g7 books canadian dollar chaos by william b.z. vukson

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Canadian DollarChaos



Canadian Dollar Chaos. Copyright 2001 by William B. Z. Vukson.

All rights reserved. Printed in Canada. No part of this book may be used or

reproduced in any manner whatsoever without written permission except in the

case of brief quotations embodied in critical articles and reviews.

Published by G7 Books

First published in 2001

Books by Vukson, William B. Z., 1958-

Canadian Dollar Chaos 2001

Political Structure and Technological Change 2001The Pound Sterling Chronicals 2001

The Regal Dollar 2001

World Money Guide 2001

ISBN 978-0-9809085-0-3

G7 Books

Toronto, Ontario, Canada

[email protected]



CONTENTS

Foreword . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .4

Canada and the Dollar . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .8

The G•7 and Exchange Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .13

Markets over Politics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .17

The Northern Peso . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .21

Two Crises: The Peso and the “Northern Peso” . . . . . . . . . . . . . . . . .24

Trapped in Asia! . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .32

First Quarter: March 21, 1992 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .34

Second Quarter: May 21, 1992 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .36

Third Quarter: July 24, 1992 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .38

Fourth Quarter: September 11, 1992 . . . . . . . . . . . . . . . . . . . . . . . . . . .40

First Quarter: December 15, 1992 . . . . . . . . . . . . . . . . . . . . . . . . . . . . .43

Second Quarter: March 19, 1993 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .45


Fourth Quarter: October 12, 1993 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .51

First Quarter: 1994; December 18, 1993 . . . . . . . . . . . . . . . . . . . . . . .55

First Quarter: February 14, 1994 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .58

Second Quarter: April 22, 1994 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .62

Third Quarter: September 25, 1994 . . . . . . . . . . . . . . . . . . . . . . . . . . . .65

First Quarter: January 5, 1995 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .69First Quarter: February 10, 1995 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .74

Second Quarter: March 30, 1995 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .78

Second Quarter: June 6, 1995 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .83


Third Quarter: September 24, 1995 . . . . . . . . . . . . . . . . . . . . . . . . . . . .93

Fourth Quarter: November 25, 1995 . . . . . . . . . . . . . . . . . . . . . . . . . . .97

First Quarter: January, 1996 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .101Second Quarter: April, 1996 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .105

Second Quarter: April 28, 1996 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .109

Canadian Dollar Chaos



Third Quarter: June 18, 1996 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .113

Third Quarter: August 7, 1996 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .118Fourth Quarter: October 2, 1996 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .122

Second Quarter: June 3, 1997 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .127

Third Quarter: September 29, 1997 . . . . . . . . . . . . . . . . . . . . . . . . . . .129

First Quarter: January 30, 1998 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .131

Second Quarter: June 19, 1998 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .133

Third Quarter: September 20, 1998 . . . . . . . . . . . . . . . . . . . . . . . . . . .135

First Quarter: January 16, 1999 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .137Second Quarter: May 9, 1999 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .139

Fourth Quarter: October 8, 1999 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .141

January/ February, 2000 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .143

March/ April, 2000 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .145

May/ June, 2000 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .147

July/ August, 2000 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .149

September/ October, 2000 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .151

November/ December, 2000 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .153

November/December, 2000 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .155

iv



FOREWORD

The G•7 Report Project came about unexpectedly. After having spent

many years in academia, trade and merchant banking, I felt that a new commu-

nications forum was needed that would bind together an inter-disciplinary

approach to the new developments and challenges faced in this emerging new

decade, the 1990s. As things turned out, the past decade proved to be one of the

most revolutionary periods in the twentieth century, with an unprecedented com-

bination of global markets and technological invention. All of this called for a

fresh new start in media, research and documentary journalism that yearned for

direction from a unique type of leader; perhaps one that brought to the table arare combination of both academic and theoretical grounding, combined with

unequalled practical know-how. To be an effective leader or strategist in the

1990s, it was not enough to just be a specialist within a narrow area of expert-

ise, nor was it sufficient to rely on just many years of “experience” within a par-

ticular sector of the economy.

In this respect, the academic approach to economics and world business

was deprived of what John Kenneth Galbraith once termed as “practical good

sense” evident in great abundance throughout the revolutionary 1990s. Even

within the confines of the “new high tech economy” a great deal is lost in tryingto understand the longer term trends that are in play, let alone in predicting the

rise and progress of this new high tech world. Very few Economists in the early

years of this decade predicted what has transpired via the internet, nor has the

profession been too adept at charting the long term trends that have been emerg-

ing in global stock markets, not to mention the currency markets. In fact, on the

latter point, most have dismissed trends in currency markets as belonging with-

in the sphere of the random walk. Asked where the dollar-yen parity may be

tomorrow or one month from now, the quick reply would have been “the same as

where the relationship has stood at the close of business today.” Asked where it would stand one or two years from today, the answer would amazingly have been

the same. Yes, the new orthodoxy in the 1990s was the random walk. Under this

method of analysing currency markets, there was no way to predict the short term

daily or hourly parities between two currencies, nor was there any strategy to

pursue long term risk management of fluctuating currencies.

The name, “The G•7 Report,” was derived from an international mone-

tary economics course that I attended and which was taught by Professor

Michele Fratianni, an expert on exchange rates and interest rates and former

Chief Economist of the European Commission in Brussels and a member of the

Council of Economic Advisors in Ronald Reagan’s Administration, not to men-

tion a good friend of mine. Of interest was how both fiscal and monetary policy

was formulated within the industrial grouping of the most powerful economies in

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the world, the interaction between them, and the effects a particular direction

would have on the emerging market group of countries that border these power-

ful G•7 nations.

In simple English, if all of the members of the G•7 were expanding fis-

cal spending or lowering interest rates in concert with one another, the disrup-

tion as reflected via fluctuating exchange rates would be kept to a minimum. This

would be of particular benefit to all parties transacting international business,

since strategy and planning within organisations find it most difficult to hedge

the effects of gyrating exchange rates. On many occasions, the serious financial

press is full of reports of disappointing earnings results due to financial hazards

that have impacted subsidiaries in various parts of the world.The initial attempts to co-ordinate official demand-creation activities

within the G•7 have been motivated to a large extent on purely trade grounds.

Liberalised capital mobility and the burgeoning “herd-mentality” lead by some

well known hedge-funds is a phenomenon that arose in the early 1990s, through

George Soros’glorious victory in ejecting the pound sterling out of the European

Exchange Rate Mechanism, which was the prelude to the present day single cur-

rency- the Euro. However, in the mid 1980s, the hey-day of G•7 policy co-ordi-

nation exercises, it was trade concerns which were at the forefront of the policy

debates.

After Francois Mitterrand’s Socialist Party took power in 1981, politi-

cians in France broke with their G•7 counter-parts in order to pursue a massive

re-inflation which ultimately proved very short-lived. To break from the pack in

such a manner, the French franc nose-dived in global currency markets as infla-

tion skyrocketed upwards. The Mitterrand government quickly learned that indi-

vidualistic approaches to policy were dead ends, and that the short-lived expan-

sion quickly made the exchange rate attractive to foreign buyers, but that the

ensuing price increases, or inflation, choked off the gains that buyers would have

had from the lower franc. In short, the “Mitterrand experiment” exacted great

inefficiencies on fellow member G•7 nations and had limited real impacts on the

domestic French economy. Mitterrand quickly retreated from this approach and

agreed to become a team player thereafter.

Not only were such policy directions between the world’s most power-

ful economies vital in understanding how business cycles interact between these

countries, but a collective decision to increase spending or to lower interest rates

exacted a real impact on the global economy, and the emerging market countries

in particular. During the transformation of Russia and the former communist countries of central and eastern Europe, many have argued in favour of a con-

certed G•7 expansion in spending and their creation of a more global demand

that would in turn assist in the transformation to a market system. This criticism

remains valid as trade and investment flows from the G•7 to the newly emerging


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market economies and vice-versa, has been disappointing, hence prolonging the

transformation process and creating more hardship than what would have been

otherwise necessary.

The G•7 Report project was not just about economics and business, but

was a new vehicle that introduced a number of journalists and commentators

unfamiliar to the readers of the daily news in major North American cities. We

retained some leading contributors over the years, such as Harvard Professor

Benjamin Friedman, Belgian Senator and leading international trade Economist

Paul De Grauwe and compliance and regulatory expert Dr. John Pattison, but

also introduced numerous writers that would normally not have had the oppor-

tunity in the commercialised or market-driven media to express their views and communicate with our readers. We became known as a media that was made

available to some leading European based journalists such as Italian based

organised crime expert, Antonio Nicaso, and to his counterpart in Canada, Mr.

Lee Lamothe, the former head of the crime section of the Toronto Sun daily news-

paper.

The G•7 Report project attained a small “niche” circulation in major

North American cities such as New York, Boston, Miami, San Francisco, Los

Angeles, Toronto and Montreal, but was never able to develop a following in

places such as Vancouver or Atlanta. Moreover, throughout 1995 and 1996 wewere also available over the retail newstrade in the City of London at selective

newsagents. Furthermore, The G•7 Report project was not something that was

developed by marketers residing in New York, Toronto or Los Angeles. In fact, I

would be the first to stick my neck out and say that this was among very few

recent launches which went the other way around. I did not “measure” or “test”

the market with this concept before launching the product. In essence, The G•7

Report made and shaped its own following and market over the years. It was a

leader which was embraced by a very loyal grouping of reader, that felt that we

had important things to say about global trends and the rising “new economy.”

The G•7 Report project was particularly foreign to advertisers, espe-

cially among the agencies in Toronto. We counted very limited success in solicit-

ing advertising support, and agency calls and presentations tended to border on

the absurd. In short, The G•7 Report was simply not a concept that was wel-

comed within this realm. Most of the major corporate supporters were much

appreciated, yet very rare. Among this select group, we are very grateful to Ford

Motor Company, the Montreal Stock Exchange, NatWest Markets and Kapital

Trade as our core group of advertisers. The problem that any “niche” publisher

must go through is retaining a core group of supporters over the long term. If this

can not be maintained, then the publication either dies or gets transformed over

the years. We greatly relied on the latter technique to ensure our survival.

However, it was interesting to note that we did not deviate much from our core

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group of readers, regardless of the format of The G•7 Report. Since 1992, we

went from an academic-looking journal to an expensive full-glossy magazine, to

a newsprint version and ending with the current newsletter look. We found that the constant throughout this entire process of transformation in design were our

core readers over the years, and for this we thank them for their ongoing and

unbending support.

William B.Z. Vukson


ix



CANADA AND THE DOLLAR

The 1990s have been even less kind than the 1980s to the Canadian dol-lar relative to the U.S. dollar. A long time ago in the 1970s, for a veryshort period of time, the Canadian dollar was actually a few penniesstronger than its U.S. counterpart. This occurred during the era of

pegged exchange rates around 1970, just before the Bretton-Woods system wascompletely abandoned during the time of the Nixon administration. For most of the inflationary 1970s, Canada pursued a nationalistic economic policy, restrict-ing foreign direct investment inflows and keeping a suspicious eye on what was

happening south of its border. During this period, politics and economic policywas formed under the premise that Canada was a closed country, and that the period of rising oil prices could effectively be shielded from consumers by reg-ulating the international market and creating what became known as a “made inCanada” price for a barrel of oil. The posture which the Liberal government of Pierre Trudeau opted to pursue during this time, was very much reflected by itsactions in the oil and gas market.

The 1970s were very much a decade where commodity-producingcountries were left in a respectable strategic position, in contrast to the resource-

poor countries which needed to struggle with ridiculously high energy and com-modity prices. Even local governments were singularly defeated over their pric-ing policies with respect to gasoline and energy. The Conservative governmentof Joe Clark was in power less than a year in 1979, when it introduced a budgetwhich pushed local gas prices closer to world market prices, inciting massive protests. Ultimately, the Clark government was defeated in a non-confidencemotion over gasoline, and the Liberals under Pierre Trudeau were once again res-urrected from defeat.

The 1970s were also an era of large-scale capital projects; such as theAlberta tar sands, which held large reserves of heavy thick oil that was difficultto refine and distribute, and the massive investments in energy exploration con-ducted in the northern arctic regions. The Cold War system of fragmentedregions, was very friendly to large, resource-rich countries such as Canada.Investors came to view these countries as carrying a real premium, based on thehigh standard of living that such an abundance could bring. Often, Canada andthe Soviet Union were comparable to one another from the perspective of sizeand resource richness during this time.

During the 1980s, Canada became even more attached to the U.S. mar-ket, as exports as a component of overall income grew to about one-third, as thenatural allure of a boom created by deficit spending by the ReaganAdministration was very difficult to resist by most Canadian manufacturers. The

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boom-time conditions after the interest-rate induced recession in 1980, resultedin the dependency ratio rising in relation to the U.S. market. More and more, as

the Liberal era of Pierre Trudeau was swept aside, and politics took on a moreConservative bend, very soon there was an unstoppable inertia which swept informal free trade arrangements with the U.S. Aside from the local rhetoric inopposition to free trade with the U.S., the Conservative government of BrianMulroney sensed that an era of more open global commerce was upon us, andthat Canada would do well in moving quickly to protect its most vital market, theUnited States.

After the collapse of the Bretton Woods system of currency pegs in

1972, the Canadian dollar was on an unending downward spiral in relation to thecurrency of its most vital trading partner, the U.S. dollar. Despite constant agita-tion among the Senators representing border states, every administration in theU.S. understood that without easy access to their vast market by Canadianexporters, one-third of all incomes could potentially be affected in some way. Inaddition, Cold War strategic interests also prevailed, as the U.S. needed Canadianco-operation in order to patrol the northern reaches of the arctic for any Sovietintrusions that could threaten the United States directly. The low dollar politicstook on an inertia over the 1980s that was difficult to reverse, even though many

Senate leaders in the U.S. Congress constantly received opposition from their constituents who had to deal with very competitively priced Canadian exports.

