less the same when the prices are converted into a common currency. In other words in a world with a varying degree of inflation across countries the currencies of those countries that suffer a modest rate of inflation would gain against the currencies of the countries suffering from a higher rate of inflation. Yet, another way of putting the same argument is if a currency can only buy a smaller bundle of goods domestically then it is also going to buy a smaller bundle internationally.
There are two versions of the PPP: (a) Absolute Purchasing Power Parity and (b)
Relative Purchasing Power Parity; and let us examine the two versions.
Absolute Purchasing Power Parity Theory
Under Absolute Purchasing Power Parity theory, exchange rate (E) is determined by the ratio between the two countries' price level of a fixed basket of goods and services.
Denoting the domestic price level by P and foreign price level by P , the absolute PPP relation is written as following:
E = Pf/P (3.1)
The price level should be calculated by including only tradable goods and services. While calculating the price level of a basket of goods and services, the individual prices receive 49 weights in proportion to the importance of the particular items. The best way to explain the weighting scheme is by looking at the weighting scheme used in the calculation of the consumer price index (CPI). It must be mentioned here that many non-tradable items are included in the CPI, and weights must be recalculated once the non-tradables are excluded.
The final price level is a weighted average of the prices of the goods and services surveyed.
Absolute PPP, as expressed by the above equation, states that exchange rate between any two countries will be equal to the ratio of their average prices. The above equation can be rewritten as following and basically stresses the same point from another angle.
Pf= E. P (3.2)
The foreign price level is the product of the domestic price level and the exchange rate.
Although the absolute PPP theory is stated in terms of price level of a basket of goods and services the simplest exposition is perhaps using one tradable commodity, and the
Economist magazine has been doing a great job of explaining absolute PPP by using a single commodity. The magazine has been publishing a Big Mac index for the last twenty years or so. The Big Mac index is a crude version of the PPP concept and the argument here is that the Big Mac must cost the same in every country if the exchange rate is in equilibrium in PPP sense. It must be mentioned here that a Big Mac is not a tradable good and hence the example is to make the concept of the Absolute PPP highly simplified for illustration purpose. Here is how the Big Mac PPP is described. If a Big Mac costs $3.00 in St. Stephen, NB and $2.50 in, Calais, ME then the PPP equilibrium exchange rate is 50 USD 0.83 for one CAD. If in reality the price of CAD on the foreign exchange market is
USD 0.75 then the Canadian dollar is undervalued. And similarly, if the CAD trades at parity then it is over-valued. In the long-run, if the Canadian dollar is over-valued or under valued, it will lose/gain until it reaches the equilibrium.
The following table (Table 3.1) shows Big Mac prices in 11 different countries and the implied PPP rates have been calculated and presented along with the exchange rate from the Forex market. It is quite obvious that the Europeans pay quite a bit more for Big
Macs than the Asians. In Norway it costs USD 6.63 as against USD 3.33 in USA and hence
Norwegian Krona is grossly overvalued and must lose about half of its value so that it is aligned in Big Mac PPP sense; the Norwegian Krona is 105% over-valued. The case of
China is exactly the opposite where a Big Mac costs even less than half in USD term while the Chinese price is converted using the market exchange rate and hence the Chinese currency is undervalued 56%.
One has to be careful while discussing the Big Mac parity. We should not treat the
Big Mac as an imported good. We are interested in comparing the price of a basket of goods across countries and we make the basket simple by just including one item in it. It is a locally produced good in every country that requires the same types and quantities of ingredients. If the absolute Purchasing Power Parity is valid then the Big Mac must cost the same in every country; the law of one price must hold. If the Big Mac price converted into a hard common currency, i.e. USD is different, then the exchange rate must change.
The movements of the exchange rate between the two countries must equalize prices.
Exchange rate of the countries with cheaper Big Macs should appreciate and the countries
51 with expensive Big Macs should experience depreciation in their currencies. As mentioned above, China, for example, where the Big Mac is very cheap has an undervalued currency.
On the other hand, most European countries where the Big Mac costs more than in USA have over-valued currencies.
It must be emphasized that this highly simplified example is only suggestive and it is very difficult to test the absolute PPP theory. In reality, the relative PPP that states that a country with a higher rate of inflation than its trading partners will experience depreciation is easier to test, and that is what has been tested in the current work.
In China, almost everything appears to be cheaper to a tourist and tourists return home with lots of goods from there; this itself is a proof that the Chinese currency is cheap or undervalued. Similarly, importers from USA , Canada and the rest of the world find
China a cheap source of consumer goods including clothing, electronics, toys, etc.. US politicians have been repeatedly urging the Chinese authorities to revalue their currency and stop exporting to the United States using their under-valued currency which gives
Chinese exporters an unfair competitive advantage. If China were to move to floating exchange rate then its currency will appreciate against all major currencies and its exports will suffer. In the Table below where we have discussed the Big Mac parity, we find that
China's currency is under-valued by 56%.
52 Table 3.1: Big Mac Exchange Rate (January 2007)
Big Mac Prices Implied Exchange Under (-), Over(+) PPP of Rate on Valuation against $; st Countries In Local in The January 31 , % Currency Dollars Dollar 2007 U.S.A. $3.22 $3.22
Australia A$3.45 $2.69 0.93 0.78 -17
Britain £1.99 $3.90 1.62 1.96 +21
Canada C$3.63 $3.09 0.89 0.85 -5
China Y11.0 $1.43 0.29 0.13 -56
Denmark DKr27.95 $4.75 0.12 0.17 +51
Malaysia Ringgit5.50 $1.60 0.58 0.29 -51
Mexico Peso29.0 $2.61 0.11 0.09 -18
Norway Kroner41.5 $6.64 0.08 0.16 +105
Russia Rouble49.0 $1.96 0.07 0.04 -43
Switzerland SFr6.30 $5.04 0.51 0.80 +57
Note: The data is from The Economist magazine (http://www.economist.com/finance/displaystory.cfm?story_id=l 1793125)
53 Relative Purchasing Power Parity
The relative PPP theory states that the percentage change in an exchange rate is equal to the
difference of inflation rates in the two trading partners. Thus, a higher rate of inflation in
Canada versus USA will lower the value of CAD against USD. Let us say that CAD/USD
exchange rate is 0.96 and the Canadian inflation rate is 2% above the US inflation rate then
we expect CAD to lose 2% against the USD. Once the adjustment has taken place, one
Canadian dollar will be worth USD 0.9408.
