The Commodity Price-Exchange Rate Transmission Mechanism

Well, it happened. The petro-fueled loonie broke parity with the greenback yesterday, and is headed higher still.

I can’t believe that so many people still interpret this as a symbol of our national renaissance.  In fact, the reverse is true.  The dollar’s flight both reflects, and simultaneously reinforces (in fine Kaldorian fashion) our regression into serving once again as a resource supplier to other, more industrially developed economies.

As we all know, it’s a disaster for manufacturing (I predict the current job toll, already something close to 400,000 jobs, will double in a decade if the dollar stays anywhere near parity).  Less well-known is what a rip-off it is for Canadian consumers — and there’s room for a lot more research on this subject.  Someone should put a number (it’ll be very big) on the amount of un-passed-through import cost savings that are being pocketed by the wholesale-retail industry.  This absence of pass-through is another nail in the coffin of the Bank of Canada’s model of CPI-determination.  Exchange rates had almost no effect on the CPI when the dollar was falling, and they’re having almost no effect when the dollar is rising.  (The output gap, by the way, doesn’t seem to have any impact on the CPI, either.  In fact, it’s not at all clear what — other than inertia and self-fulfilling expectations — does have any impact on the CPI.  Another fruitful research topic for progressive economists.)

Many analysts make an automatic link between resource prices and the value of the loonie.  And the empirical connection is clear: especially since the late 1990s (perhaps when currency traders lost their fear of Canada’s by-then rapidly shrinking public debt), our currency has marched hand in hand with commodity prices — first retreating in line with the post-9-11 global slowdown, then bubbling up more recently with the China-fueled global boom.  The oil price is the most important commodity price for the loonie.  But other commodity prices (like metals) are also clearly important.

What has been less pondered, however, is exactly why and how higher commodity prices are driving our dollar higher.  For policy purposes (namely, in my view, figuring out how to bring the loonie back down a notch or two), it is important to think about that link.  Because the connection between the two — the “transmission mechanism” linking higher commodity prices with a stronger loonie, if you like — is not at all self-evident.

I did a bit of reseearch on this topic earlier this year in Melbourne, when I developed a presentation (at LaTrobe University) on Dutch Disease effects that are visible in both Canada and Australia.  The data in both countries refute the notion that the two currencies appreicated due to strong trade balance or current account effects (resulting, in theory, from a higher value for their respective resource exports on world markets).  In fact, current account balances have deteriorated in both countries as the global commodity boom has concluded.  This is more evidence (to add to the strong consensus already out there) that exchange rates have nothing to do with real trade flows.

Real capital flows, similarly, seem to have no relationship to the appreciation.  Despite the swads of foreign capital going into Alberta’s tar sands, Canada continues to export as much (or more) real FDI, than it imports.  Australia’s experience has been similar.

I think it is now well recognized that exchange rates are a financial phenomenon, not a real phenomenon, in which case it is financial flows that must be driving the appreciation (not real trade, terms-of-trade, or FDI factors).  After all, flows of “hot money” (in currency, money, and equity markets) dwarf flows motivated by real trade balances and direct investment decisions.  So it will probably be most fruitful to consider precisely how those financial flows are occuring, how they have been affected by the global commodity price boom, and how all this impacts the Canadian dollar.

I can imagine several probably complementary options here:

1. High profits in Canadian-listed resource companies drive up their equity valuations, attracting net inflows of portfolio capital (either new foreign money, or returning Canadian money).  In this sense, the rising loonie is connected to the rising TSX (and that, in turn, can become mutually reinforcing — since expectation of a rising loonie makes it all the more lucrative for foreigners to buy Canadian equities).

2. Those same high profits (and valuations) attract buyout interest from foreign investors, and hence the wave of resource takeovers that has been witnessed.  (An open question: to what extent should those takeovers show up in FDI data?  They are not currently very visible in that data at all, despite the massive buyouts that have occurred.  This is a staistical issue I’d like to learn more about.)

3. Foreign exchange traders, internalizing these (and perhaps other) underlying models, drive up the loonie solely on anticipation that there will be a positive link between commodity prices and the loonie.  In this sense, the belief that the Canadian dollar is now a petro-currency becomes self-fulfilling.

Of course, speculative pressures in financial markets can exaggerate movements like these — whereby investors buy the loonie purely because it is rising.  But I think it would be a mistake to blame speculation per se for the overall trend.  The speculators ultimately need something to hang their hat on.

Also, while I have been very critical of the Bank of Canada’s inaction in responding to the appreciation, and while the Canada-U.S. interest differential (which shifted by 50 basis points this week, contributing to this week’s surge in the loonie) is a demonstrated determinant of our exchange rate, we cannot blame the whole run-up on monetary policy.  There is something else happening, related to Canada’s regression into resource supplier, at work.

Any comments or ideas on how to more precisely understand the transmission mechanism linking commodity prices and our currency, and subsequently imagine ways in which to manage or moderate that relationship, would be welcome.