The difference between the two dollar parities in the period of the ColdWar, when compared to the era of emerging globalisation in the 1990s, was thatthe Canadian dollar began to track the deflating prices of commodities in the lat-ter period. This behaviour was not obvious during the Cold War period, espe-cially when rising oil prices during the 1970s, resulted in a dollar which wasweakening in relation to the U.S. dollar. Why did this happen and can it beexplained by economic logic? If the Canadian dollar was dependent on the bal-

ance of trade during the 1970s, as many of its G•7 counterpart currencies were,then it made sense only if the trade balance with the U.S. was on a long termtrend downwards. However, this was difficult to imagine, since Canada was a netexporter of energy products, such as certain grades of oil and natural gas to theU.S. market, especially during the years of the OPEC oil embargo in the late1970s. However, despite this, the activity on the capital account of the Canadiandollar worked against it, as travel to the U.S. and abroad kept a steady demandfor the Canadian dollar low.

Under the period of emerging globalisation in the 1990s, the collapse of Communism began to tie all of the “emerging market” countries together now ina single global marketplace, driven by advances in high technology and commu-nications. This started the new decade off with a challenging dose of “disinfla-tion” as Canadian commodities that were priced in international markets, were


9



now being challenged by continuously lower-priced commodities of the former Soviet Union countries. Not only was world market oil and gas production now

located in Alberta and the North Sea, not to mention the Arab countries, but itwas also very plentifully available from Kazakhstan and Azerbaijan; the newly-emerging markets of the old Soviet Union. This was also the pattern for manyother basic commodities that were traditionally mined, sending prices lower and battering the price of gold well below three hundred dollars U.S. for the remain-der of the decade. As a general gauge of inflation over history, it is interesting tonote how gold has behaved in the era of globalisation, as disinflation in somecountries combined with outright deflation in others, to exert an overall impacton lower and declining prices in general on a basket of commodities.

The Canadian dollar went down with the price of commodities, as it pushed to record low levels inviting criticism along the way from commentators,and adopting the unofficial “Northern Peso” label from those most critical of itsrecent performance. As the Asian crisis hit in 1997, it spread to Russia and thecentral European emerging market countries in the fall of 1998, also affectingsome members of the G•7 and Canada in particular. Having dipped below theimportant seventy U.S. cent point very briefly during the very close QuébecReferendum of 1995, the ensuing emerging markets crisis in 1997 was notable

from the perspective that the Canadian dollar was taken down simultaneouslywith the Thai Baht, Indonesian Rupee and the Russian Rouble. History wasmade, and Canada was distinct among G•7 countries for being the most vulner-able to such a crisis originating in the newly-emerging markets. Even an aggres-sive reduction in short term interest rates engineered by the U.S. FederalReserve, could not save the Canadian dollar from its slide towards sixty U.S.cents.

The slide in the Russian Rouble preceded one of the biggest financialcrises that the New York banking brethren has seen, and one of the most danger-

ous financial risks since the collapse of Barings bank. I refer to the near collapseof the Long Term Capital Management (LTCM) fund, which was directed by agroup of star nobel prize winning academics and famed New York trader JohnMerriwether. Nobel prize winners Merton Miller and options pricing theory guruMyron Scholes were among the partners in the speculative fund that took posi-tions based on historical financial relationships in the markets confirmed over time. The leverage that LTCM amassed was so great, and the individuals so influ-ential to have received so much credit backing, that a turn for the worse duringthe emerging market crises stood traditional relationships on their head, and at

the same time created an unprecedented situation of panic. So severe was the potential impact on the U.S. and the world financial system, that Federal ReserveChairman, Alan Greenspan, took the unprecedented step of seeking help from allmajor global commercial and investment banks, along with an aggressive pro-

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gram to reduce short term rates, and add liquidity to U.S. and world financialmarkets.

Despite this crisis in New York, the consequences were felt more in the Canadiancurrency and stock markets in Toronto, than they were on Wall Street. The fears being that the deflation-ravaged domestic Canadian economy was about toabsorb yet another dose of confidence-shattering crises. Such an event woulddestroy the consumer confidence that was so difficult to rebuild after the early1990s commercial property crash, and several “double-dip” recessions thereafter.Immediately, the Canadian dollar followed the Rouble, Baht and Rupee down-wards, much to the surprise of many investors. The crisis in Russia was particu-

larly troubling, as many commodity exports such as oil and gas, were now far more competitive in global markets after the Rouble’s collapse. Furthermore, themetal-based commodities that Russia exported impacted the Canadian economydirectly, calling for a lower dollar in order to compete on international markets.

The 1990s began with a crisis at Canada’s central bank, which was sup- posedly independent. Governor John Crow, appointed during the era of BrianMulroney’s government, was a devout monetarist and inflation fighter. He pur-sued an aggressive policy which was designed to enhance the credibility of theBank of Canada, as an inflation-fighting institution. This policy was implement-

ed by a combination of high real interest rates and an appreciating dollar, whichwas impacting the bottom-lines of the all too-important exporters in the manu-facturing sector. The election of the Liberal government of Jean Chrétien in1993, elevated the comments of Finance Minister Paul Martin Jr., which werevery much anti-Crow and against the Bank of Canada’s uni-dimensional pursuitof fighting inflation. Martin quickly orchestrated a campaign to remove Crowfrom the Governorship of the Bank, in favour of a mild-mannered career central banker, in the form of Gordon Thiessen. The severity of the downturn in the early part of the 1990s, was a good enough reason for the government to reject the

harsh monetarist policies of John Crow, under a period where technologicalchange would have made the entire concept of fighting inflation somewhatredundant anyhow. However, what was at stake under the Crow episode, was theentire concept of the role of an overly-independent central bank, that was too sin-gularly focused on one thing; fighting inflation. It also brings into question theentire trend in the 1990s of independent central banks pursuing their own agen-das among the industrialised and advanced G•7 countries, when rapid techno-logical changes in the latter half of the decade would have been a natural hedgeagainst price increases anyway. In essence, to have a double dose of rigid central

bank independence, as well as technological change and heightened levels of competition, combined together, was just too much to handle for some countrieslike Canada.

Just how independent is the Bank of Canada? It is independent only up


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to a certain point, as the Liberals so vividly illustrated via the Crow affair. Withan ailing economy for most of the 1990s, and with constant attacks on Canada’s

standard of living from abroad via the global marketplace, political expediencyruled the day. In this case, foreign investors also reacted with dismay, as theCrow affair ran so much against the mainstream investor logic on central bank-ing independence, not only among the G•7 countries, but also among the emerg-ing market countries which so much aspired to inherit independent central banksand sound currency policies. It can be argued that the continuing structural weak-ness in the Canadian dollar, was also very much due to the interference that theLiberal government chose to implement against the Bank of Canada, in the early part of this new decade of globalisation.

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THE G•7 AND EXCHANGE R ATES

The G•7 members including the U.S., Canada, Germany, France, Italy,Japan and the U.K., with the latter inclusion of Russia, have always been a fis-cal and monetary policy information forum. Only for a very brief period of timesince its creation, did the G•7 actually co-operate to co-ordinate the direction of economic activity. Central to the whole concept of policy co-ordination is con-trolling wildly fluctuating exchange rates among the world’s major industrialisedcountries. Adverse exchange rate movements distort international investments,as well as strategic planning initiatives, while creating uncertainty and project

delays. Based on the premise that it is good to control the fluctuation of exchangerates, a good beginning would be to co-ordinate fiscal and monetary expansionsamong a grouping of countries. If the G•7 moved in tandem to expand moneysupply by ten percent, meaning that money supplies in dollars, euros, yen and pounds sterling went up by ten percent, inflationary expectations would be thesame in all of the G•7 countries and there would be no real effect on exchangerates. However, if the G•7 decided to expand money supply by ten percent, withthe exception of Japan; preferring to hold its growth to zero, then the yen couldappreciate by ten percent relative to the dollar, pound sterling and the euro. This

latter unco-ordinated approach would cause havoc in global currency markets,hence distorting investment and trade. In short, it should be avoided.

The historical development of the G•7, must be traced back towards thedevelopment of the Bretton Woods System of pegged exchange rates after thesecond world war, and was influenced by one of the most well known economistsin modern times, John Maynard Keynes. Where Bretton Woods ended off in1972, during the peak of the Vietnam crisis, the European Monetary System triedto take over the function of coordinating monetary policies. Both the BrettonWoods system and the European Monetary System are fundamentally different

from the G•7. Whereas the former two are formal agreements to coordinate mon-etary policies and inflation rates by fixing exchange rates, no such formal agree-ment exists within the G•7. In that respect, the G•7 is a forum that idealises theconcept of coordinating policies in three different trading blocs throughout theworld. However, there is no enforcement mechanism that forces its members to pursue monetary policies based on some form of pre-arranged fluctuation bandfor the group of currencies, and there is no assurance of success, given that nomember is obliged to follow the final communique’s that are issued at the year-ly summits and through the more informal gatherings of Finance Ministers

throughout the year.

In Europe, monetary policy coordination has a long history that predatesthe famous Schmidt-Giscard d’Estaing agreement to formally establish fluctua-tion bands in 1978. It was as early as 1959, that the European Parliament pro-


13



posed the formation of an institution patterned after the U.S. Federal Reservesystem for the purpose of coordinating monetary policies in Europe. The

European Monetary Agreement of 1958 strengthened the provisions of theBretton Woods system, which was already in place and functioning. However,the Monetary Agreement of 1958, proposed that the bilateral margins of fluctua-tion among the EC currencies be limited to three percent.

At the same time that the European Community decided to “harden” itscommitment to monetary coordination practices alongside its commitment to theBretton Woods system of pegged exchange rates, the Bretton-Woods system wasunder severe strains. The gold standard under which its central currency, the dol-

lar was based on, began to slowly unravel in the 1960s at the height of theVietnam war and the spending commitments made for the arms race, together with the strains of Lyndon Johnson’s Great Society programs, proved to be toomuch for the system to bear. By 1968, gold convertibility at $35 per ounce hadvirtually ceased, when President Richard M. Nixon moved to formally end it onAugust 15, 1971.

In 1969, the French franc was devalued and Germany allowed the mark to appreciate, while a wholesale unravelling began the process that would see theeventual demise of the Bretton Woods system. In 1973, the United States itself,

the anchor currency in the Bretton Woods system, announced a ten percent deval-uation of the dollar, hence formally ending the international experiment of cur-rency management which held together since the second world war.

The demise of monetary co-ordination in the 1960s, culminating with theFrench devaluation and the German revaluation, put enormous strains on theEuropean Community, which considered monetary coordination a vital element infurthering the twin goals of political and economic union. After the crisis with thefranc, mark and dollar began to appear, German Chancellor Willy Brandt, put for-ward an idea for monetary union at the summit of the European Council in theHague in 1969. This lead to several attempts to coordinate exchange rate fluctua-tions, resulting in the “snake” agreement in 1972. However, this was short lived,as the O.P.E.C. oil embargo and the general inflationary environment during the1970s, caused severe fluctuations in exchange rates, chaotic policy initiatives anddesperate political manoeuvring in Europe, to cope with the rising energy costs.

In 1978, German Chancellor Helmut Schmidt and French PresidentValéry Giscard d’Estaing, created a new initiative that would establish the endur-ing European Monetary System and a formal Exchange Rate Mechanism (ERM),

which would govern fluctuations among European member currencies tied tofluctuation bands of 2.25 percent on either side of the central parity for somecountries, and six percent trading bands for other countries that were not consid-ered to have a good inflation record. This was the final solution that eventuallyyielded a single currency and one European Central Bank.

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The G•7 has at its core this incredible accomplishment among itsEuropean members, that moved a loose framework for policy coordination, into

outright monetary union. Certainly, the G•7 never moved to replicate what hadexisted in the Bretton Woods framework of pegged exchange rates prior to 1969.For whatever reason, the G•7’s agenda was a far more informal mandate to loose-ly exchange information and to act only when periodic financial crises arise inthe global financial system. In essence, the G•7 has admitted that what hasworked among its European members, can not necessarily be extended to includecountries located among three diverse trading blocs around the world.

The glory period for the G•7 culminated in the Plaza Accords, negotiat-

ed in New York in 1985, and formalised two years later in the Louvre summit inFrance in 1987. The growing trade deficit in the U.S. automotive accounts withJapan, required a revaluation of the yen and Deutsche mark and the devaluationof the U.S. dollar, which lead to a new trade equilibrium in this turbulent period. Never again has such a high level of cooperation been noticeable, as the new eraof globalisation presented an interesting new set of challenges. With deflationaryconditions prevalent in the early 1990s, the “Anglo-saxon” grouping of countriesthat included the U.S., Canada and the U.K. were experiencing a sharp adjust-ment and a severe downturn, while the continental European members were

experiencing a boom from German reunification. Under such a period of “struc-tural” change, it was difficult for these two groupings of G•7 countries to be onthe same point in their respective business cycles, hence unwilling to pursue anycoherent form of policy coordination that made any sense.

For example, if the “Anglo-saxon” group of countries had argued for anexpansion in the money supply or in fiscal spending, it would be, and was coun-tered with a negative response from the inflation-conscious GermanBundesbank. The fact that globalisation brought naturally diverging responses inthe 1990s, made the whole mandate of the G•7 somewhat redundant. How could

policy be effectively coordinated in light of each country being at opposite endswith respect to its business cycle? Moreover, there did not seem to be any roomfor any compromise or middle ground either, which was probably the most dis-appointing part of the failure to take an active role in policy coordination amongthe members of the G•7 during this period.

The 1990s have become a decade of open capital flows, budgetary sur- pluses and less active monetary policies. The role of the G•7 is now more impor-tant than it was ever before, during the closed economic era of the Cold War.Speculative pressures are now far more prevalent than at any time after the sec-ond world war, and many respected world leaders have called for some form of control in global currency markets. Many have even called for a reinstatement of the old Bretton Woods system, that would be much more far-reaching than theEuropean Union was in establishing the Euro. The difficulty with any such


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moves, however, has to do with the divergence of interests of members in termsof where they are in their respective business cycles. As in the early 1990s,

Germany wanted to see a decrease in spending, while most other recession- plagued countries called for an expansion. This kind of coordination is redundantin the world of growing global capital flows, which would create severe specu-lative pressures on currencies if such an imbalance were allowed to proceed atthe policy end.

The hope that remains in coordinating business cycles, is the expansionof the information economy, even in countries on continental Europe which haverealised that the rigid labour structures that have come to define this region, will

inevitably need to disappear over time. These are the kinds of “structural” imped-iments which make co-ordination of policies very difficult, but which have the potential to lay a framework for a successful G•7 agenda over the next five to tenyears.

