The Oil Price-Loonie Transmission Mechanism
The most interesting comments from Bank of Canada Governor Mark Carney last week, in releasing the Bank’s semi-annual Monetary Policy Report, dealt with the relationship between the price of oil and the Canadian currency.Â The Globe and Mail reported Carney as publicly questioning why currency traders automatically presume such a direct link between the loonie and the world oil price.Â After all, he accurately pointed out, Canada produces a lot more than just oil.Â Why do traders associate our currency with commodity prices in general, let alone this single particular commodity?
Mr. Carney’s remarks had an obvious underlying motivation:Â one important concern restraining any future interest rate tightening by the Bank is its concern over a subsequent upward shock to the loonie (which would further batter our already-weak trade performance).Â By encouraging currency traders to interpret the dollar’s value more broadly, Carney is trying to short-circuit that kind of reaction.
Moreover, I would argue, there are deeper questions regarding the nature of the “transmission mechanism” by which changes in the oil price would indeed impact the exchange value of our loonie.Â The statistical correlation between the two variables seems undeniable: a simple first-difference regression finds that oil prices explain 86% of the variation in the dollar (as described in the CAW’s recent paper on auto policy, “Rethinking Canada’s Auto Industry“, p. 15).Â But what explains this link in behavioural terms?Â That’s a question that is rarely asked.
Many analysts explain the link simply as reflecting “strong world demand for the things Canada produces.”Â This is not directly true.Â Canada’s exports of petroleum and a few other staples have boomed, it’s true (both because of growing real quantities and rising unit prices).Â But Canada’s overall trade balance has sagged badly during most of the last decade’s energy boom.Â The decline in non-resource exports of all kinds (both goods and services, undermined by the overvalued currency) has far outweighed the expansion in resource exports.Â In sum, we presently run a current account deficit worth some $50 billion at annualized rates.Â That’s a much bigger deficit than the federal government deficit (and much more dangerous, I would argue), yet it gets a fraction of the public attention.Â If the world really wanted more of Canada’s output, we wouldn’t be experiencing this contractionary deficit.Â (Arthur Donner and Doug Peters recently shone some badly needed light on the current account deficit in this Globe and Mail op-ed.)
The link between real FDI flows (in and out) and the level or change in the dollar is a more realistic possibility, but still not fully convincing.Â To be sure, many petroleum companies and projects have been acquired by foreign companies and investment funds, and more are on the shopping list.Â In total, however, Canada has been a significant net exporter of FDI since 2007 (after the completion of the extraordinary wave of foreign takeovers that year), which should imply a lower demand for loonies (and hence a lower exchange rate).
I think the link between oil prices and the dollar is experienced more broadly in the form of enhanced foreign appetite for Canadian assets (and especially resource assets) more generally.Â That doesn’t require actual FDI flows, or capital flows of any kind, since forward-looking currency traders will build those expectations of value into their judgmentsÂ and portfolio decisions.Â Petroleum super-profits have made Canadian resource companies attractive assets for investors of all nationalities.Â Substantial corporate tax cuts reinforce this unique profitability.Â Meanwhile, Canada is unique among major oil-exporting countries in having virtually no limitations on foreign ownership of the non-renewable resource itself.
I recently wrote a “primer” on the determinants and effects of the Canadian dollar for Relay (the journal published by the Socialist Project).Â There (and elsewhere)Â I have argued that the link between the price of oil and the currency could be broken by measures aimed at slowing and more carefully regulating the pace of energy developments (especially in the oil sands), reducing the profitability of those projects (through higher taxes and royalties), and by restricting foreign ownership of petroleum assets.Â Structural measures like that would be more effective in the long-run, I suggest, than traditional central bank interventions (selling Canadian-dollar-denominated assets in international markets), and certainly than “jawboning” by the central bank.