The relationship can be expressed by the following equation:
%Change in E - %Change in P - %Change in Pf (3.3)
While under absolute PPP theory price levels of a fixed basket in two different countries are compared in relative PPP it is the change in the price levels that is important.
In a way, the absolute PPP is a static concept and the relative version is dynamic because it stresses the change over time in price levels. On a practical level, it is also easier to collect reliable data on inflation rate of any country and it is easier to test if the relative PPP holds.
Comments, Criticisms and Some Debate about PPP Theories
Economists agree that the PPP theory in either form is a long-run theory. If there is a persistent difference in inflation rates between two countries then the currency of the country with the lower rate of inflation will gain over the currency of the country with the
54 higher rate. However, the PPP cannot be used as a high precision determinant of the
exchange rate; it can basically predict the direction in which the exchange rate will move.
The exchange rate fluctuates continuously and often deviates quite significantly
from the PPP equilibrium. A rigorous test of PPP faces several difficulties. First, it is very
hard to find an accurate price level for an identical basket of goods across the borders. In
fact different commodity baskets in different countries might cause PPP not to hold. Some
authors have suggested using the Consumer Price Index basket for this purpose but
presence of "non-tradables" makes the exercise inaccurate. Immovable items such as
housing, services (including medical, dental, tourism, etc.), and presence of perishable
goods in the consumption basket make it difficult to assess whether PPP is valid or not.
Second, a study by Pippenger (1993) concluded that the Real Purchasing Power Parity
(RPPP) holds in the long run and Absolute Purchasing Power Parity (APPP) does not hold
in either short or long run using data since 1920 that covers four periods of floating
exchange rates and three periods of fixed rates.
Thus, PPP theory is not adequate to explain short run fluctuations in the currency value and is difficult to test whether it holds or not. A quick review of the value of
Canadian dollar against USD in recent past or for that matter for the last decade or so will clearly indicate that inflation rate differentials between USA and Canada do not justify the severe fluctuations of CAD against USD.
The PPP theory emphasizes trade in real goods, merchandise trades provide the adjustment mechanism that ultimately brings about equilibrium exchange rates. However, the modem global world is characterized by well-developed financial markets and large
55 flows of capital across the borders. Thus, in order to understand the foreign currency markets one cannot just focus on the goods markets and ignore the importance of financial assets. It is in this spirit that the asset theory of exchange rate has been developed, and a review of which is presented in the next section.
3.2.2. The Asset Theory of Exchange Rate
In the asset theory of exchange rate, a currency is treated as an asset and an exchange rate is the price of that asset. Under the asset theory, a currency's price on the foreign exchange market can be analyzed by examining its supply and demand just as in the case of any other asset. The asset approach was introduced in the mid-seventies, and prior to its introduction, it was common to emphasize international trade flows as primary determinants of exchange rates. A dominant conclusion of the traditional theory was that trade surplus will lead to appreciation of the country's currency and a trade deficit will lead to depreciation. In fact the changes in the value of the currencies were supposed to eliminate trade imbalances.
However, the real world did not work quite the same way. Many countries with trade deficits saw their currencies appreciating and countries with trade surpluses found their currencies depreciating. The United States of America has been running trade deficits from the 1970s but its currency started to depreciate beginning only in 2003.25 This has been possible because of a capital account surplus. Foreign investors were eager to accumulate
US financial assets. Similarly, fast-growing developing economies of the Far East ran trade
See the webpage of the Bank of International Settlements, http://www.bis.org/publ/rpfxf07t.htm
56 deficits in the eighties and most part of the nineties and the deficits were offset by inflow of foreign capital that was attracted by high expected rates of return.
According to the asset theory, the demand and supply of financial assets play an important role in determining the exchange rates. The traditional view of exchange rate determination based on trade imbalances cannot explain why exchange rate changes continuously each business day. Trade in financial assets, such as bonds, can provide the much needed explanation for the continuous fluctuations in exchange rates. Goods prices move very slowly relative to financial asset prices, and financial assets are traded continuously each business day. Thus, shift in emphasis from goods market to financial market has important implications for understanding the day-to-day fluctuations in the value of a currency. Exchange rate models that emphasize the importance of investment and trade in financial assets assume perfect capital mobility. In other words there are no capital controls or significant transaction costs that can hinder capital mobility.
Within the family of asset models, there are two important groups: the monetary approach to balance of payment (MABP) and the portfolio-balance approach (PBA) but before we can discuss these two groups of models, it is important to introduce the concept of interest parity.
Interest Rate Parity
There are two types of interest rate parity models: Uncovered Interest Parity (UIP) and
Covered Interest Rate parity (CIP). Under UIP model, the rates of return on equally risky
See, Bruno Solnik (1996), p. 56.
