Clipping the Loonieâ€™s Wings
Comments in the Bank of Canadaâ€™s last two interest-rate announcements and by its Governor have fuelled speculation that it might intervene in currency markets to moderate the overvalued Canadian dollar.
Of course, these remarks may be garnering undue and unintended attention. With the Bank conditionally committed to no interest-rate changes for a year, comments on the dollar have been the only newsworthy item in its most recent couple of interest-rate announcements. Given little room for the usual speculation on what the Bank will do with interest rates, it is hardly surprising that speculation has shifted to what the Bank might do with exchange rates.
Another possibility is that the Bank hoped that simply flagging the loonieâ€™s rise as a problem would scare off enough currency traders to stop this rise. If so, the Bankâ€™s talk does not seem to be working.
When the Bank first complained of “the unprecedentedly rapid rise in the Canadian dollar” on June 4, a loonie bought US$0.91. When the Governor opened the possibility of intervention on July 24, the loonie was worth US$0.92. It has risen to US$0.93 last week and US$0.94 so far today.
Canadaâ€™s goods-producing industries buy most of their inputs at Canadian-dollar prices, but sell much of their output at prices denominated in US dollars. The revelation that these industries contracted even more than expected should heighten concern about the loonieâ€™s ascent.
But should the Bank take action? On July 25, The Financial Post printed “Seven reasons why calls for Bank of Canada intervention in the currency market are misguided.”Â The seven points support two lines of argument: that the loonie is not sufficiently overvalued to warrant intervention and that such intervene would fail anyway.
Is Intervention Needed?
The authors concede that the Canadian dollar is overvalued relative to purchasing power and other benchmarks, but contend that this overvaluation is not large enough to justify intervention.
An obvious retort is that the loonie has appreciated further since July 25. It is presumably more overvalued now than it was then.
More importantly, this question must be answered in a broader economic context. True, the Canadian economy has survived much larger deviations from our dollarâ€™s fundamental value at various times in history.
If Canadaâ€™s goods-producing industries were profitable and growing, we might reasonably expect them to cope with a somewhat unfavourable exchange rate without calling for Bank intervention. Indeed, some commentators used to argue that higher Canadian-dollar costs would just help discipline business managers to find greater efficiencies. (As Jim has pointed out, the same “logic” could be used to argue for higher wages or higher taxes on business.)
But today we are in the midst of a severe economic crisis. Because Canadian exporters already have their backs against the wall, the Bank should be less tolerant of an overvalued Canadian dollar.
There is no absolute threshold of overvaluation (or undervaluation) for central-bank intervention. In making this decision, the Bank should assess the exchange rate in the context of wider economic conditions.
Would Intervention Work?
The authors argue that the Bank is too small in the scheme of global currency markets to make a difference. They cite its unsuccessful attempt to support the Canadian dollar in 1998.
However, there is a fundamental difference between trying to raise your currency and trying to lower it. The Bank has finite reserves of foreign currency with which to buy Canadian dollars. When the Bank entered currency markets to strengthen the loonie, currency traders were aware of this limitation.
Conversely, the Bank has unlimited capacity to sell Canadian dollars. It seems reasonable to assume that currency traders would respect this fact if the Bank intervened to weaken the loonie. So, the failure to raise the exchange rate in 1998 does not suggest an inability to lower it today.
A clear result of Japanâ€™s quantitative easing was a weaker yen, which greatly benefited Japanese export industries. Since the Bank of Canada has already unveiled a framework for quantitative easing, printing Canadian dollars for sale in currency markets is a plausible policy option.
UPDATE (October 16): Quoted by Canadian Press