Canadian dollar at the pivot point

Commodity prices and in particular, the price of oil, continue to impact an already weaker Canadian manufacturing sector.

Persisting softness in manufacturing negatively impacts our entire economy. The weakening in our industrial sector has multiple causes—among them a lack of support for innovation.

We’re “continuing to focus on low value-add, commodity-based products instead of leveraging high value-add, knowledge or serviced-based products,” according to a recent report from the Canadian Chamber of Commerce. “Competing on cost inputs leaves Canada at a disadvantage.”

However, some would argue Canadian manufacturers have been battling the high exchange rates of the US and Canadian dollar pair for many years now, and has been losing ground due to “Dutch syndrome.”

The main question is will a lower dollar fill the gap in our exports created by the decline in oil prices? The answer is “no.” Canadian manufacturing requires more time to rebuild itself in the environment of a slow and steady decline of the loonie.

In terms of the impact of oil prices, countries such as the US and China are seeing lower demand for the commodity, due to weaker manufacturing. They’re also introducing technologies to reduce oil consumption or replace it as a fuel altogether. The recent reduction of Chinese investment in the Canadian oil sands signals stagnation.

Canadian oil exporters are facing increased supply costs, heightened environmental concerns in Canada, the US and Europe, and much lower prices for crude.

In my opinion, lower oil prices are here to stay for the longer term. The trend will not only affect the Canadian economy, but Russia’s exports and Chinese investments in oil resources.

We’re currently trying to sell Canadian crude oil and bitumen to the biggest oil producer in the world—the US, which introduced policies regarding the reduction of oil imports dependency years ago.

Going forward, we can expect relative cooling of oil exports and an indirect lowering effect on the Canadian dollar. On a positive note, the lower value of the loonie will be welcomed by Canadian oil exporters, due to currency exchange gains and lower supply costs as a percentage of sales.

In addition to oil, other commodities—and recent trends with our dollar—are impacting manufacturers and the broader economy:

Wood
Exports of wood and related products elevate our dollar. By value, Canada is the world’s leading exporter of softwood lumber, newsprint and wood pulp. The demand for softwood lumber as a construction material fluctuates according to the real estate market.

The US real estate market—after the collapse in 2009 and 2010—is on the road to recovery. There are already some pockets of real estate markets in the US experiencing price growth of 15 to 20 per cent annually.

Although there are sporadic areas of real estate revival in US, it’s safe to say the real estate market is still suppressed due to lack of income and existing mortgage restrictions. In 2012 however, our exports of softwood lumber to the US surpassed the decline of 2011 with an impressive growth of 10.8 per cent.

On the other hand, “strong growth of exports to emerging economies such as those of China and India has reduced the Canadian forest industry’s reliance on US markets,” according to Natural Resources Canada.

China has experienced exaggerated growth in its real estate prices for years, due to growth of income, high demand for private housing, as well as hidden private financing. The Chinese government has already introduced policies with the objective to moderate real estate price increases.

The loonie
Since 2010, central banks and monetary authorities have started adding Canadian-dollar assets to their official foreign reserves portfolios, in an effort to diversify. These foreign portfolio reserves are usually held in American dollars, Eurozone currency, Japanese yen, the British pound and Swiss francs.

The stability of the Canadian and Australian financial systems has encouraged central banks to add the Canadian and Australian dollars to their portfolios, increasing the demand for these currencies.

According to recent survey data from the International Monetary Fund, the Canadian dollar accounted for about 1.8 per cent of reported global foreign reserves in the third quarter of 2013. The 1.8 per cent participation of the Canadian dollar in global foreign reserves is probably highly underestimated since it’s based on responses of managers holding only 54 per cent of the total US$11 trillion value of foreign reserves.

A country’s foreign reserves are considered an insurance against the market’s turmoil and are rarely traded by the foreign reserves managers. These same managers will act against the Bank of Canada’s efforts to lower the value of the loonie.

Housing prices
The divergence in housing prices between the US and Canadian real estate markets provided an uplifting effect on the Canadian dollar. The prolonged boom in Canadian real estate has been fuelled by increased foreign investment and the security of our banking system.

Foreign investment in our real estate has been growing since the US market collapse in 2009 to 2010, with buyers originating mostly from emerging economies. Fortunately for our economy, foreign investment has provided employment opportunities in the construction sector and boosted demand for construction materials.

Employment in the construction sector has contributed to an overall reduction in Canada’s unemployment rate, which would have significantly increased due to the decline in manufacturing.

Currency exchange rates
Prime Minister Steven Harper has been raising awareness among developed nations of the damaging effect of a higher Canadian dollar on our economy. The increase of the Canadian dollar by almost 40 per cent within a few years has been left without a response. The Canadian economy has lost about 5,000 manufacturers and the sector is going through major structural changes.

Unfortunately, the recent reduction in exchange rates has provided only moderate increases in exports. The motor vehicles and parts export is leading the way, with the rest of manufacturing lagging behind.

Clearly, the Bank of Canada’s careful approach to reducing the currency exchange rate has not brought the expected growth in manufacturing and there’s an overall lack of urgency to lower the loonie’s value.

Stronger greenback
The American economy is gradually improving after the financial crisis, leading to positive positioning of the US dollar against other currencies, including the loonie. The higher value of the USD translates to diminished value of the loonie in the currency pair.

The perception of the US dollar as a “safe haven” in troubled times contributes to the trend. Conflicts in Syria, the Ukraine and Iraq should continue to fuel fear and therefore spur interest in the US dollar. Additional fear of Ebola’s effect on the global economy will also fuel the trend.

The American economy is still seeing persistent weaknesses in employment, low income growth, budgetary struggles and relatively weak manufacturing. These developments could result in attempts to lower the value of the USD.

Looking ahead
The USD/CAD pair is fluctuating at rather high levels, considering the slowing global economy and associated softer demand for our natural resources.

The relatively high level of the loonie is being spurred by international demand for a safe currency, and a lack of housing price correction in our real estate market. The only real depressing factors on the loonie are the growth of the US dollar and the radical reduction in oil prices.

The growth of the US dollar will temporarily slow with an expected correction. That will allow the Canadian dollar to remain relatively high. Lower oil prices will reduce the value of loonie in the long term, but in the shorter term, they could prompt the Bank of Canada to provide temporary support doe the loonie.

The Bank of Canada has to balance the decline of the Canadian dollar—which will support Canadian manufacturing and exporters—with the perception of our dollar as a stable currency.

The most recent data suggest that loonie will improve in next couple of months. The US dollar is now in correction mode and oil is starting to bounce back. As long as the moderate correction of the US dollar continues and oil prices stabilize, the value of the Canadian dollar should improve a little.

If the global economy signals another reduction in oil prices and an overall rise in global risk, the US dollar will creep higher, and we’ll see an exchange rate of $ 0.85 CAD/USD before the end of this year.

At this level, I would expect “smoothing” action to be taken by the Bank of Canada to bring the loonie back to $0.88 levels.

Darek Wozniak is president of JW Investrade, a currency exchange consulting firm in London, Ont. He may be reached via email.