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MARKETS OVER POLITICS

Rising International Influence of the Montreal Exchange

Interview with: Gerald Lacoste,

President & CEO,

Montreal Exchange

Directed by: William B.Z. Vukson

Why would the Montreal Exchange’s products be interesting to foreign

investors or fund managers?

When we talk about foreign investors, we are mainly referring to prod-ucts that are traded in our derivatives section, which are our three monthBanker’s Acceptance contract (BAX) and our contract on ten year Governmentof Canada bonds (CGBs). These contracts are useful for any pension fund man-agers in Canada or elsewhere to ensure that they properly manage their portfoliorisks via hedging or specific investments. These would be our primary productson offer along with access to our stock market, where we have a listing of most

of the large Canadian public corporations, and an impressive number of smaller Quebec-based companies.

Does the Montreal Exchange have some kind of comparative advantage over

other North American exchanges with respect to these two derivative products?

These two specific products are traded only on the Montreal Exchange,although there was an attempt last year by the Chicago Board Options Exchange(CBOE) to trade a similar kind of product. This was eventually de-listed, becausethe market was already well-established in Montreal.

What would you say would be the comparative advantage that Montreal has asa financial centre in North America?

It is a modern exchange that is well equipped with the most state of theart technology to start with. Moreover, it is an exchange in a city where there isquite a good expertise in trading and portfolio management. In addition, it is amulti-cultural milieu, where people have a very good quality of life. Montrealhas a very good infrastructure from a social basis, with good universities and ahigh quality telecommunications network.

Have you tried to model the Montreal Exchange on any other exchanges in theworld, or is it a unique type of institution that is very specific to itself?

It is unique in the sense that we have three unique markets all under oneroof. We have the stock market, an options market and the futures market. This

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is quite unique, since in most of the other financial centres in the world these areusually operated quite separately by different exchanges. This adds multiple trad-

ing activities and generates enormous synergies on the Montreal Exchange.Traders are able to move with great ease between each of the three markets andare able to combine strategies between the three. Moreover, a similar regulatoryenvironment exists among the three making it very conducive for cross-markettrading strategies among the traders in Montreal.

Has the Montreal Exchange made any moves towards formalising co-operative

ventures with any of the other exchanges throughout the world?

We are making some very loose arrangements with other exchanges in

different time zones. This would allow our products to be traded in these differ-ing time zones irrespective of the time of day in Montreal. Conversely, the prod-ucts of other exchanges will be traded in Montreal. These plans are all currently being discussed, and are in progress.

Have you considered any joint efforts with the Matif in Paris?

I don’t think that the cultural similarity or proximity is a good reason for moving towards such arrangements, since it depends more on the type of prod-ucts that are on offer. It also is a question as to how much Canadian debt is being

managed among the participants and members of these exchanges? These eco-nomic and financial considerations are far more important in deciding any jointventure projects across exchanges, than are any issues that relate to cultural sim-ilarities.

Has the new Bouchard government done anything in particular to advance the

transparency of the Montreal exchange?

The exchange is a privately owned organisation that is held by its members. It is regulated by the government through a quasi-judicial body, which is

the Securities Commission. In that sense the government does not have any saywith respect to the affairs of the exchange. In that sense, the answer is no, but itis an answer that does not in any way relate to any policy initiatives which thegovernment may have advanced. Overall, I think that the current and past gov-ernments have been very supportive of our initiatives. A very good example of this came at the end of the 1970s, when the Lévèsque government at the time,created a stock saving plan for all Quebeckers. The plan was proposed to the gov-ernment by the Montreal exchange and was supported by a task force made upof various officials. This plan together with all of its regulatory aspects was cre-

ated by the securities industry, which is a good example of government assistingthe development of the exchange. Most if not all of the past Quebec provincialgovernments have been very supportive of further developing the Montrealexchange.

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What would you say is the single most important direction for the Montreal

Exchange over the next five years that you would like to see develop?

I would like to see the Futures achieve a much higher level of volumeto the extent that it could become a far more mature market. Currently, about10,000 BAX contracts are traded daily, but we would need to double this volumein order to reach that level of maturity. This level of achievement would imme-diately attract more fund managers and investors.

How do you plan to attract such volumes?

Derivatives markets tend to develop over a number of years, especiallywhen there exists some kind of complicity between governments, industry par-ticipants and financial officers and exchanges. This collaboration is very much in place now, but we must create a habit and educate potential users of the benefitsof our products that are available. We must remember that this type of Futuresmarket is only about 20 years old and has a very long way to go yet. I am confi-dent that we will be able to successfully develop new products that will comealong.

Is there any kind of relationship that the Montreal Exchange has with

exchanges in emerging market economies?

There is no official relationship, but we have been together with theMontreal financial community over the years, involved with emerging marketsin terms of support of information and training. We frequently see people fromMontreal travelling to these markets for these purposes. More importantly, weare operating through a legal system of civil law in Quebec, in an anglo-saxoncontext of business law and we have been able to successfully make a junction between these two systems and cultures. This probably makes our consultants far better in tune to the cultural challenges that these countries may pose. I think thisis an asset that we make very good use of.

What is unique about the financial culture in Montreal?

We have a lot of enthusiasm in what we are doing. It is a closely knitcommunity with a very open relationship with people more based on trust andconfidence.

Is the Montreal Exchange an important fixture to the Montreal economy?

Exchanges in the world are essential to communities, because they rep-resent entry points to the global marketplace. All of the Exchanges in the world

are regional exchanges except London and New York, even Tokyo cannot beconsidered as a global exchange due to its restrictions and difficulty for foreign-ers to operate in. All of the regional Exchanges play an important role in chan-neling capital to their respective companies operating within the region. They area gateway for their respective companies that operate in their regions, to even


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larger pools of international capital in New York and in London. As a companygrows into an even larger entity, it requires larger levels of capital and liquidity

that the regional Exchanges may not necessarily be able to meet. When one of our companies achieves such a status, we don’t view it as a loss, but instead, wetry to regain an important part of their trading activity.

With technology advancing the way that it is, will there not be one global

Exchange in the not too distant future?

There is a global market, and you have to make a distinction betweenthe market as such and marketplaces. Finance is a human activity and involvesinterrelationships among people. This is why we have so many exchanges in the

world, because they are all reflections of this human activity at work. What wemay see, however, is a network of inter-activity between all of the Exchanges.Over the years this global market will be better organised, as tendencies to pro-tectionism and impediments in a regulatory sense will be overcome.

What do you not like about the development of world stock Exchanges?

It is going a little too slowly, which frustrates me.

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THE NORTHERN PESO

A Vote For Separation In QuebecWill Create Another Peso Effect

Alan M. Rugman

The Mexican currency crisis of December 1994 devalued the peso bysome 40 percent until promises of loan guarantees from the United States of $40 billion stabilized the peso-dollar exchange rate. One new and unexpected devel-opment of the peso devaluation was a run on the Canadian dollar. It fell below

70 cents US for a time and has depreciated over 20 percent against the US dol-lar since 1991.

For the first time the Canadian dollar was sideswiped by a LatinAmerican currency crisis. Thanks to the North American Free Trade Agreement(NAFTA), Canada and Mexico are now linked in the international currency mar-kets, such that problems in Mexico now draw attention to Canadian problems.International investors have shown a preference for the US dollar against either the peso or Canadian dollar in times of a currency crisis.

The parallels between Mexico and Canada are disturbing; both haveeconomics-based debt problems and politically-based separatist regimes. Sincethere is a significant amount of political risk in Canada - especially given thevolatile situation in Québec - the wrong series of events could make the Canadiandollar a northern peso.

In terms of economics, after NAFTA, the Mexican current accountdeficit was spurred by a surge in consumer imports not compensated byincreased exports. Due to NAFTA, major readjustments are underway, especial-ly in Mexican manufacturing, but these will take several years to turn around its

trade deficit. In 1994 the Mexican inflation rate of seven percent was well aboveUS and Canadian rates as were increases in its unit labor costs. Mexico’s inter-est rates were as high as 18 percent after its April 1994 devaluation of 8.5 per-cent. After the Christmas 1994 currency crisis, Mexican interest rates went to 40 percent. In Canada, the federal debt has been increasing at the rate of Cdn. $30-40 billion a year for the last decade and provincial deficits, especially in Ontario(under a socialist government for over four years) and Québec (now under asocialist and separatist government) add to the total debt. Canada’s total federaland provincial debt is Cdn. $780 billion, or Cdn.$27,000 per capita. Also, over

40 percent of this national debt is held by foreign investors, worse even than Italywhose debt is mostly held by domestic investors. Canada’s inflation rates arelow, but her interest rates are being pushed up by rising US interest rates.

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In terms of political risk, in Mexico the January 1994 rebellion of theZapatista National Liberation Army in the Chiapas region was allegedly tied to

anti-NAFTA sentiment. A year later, after the assassinations of two major politi-cal leaders and the kidnapping of business executives, this underlying politicalrisk fuelled negative investor perceptions of the peso in the Christmas 1994 cur-rency crisis.

In Canada, the new governing party in the province of Québec, the PartiQuébecois, will likely hold a referendum in summer 1995 to vote on the creationof a sovereign state in Québec, and its separation from Canada. The anticipatedvote, the timing of the vote, debates about how separation could occur, and if it

is legal and/or feasible, are all politically unstable events which could trigger acurrency crisis in Canada.

The PQ has said that it will use the Canadian dollar as its unit of accountafter separation, but that Québec will not take responsibility for its quarter of Canada’s national debt, and will only remit its share of interest payments on thedebt if its separatist agenda is agreed to by the federal government. Obviouslythis means trouble. While there is unlikely to be armed conflict if Québec leavesCanada, there will be an extremely difficult and tense transition period duringwhich the Canadian dollar is at risk.

The current premier of Québec, Jacques Parizeau, has attempted tosmooth the painful transition process by statements minimizing the economiccosts of Québec separation. He asserts that Québec will remain a member of NAFTA, the GATT/WTO and NATO. Yet all of these linkages, in contrast to hisassumptions, will have to be renegotiated. The entire process of separation willcreate a period of acrimony and political uncertainty, giving currency risk to theCanadian dollar.

Indeed, in the face of a determined attempt by the government of the

province of Québec to make a de facto unilateral declaration of independence,and reject ownership of its share of Canada’s huge national debt, there is everyreason to believe that the international money markets will engage in a massivesell-off of Canadian dollar denominated assets. This would lead to a major cur-rency crisis with substantial devaluations of the Canadian dollar. It could becomea northern peso.

It is difficult to predict how far the Canadian dollar would fall. With acomplete loss of investor confidence due to Canada’s failure to reduce itsdeficits, Québec separation, and Québec reneging on its share of the national

debt, there is no realistic equilibrium value of the currency. (In purchasing power parity terms currently it should be closer to eighty than seventy cents against theUS dollar). The foreign exchange reserves of the Bank of Canada and existingcredit lines would be lost in a few days in a major currency crisis. As

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International Monetary Fund (IMF) credits are too small and slow to mobilize,only quick intervention by the US government and US Federal Reserve would

work.

Since Canada is the largest trading partner of the United States, and pre-sumably even more important than Mexico in NAFTA, the US loan guaranteesand other financial support from the IMF would help to stabilize the Canadiandollar. However, Canadians are, in general, reluctant to lose sovereignty and a bail out by the United States would undoubtedly be accompanied by US pressureto reduce the deficit, for example, by cutting Canada’s social programs and relat-ed government expenditures.

The external US pressures to influence Canada’s internal policies wouldworsen the political situation in Canada, where strong anti-American sentimentwould be coupled with Québec separatism to increase political instability inCanada. Hopefully, Québec will not vote to separate. Hopefully, Canada’s hugefiscal deficit will be reduced. However, if these two events do not come to pass,then a northern peso may.

The bright spot is that it is also possible that NAFTA could act as a stabilizing, rather than destabilizing, force. If both the peso and Canadian dollar are

substantially devalued then both Mexican and Canadian exports to the UnitedStates should increase, and imports decrease. As Mexican manufacturing recov-ers and the strong resource-based fundamentals and high productivity of Canadareduce the short-run political risk, then both the peso and Canadian dollar shouldstrengthen against the US dollar.

Under NAFTA, there should be renewed foreign direct investment into both Mexico and Canada and more political stability in their regimes. Cross-list-ed Mexican and Canadian stocks (on the US stock markets) would again becomeattractive with a high volume of trades. So, if Canada can only resolve theQuébec issue (and stabilize its deficit) then a northern peso may be avoided.

Alan M. Rugman is Thames Water Professor of International Business at Oxford University.


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TWO CRISES: THE PESO AND

THE “NORTHERN PESO”

Interview with: Alan M. Rugman

Directed by: Jerry J. Khouri and

William B.Z. Vukson

Canada Joins Soft Currency Club

The Wall Street Journal labeled Canada as an honourary member of the Third World. Can you comment?

The analysis in the Wall Street Journal is correct. The value of theCanadian dollar is low for two main reasons. The first reason - Canada has a hugefiscal deficit and no government at the federal level has really been able toaddress the debt problem. Canada has more debt per head than any other coun-try except Italy. The problem is that Canadian debt is foreign-owned, so there isa tremendous amount of instability, reliance on external financing, and really nocontrol over the value of the Canadian currency that is held by the international

financial community. The second problem for Canada is an internal politicalissue. There is a real probability that Québec may vote in 1995 to leave Canada.If that were to happen, there would be a dramatic devaluation in the Canadiandollar.

Do you have a particular value in mind?

In terms of the budget deficit, I don’t think the Canadian dollar woulddepreciate much below the 70 cents US to one Canadian dollar. However, in thesecond scenario where Québec separates, I really see no floor to the Canadian

dollar. It wouldn’t surprise me at all if Québec voted to separate, and financialmarkets are already discounting this political risk in Canada. If the Canadian dol-lar would just keep falling, it could end up at seven cents US. In that case, Iwould call it a “Canadian peso.”

Now that we have a currency range, can you also say something about a par-

ticular danger point for the Canadian debt and deficit ratios?