57 financial assets should be equal across the borders. This will happen if there are no risks of exchange rate changes or the country is following strict fixed exchange rate such as currency board system. If a person can borrow at 6% per year and invest at 8% per year then this person can make 2% on his investment. In fact, the concept of Uncovered Interest
Parity (UIP) indicates that simple arbitrage will take place based on the interest rates differential until the room to make money from arbitrage disappears. Although in its simplest form one can assume that exchange rates will not change, but an expected change in the exchange rate can be incorporated in the UIP theory.
The most significant contribution of the asset theory to our understanding of how asset prices influence exchange rate can be explained by analyzing the Covered Interest
Parity (CIP) theory. Under the covered interest parity, investors will borrow from low interest rate countries and invest the borrowed funds in high interest countries. However, if during the intervening period the exchange rate changes, depending on the direction of the change the person can achieve a higher rate of return or end up even losing. So, under covered interest rate parity, the investor will try to cover his risk by entering into a forward contract that involves making a transaction in the forward market. This process of arbitrage will continue as long as there is room for making any money by borrowing in the lower interest country and investing in the higher interest country.
Here is how the CIP works. We can invest in Canadian bonds one Canadian dollar and receive (1 + i) at the end of the year; where I is the domestic interest rate.
Alternatively, we can convert C$1.00 into USD first and invest to earn the US interest rate ( i ) and we shall receive E(l + i ) at the end of the year; this amount will be received in
58 USD. We now can buy a forward contract to convert our USD proceeds into Canadian dollar so that we now know beforehand how much CAD we shall receive at the end of the year. Arbitrage will continue until the following equilibrium is reached:
1 + i = E(i + if )/F
This can be rearranged as following:
(i + ify (1 + i) = F/E
Monetary Approach to Balance of Payment
In the monetary approach model, the exchange rate between any two currencies depends on the relative money demand and money supply within the two countries. If there is excess supply of money in one country then the excess supply will find its way into the other country. On the other hand, if there is excess demand for money in the domestic economy, this will be satisfied by inflow of foreign money. Relative supplies of domestic and foreign bonds are not relevant.
The monetary approach has a long history. David Hume in his book "Of the
Balance of Trade" published in 1752 used a simple example to explain the inflow and outflow of funds in response to excess demand or supply of money.27 In his example he wants us to consider the following scenario. If four-fifths of all the money in Great Britain were to be destroyed today then all the prices must sink by equal proportion. The falling prices will lead to rising exports and falling imports. This will lead to rising trade surpluses
27 See p. 160 of Melvin (2000).
59 and as the exporters convert their export earnings into domestic currency the money supply
will rise and price level will move upward. This process will continue until the lost money
is recovered and the competitive price advantage disappears. This is what happens under
fixed exchange rate or as in David Hume's time under gold standard. The above
conclusions do not change much under the flexible exchange rate. Under the flexible
exchange rate the new free market equilibrium exchange rate will be established after the
sudden shock of four-fifth reduction in money supply.
In the monetary approach, the domestic and foreign bonds are perfect substitutes
and the demanders are indifferent to the denomination currencies of the bonds as long as
the expected rates of return are the same. The bond holders do not require a premium to
hold foreign bonds, and their activities will equalize the rates of return across the border.
As the PPP theory is often referred to as the law of one price, the MABP can be referred to
as the law of one yield. In other words, the uncovered interest parity holds in the monetary
approach models.
Since the MABP emphasizes the cross-border investment in financial assets which
are sensitive to financial market conditions such as interest rate movements, it can explain
short term movements in exchange rates.
Portfolio Balance Approach (PBA)
Under the portfolio balance approach the foreign and domestic bonds are assumed to be
imperfect substitutes. This is a reasonable assumption because the tax treatment, political risks, and economic environment are different across countries. Therefore, under the PBA model, the demanders are not indifferent to foreign and domestic bonds and will invest 60 their portfolio over different countries' assets. If the supply of one country's bonds increases then the rate of return on those bonds will have to be more attractive for the investors to buy those bonds. In fact this is quite consistent with basic demand and supply theories of bonds. As the supply increases the bond price declines and the yield rises. One can view this higher rate of return as risk premium. As a country issues more bonds to borrow from the international markets the chances of default rise and hence a higher risk premium is needed to induce the investors to buy these bonds.
The Portfolio Balance Approach is better than the Monetary Approach because under the PBA the unrealistic assumption of perfect substitutability of foreign and domestic bonds is relaxed. Under this approach the exchange rate is determined by relative supplies of foreign and domestic bonds as well as foreign and domestic money supplies. The
Portfolio Balance Approach is a broader and more realistic approach.
Overshooting Model
Dombusch (1976) and Frenkel (1979) argued that the exchange rates exhibit much more volatility than the price levels. When there is a disturbance in an economy such as news about a higher trade deficit, the spot exchange rate does not move smoothly to its new equilibrium. In fact, the exchange rate will suddenly jump in the right direction but will overshoot its new long run equilibrium. In the short run, following some disturbance to equilibrium, prices will adjust slowly to the new equilibrium but the exchange rates and interest rates will move more quickly. The difference in speed of adjustment of prices of goods and services versus exchange rates allow for the possibilities of overshooting the new equilibrium value.
61 3.3. Summary
The PPP theory is based on the role of trade as the main determinant of exchange rate whereas the modem theory emphasizes demand and supply of financial assets and the consequent demand for the currency in which the assets are denominated. Another difference between the two approaches is that the PPP theory is a long-run theory and the asset theory attempts at explaining the short term fluctuations.
The asset theory provides a very important explanation for sudden overshooting of exchange rates. Investors in currencies do not necessarily have long time horizons and where the short-term speculators' time horizon ends and the long-term investors time horizon begins is difficult to clearly define. The exchange rates are difficult to forecast because the market is continually reacting to unexpected events and news but exchange rate theories are not about forecasting these unexpected vibrations. The PPP theory is a long term theory and the question may be how long is the 'long-term'. Similarly, the interest rate parity drives the exchange rate to an equilibrium value but interest rates can change more frequently because these are policy variables of the central banks.
