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 © Mahmuda K. Siddiqua, 2009 Library and Archives Bibliotheque et 1*1 Canada Archives Canada Published Heritage Direction du Branch Patrimoine de I'edition 395 Wellington Street 395, rue Wellington Ottawa ON K1A 0N4 Ottawa ON K1A 0N4 Canada Canada Your We Votre r&terence ISBN: 978-0-494-80739-2 Our file Notre r6f6rence ISBN: 978-0-494-80739-2 NOTICE: AVIS: The author has granted a non­ L'auteur a accorde une licence non exclusive exclusive license allowing Library and permettant a la Bibliotheque et Archives Archives Canada to reproduce, Canada de reproduire, publier, archiver, publish, archive, preserve, conserve, sauvegarder, conserver, transmettre au public communicate to the public by par telecommunication ou par I'lnternet, preter, telecommunication or on the Internet, distribuer et vendre des theses partout dans le loan, distribute and sell theses monde, a des fins commerciales ou autres, sur worldwide, for commercial or non­ support microforme, papier, electronique et/ou commercial purposes, in microform, autres formats. paper, electronic and/or any other formats. The author retains copyright L'auteur conserve la propriete du droit d'auteur ownership and moral rights in this et des droits moraux qui protege cette these. Ni thesis. Neither the thesis nor la these ni des extra its substantiels de celle-ci substantial extracts from it may be ne doivent etre imprimes ou autrement printed or otherwise reproduced reproduits sans son autorisation. without the author's permission. In compliance with the Canadian Conformement a la loi canadienne sur la Privacy Act some supporting forms protection de la vie privee, quelques may have been removed from this formulaires secondaires ont ete enleves de thesis. cette these. While these forms may be included Bien que ces formulaires aient inclus dans in the document page count, their la pagination, il n'y aura aucun contenu removal does not represent any loss manquant. of content from the thesis. ••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.