If we analyze the debt problem in more detail, I believe that interna-tional financial markets will be happy with the current budget tabled in Canada,

and the series of follow-up measures which are expected to reduce the annualshortfall, currently forecast to be $35 to $40 billion dollars. Anything below thatwould send a strong signal to the international financial community, that theCanadian federal government is not serious about reducing expenditures. I alsoagree with the Wall Street Journal editorial. The analysis about the good progress

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made by some of the provinces should be of note. The province of Alberta in par-ticular, not only reduced the growth in its debt, but by reducing the current

increase in the deficit, is now trying to reduce the stock of debt.

At this point in time, the easy way out for Canada and other soft currency

countries would be to organise into a “soft-currency” club, so that a solution

to the debt crisis within countries like Canada, Italy and Sweden can be imple-

mented without recourse to severe austerity measures imposed by institutions

such as the IMF. How do you view such a scenario?

It has several points of merit. I agree with you that Canada has joined agroup of soft currencies and Canada has the additional problem that the dollar

can also be hit because it is a member of the North American Free TradeAgreement (Nafta). We now see in December 1994 and January 1995 a new phe-nomenon, the devaluation of the Mexican peso and the costly price of the pesowhich ended up in spilling over to the Canadian dollar. The Canadian dollar start-ed falling immediately after the peso was devalued, so we have a situation of uncertainty against the peso and the Canadian dollar within the North Americancontext. This effectively links Canada to latin American currencies.

The Canadian dollar is in a very vulnerable position now, with Europe’sweak currencies like Sweden and Italy, but it is also together with very weak Latin American currencies. What this means is that the attention of foreignexchange traders is now being focused on Canada. The Canadian dollar hasalways been a boring, and uninteresting currency which nobody paid much atten-tion to, and now this scrutiny has cast that up to the searchlights.

What if the soft-currency bloc does not pay attention to the actions of foreign

investors and currency traders and continues to accumulate deficits, while

avoiding any serious measures towards austerity?

We need to be concerned about the Canadian dollar for the first time in

our history. There is a currency crisis. We could be subjected to a currency crisisfrom the analysis of the debt, but I am certain that we will get a currency crisisif Québec separates. I do not believe that Canada has enough foreign exchangereserves at this very moment. In addition, I don’t think Canada can arrange cred-its with other major countries in order to save the Canadian dollar.

Therefore, in a classic currency crisis, the Canadian dollar would justkeep falling and the IMF would be called in. That would then signal that theCanadian government would be forced to implement austerity measures whether

they like it or not, measures which they have been delaying for some 15 to 20years now since the first Trudeau government.

After the IMF is called on, what would be its first practical order of business

in Canada?


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I think it would follow the traditional route. What the IMF does is a basic macro analysis, so it requires that domestic expenditures be reduced and

government expenditures on social services in Canada be cut. A package of inter-nal measures would then be accompanied by some external co-operation whichthe IMF could bring, in terms of more credits and outside support for theCanadian dollar. I think that the mere request for IMF intervention and its even-tual arrival would be enough to bring a halt to a currency crisis. The measureswhich then follow, are more long term in nature, and have been successful inmany countries such as Great Britain in the 1970s and more recently NewZealand. The Canadian situation would be just a continuation of that pattern.

However, in the Canadian case, you would need to have IMF intervention bothat federal and provincial levels of government, since the provincial budgets are

some of the ones that are far more unbalanced ?

First of all, I would not call it intervention. What I mean is that the IMFis basically there as an ally, as a friend, or as a linkage to the international financialcommunity. Most countries are members of the IMF, so it in a way mobilizesresources and outside help, but it is also a broker for the international financialcommunity. In the case of Canada, the federal government would initially act torequest help, and a federal/provincial conference on the economy would need to

follow shortly afterwards. Indeed, I agree with you, provincial expenditures wouldalso have to be reviewed. That would be quite tricky. Ten provinces with differentgovernments; socialist, liberal and conservative, would have to be disciplined. Iagree this is a major problem. The provincial debt in many cases is outpacing thegrowth of the federal debt. At the moment, it’s almost an insoluble problem.

Canadian politicians may favour such a scenario, since it is much easier and

simpler to place blame on unpopular measures of austerity with the ensuing

social program cutbacks on an abstract and ambiguous external organisation

such as the IMF?

I agree. There’s good news and bad news when the IMF comes. Thearrival of the IMF is the bad news; it means you’ve failed. It means you’re giv-ing up control over economic policies and it means that you should be. Basically,your currency is becoming worthless, interest rates are high, inflation is acceler-ating, and so on. The good news is that the IMF can assist in getting a more sen-sible economic policy. So, an austerity program can be pushed through easier bythe Canadian governments if the IMF insists on it.

I recall that in the case of the British devaluations, the British used to

blame the gnomes of Zurich. Now Canadians would be able to blame the NewYork financial market. But it’s the same. I mean you blame somebody else for something you should have been doing all along.To go back to the hypothetical intervention or possible incursion into Canada.

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Don’t you think that both sides of the divide on the debt; the social policy lead-

ers and economists have legitimate concerns. While the debts and deficits are

important to reduce, there are also the social and political problems that will persist in Canada. Why are they working at cross purposes?

I think it is the basic economic problem of efficiency versus equity. Wehave financial markets judging Canada on its performance, on its productivity,on its competitiveness, on its efficiency, and that performance is not good. Theexchange rate is depreciating, which represents the correct measure of Canada’slack of competitiveness. Why is Canada not competitive? Why is there a budgetdeficit? The answer is that Canada’s political system is geared up to serve spe-

cial interests, racial interests, almost tribal interests in the sense of accommodat-ing Québec and bribing Québec to stay within Canada over the last 40 years. SoCanada is driven politically by equity considerations and we all know from basiceconomics that equity distribution considerations are incompatible with ones of efficiency. Until Canada can solve its political problems, where it’s probably oneof the most confused countries in the world in terms of its constitutional arrange-ments, giving immense powers to the provinces, the future for the Canadian dol-lar doesn’t look very good.

Mexican Peso Crisis

What are the short and long term lessons from the Mexican crisis, especially

in context with the North-South relationship?

I think the Mexican peso crisis of December, 1994 and January, 1995was unfortunate. There should have been a devaluation of the Mexican peso probably in 1993 rather than 1994, and perhaps just after Nafta was ratifiedwould have been an opportune time. The Salinas government was committed tonot devaluing its currency. One economic strategy was geared up towards pro-viding confidence in the value of the peso and encouraging foreign investment.

It was largely successful, but the trouble was that the new Mexican administra-tion inherited a suppressed economic problem, which required a devaluation inDecember.

Having said that, the peso crisis was partly the fault of the new govern-ment, because they bungled the devaluation terribly. They did it just beforeChristmas, and then they all went on vacation, while the money markets hadabout a week to ten days without any solid policy pronouncements with regardsto the ensuing developments. It was appalling that the week between Christmasand January 1, 1995, when the trades on international money markets are verythin, there was no information coming from any Mexican authorities. What hadexisted was the total absence of policy and nobody to reassure the internationalfinancial community. I think the Mexicans made it worse for themselves, and sothe 40 percent depreciation in the peso turned out to be double what should have


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been the case, and it turned into a classic currency crisis.

The lessons from the crisis in Mexico are threefold. Firstly, if you aregoing to have a devaluation, plan it properly. Secondly, have your people on sideto talk to the New York bankers about the shift in domestic economic policyframework, and lastly, don’t go on vacation the week after you devalue.

You blame the Mexican government, but should blame not also be apportioned

to Washington and Ottawa for over-promoting Mexico as a location for invest-

ment?

A somewhat provocative question! I have a definite answer. TheMexican peso devaluation has nothing whatsoever to do with policy inWashington or Ottawa. There is absolutely nothing that the United States or Canada could have done or could do in this case. The problem is with theMexican government, which has a current account deficit that has been steadilydeteriorating.

The Mexican government could have solved it by a timely devaluation.Salinas should have done that. There is a history of Mexican presidents doing thedirty work in their last few months in office, and handing over a devalued cur-rency to their successor. Salinas is partly to blame, but certainly no one in the

United States or Canada.Would the peso crisis have been a lesser crisis had Nafta not been in place?

Nafta sends mixed signals around the investment and economic com-munities internationally. Nafta also gives Mexico access to the world’s richestmarket, the United States, but it’s not perfect access, it’s a negotiated access andwhat Nafta did for Mexico is to give it an opportunity to become more efficient,especially in its manufacturing sector. Of the three countries in Nafta, Mexico isthe one with the biggest adjustment problem, so a year into Nafta, one would

expect Mexico to be having difficulty. Its manufacturing sector is tremendouslyinefficient, it has low productivity, and has to be completely restructured.Presently, it is in the process of restructuring, in the process of privatization, con-sequently, it needed a small currency devaluation to help it along.

Now that Mexico is part of the Nafta treaty its adjustment process will be even

more intense, since the US will not tolerate a weaker peso. Meaning that

domestic Mexican industry will need to become even more productive in order

to successfully compete in the US market, since there is only a limited amount

of time under which a devaluation will be tolerated in the US Congress. Do you

have any views on the politics of Nafta?

I agree with you. I think that Mexico has a higher profile for interna-tional analysts being a part of Nafta, and especially to analysts resident in theUnited States. Americans are notoriously xenophobic. Only 15 percent of

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American citizens carry a passport. Which means 85 percent don’t care muchabout anything outside of the US. There is not a leading community in the US

which understands international finance and economics.

The debate on Mexico getting into Nafta, was big news in the UnitedStates. It was one of Bill Clinton’s few successful policies. Since Congressapproved Mexico’s entry into Nafta, interest in the entire matter accelerated tothe point where there is a lot of interest in Nafta now. It has been manifested inUS investment in Mexico increasing, but also by a lot of speculation in the stock market to the extent that in 1994, of the ten most traded stocks on the New York stock exchange, two of them were Mexican stocks in the telecommunications

and petro-chemicals sectors. With the volume of trades increasing in Mexicanstocks, American investors have become more aware of what is going on inMexico, since Mexico is more exposed. And if it doesn’t have a good story totell, the risks will reflect in currency depreciations.

How will the succession of countries such as Chile into Nafta potentially affect

North America’s relations with the European Union?

Personally I don’t see a great rush to let Chile into Nafta. Having been a participant in the Canada/US free trade agreement (FTA) negotiations and in Nafta, I can tell you that there will be discussions initially in harmonizing tariffswith the three countries in Nafta. There will be a move towards having Chileadopt a national treatment for foreign investment, and that Chile would then besubject to all of the dispute mechanisms and institutional framework in Nafta. ButI don’t think this will be accomplished very quickly. Moreover, I believe that thisentire process with Chile is a special case, so I don’t think other Latin Americancountries are going to get into Nafta within the next five years. I don’t see anyconstituency presently in the key country- the United States, even to rush toapprove negotiations with Chile. In fact, negotiations with Chile are not proceed-ing on the fast track, so it’s most likely the US Congress would not approve it.

How about countries such as Chile moving to become members of the Asia

Pacific Economic Co-operation (Apec), or even the European Union?

Chile does not have many alternatives. Apec, for example, is not a for-mal trade agreement. Apec is just a talking club and they have agreed to talk tothe year 2020, so a quarter of a century from now, Apec may start to do what Nafta does, lower tariffs and adopt national treatment. However, at this moment,the interests are so strong that there are neutralizing forces preventing Apec frommoving much faster.

The key players in Apec are Japan, China and the United States. Apec will notturn into a regional trade agreement, but I could be wrong, and it may be that thiscould be the first trade agreement designed to handle investment relationships. Inthat sense, the countries would be forced to move faster. Presently, I don’t see


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Chile having any second choice in an organisation such as Apec. However, Chileis interesting in the sense that its trade is diversified between Asia and Europe,

so it may very well turn out that a better alternative for Chile would be to seek acloser association with the European union, since as much of its trade is goingthere as it is with the United States.

To remain with the peso crisis, can you tell us anything about the timing of the crisis?

The currency crisis developed due to a herd instinct in the foreignexchange markets that reflected the underlying fundamentals. The underlyingfundamentals in terms of the purchasing power parity conditions for the pesoagainst the US dollar as long ago as 1993, supported a small devaluation by

September 1994, when Salinas was on the way out. It was clear that there should be a devaluation, and that it should be around 15 to 20 percent.

Around December 20, 1994 the Mexican government devalued the peso by an amount which the market perceived as insufficient, after which a full- blown currency crisis started. The Mexican government basically did not have aneconomic package ready to satisfy the international financial community. In theinterim, the finance minister failed to reassure the investment community andsubsequently had to resign. The end result is that the devaluation is greater thanit should have been.

Do you think that the peso crisis will produce some kind of protectionist back-

lash which might see some kind of move to reverse Nafta?

I don’t see any impact on Nafta. What I see is more suspicion of Mexico by American investors. I believe that American investors have wised up, and theyare more risk averse about Mexico, but I don’t think it is in any way related to Nafta. In the long run, Nafta will encourage a higher rate of American investmentin Mexico and the stock of foreign direct investment will increase.

From a political perspective, Congress would probably evaluate any kind of peso devaluation as something that would be very detrimental to American

industry. They are already afraid of having cheap American imports sucked

into the United States. Do you share their views?

I don’t share this view, because I think the US Congress is focused onone trade enemy at this point in time, and that enemy is Japan; not Mexico. Iexpect that there will be more protectionism, coming in a disguised form. Thetarget is clearly Japan, not Mexico. If anything, Nafta serves to isolate Mexicoand Canada from the worst excesses of US protectionism in Congress.

Why are Japanese trade deficits barely an issue in the European Union? Is it

the case, as with the European steel industry, where European and Japanese

manufacturers have come to a tacit understanding to stay away from each oth-

ers’ respective markets?

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There is a very simple reason why there is less tension between Europeand Japan, and that is because there is less of a trade deficit between them.

Furthermore, there is much less trade and investment between Japan andEurope, as there is between Japan and the United States, so less tension exists.Trade between Japan and the European Union is trivial in comparison to the intraEU block trade.

Is it solely based on the trade deficit issue, or is it a cultural misunderstanding

between Japan and the US as opposed to Europe and Japan?