62 Chapter Four: Factors Determining the Value of the Canadian
Dollar on the Foreign Currency Market
4.1. Introduction
Is the Canadian dollar a hard currency? This question must be asked at the very outset. It is one thing to analyze the value of a currency which does not freely trade on the international market but it is another thing to evaluate an international currency. A hard currency is a currency that trades on the international money market and the Canadian dollar is one of the hard currencies. Unfortunately, a currency that freely trades on the money market attracts investors and speculators and this can contribute to unwanted fluctuations. The Canadian dollar is a hard currency because it is easily convertible into other currencies and it freely trades on the foreign currency market. Thus, to study the determinants of its value we need to refer to the theories of exchange rate determination.
In this chapter an attempt is made to study empirically the relationship between the value of the Canadian dollar and its various determinants. Following the theory of
Purchasing Power Parity and Interest Rate Parity, and following the studies by Francis,
Hansen and Lothian (2001), Antweiler (2002) and Murray, Zelmer and Antia (2000), we have included in our regression model the difference between US-Canada interest rates and inflation rates. We have also included the commodity price indexes both energy and non-
63 energy. Results obtained from this very simple empirical exercise are consistent with what have been found in previous studies many of which are quite complex and sophisticated.
Prior to presenting the results of the empirical exercise, we have discussed the sources and nature of data. We have plotted the value of the Canadian dollar from 1972 to
2006 that shows how it has performed on the foreign currency market. Since USD itself has fluctuated against other major currencies, we have presented a graph of the value of the
Canadian dollar in terms of Yen for the sake of comparison.
4.2. Sources and Nature of Data
All the data used in this study, except the value of CAD in terms of Japanese Yen, have been obtained from the CANSIM database maintained by Statistics Canada. The data on the exchange rate between Japanese Yen and CAD has been collected from the Pacific
Exchange webpage maintained by the Sauder School of Business, the University of British
Columbia.
The value of the Canadian dollar in terms of USD has fluctuated quite a bit during the sample period. It is interesting to note that the value of CAD in terms of JPY shows similar fluctuations, and both the series have moved up and down together. For example, between January 2001 and December 2007, the price of CAD in terms of JPY rose 44% and the price in terms of USD moved up 50%.28
Price of one CAD in January 2001 was 77.674 Yens and US$0.66528. The price rose in December 2007 to 112.041 Yens and US$0,997. These are monthly average prices collected from Pacific Exchange webpage maintained by UBC.
64 Plots for two other series are also presented below; these are energy price index and commodity price index. Once again both the series have fluctuated during the sample period and exhibit quite a bit of similarity. This is not surprising because oil is an important component in commodity price index.
The exchange rate both vis a vis USD and Japanese Yen are compared over a thirty- five year period 1971 to 2006. The fluctuations of the C$ against the two very important hard currencies show that our dollar has lost against both the currencies. The USD has lost against all the major currencies in the last few years. For our empirical analysis, we used the full sample to estimate the regression model and then we disaggregated the sample period into four time periods (1972-1975, 1976-1986, 1992-2000, and 2003-2006) which as
Figure 1 demonstrates are periods where there was a downward or upward trend.
Figure 1: Exchange Rate; Price of One C$ in US$
1.05 -r
1.00 -
0.95 -
0.90 -
0.85 -
0.80 -
0.75 -
0.70 -
0.65 -
0.60 - 1972 1976 1980 1984 1988 1992 1996 2000 2004
65 Figure 2: Price of One C$ in JPY 400
Tl I I 1 I I I I I I I I I I I I I I' rrTT-TTTTTTTT 1971 1975 1979 1983 1987 1991 1995 1999 2003 2007
Figure 3: Energy Price Index 350
I I I I I I I I I I I I I I I I I I ! I I I ! I I I I I M I I I I I I 1971 1975 1979 1983 1987 1991 1995 1999 2003
66 Figure 4: Commodity Price Index 225
200
175 -
150
125
100
75
50
25 I I I I I I I I I ! I I I I I I I I I ! I I I I I I I I I I I I I I 1971 1975 1979 1983 1987 1991 1995 1999 2003
4.3 Empirical Exercise
In this section, an attempt has been made to explain variations in the value of CAD by examining the influence of commodity prices, price of energy, difference in inflation rates between Canada and USA and the difference in long-term interest rates between the two countries.
We have estimated the following model:
e = f(m, g, di, dr,...) (4.1)
67 Where, e = exchange rate defined as the price of one CAD in terms of USD; m = Commodity price index; g = Energy price index; di = difference in inflation rates between Canada and USA calculated by subtracting US inflation rate from the Canadian rate; t = time trend; dr = difference in real long term interest rates between Canada and USA calculated by subtracting the real US interest rate from the real Canadian rate.
We ran regressions over the entire sample period and then, as mentioned above, we divided our data into several sub-periods. The results for the entire sample period (1972:01 to 2007:09) are satisfactory but for the sub-samples the results are mixed which may have happened because of short term problems including the formation of OPEC and referenda in Quebec.
The full-sample regression was run including either the commodity price index (m) or the energy price index (g) and in both equations these indices came out with positive signs. Both the times the coefficients are statistically significant. Results support the claim that commodity prices or energy price have positive influence on the Canadian dollar. As it can be seen from Table 5 in Appendix A the energy sector has a heavy weight (27.79%) in
68 S&P/TSX composite index as against a 11.68% weight in the S&P 500 index, and the
materials sector has a weight of 15.66% in Canada as against 3.23% in USA .29
The inflation rate differential (di) has a negative sign but is not statistically
significant. The negative sign indicates that the Purchasing Power Parity theory is valid. If
the inflation rate in Canada is higher than in USA then the value of the Canadian dollar
should fall so that the law of one price holds.
Another important variable included in the regression is the interest rate differential
(dr) and the variable has turned up with a positive sign supporting the covered interest
parity hypothesis. These results are in line with what Werner Antweiler (2002) among
others has found using a more sophisticated model.
A time trend was used in the full-sample estimation to capture if there is any secular
trend. The variable comes up with a negative sign which indicates that the value of the
Canadian dollar has by and large declined over this 36 year period. In fact, in Figures 1 and
2, it is quite clear that the Canadian dollar has lost against both USD and Japanese Yen over
the sample period. There were periods of up swings but these were followed by down
swings.
Having discussed the results for the full sample period, we shall now turn to the
sub-sample periods. The regression model for the sub-sample periods was estimated
including the same set of variables as in the full-sample case.
Please see the Table in the Appendix for the sectoral distribution of weights of the various sectors in the two stock indices.
69 4.3.1. OPEC Formation Period
The first sub-period is the seventies that covers the period of OPEC formation and sudden rise in the value of the Canadian dollar. OPEC, the Organization of Petroleum Exporting
Countries, was formed in 1973 and the price of crude oil more than quadrupled in a short period. OPEC members are major oil exporters, and an agreement to restrict supply and charge a high price for crude immediately raised oil price on the international market.
Canada, although not a member of OPEC, as an oil exporter benefited from this sudden rise in oil price and the Canadian dollar gained against the USD during this period.
A regression of the exchange rate on the commodity price index (or the energy price index), the difference of inflation rates, and the difference in interest rates was run for the period 1972 to 1975. It was a period of economic disruption with a high inflation rate and high energy price. The energy price index has the expected sign but not statistically significant and the commodity price index had a negative sign that is counter-intuitive but this is also not statistically significant. Thus, energy and commodity price indices were not important determinants of the exchange rate during that period. The difference in inflation rates did not have the expected sign but the difference in interest rates had. In other words the results do not support the PPP hypothesis. The interest rate differential has a positive sign and that is consistent with our expectation because we expect a higher rate in Canada should strengthen the value of the Canadian dollar. This result indicates that the asset price theory is valid, i.e. if the Canadian interest rate is higher than the US rate then it will make the Canadian dollar stronger.
70 Table 4.1: Regression Results
Eqn. Period const. m g di dr t Adj. # R2 1 1972:01-1975:01 0.997 0.001 0.006 0.002 -.001 0.49 (196.05) (1.070) (4.526) (1.449) (-0.955)
2 1972:01-1975:01 1.039 -0.0009 0.009 0.004 0.001 0.50 (34.052) (-1.449) (3.649) (2.845) (1.615)
3 1976:01-1986:12 1.139 -0.0003 0.004 0.005 -0.002 0.93 (116.35) (-5.154) (2.815) (3.605) (-37.097)
4 1976:01-1986:12 1.189 -0.001 -0.003 0.004 -0.002 0.64 (91.613) (-7.459) (2.531) (3.267) (-38.569)
5 1992:01-2000:12 1.449 -0.001 0.011 -0.001 -0.002 0.93 (56.742) (6.657) (5.696) (-0.641) (-18.194)
6 1992:01-2000:12 0.544 -0.0004 0.012 -0.006 -0.002 0.92 (11.451) (-2.722) (3.723) (-2.671) (-14.242)
7 2002:01-2006:12 -0.559 0.0002 -0.023 0.002 0.003 0.90 (-2.694) (0.519) (-5.123) (0.342) (4.756)
8 2002:01-2006:12 -2.009 0.0003 -0.033 -0.0006 0.003 0.91 (-12.337) (1.955) (-5.388) (0.073) (8.539)
9 1972:01-2007:09 0.974 0.0002 -0.0006 0.0051 -0.0008 0.71 (132.78) (3.436) (-0.265) (2.730) (-26.079)
10 1972:01-2007:09 0.950 0.0006 -0.0011 0.0045 -0.0009 0.71 (91.238) (4.090) (-0.496) (2.393) (-23.571)
71 4.3.2. Political Turmoil in Quebec (1976 - 1986)
From the mid-seventies to the mid-eighties and from the early nineties to the end of that decade, the separatist forces in Quebec were very active and it is expected that during these periods, the relationship between the exchange rate and other variables including commodity prices, and interest rates will be disturbed by the political problems in Quebec.
Investors in general prefer political stability.
The separatist movement in Quebec is quite old but it gained momentum with the election in 1976 of Parti Quebecois (PQ), a party committed to Quebec separatism. The PQ passed several measures to strengthen the separatist movement. In 1977, the PQ passed a bill called the Quebec Charter of the French Language (Bill 101) which severely restricted use of English in schools, offices and in all aspects of life; the purpose of the bill was to establish a French-speaking nation. Under this controversial law, education in English- language schools was greatly restricted. The bill also imposed French as the language of business, court judgments, laws, government regulations, and public institutions. This prompted an exodus of English-speaking people from Quebec and over the next decade more than 300,000 people left Quebec. Many investors moved their investments from
Quebec to Ontario or other provinces but in some cases investments moved across the border.