I think both. I think there is an underlying economic reason for US-Japanese tension. There is this huge and persistent US trade deficit for the last ten

years at some $40 billion dollars a year; there is a deficit in foreign direct investmentstock between the US and Japan and there is a cultural problem. The US and Japanwere at war, America helped Japanese restructuring and the Japanese are now beating the Americans in the economics and finance game. I just don’t see thattension existing between Europe and Japan. Europeans are much more culturallysecure. They are used to dealing with other countries within the EU, and to do thatthey are used to having a more international mind set than the Americans.Americans are extremely inward looking. If I were to ask the basic international business question to both a European and an American: What is the language of

business? I am sure that the American would respond by saying English, but theEuropean would give the correct answer: the language of your customer.

How do you account for the strong value in the yen these days. Why do we see

the yen appreciating vis à vis the German mark and the US dollar continu-

ously?

You have to do an analysis of Japan. Despite the bursting of the speculative bubble in Japan and the world-wide recession leading to the fall in the Japanesestock market. It is quite clear in retrospect, that within the triad of the world’s

wealthiest countries, the world’s fastest growing and overall leader in trade andinvestment is Japan, so the Japanese yen reflects this hegemony.

Having said that, it is also the most liquid economy in the world, and inthe recession in Japan, some interesting things have developed. Basically, theJapanese have maintained their ability to make foreign direct investment, they haveturned their attention toward south east Asia and China, so Japan continues to bethe world’s economic engine. Asia is the fastest growing area, with huge rates of growth when compared to North America and Europe. This is where the action is.To be a player internationally, you have to be in Asia. One amazing fact is how few

American firms or European firms are competing with the Japanese. In short, Japanis leading world trade and investment which is why the yen is so strong.


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TRAPPED IN ASIA!

Canadian Dollar & Canadian Companies

William BZ Vukson

Canadian politicians are quick to point out that all of Canada’s eco-nomic fundamentals are in good shape. For the first time since the 1960s, the fed-eral budget is in balance and inflation has virtually disappeared from the eco-nomic landscape. Despite all of the good news, the surprising collapse in the cur-rency leaves a puzzling thought to many. How could it be that the Canadian dol-lar is not keeping pace with the rest of the economy?

While the dollar has slowly sunk into its new trading range betweenUS$0.65 to US$0.70 cents, it continued to disappoint by reaching an all-time lowof US$0.634, as the Bank of Canada under the direction of Governor GordonThiessen; reacted in a fit of desperation by raising the short term bank rate by one percent in order to protect against any further declines that may come. This futileaction was a clear signal to most business people that the Bank of Canada ishopelessly out of step when considering the prevailing orthodoxy of central banking among most industrialised countries. The desperate attempt to raise rates

only did more harm to the dollar over the medium and longer term.The surprising aspect of the decline is that Canada became more linked

to events in Asia, while severing its historic financial link to its main trading part-ner- the US. As the yen fell on world markets, it seemed as though it carried theCanadian dollar with it. Unfortunately, the fortunes of Canadian economic devel-opment were set back decades, since the dollar tracked the general fall-out inglobal commodity prices, whose declines were accelerated by the deflationaryeffects that were beginning to build within the east Asian trading zone.

Despite the grand efforts of the Liberal Chrétien government to changethe nature of the economy, into one that encouraged the development of a hightech and telecommunications sector, the cold reality is that 40 percent of allexports are still very much resource-based. Although Canada has several global-ly competent firms (Northern Telecom, Bombardier, Magna International, etc.)in the area of high tech development, they are still too few in number to have anylasting effect in changing the overall nature and perceptions of investors of it being a predominantly resource-based player in world markets.

What may be even more disturbing is the push that reluctant Canadian

companies have been given by an aggressive federal government in opening uptrade in countries like Indonesia, Malaysia and Thailand. The “team Canada”trade missions were regular trips to high growth areas such as east Asia, whichwere designed to initiate Canadian firms to the benefits of foreign markets in the

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hopes that it would expand overall sales and in the process improve balancesheets, diversifying away from the limited domestic marketplace. With east Asia

in crisis, the question now is whether these innovative participants will ever be paid for the work that was performed or for the goods and services that were sentto this region?


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Economic and Financial Review

With over one-third of Canada's income generated by trading with theU.S. The tight U.S. economic conditions have adversely affected Canada. This,coupled with a high dollar supported by the zero inflation goal of the increasinglyindependent Central Bank, has worked against any hopes of a robust recovery in

the near term.

The Canadian dollar, however, has come under heavy pressure thatresulted in intervention by the Central Bank This comes in light of the fact thatshort-term rates in the U.S. were lowered to historically-low levels, with thespread remaining well above the 250-300 basis point range.

Furthermore, recent massive borrowings in the Eurobond markets for the Province of Ontario and Ontario Hydro, all in Canadian funds, has put

upward pressure on the Canadian dollar. In spite of these three positive factorsabove, the dollar has continued to fall from a level of 0.88 cents to one U.S. dol-lar to approximately the 0.83 cents level as of March 19, 1992.

What is the reason for such a large fail, when the fundamentals indicatethe reverse ? This has much to do with the present constitutional crisis with theProvince of Quebec Moreover, four of Canada's vital industries at the presentmoment are in a contractionary phase: automobiles, real estate in southernOntario, Oil and Gas, and natural resources. Damaging foreign investors' confi-

dence in the domestic economy.

The automobile industry has been in a world-wide free-fall over the pastyear and a half, with recent record loss figures being recorded by the big three North American firms: General Motors, Ford and Chrysler, and record layoffs being implemented in a vast restructuring program for General Motors. Therepercussions in the industrial parts of Canada have affected all other sectors thatnormally rely on spinoffs from the car-making process.

Real estate is one industry that especially supports most of the white-collar employment in Canada. It has not been Impervious to the world-wide gen-eral slump. And the restructuring of the industrial-base in southern Ontario willaffect this market for quite a while yet.

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First Quarter: March 21, 1992



The world-wide suppression of Aluminum and Pulp and Paper prices is just another example of how conditions in world markets are affecting the

resource-based provinces. The addition of possible large Russian dumping onworld markets, as was the case in the Aluminum sector during the early part of 1992, will further add to the grief experienced up to now.

World market conditions in the Oil and Gas industry have also severe-ly dealt a blow to major exploration activity in the Canadian north and western provinces. The most serious was the pull-out of Gulf Canada in the largeHibernia project off the coast of Newfoundland, a project that has provided animportant economic contribution to that entire region.

Currency Outlook

The real question is when will the Bank of Canada break, in its unre-lenting support of the currency, in light of the serious factors that are at work atthe moment ? The difficult world price for oil, pulp, paper and aluminum couldgreatly benefit by a devaluation of the currency Into the high seventy cent rangerelative to the U.S. dollar. This would enable Canadian producers to obtain aslight important edge over competitors, hence providing for a more stable envi-

ronment domestically.

Unlike the economic, the political situation with Quebec can be temporarily dealt with through a high degree of intervention on world currency mar-kets by the Bank of Canada, in combination with a moderate increase in the dis-count rate, although that would add to the domestic pressure on the real estatesector and on automobile purchases.

The medium-term outlook for the dollar is a continuation at the present

level, unless a setback occurs in the U.S. recovery, which the Canadian authori-ties are hoping would revive an export-led recovery. If not, and if the U.S. recov-ery falters in any way, then severe pressure may prompt the Bank of Canada towork in the low end of the eighties relative to the U.S. dollar, and may even comeas dose as the .80 to.81 cent levels. The smart bet, however, would be in favour of continued Bank of Canada support through a combination of massive inter-vention on the foreign exchange markets and increases in the central bank rate.


35



Economic & Financial Review

Nothing seems to be going right for Canada, as problems persist on thereal side of the economy coupled with Constitutional turmoil and a very weak recovery south of the border. In particular, the weakness in the domestic indus-trial and property sectors continue to exacerbate the grim employment picture.

And, in addition to the disappointing prospects of an export-led recovery fromthe U.S, the Bank of Canada may find that the outright abandonment of its pur-suit of a hard dollar policy may be inevitable.

As mentioned above, there can no longer be any reliance on a U.S. ledrecovery, and with the fiscal budgets strained both Federally and Provincially,Monetary Policy is the only policy lever that has any room to manoeuvre at this juncture.

To the Deutsche Mark. From this moment, the persistently high rates onMark denominated securities coupled with the decreasing rate on dollar instru-ments will add further downward pressure on the dollar over the remainder of thesecond quarter. As it seems that recovery will not be certain until at least thattime or into the third quarter of the year.

For that matter, we re-iterate our views from the February/March issuethat called for the trading range to settle eventually between 1.5 and 1.6 vis-A-vis the Deutsche Mark. However, once participants are convinced that recovery

Is firmly in place with upward pressure on prices, then this scenario will reverse.Furthermore, the trading range with respect to the Japanese Yen will be influ-enced by the external trade Imbalance. As the market operations by the Fed aswell as the Bank of Japan will not allow a further depredation of the Yen, regard-less of the deterioration in the domestic Japanese economy. The increasing sur- pluses registered recently,,Aill be fought through an appreciation of the Yen tothe 1Z5 to 130 range with respect to the U.S. dollar. To re-iterate, the parities between the U.S. and japanese currencies are overwhelmingly determined byexternal conditions.

The economy showed signs of severe pressure, as the recession deepenedover the past two months with an increase in 57,000 jobs lost in April/92, representingthe sixth straight monthly decline. As a survey conducted by the CanadianAssociation for Business Economists attributes half of the current weakness to

36

Second Quarter: May 21, 1992



severe structural change In the economy. Among the sectors that according to thesurvey are experiencing this are: airlines, forest products, automotive, food processing

and distribution, wholesale and retail trade, high technology (telecommunications,computers, aerospace, pharmaceuticals), and machine tools.

Among the impediments to change that were cited in the survey werefront and foremost management inertia, poor labour relations, tax burdens, inter- provincial trade, insufficient investment and barriers to competition. Theyemphasize that a proper response to deal with these structural changes in theeconomy was not forthcoming by a large proportion of Canadian managers.

in addition to the problems on the real side of the economy, theConstitutional problems with Quebec's threat of secession affect the inflow of foreign investment to Canada, adding downward pressure to the dollar on foreignexchange markets. Recently, the Business Council on National Issues estimatedthat the Canadian economy would immediately contract by 2 percent if Quebecwere to separate, or an average of $ 1100 in losses in annual income for eachCanadian citizen.

Recently, the Bank of Canada has reacted to the depressed real econo-

my by reducing the prime lending rate to 7.5 percent, a 19 year low. It was report-ed on May 11/92 that the dollar dropped one third of a percentage point to a 2year low of U.S. 83.13 cents. It is hoped that the Monetary policy option willattenuate the severe impact of the restructuring on the real end.

Currency Outlook

The continued low growth In the economy, together with the restructur-ing that is presently taking form and the political influence on the markets should

leave the Canadian dollar in the low end of the eighties with respect to the U.S. Thelikelihood of it falling into the high seventy cent range is low at this point in time.


37



Economic & Financial Overview

The Canadian dollar moved in a narrow range between 0.82 to 0.84cents to the U.S. r1rrdzIar over the past two month period. The currency held Itsground as it followed the Federal Reserve of the U.S. In slashing the Bank of Canada rate down to a record low level at S.66 percent as at July 15, 1992.

Since the weak U.S. recovery was unreliable in pulling Canada con-vincingly out of this recession, it was still the export performance that was at thecentre of any domestic revival. As the merchandise trade surplus rose 0.8 percentto Cdn. $12.9 billion In May/92 from the previous month, a fall of 3.4 percent Inautomotive product imports caused overall Imports to fall 3.4 percent to Cdn.$11.7 billion. Clearly, the weakness of the Import component confirmed that theeconomy was sluggish, as new orders in manufacturing recorded an additional2.4 percent decrease.

Still a positive aspect to the economic profile had inflation recordedthrough the Consumer Price Index (CPI) down to a 30 year low, as the June/92rate attained 1. 1 percent. This was a further indication of economic weaknessthat the Bank of Canada was able to exploit by reducing rates in stride with thereductions coming from the U.S. Federal Reserve.

In addition, the preoccupation with the constitutional crisis andQuebec's insistence that the present negotiated agreement by the Provincial

Premiers go further than what was agreed to in terms of acknowledging that Itwas a distinct sodety~ will also exert downward pressure over the CanadianDollar In the long-term. Moreover, the dissension within the ruling Conservative party itself was not a very encouraging sign. Of the comments that were made,none were so poignant in the economic sense as were those of Trade Minister Michael Wilson who commented on the failure to address the weakness of theeconomic union of the country: "It doesn't lead to a stronger Canadian economy".

In addition to the political problems are continuing signs of weakness

In the resource base of the country. As world market prices In areas of pulp and paper, aluminum, oil and gas, and agricultural products remain on the low side.In addition, the tragic announcement of the closure of the Newfoundland fishingindustry for a two-year period due to stock depletion, further exacerbated theregional economic disparity in the country.

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Third Quarter: July 24, 1992



Currency Outlook

In light of the continued sectoral weakness of the Canadian economy,and serious political problems which in the upcoming months may only acceler-ate. The Dollar remains remarkably stable as the enduring effects of the credibility attained by the Bank of Canada as an advocate of price stability still exertthe predominant sentiments in the markets. If constitutional problems accelerateto unbearable levels, however, it is doubtful If the Bank of Canada could main-tain the Canadian Dollar at its present level vis-A-vis the U.S. without foreignassistance. This is one factor, the severity of which, is difficult to speculate on.However, barring any severity of such a sort over the next quarter, the Dollar

should in all likelihood retain its present level of support, in the low end of theeighty cent range relative to the U.S. currency.


39



Economic & Financial Overview

While politicians focused their attention on the Constitutional negotiations,the Bank of Canada was left to mind the faltering Canadian economy. Due toaggressive monetary easing& the Bank rate fell on September 3, 1992 to its lowestlevel since 1973. The 14 basis point fall to 4.93 percent prompted the large chartered

banks to lower their prime lending rates to 6.25 percent from 6.5 percent inanticipation of the outcome of Thursday's T-bill auction.

In fact, the anticipated export boom from the U.S. economy did notmaterialize, as a triple-dip scenario became the primary focus. And, even more soIn this environment, the U.S. administration was more interested in aggressivelyencouragIng their own exports to revive G.N.P. Any additional push into the U.S.markets, under the present environment, would elicit an equivalent ,response fromAmerican exporters. With the U.S economy on the verge of another marked decline,

traditional Canadian exporters into the U.S. market are thinking twice aboutdiversification.

Irregardless of whether or not closer trading links with the U.S. or Mexicohave recently been negotiated, it remains that Canadian exporters cannot any longer patiently await for a resurgence in the confidence of the American consumer.

With G.N.P. off by 0.4 percent in the second quarter and a complete absencein inflationary pressures, the prospect for further monetary easing becomes ever

more real. As the real economy continues to register disappointing results, fiscal policy is unable to provide any useful stimulus due to the deficit hangover. Withautomobile sales from the big three North American manufacturers falling by 7.6 percent in August/92 over a one year period, total manufacturing employment wasdown through the elimination of 27,000 jobs in August/92. Consequently, theunemployment rate came in unchanged at 11.6 percent for the month of August/92.

Furthermore, the restructuring of the Canadian economy was very much atopic of conversation, as the overvalued Dollar, coupled by an anaemic recovery

prompted several companies to respond through the process of labour-shedding.This was captured by the decline in total paid hours by 0.6 percent in the secondquarter, which represented the third consecutive decrease. On the flip-side corporate profits rose by 5.1 percent in the second quarter and continued to show a promising positive trend. The question remains as to whether this development should cause a

40

Fourth Quarter: September 11, 1992



fall in the Dollar relative to the U.S. Dollar, as the Bank of Canada further easesrates? Or will the Bank rate eventually come closer to the short-term Federal Reserve

discount rate?

The question of spreads between the U.S. and Canadian rates has always been on the minds of international investors, as Canadian Provincial debt has always been In favour. Eurobond Investors have bought C $24 billion this year alone, as thespread offered over comparably risky Treasury bills in the U.S. has always beenfavoured for the higher yields offered on the Canadian issues. This factor is anadditional element that has supported the Canadian Dollar at the present 0.83 centto the U.S. range on average over the past year. The Bank of Canada with its pre-

commitment to a zero rate of inflation, along with enjoying a relatively independentdirection in monetary policy from the political authorities in Ottawa, Is an additionalattraction to foreign investors.

The wild-card in the currency markets will be the reaction of participantsto the nation-wide referendum on the Constitution to be held on October 26, 1992.The agreement has gone a long way in satisfying each regional element in Canada;the Westerners with equal representation in the Senate, and the Natives and Quebecers being recognized as having distinct societies. Sadly, though, the agreement does not

go very far with regards to the concept of free-trade between the Provinces.

Currency Outlook

Over the past several months, the Dollar vis-A-vis the U.S. has more or less fluctuated around 0.83 cents. As outlined In the economic and political com-mentary above, the factors that will have some effect on currency markets are theconstitutional vote, the continued long-term restructuring of Canadian industryand the long-term effects of high unemployment, and the spread over the U.S.

Federal Reserve short-term rates. Of which the Constitutional vote will over-shadow the other factors considered over the immediate term.

Assuming that the referendum registers an affirmative vote, then the positive sentiment flowing to the Dollar markets will ensure that the higher dol-lar will continue to affect long-term labour shedding. If the vote does not go as planned, a serious fall in the Dollar to the. 70-.80 cent range will ensue. And theBank of Canada may not respond in kind with an adjustment in short-term ratesfor the fear of creating a greater economic crisis.

Being optimists, we assume that the referendum produces one unitedCanada. Under this scenario we can foresee positive side-effects strengtheningthe Dollar and allowing the Bank of Canada to ease further, as a stronger Dollar will be detrimental to a badly needed push on the export side. Overall, a positive


41



vote, as expected, should be beneficial In stimulating the domestic economy, aslower rates from the fall-out and the positive climate for investors should be a

welcome element. that has for a very long time been sorely missed. Under thisscenario, we expect that the Dollar will settle at an average range of 0.84-0.86 tothe U.S. currency.

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• Referendum rejects new Constitutional accord

• dollar falls below 79.60 u.s. in anticipation ofpolitical uncertain on September 30,1992

• Bank of Canada raises prime lending rate from 6.2sto 8.25% on October 1, 1992 in support of the dollar

• World commodity prices continue to be depressed

• dollar falls below 79 u.s. for first time in 5 years

• fiscal position dramatically deteriorates

• faith is placed on recovery in u.s. to end recession

A combination of political uncertainty and deterioration in economicfundamentals have caused the Dollar to fall below .80 U.S. In addition, lingeringover-supply in world commodity products has depressed prices and directlyaffected the profItability of Canadian exporters. With the only remedy being thecontinued fall In the value of the Dollar.

The Bank of Canada has had to use a wildly fluctuating prime rate inorder to target the desired external value of the Dollar in the run up to the refer-endum on a Federal political agreement, as well as once the after-shock hadoccurred. In very untypical fashion the Canadian public had rejected the compromise agreement known as the "Charlottetown Accord". The prevailing con-sensus is that the vote was a reflection of the frustration felt toward the rulingConservative government, which had presided over three years of sub-par eco-nomic performance. The reaction of the Bank of Canada was swift, and orches-trated to preserve the credibility that it had achieved over the past five years, asthe focus turned to protect the external value of the Canadian Dollar in its goalto preserve the 1% rate of inflation that It had achieved.

The rate of Interest was raised Initially to 8.2S% on October 1, 1992 andthen lowered to 7.75% on October 28, 1992 after the negative outcome of the ref-erendum, very briefly caused the Dollar to rise by 0.5 of a cent against the U.S.Dollar. With the present prime lending rate as of December 3, 1992 at 9.0%, andthe Dollar averaging .78 U.S., there remains an 8% real rate that will positivelyaffect the inflow of international portfolio investment, but which will contract

43

First Quarter: December 15, 1992



productive Investment spending. As a capital project is discounted at higher interest rate levels, it becomes less profitable until It Is delayed altogether. This

is one of the present difficulties that the Canadian economy is experiencing fromthe policy to preserve the external value of the Dollar.

In addition, the depressed state of world commodity markets require asimilar cheap Dollar polIcy in order to pull the country out of recession.Compounded by the fact that both this years' and next years' deficits will severe-ly overshoot initial forecasts. The unexpected drop in tax revenues of $18 billionhave prompted Finance Minister Don Mazankowski on December 2, 1992 to propose spending reductions of $8 billion over the next two years without rais-

ing taxes. As a result of this action, the Dollar immediately rose in European trad-ing from 77.73 U.S. to 78.08 U.S. It seems that this positive sentiment will bemaintained until a general election is called during the course of 1993.

With the domestic economy depressed through high rates, depressedworld commodity markets and continuing political turmoil, the high Interest rate policy of the Bank of Canada is hoping to counter-balance these negative effectson the currency. In addition, the ruling party has placed faith in a quick U.S.recovery in order to gain the positive export stimulus dividend. As the Finance

Minister openly stated: "We believe with the U.S. pickup and some pickup in theworld economy that we've got some brighter days ahead"

Currency Outlook

The negative factors as mentioned above include lingering doubts aboutthe political Identity of Canada, depressed commodity prices and the effect of high interest rates on the domestic economy. On the other hand, action to addressthe deteriorating fiscal position and the impending U.S. recovery coupled with

the commitment of the Bank of Canada In preserving the value of the currencyIn order to keep Inflation low will all be posItively reflected on the value of theDollar.

With a seriously high unemployment rate and high excess Industrialcapacity, the positive factors from any demand-pull out of the U.S. will be along-term effect. On the other hand, the medium term fiscal program to limit thedeficit will be a good complement to the efforts of the Bank of Canada to main-tain a strong value of the Dollar. Consequently, over the medium-term, the value

of the Dollar should fall within the 75-80 cent range to the U.S. Dollar.

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• Kim Campbell chosen as new Prime-Minister

• general election expected to be called in the fall of 1993

• structural recession causes large Provincial deficits

• excessive Provincial debt causes downgrades from rating

agencies

• foreign investment reaches record levels in recent months

• central bank rate lowest in history

• g.dp. increase of 3.8 percent recorded in flrst quarter of 1993

• g.d.p. highest in 2 years driven by exports

• retail sales recover in april 1993

• Bank of Canada targets growth and external value of dollar

Economic and Financial Overview

Kim Campbell has not only become Canada's first woman Prime-Minister, but Is also the choice of the Progressive Conservative party to lead itInto the upcoming election that is expected to be called in the fall of 1993.Although not much is known at this time concerning the political skills of thenew leader and how they may ultimately set the policy agenda in the upcomingelection, early indications point to across-the-board restraint.

While the Bank of Canada works to defend the external value of the dol-lar, politicians both on the Federal and Provincial stage are showing early signsof responding to the debt dilemma. While most of the economically significantProvinces have been reluctant recipients of recent debt downgrades, Provincial politicians have had to Invest extra time In order to make politically unpopular decisions on cutting back expenditures. This Is not surprising as the structuralrecession has seen approximately 200,000 manufacturing jobs disappear inOntario alone. The revenue shortfall becomes even more striking as Canadafaces up to a situation which is unprecedented in the sense that a large portion of the debt Is in foreign control:

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Second Quarter: March 19, 1993



CANADIAN LIABILITIES TO NON-RESIDENTS

1981 13,313 1987 17,253

1982 16,552 1988 20,890

1983 9,643 1989 22,450

1984 9,232 1990 24,284

1985 14,912 1991 45,399

1986 25,094 1992 42,601

Source: Bank of Canada Review

As the table Indicates, there has been a virtual doubling of Canadiandebt that Is now held by foreigners. The volatility that this brings to the externalvalue of the Canadian dollar forces the Bank of Canada to pay much more atten-tion to interest rate adjustments as opposed to previous years. Moreover, this Isa major reason that explains the program of cutbacks that the country's largestProvince- Ontario is now uncharacterIstically forced to make In light of the factthat It Is governed by the socially-oriented New Democratic Party.

One may interpret this unprecedented recession and the actions that go

with it as a symptom of the Increasingly global market for finance. With the pro-liferation of new Impressive advances in Information technology and the endingof the cold war, Canada, not unlike many other advanced western countries suchas In Scandinavia Is finding It very difficult to adjust to the new realities. TheInertia that is shaping economic and political, relations in the world today willtend to be most unkind to the smaller players In the world economy such asCanada. Although being a very large country with abundance In naturalresources, the fact remains that Canada's domestic market Is very small due to itslow population.

For that matter, it must increasingly rely on exports in new markets inorder to replace lost jobs to the continuing outflow of old manufacturIng indus-tries towards underdeveloped countries, as falling tariffs and technologicaladvances encourage shifting of production facilities out of the advanced indus-trial countries. In addition, as the world becomes more price competitive, costsand wages will even more so become governed by the country that is the most productive and cost efficient. This, as we have already witnessed, will continueto erode employee social benefits and will Increasingly cause friction as jobs that

are non-essential to the bottom-line will continue to be reduced.

In such circumstances, political parties which desire progress andattempt to re-sell the stability creating policies that were so successful In the pastrun the risk of outright rejection of the electorate. As the challenge that faces all

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of the candidates come this fall is how to effectively govern in a period that Isactively ungovernable. Any attempts otherwise will cause wild fluctuations in

the dollar, and also any attempt by any of the political parties to propose policiesthat were successful in the past during the run-up to the elections could over thefollowing months yield continuous excitement in the dollar markets.

Currency Outlook

The Bank of Canada's stabilizing effect on the dollar may only play asupporting role over the next several months during the run-up to the electioncampaign. Foreign exchange markets will keep an eye on politicians proposing

a return to the prosperous policies of the past. In addition, the austerIty measuresadopted In the major Provinces concerning debt management will also affectconfidence in the dollar.

These factors, being political, are so difficult to judge. However, giventhe uncertainty that Is ingrained at this moment, it would be safe to conclude thatthe Canadian dollar vis-a-vis the U.S. would not exceed the .80 cent level. For that matter, we can anticipate a trading range of .74 to .79 to the U.S. dollar dur-ing the run-up to election day.


47



• New elections called on October 25, 1993• Election uncertainty and weak dollar weakens bond market

• Dollar slips below real competitive rate relative to U.S.

• Technological change causes low levels in capacityutilization

• Construction permits issued continue to fall

• Unemployment rate continues at high levels

• Official discount as well as prime interest rates fall

• Improvement in the balance of trade reflects weak domestic demand

• Bank of Canada faces policy dilemma as recovery

stagnates• Early signs that Provincial expenditures must be cut further


Canada's real manufacturing side of the economy has hardly begun to showany convincing signs of growth despite the fact that the weak dollar vis-a-vis the U.S.has fallen below its competitive value of around 0. 78 cents. With unemploymentfrozen at historically high levels and with an election only days away, the interest onthe domestic state of manufacturing and industry has been elevated as one of the prime concerns.

The concerns that surround the unprecedented changes that have impactedthis sector recently are not just relevant to Canada, but are an affliction in most indus-trialized countries today. The rapid technological changes occurring in the way indus-try co-ordinates production along with the intensification of global competition bothcontribute to the present jobless environment. Although the upcoming election cam-

paign will focus on the issue of joblessness, the rhetoric, unfortunately, will focus onthe wrong causes such as the recently negotiated free trade agreements.

Should a setback occur in the ratification of the North American Free TradeAgreement (Nafta), or should the politicians mobilize to re-open the existing Free

48




Trade Agreement (FTA) which was concluded in 1988, the fall-out on the CanadianDollar would be enormous. Such an action could be one of the most irrational acts

this century, as the trade agreements represent late reactions to what is already a real-ity. Specifically, new technological techniques and improving "information super-highways" have already allowed companies to become geographically fragmented.Any rejection of this obvious fact by politicians will only serve to increase uncer-tainty and domestic regulatory burdens, while making matters worse.

What is of great interest at this moment is the reaction of the Bank of Canada as it simultaneously tries to balance the interests of a number of groups.The pressure on politicians to act on the unemployment problem has resulted in

great pressures for lower rates, even though the new manufacturing age is noteasily subjected to the familiar business-cycle cures of the past. At the same time,the Dollar must retain some stability, especially now that an increasing propor-tion of foreigners hold Canadian Federal and Provincial debt.

In essence, this problem has become politicized, since low rates are notmaking any impact on job creation while manufacturing continues to produce ata steady rate as is evidenced through the table below. It is a fact that technolog-ical changes have resulted in redundancies, while the volume of production has

been steady at low rates of utilization over the past three years. A very unfamil-iar situation just half a decade ago.