A referendum to make the province of Quebec an independent country was held in
1980. Although the Quebec voters rejected the idea but the campaign about the referendum hurt the Canadian dollar. Foreign investors withdrew investments from Canada and the
72 Canadian dollar was not considered to be a safe currency. Although the voters rejected the
idea of separating Quebec from Canada in 1980, the PQ was re-elected in 1981. The
relationship between the provincial government of Quebec and the Federal government
remained quite strained. In 1981, the Federal government led by Pierre Trudeau made a
constitutional deal with nine Anglophone provinces without Quebec. Repatriation of the
constitution from Britain in 1982 without the support of Quebec further deteriorated the
relationship between the Federal and the Quebec governments. The issue of Quebec
separatism remained quite alive and the currency must have suffered from the perceived
political instability. The threat of separatism eased a little bit when Brian Mulroney was
elected as Prime Minister in 1984 and the Liberals won in Quebec in 1985. However, the
unity issue remained in the fore front with the discussions surrounding the Meech Lake
Accord which was agreed by the federal and provincial governments in 1987 but it was
never ratified. Thus, the period from the mid seventies to the mid eighties was a period of
political uncertainty.
Regressions results for this sub-sample period are not exactly similar to what was
found for the full sample. While the interest rate differential (dr) came out with the
expected sign in both versions of the equation, the inflation rate differential had the
expected sign in one equation and the opposite sign in the other one. Energy and
commodity price indices had negative signs that is contrary to our expectation but is
30 In 1987 the Meech Lake constitutional accord recognized Quebec as a "distinct society" and transferred extensive new powers to all the provinces. Quebec promised that it would accept the 1982 constitution if the accord was approved by all the rest of the provinces. The House of Commons ratified the Meech Lake accord on June 22,1988, but the accord died on June 23,1990, after Newfoundland and Manitoba withheld their support.
73 indicative of the disruption that occurred during this politically volatile period. All that we can conclude from this exercise is that the fundamental relationships among the important variable were disturbed by the political instability in Quebec.
4.3.3. Quebec Politics in the Nineties (1992 - 2000)
In 1990 the Meech Lake accord collapsed because two provinces failed to ratify it. Lucien
Bouchard, a charismatic federal cabinet minister on Mulroney cabinet, resigned his cabinet position and formed a new federal separatist party - Bloc Quebecois. The political debate of how to unite the country intensified but there were no decisive progress. In 1994, PQ won the election in Quebec and conducted another referendum in 1995. This time the separatists lost by a very slim margin. Although PQ lost the referendum, it was re-elected in 1998. Thus, starting from the early nineties to the end of the decade is another period where the threat of separatism was always present sometimes the threat was severe but other times perhaps not so severe. But the discussions of separatism did not help the
Canadian dollar on the foreign exchange market.
Fortunately, by 2001, it became quite clear that support for separation was declining among Quebec's population. The charismatic separatist politician, Lucien Bouchard, retired from politics and that basically sent a signal that the separatists were losing faith in their cause. The regression results for this period show that almost all the variables have unexpected signs except the time trend. The time trend confirms a secular decline in the value of the Canadian dollar during that period.
74 4.3.4. Recent Commodity Boom (2003 - 2007)
The commodity boom driven by the growth in China and India and a large number of developing countries has helped the Canadian dollar in this period. As it can be seen from
Table 2 in the Appendix, currencies of Australia and New Zealand have benefited even more. Between January 2, 2002 and January 25, 2008, the NZ dollar, Australian dollar and the Canadian dollar gained against US$ 82%, 71% and 59% respectively.
The regression for this period supports the fact that rising commodity prices strengthens the Canadian dollar. The inflation rate differential (di) ha sthe expected sign in both the equations but and the interest rate variable (dr) has the expected sign in one.
4.4 Summary
The empirical exercise for the full sample period using a fairly simple model has found results that are in line with what are expected based on the Purchasing Power Parity
Theory, Interest Parity theory, and the influence of commodity prices on the value of the
Canadian dollar. However, while the same regressions were run over several sub-periods results were mixed. It appears that in the short term political or economic disturbances affect the long term relationships that exist between the important variables like interest rate, inflation rate, energy price and the exchange rate.
75 Chapter Five: Summary, Policy Options and Concluding
Comments
5.1 Summary of the Study
The debate about how to manage the value of the Canadian dollar in the foreign exchange market is as old as the Canadian dollar itself. There were periods when fixed rate was the norm, such as Bretton Woods, and then post Bretton Woods was characterized by the popularity of the floating exchange rate. The debate has assumed a greater significance in recent years because of the accelerated pace of globalization and the introduction of Euro in the European Union. The accelerated pace of globalization characterized by an increasing volume of trade and cross-border flow of capital has underscored the need for having a stable currency.
The fixed exchange rate system was the preferred exchange rate regime for a vast majority of the countries after the Second World War. The International Monetary Fund
(IMF) was founded to promote trade and to provide stability to the international financial system. However, by 1973, the fixed exchange rate system known as the Bretton Woods system collapsed. All major countries moved to the flexible system and all the international agencies, directly or indirectly, encouraged every country to embrace flexible exchange rate. However, the introduction of Euro and the performance of the Euro area
76 economies in recent years have now given new life to the old debate - which exchange rate regime is better.
The IMF has been and remains a strong advocate for the flexible exchange rate regime for all its member countries. In Canada, the Bank of Canada authorities are committed to conducting monetary policy on their own and are opposed to giving up this important role by adopting a fixed exchange rate regime. The most powerful arguments in favor of a flexible exchange rate regime are the same as that for the free market economy.
Any intervention in the free market ultimately creates serious problems of shortage or surplus. Today, with the exception of a few countries such as Cuba and North Korea almost every country acknowledges the benefits of freer trade. Both India and China were very slow to open their borders for trade but as they increase their participation in international trade they are slowly relaxing foreign exchange controls.
If the currency is pegged, it should be pegged at the equilibrium exchange rate that reflects the market demand for and supply of the particular currency under consideration.