PRODUCTION: Indices of Real Domestic Product 1985=100

YEAR Industry Manufacturing Construction

1991

1 101.1 95.3 93.5

11 101.8 103.4 111.6

111 97.3 97.9 132.7

IV 101.1 97.5 121.1

1992

1 101.7 95.8 90.5

11 102.0 102.8 106.8

111 97.5 97.1 127.1

IV 103.7 100.5 104.9

19931 107.2 101.6 82.2

Note: Industry includes: mining, quarrying, oil, manufacturing & utilities

Source: OECD


49



In addition, the possibility of a fragmented coalition government is veryreal. With the number of official parties increasing to six from the traditional

three, this will bring about a situation similar in many ways to the gridlock thathas been experienced in several European countries. The present day politicalmap can be envisioned between the traditional parties and three new regionalones: Traditional/National: Conservative, Liberal, New Democratic Party

Regional: Bloc Quebecois, National, Reform

The uncertainty will be a drain on the Dollar, but the actual outcome,whatever it may be, will not have any substantial effect on the real economy or

on further progress in the trade negotiations.

Currency Outlook

The Bank of Canada will continue to balance the interests at this pointin time, being very careful to avoid any major foreign sell-off in the Canadian bond markets. This will be a great challenge over the short-term as the politicalcampaign and outcome will become the focus of attention. In addition, foreigninvestors will monitor the reactions of Provincial governments, especially in

Ontario should there occur further budget shortfalls.

Over the next quarter, the Canadian dollar is very unlikely to exceed itsequilibrium competitive rate of 0. 78 cents U.S. The pressure bias will, howev-er, be on the down side considering the negative short-term effects outlinedabove. Consequently, a range of 0.72 to 0. 7 7 would be fitting given the cir-cumstances.

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50



• Jean Chretien becomes new Canadian Prime Mu-minister

• the Liberal party is elected. by majority support

• Ontario debt downgrade for third time in as many years

• majority government helps to stabilize Dollar

• Bank, of Canada Governor John Crow's 7 year term ends inJanuary 1994

• federal budget.overshoots original forecast by $15 billion

• inter-provincial trade wars erupt between Ontario andQuebec

• budget problems due to sluggish revenue rather thanoverspending

• commodity prices such as wood and newsprint remain weak • big test for Dollar to come as Quebec holds elections in 1994


The discontent displayed by the Canadian elec-torate as demonstrated in theFederal election results on October, 25, 1993 is no different from most other industri-alized countries at this very moment. With the ruling Progressive Conservative party

almost entirely wiped off the Canadian political-ical map, stagnant economic per-formance over the past three years coupled with an unprecedented campaign of corporate re-structuring and down-sizing, prompted the electorate to release their anger on the political party of the most unpopular contemporary Canadian Prime-Minister-Brian Mulroney.

The new political alignment includes two new powerful regional parties (BlocQuebecois, Reform Party of Canada) at the expense of the tra-ditional left-wing socialists-the New Democratic Party and the Progressive Conservatives men-tioned above.

The result is not too surprising when the indus-trialized countries of the G-7are placed into a global context. This is an absolute necessity under present geopolit-ical and economic events in the world, if individual results such as the recent Canadianelection are to be fully understood.

51

Fourth Quarter: October 12, 1993



What is of some interest, is the fact that Canada was one of the first indus-trialized countries to experience unprecedented re-structuring. In fact, it may be wise

for countries of the European Union to take note, since recent Canadian economic and political experiences may shortly be shared by a number of countries there. The elec-torate of whom shares a similar disillusionment, as in the contem-porary Canadianexperience, with the general process of de-industrialization.

To a large extent, unprecedented technological changes have temporarilydisplaced a large portion of the labour force in the G-7 countries. However, this natu-ral process of evolution has combined with the recent opening up of areas in the worldwhich were previously off limits to free markets. With the recent net addition of the

natural resources of Russia, the enormous human capital of China and eastern Europeto the existing pool of world resources, has opened up great opportuni-ties, while atthe same time causing great disloca-tion.

Specifically, when the Russian and Chinese markets were off limits onlyfour years ago, the G-7 was able to enjoy an artificially high standard of living, sincethe resources of the other half of the world were not available participants in the mar-kets. Simply put, Canadian natural resources for export must compete with an evenlarger volume of Russian wood, aluminium and coal today. The same goes with the

new 1.2 billion strong Chinese market, which has almost become a magnetic attrac-tion to North American industry.

Such scenarios have already impacted the real industrial sector of Canada'seconomy, and will continue to do so. The challenge is for Canada to take advantageof the new environment by adopt-ing an aggressive export stance. This would not onlyinclude traditional markets such as the U.S., but also thelarge number of recententrants into the world market.

Number of Parliamentary Seats Held By Canadian Political PartiesPolitical Party New Alignment Old Alignment

Progressive Conservative 2 157

Liberal 178 80

New Democratic Party 8 44

Others & Vacancies 0 14

Bloc Quebecois 54 0

Reform Party of Canada 52 0

Independent 1 0

Totals 295 295

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52



This process of on-going re-structuring has enormously impactedFederal and Provincial gov-ernment revenues. The shortfall can be attributed to

some of the following reasons:

a. re-location of labour intensive industries to lower wage areas of the world

b. high wage corporate redundancies who have decided to accept lower

paying employment in the service sector, or have set up a self-

employment practice

c. chronically high tax rates at all levels which have encouraged less work

effort and a high degree of tax evasion together with a rampant blackmarket economy

d. natural attrition of jobs through technological changes

e. regional sectoral recession in areas such as real-estate and property

development and natural resource exports

What is interesting to note is the fact that a growing segmented work-force which is self-employed is becoming a more common occurrence in indus-

trialized countries such as Canada. This has very serious revenue collectionrepercussions, as taxes are no longer conveniently deducted at source, but arecollected under trust that a self-employed individual fully declares their income.

The rampant black market economy ensures that the government willnot be able to tax an ever larg-er proportion of economic activity. Hence leadingto ever more revenue shortfalls. The solution to the entire problem of tax evasionis a lower income tax rate along with cutbacks in social services and a pro-gramme of continued privatization.

In short, if the fiscal finances continue to deteri-orate on a relative basisvis-a-vis the record of other G-7 members, then the Dollar will shift downwardsto a new lower trading range vis-a-vis the U.S. Dollar.

Furthermore, the monetary side under the lead-ership of Bank of Canada Governor John Crow has come under serious attack recently for its pur-suit of a zero inflation goal. Although low inflation is now the norm, the criti-cisms in this respect cannot be further from the truth, since once again the actions

of John Crow and the Bank of Canada must be placed in a relative international perspec-tive. Recently, the Bank of France, the Bank of Italy and the Bank of Japan have joined the German Bundesbank and the U.S. Federal Reserve as independent central banks.


53



What this means is that monetary policy is determined without the

influence of politicians. Since politicians always look for short-term solu-tions to problems, any control over a policy lever such as money would tempt them toease up on credit liquidity, in order to achieve greater levels of employment. Withthe advantage of having the recent experience of the U.S. Federal Reserve, thisdoes not always work. But, over the long-term it has the potential to generateinflation which will not solve the long-term structural unemployment problemsof industrialized countries like Canada.

Recent rhetoric opposing the re-appointment of John Crow fails to place

the workings of the Bank of Canada within an international context. In other words, yes, John Crow can be replaced by a politi-cal appointee and preferablya politician from the Ontario New Democratic Party. But, if a majority of theother members of the G-7 decide that a cred-ible and independent central bank would best serve them over the long term, then Canadian financial markets suf-fer and the Dollar plunges.

If a far-reaching change such as this must be made, then let us all makesure that a majority of the industrialized countries also do it. Canada is much too

small a global player to take an initiative such as this all unto itself, without expe-riencing a serious fall-out over the longer term. In that respect, Jean Chretien hasno choice- just as he didn't have any real choice under Nafta- but to re-appointJohn Crow for another seven years.

Currency Outlook

What is important to watch over the next quarter is how the Chretiengovernment attempts to bring the Federal deficit under control. In other words,

how he is able to maintain a borrowing require-ment that is comparable to other industrialized countries. The ease to which this goal is attainable is dependent toa large extent on how robust the recovery is in the U.S. economy, hence spillingover into Canada.

If the U.S. begins to stagnate in any way, then the chances of reducingthe deficits in line with the other G-7 members will be much more difficult. Thisfactor will preoccupy the markets over the next quarter and should see the trad-ing range of the Canadian dollar vis-a-vis the U.S. at 0.72 -0.76 cents. If John

Crow is not appointed, then it is highly probable that the Dollar settles in thelower end of this range.

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54



• Bank of Canada Governor John Crow replaced by GordonThiessen

• Finance Minister Paul Martin Jr. tables new budget

• Liberals announce measures to reduce dfenseexpenditures,

• public debate held on tax and social security reforms

• current unofficial rate of unemployment stands at 26%

• Canadian general government debt at 86.2% at end of 1"3

• dollar under pressure as short- term rates approach U.S.rates

• January/94 official unemployment rate rises from 11.2%

to 11.4%• 48,000 additional manufacturing jobs eliminated

• uncertainty mounts as Quebec election expected in fall of1994


The resignation of former Bank of Canada Governor John Crow is one

among a number of factors that may lead to a dollar crisis. While this did notcause an immediate panic, it doubtlessly will reemerge as an unstable element if the upcoming budget does not address the $45 billion fiscal deficit. Moreover,the fact that the U.S. Federal Reserve has just moved to raise its short-termFederal Funds rate (valid on interbank loans) to counter an over- heated econo-my, will undermine the historic premium in which Canadian short- term securi-ties were able to offer investors. This will divert capital flows away from Canadaand into U.S. investments.

The combined effect of all these factors will be difficult to overcome,since the trade- off at this point in time presents very difficult choices. Short of any dramatic restructuring in the Canadian government bureaucracy, the pres-sure will culminate in an eruption which will send the dollar spiralling down-

55

First Quarter: 1994; December 18, 1993



wards. For that matter, it is essential that Finance Minister Paul Martin Jr. actsdecisively to cut the top- heavy Canadian military. Immediately to be followed

by a program which retires most government employees above the age of 52, andoffers a scheme whereby these talents can be diverted into the private businesssector.

This re-deployment of the civil service into areas of productive usemust be co- ordinated with the Provinces, and be followed by lower taxes andeasier access to business and venture capital, in order to move the country out of its present state of stagnation. With the U.S. experiencing a recovery for over ayear now, Canada has yet to participate from the traditional spill- over effect, in

the way that past U.S. recoveries have enabled exports to accelerate Canada outof recession.

The inability to generate growth and reduce its traditional partner has-the United States. employment after pursuing a very easy monetary pol-icy, leadsto the suggestion that the present state of the Canadian bureaucratic superstruc-ture must come to an end. Such a structural change, although diffi-cult, is whatis needed on a relative basis vis- a- vis similar actions on behalf of other indus-trialized coun-tries within the G- 7. Canada has waited long enough for the U.S.

economy to pull it out of recession. This has not happened, and now it must be prepared to enact some very difficult measures in order to main-tain the strengthof the dollar.

On a relative scale, it is very interesting to note that Canada's debt toG.D.P. is the worst, save Italy. And only the growth of debt accumulation in Italyand the U.K. can be matched to the Canadian scenario over the past three years.As the following table indicates:

To reiterate, it is important at this juncture that Canada is also seen as acountry which is enacting measures in order to improve its fiscal finances. Onceagain, we cannot stress more the importance in which such decisions are interpreted within a relative context among all advanced industrialized countries.

Therefore, Finance Minister Martin has an unenvi-able task on hishands. This has turned into a far more serious proposition, since Canada has notnear-ly experienced the recovery to the same extent that its traditional partner has- the United States.

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Currency Outlook

In order to save the dollar, the Liberal government must reduce itsdeficit through a radical re- organisa-tion of the Canadian bureaucracy, which isinevitably accompanied by real spending cuts. Any moves to avoid these hardchoices by further plugging tax loopholes, or raising taxes will continue to stag-nate the domestic economy.

In that sense, only spending cuts will offset the natural tendency of thedollar to fall now that the U.S. is raising its short- term rates in order to counter its robust recovery, while Canada is still reducing its rates to counter stagnation.

The danger is that if for-eign investors do not perceive the budget as seriouslyaddressing domestic stagnation, the dollar could drop to the 0.67 to 0.72 rangevis- a- vis the U.S. dollar. Otherwise, it will trade in the 0.74 to 0.78 range, pend-ing a successful budget.

General Government Debt (% Debt to GDP)

1991 1992(g) 1993(a)

Canada(b) 77.6 83.0 86.2

France 48.5 50.1 52.4Germany 45.0 45.9 48.5

Italy 101.3 106.8 112.2

Japan (b) 68.2 66.2 66.0

U.K. 41.1 45.9 52.6

U.S. 59.8 63.2 65.1

(a) 1992 and 1993 data are Commission forecasts

(b) Source: OECD Economic Outlook 53, June, 1993Source: European Economy, Annual Economic Report 1993


57



• February 1994 budget reveals plan for gradual deficitreduction

• defense spending reduced by $7 billion over 5 years

• dollar falls to historic lows

• Moody’s Investor Services places foreign cumrrency debtin review

• unemployment falls from 11.4% in January 1994 to 10.6%in March 1994

• bonds experience worst decline in over 12 years

• net government debt rises 11.2% in fiscal year March 1994

• net government debt presently at 93% to GDP- up from

30.6% in 1982• provincial foreign debt doubles to $120 billion over last

5 years

• Japanese investors become net sellers of Canadian debt

• 30% of net Canadian debt ($266 billion) held byforeigners


Recent evidence confirms the view that in a period of deflation, the proportion of debts to assets accelerates upwards. This problem becomes ever moreacute, when governments are either unwilling, or unable, to curtail the degree towhich they participate in an economy. As technological change and the integra-tion of new countries into the multilateral trading system proceeds, the revenue base of a national budget is more and more determined globally, while the expen-diture side must still contend with the national demands of a constitutional

democracy.