Unfortunately, the demand and supply are affected by many different variables and as one or more of these variables change so does the equilibrium value. If these disturbances can be quickly corrected then the fixed rate can be defended. What happens in reality is quite complicated, and often a chronic disequilibrium situation develops and the value of a currency can be significantly different than its true equilibrium value. Ultimately, an adjustment to the peg has to be made. In other words market forces cannot be ignored in the long run; devaluation or revaluation has to be made.
77 Notable Canadian economists such as Thomas Courchene (1999, 1999, 2000 and
2001) and David Laidler (1999) have compared the two different currency regimes and
Courchene prefers formation of a North American Monetary Union (NAMU) which is some form of a fixed exchange rate regime with a united central bank for both USA and
Canada. David Laidler on the other hand feels that the current model followed by the Bank of Canada is the best option available to Canada. Although the argument for creating a
NAMU or adopting a fixed exchange rate has derived some credibility from the formation of the Euro area, the overall thinking of the monetary authorities throughout the world favors a managed floating system. The chances of Canada adopting a fixed exchange rate are simply not there. We have been under flexible exchange rate since 1973 and the Bank of Canada has repeatedly affirmed its commitment to flexible exchange rate. It is also important to understand that although Euro provides a fixed exchange rate (or a single currency) for its member nations, this new currency is flexible against all the other currencies in the world. The point I want to make is that the fixed exchange rate provides stability between a pair of currencies but beyond that one has to deal with issues of flexibility.
While USA, Japan, U.K. and many other important economies are on the flexible exchange rate system some very large fast-growing economies including India and Brazil are on floating exchange rate. Yes, these economies watch their currencies more closely than Canada or other developed economies on floating rate but their currencies are not pegged against another currency. It is interesting to watch how China is slowly moving away from an orthodox fixed rate.
78 Given the fact that we are on a floating rate system and we shall remain on this system for many decades to come it is important to examine again and again what are the factors that affect the value of the Canadian dollar and what drives its movements. The more we understand the factors that drive the movements the better it is for the monetary authorities to manage the floating rate. Of course, currencies respond to two different types of factors: one set on which the central banks and the governments have control and the other set on which there is hardly any control by the authorities. For example, inflation rates, interest rates and trade deficits can be managed by the government but when it comes to speculative attacks on a currency and global boom creating extra-ordinary demands for commodities, the central banks cannot do much.
The empirical work carried out for the current study has found support for the
Purchasing Power Parity theory in the long run. The prices of commodities (oil and non- oil) have positive influence on the Canadian dollar. The interest rate differential between
Canada and USA has an effect on the currency in line with the Covered Interest Parity hypothesis. An important finding of the study is that the political disturbances in Quebec distort the relationship among the key variables as dictated by the commonly accepted theories. Given these findings, what are our policy options?
5.2 Policy Implications
The goal of the policy makers is to achieve stability in the value of the Canadian dollar on the foreign exchange market. It has been mentioned earlier that the goal of a central bank is not to have a weak or strong currency. Stability right around the equilibrium is the goal.
We often get distracted from this primary goal when we see China vehemently defending 79 its weak currency policy or as cross-border shoppers we enjoy the strength of the Canadian dollar.
Our empirical findings point out that the value of the Canadian dollar is influenced by commodity prices. The policy implication of this finding is simple but not easy to implement. If an economy has a very high dependency on a sector or two then its currency will be more volatile than the currency of an economy with a diverse base. Thus, diversification of the Canadian economy should be actively pursued. Although natural resources as a proportion of the value of our total export have declined over the last two decades, it is still high, and hence the fluctuation in resource price is an important factor in determining the value of the dollar. As one can see from Table Al presented in Appendix
A, energy and materials account for 43.45% of the Canadian stock market index (S&P
TSE) as against 14.91% for the US (S&P 500). In fact a ten-sector breakdown of the two stock indexes show that US economy is more evenly diversified across sectors and the
Canadian economy is dominated by energy, raw materials, and financials.
Heavy dependence of the Canadian economy on energy and raw materials make the
Canadian dollar a cyclical currency. When the world economy grows at a faster rate, the demand for raw materials rises and with it the value of the Canadian dollar also moves up.
The demand for energy also depends on world growth but energy market is also subjected to political problems. Oil has been used by some OPEC members as a political tool to put pressure on the West. The OPEC itself is a cartel and hence a disruptive force in a free market environment.
80 While its economy is heavily dependent on a few sectors, when it comes to trading
Canada is virtually dependent on one trading partner. Despite a strong desire to reduce our dependency on USA as the primary trading partner its importance has remained the same.
This is not surprising, and only confirms that the market forces will determine the results.
Americans buy from Canada because they need what Canada has to offer. Taking into account the quality, price and transport costs there are no effective competitors in the market place who can displace the two neighboring trading partners from their respective position of importance. So, diversification of import and export destinations will perhaps need a lot longer unless some deliberate policy measures are adopted by the government.
The governments (both the federal and the provincials) can play an active role of diversifying the production base and export destinations.
While we need to diversify our economic base and reduce heavy dependence on
USA for trade we need to be better prepared to deal with fluctuations in our currency. The government should educate the exporters and importers how to hedge against foreign currency risks. Hedging is like buying insurance but the costs and complexity deter many exporters and importers from buying these financial instruments.
Two other important findings of our work that PPP and Interest Parity hold lead us to familiar policy prescriptions for the central bank. The bank should stick to its inflation fighting goal. The bank also does a good job of watching the full range of interest rates and this must be continued.
81 5.3 Concluding Comments
It is now amply clear that freer trade is in the best interest of individual economies, and what is good for individual economies must be good for the world economy. It is also clear that free-market economy model, by and large, is superior to 'command economy' model.
In an economic environment dominated by free market economy and free trade, it is logical to have a market determined exchange rate for a hard currency, such as the Canadian dollar.
Economic forces affecting Canada are always not the same and hence it cannot have a fixed exchange rate for a long period without adjusting it from time to time.
Flexible exchange rate works as shock absorber and protect the domestic economy from outside shocks. For example, under fixed exchange rate a trading partner can create inflation in her own economy and then export its inflation to Canada. Thus, it is important to maintain flexible exchange rate. However, it may be necessary to help the dollar from time to time so that it does not go through severe fluctuations. In order to manage the dollar a clear understanding of its determinants is helpful. The current study by using most recent data has basically found support for the results obtained by Antweiler (2002), Laidler
(1999), and the studies carried out by the Bank of Canada.
For future research, it will be helpful to examine the costs of hedging against fluctuating foreign currencies. How businesses, especially small ones, can hedge against currency fluctuations? Can the government educate the business communities on various hedging techniques? Hedging is like buying insurance and the more we understand it the better it is. Another important issue that deserves serious exploration is how to discourage speculators from raiding a currency. It is difficult to distinguish between speculators and 82 investors but many countries discourage short term trading of stocks. So, it may be
possible to identify speculative behaviors on the currency market. A further issue worth
examining would be whether political problems in Quebec are having a lesser effect on the
value of the dollar. More specifically, has each successive round of political debate
surrounding sovereignty influenced the value less and less? Yet another issue for
consideration is how to diversify away from a few exports and a dominant destination of
our exports? This is a two-part question but perhaps has one answer. If we do not produce
a diversified array of exportable goods we shall be exporting to a few countries. Thus
export diversification should be a long-term goal but how the policy makers can support
this is a difficult question to answer.
Another topic worth serious examination is the degree of autonomy that the Bank of
Canada should have. The primary goal of the Bank is to protect the value of the currency
by keeping inflation rate low and stable. The price stability itself contributes to exchange
rate stability but there are more factors to it than just keeping inflation rate under control.
Although political interference is minimal in Canada but the Coyne affair indicates that the
Federal Government ultimately obliged the Governor of the Bank of Canada to resign.
Thus, the Bank of Canada is legally not independent although in practice it has
considerable autonomy. In the past central banks printed money to fund wars and even
now central banks in many developing countries are working closely with their
governments to use inflation tax as a source of government revenues.
As guardian of the monetary system, a central bank, sets short-term interest rates, tries to achieve price stability, ensures that the financial system is sound, and acts as lender
83 of last resort to commercial banks. In order for a central bank to perform all these functions
it must be independent of the government and its political biases. During the last two
decades, central banks in the developed world have gained more independence. The success
of the German central bank (Bundesbank) in achieving price stability has often been cited
as the reasons to have independence for central banks. However, there are instances where
the political leaders have expressed frustrations about the way the central banks conduct
their affairs; the French President, Nicholas Sarkozy, has been a constant critic of the
European Central Bank and has often suggested that the European Central Bank (ECB)
should lower the short term interest rates to help the French economy.31 However, the most
member countries, and of course including, particularly Germany, prefer to have an
independent ECB. Thus, the question of how independent a central bank should be is an
important one worth researching further.
Yet, another suggestion about further research is to expand the econometric model
of this thesis. The model used here is a highly simplified one and it can be expanded to
include the impact of the growth rate of real GDP. By including the difference in growth rates of real GDP between USA and Canada in the equation we can study if a higher rate of growth in Canada has any adverse effect on the value of the Canadian dollar. A higher growth rate of GDP may cause balance of trade deficit and hence adversely affect the value of the Canadian dollar.
See (http://streetlightblog.blogspot.com/2007/05/questioning-ecb-independence.html)
84 References
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87 Appendix A: Sectoral Weights and Movements of Currencies
The Canadian stock market is heavily skewed towards energy, financials and raw materials. Table 5 presents the sectoral weights as of December 2007. In Table 6, we present the gains made by several currencies against the US$ in the last six years.
Table Al
Sectoral Weights in US and Canadian Stock Indexes
Sector S&P/TSX composite S&P 500 index _____ Consumer discretionary 5.08%
Consumer staples 2.51% 9.52%
Energy 27.79% 11.68%
Financials 30.77% 19.82%
Health care 0.58% 11.64%
Industrials 5.48% 11.51%
Information technology 5.02% 16.18%
Materials 15.66% 3.23%
Telecom services 5.51% 3.75%
Utilities 1.59% 3.44%
Source: Report on Business, December 29, 2007
88 Table A2 Movements In Major Currencies Versus $U.S. from 2002 - 2008
From Jan. 2,2002 To Jan. 4,2005 To Jan. 2, 2007 To Jan 25,2008
Australian dollar 49% 55% 71%
Canadian dollar 30% 37% 59%
New Zealand dollar 67% 67% 82%
Euro 47% 47% 62%
British Pound 30% 37% 37%
Japanese Yen 27% 11% 23%
89 Curriculum Vitae Mahmuda K. Siddiqua
Address: 67 Rivershore Drive Saint John, NB E2K 4T5 Phone: (506) 652-8292 Email: j [email protected]
Education:
Bachelor of Arts (Honors in Economics), Mount Allison University, Sackville, NB, 1986.
Work Experience:
Research Assistant to Dr. Neil Ridler, University of New Brunswick, Saint John, NB. Collected data from Atlantic Coastal Action Plan (ACAP) on Fisheries and Aquaculture related activities, 1999-2000.
Research Assistant, Centennial Management, Research involved studying the Far Eastern Educational Markets, 2000-2004.
Volunteer Work: Always working with new immigrants to help them settle down.
Hobbies:
Debating, Reading (includes biographies, Fortune and Forbes), Gardening, Listening to Music, and Cooking.