In the Canadian situation, net government debt has virtually tripledfrom a level of 30.6% of GDP in 1982 to 93% at this very moment. In this case,it is not wholly a question of apportioning blame to one particular government or

58

First Quarter: February 14, 1994



another that has governed the country in the recent past. A major constraint onthe policies of any political party in a constitutional democracy, are the periodic

recurring elections that exist usually every 4 to 5 years. In that sense, the mostdifficult actions inevitably have to do with austerity on the expenditure side.

Admittedly, revenues have become more difficult to collect now thattrade and investment flows have become liberalized. In addition, technology andthe persistent re-structuring, combined with recession over the past three years,has led to a completely different environment on the revenue collection side of the budget. As Canadian citizens continue to demand what they believe to betheir basic rights in society in a continuously changing global environment, debt

will continue to grow.

For countries like Canada, Sweden, Finland and certain members of theEuropean Union, recent changes have delivered a severe shock to their politicalsystems. Unquestionably, the basic rights and demands of citizens from their governments, has not kept pace with the new global industrial reality affectingnational revenues. Once again, any progress to reduce the imbalance betweenrevenues and expenditures must be co-ordinated between all countries, if cur-rency and financial market turbulence is to be avoided.

Over the short term, Finance Minister Paul Martin Jr. had tabled a budg-et last February, 1994, which was designed to implement austerity very gradual-ly. Shortly afterwards, the Canadian dollar came under heavy attack, whichforced the Bank of Canada to intervene in the currency market on several occa-sions, and eventually raise the short term bank rate back to its historic spreadwith the United States. The entire crisis would have been entirely averted, if onlyCanada was not geographically adjacent to a super power to her immediatesouth, which continues to show good economic fundamentals.

Specifically, the budget high points include: no new taxes; defenseexpenditure reductions by $7 billion over 5 years; capital gains exemption reduc-tions and a public service salary freeze. The budget forecasts are presented on p. 17.

The danger at this point in time is that these forecasts were made short-ly before the Canadian dollar came under speculative attack. Consequently, the"Interest on Debt" has already been estimated to have added an additional $1.5

to $2.0 billion to the above forecasts. If the current pressures persist, then it willnot be too surprising if the Finance Minister is forced to introduce a mini-budg-et to address the disparities, shortly after the Quebec Provincial elections.


59



Currency Outlook

Federal Revenues and Ex penditures(February 1994 forecasts)

(Cdn.$ billions) 93/94 94/95 95M

Revenues 114.7 123.9 132.0

Expenditures -121.8 -122.6 -122.7

Operating Surplus/Deficit -7.1 1.3 9.3

Interest on Debt -38.5 -41.0 -42.0

Budget Deficit -45.7 -39.7 -32.7

The budget has not convinced foreign investors to remain exposed toCanadian dollars. The recent re-patria-tion of Cdn.$3.4 billion by Japaneseinvestors is a disturbing signal, since this is the first reversal in foreign invest-ment flows from Japan since 1976. Moreover, it comes at the worst time, justwhen flows ought to be accelerating into Canada to service the growing debt.

Hopefully, this reversal will not be the prelude to a general movement

away from Canadian dollar denominated debt instruments over the next severalquar-ters. This very moment represents a bad period for Canada, when placed ina his-torical context, coming just months before another Quebec Provincial elec-tion, again based on the theme of separa-tion from Canada.

However, it is expected that Quebec will remain a part of Canada, giventhe enormous economic risks that an out-right move toward separation will exertupon itself. However, the uncertainty surrounding the entire issue, is worth a political risk premium that is estimated anywhere from 0.2 to 0.5 cents to the

U.S. dollar. The long-term fundamentals point towards a very gradual reductionin debt levels, and any moves to acceler-ate the outflow of foreign investmentwill lead to much higher interest rates and a weaker dollar.

However, there is also an important political limit to a fall in theCanadian dollar. Given that the North American Free Trade Agreement (Nafta)is now being implemented, and Canadian access to U.S. markets is more certainthan ever before. Any use of a weaker dollar to cheapen exports to the U.S., willcome under growing protests from producer interests in Congress.

This is a situation which may escalate trade tensions with the U.S., evenunder Nafta (see article by Rugm,an and Warner in Vol.11, No.V). Evidence points to the fact that domestic U.S. pro-ducer interests will not tolerate anyunreasonably low levels in the value of the Canadian dollar. The current specu-

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60



lation is that levels in the mid-$0.60 cent range relative to the U.S. dollar, mayresult in political moves in Congress which favour an I.M.F. solution to the

growing Canadian deficit.

Consequently, in respect to the above considerations, it would be con-ceivable to see the Canadian dollar trade in a range of 0.68 to 0.73 cents to theU.S. dollar over the next quarter.


61



• United Nations rates Canada as having highest standardof living

• attention turns towards the Quebec Provincial elections

• public debt charges rise by 0.6% in April 1994 from 1993

• business credit continues to decline• consumer and mortgage credit on the rise

• current account deficit widens

• debt rises higher than in any other industrial country

• debt and political risks force real long-run rates toexceed 9 percent

• surge in demand for automobiles raises capacity

utilisation rate• net international reserves at all-time low


All eyes have turned towards the upcoming Quebec provincial elections.The ruling Federalist Liberals under Premier Daniel Johnson must confront a popu-lar Parti Quebecois under Jacques Parizeau. Should the latter win, pron-dses of an

early referendum on Quebec's eventual separation from Canada will instill an atmosphere of fear and panic in financial markets indefinitely, and perhaps for the remain-der of this decade.

Never have the stakes in previous rounds of Quebec separatist fever beenas high as they are this time around. In addition to this political crisis, Canada is facedwith very serious questions concerning the overall climate of economic under per-formance. With the US recovery now going into a phase of consolidation, Canadaseems to have missed the entire upturn. A divergence from the historical norm.

What makes separation far more desirable for Quebecers in the upcomingelections, is that they will be able to cast their votes on political and economic con-siderations. Unlike past referendums on separation which have been conducted ingood economic times, any referendum now will come at a time of record unemploy-

62

Second Quarter: April 22, 1994



ment and de-industrialisation. An economic climate which often leads to dangerous political outcomes.

Assuming that the governing liberals under Daniel Johnson win. Quebecwill not face a referendum, but Canada will still need to face one on its economic per-formance. The problem over the past three years, was that economic restructuringand overall industrial decline have been far more vigorous in Canada than in mostother countries organised under an Anglo-Saxon system. Unfortunately, neither thecountries' elected representatives nor the electorate who put them in office, havegrasped the overall geopolitical changes in the world which have forced such an envi-ronment.

For this, it would be very difficult to directly accuse anyone of misman-agement. What is known, however, is that the present low inflationary climate in theindustrialised countries, together with freer trading and investment arrangements,have adversely impacted all resource-based, protectionist j urisdictions such asAustralia and the Scandinavian group of countries, in addition to Canada.

What is becoming very clear is the extent of the protectionism that has beenoffered to low-skilled, undesirable industries. Industries which as soon as the barri-

ers came down, picked-up and settled in some of the most low-cost and unregulatedregions in the world. A situation that is not as visible in pro-ductive, high value-addedindustries, that are more usually than not, located within countries such as the US,France, Germany and the Netherlands.

At a micro-level, the problem of channeling credit to finance produc-tiveventures has been virtually absent. There exists a severe problem in the process of intermediation within most Canadian financial institutions. The familiar theme of vir-tually nonexistent venture capital in the country becomes even more frustrating,

when under a global environment of freer trade and easier access to larger markets inthe world, the major portion of the coun-try's credit is reserved for sectors that onlymarginally figure into the coun-try's overall productive export strength (while devel-oping a massive branch banking super-structure to assist indi-viduals with their pur-chases of real-estate, productive export industries usually do not figure into the over-all equation). Under the present geopoliti-cal structure in which the whole world isheading, this should not be allowed to exist. As the table (above) illustrates.

While the economy is being constrained by such institutional factors at

work, the level of political debate by the elected representatives leaves a lot to bedesired. Not only are most of the locally-minded politicians completely mystified bythe ongoing economic under performance, but the general populace at large can beworryingly described as being uninterested at best in the broader international factors


63



influencing present economic restruc-turing. Canadians must prepare them-selves for possible IMF intervention.

Currency Outlook

Under the most likely scenario of a Parti Quebecois victory, the imme-diate financial and currency market euphoria would send one Canadian dollar below 0.70 cents U.S. However, this will recover after several weeks to the pre-sent 0.70 to 0.73 cents range. However, once a definite referendum date has beenfixed, the market jitters would again send the dollar below the 0.70 cent level.

Such an oscillation will continue until the eventual outcome is knownin the Quebec referendum. If separation would be the eventual outcome, the firstsigns of difficulty would appear in the refusal of foreign investors to add any fur-ther Canadian dollar denomi-nated assets to their portfolios. This would imme-diately lead to an IMF brokered solution to the problem.

However, if the Liberals under Daniel Johnson win, the political tur-moil would temporarily become a sec-ondary consideration to the pressing eco-nomic questions. With recovery only based in the present pent-up demand being

felt in the automotive sector, further hard choices would be required.

The immediate euphoria over the victory of the Liberals in Quebecwould temporarily raise the dollar trad-ing range to 0.73 to 0.76 cents to one U.S.dollar. In order to sustain this level, foreign investors would need to have somesignal of change primarily in the spending levels in government, and secondari-ly in the process of bank credit intermediation and overall industrial policy, oth-erwise, expect a continuation within 0.68 to 0.73 to one dollar US.

Year Total Business Credit ResidentialMortgages

1988 10.0 15.8

1989 11.2 15.8

1990 9.3 14.1

1991 3.6 8.2

1992 2.5 9.4

1993 1.5 7.4

All figures are Rates of Change Based on Seasonally Adjusted DataSource: Bank of Canada Review

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•Parti Quebecois wins election by narrow margin

•popular vote shows strong support for federalists

•referendum may be postponed until support rises

•dollar rises as political risk diminishes

•Eurobond maturities prompt heavy reinvestment

•Confederation Life insurance company collapses

•raw materials exports surge aided by low dollar

•Canadian bond yields perform best in August/94

•credit agencies downgrade provincial debt

•current account deficit widens over debt charges

•small growth in wages reported

•automotive sector to save Canada from recession

With the strong showing of Daniel Johnson’s Liberals in the September 12, 1994 Quebec election campaign, the planned referendum on independence to be held within the ensuing ten month period, is fast becoming a farce.

Although the separatists under Jacques Parizeau won a majority of 77 parliamentary seats of the 125 total, the markets turned to the popular vote, asthe true indicator of the eventual success of a referendum on Quebec’s inde-

pendence from Canada. Consequently, the dollar managed to free itself frommost of the political risk associated with the possible break-up of Canada.

Despite the fact that both monetary and fiscal policies are continuing tomove towards austerity. The prognosis of improving demand for Canadian natu-ral resources, as well as the enormous pent-up demand that will be experiencedin the automotive sector, is expected to pull Canada out of its lingering recession.

The overall effect, however, will be somewhat restrained over the con-

tinuing reluctance of the banking system to lend to small businesses and the property development sector. However, the mere fact that the average age of both passenger vehicles and commercial trucks is far above their historical replace-ment life, will go a long way in generating optimism over the prospects of recov-ery in the latter half of the decade.

65

Third Quarter: September 25, 1994



Just as in the case of Germany, the production of all vehicles in Canadais expected to rise to a sustained level of 2.4 million units until 1999. This, com-

pared with an average production rate of 2.0 million units throughout the period1990 to 1993. The increase in production represents about 25 percent more units produced on average, in the latter half of the decade. Likewise, averageCanadian sales in the latter half are expected to rise by 18 percent. From an aver-age sales rate of 1,254,502 in the period 1990 to 1993, to an average sales rate of 1,479,565 in the period 1995 to 1999. (See table I)

The question surrounding the nature of the Canadian recovery, centreson to what extent the robust recovery in the automotive sector will affect the

spin-off parts industry, and in turn how far this will all go in generating moregrowth in the service sectors? And ultimately, will the increased activity enabletax receipts to grow, in order to cover the burgeoning deficits of all three levelsof government?

Early evidence from wage growth rates, do not yet lead one to believethat this may happen. The process of de-industrialisation in the provinces of Ontario and Quebec, has been so severe in the past four years, that it may take afurther year or two for the positive effects to emerge in higher levels of person-

al and family income. As table II shows, manufacturing unit labour costs haveexperienced the greatest relative reduction in Canada, of all industrialised coun-tries.

If there is ever a case to be made in favour of re-inflating, the Canadianlengthy recession is a textbook example. The fact of the matter is that monetary policy has been so stringently orthodox over the last five to six year period, thatthe only engine remaining to lift the country out of recession, was the naturalwear and tear (depreciation) in the stock of machines and automobiles (pent-up

demand). In essence, it will be very much a “natural” recovery, without any helpfrom either fiscal or monetary policy. Unless monetary policy is pursued moreaggressively, the duration of the trough in the business cycle will get longer and be very damaging to the social fabric of the country. Such policy considerationsmust be addressed before the current rise in pent-up demand is expected to runout, at the end of the decade.

Currency Outlook

From the viewpoint of financial markets, Daniel Johnson and the feder-alists won the Quebec election. Given that the Parti Quebecois received only13,500 more votes in total than the ruling Liberals, the prospect of conducting asuccessful referendum campaign is quickly receding. In fact, Mr. Parizeau may

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find it wise to take the advice of the leader of the Federal Bloc Quebecois, LucienBouchard, and postpone the vote altogether, until public opinion is willing to

risk independence.

However, if a referendum is called over the next ten month period, as promised, it will inevitably affect the risk premium attached to the Canadian dol-lar. And every successive public opinion poll, until the final day of the vote willcause movements in the currency markets, in accordance to the attitude of theQuebecois.

The expectation is that the natural economic recovery will go a long

way in capturing the headlines. This is vital, in the sense that a robust recoveryin first the automotive sector and raw materials, will tend to even further relegateseparatism to being a secondary issue.

In addition, the present phase of recovery will be under scrutiny, if itwill generate enough activity to raise tax receipts, and cover the enormous debt burdens created by all three levels of government. Early signals to this being suc-cessfully fulfilled, will be in the growth of personal incomes and employmentlevels.

Therefore, with the political risk premium no longer a pressing concern,the natural recovery on the real side of the economy will favour a rise to the 0.74to 0.78 range with respect to the US dollar. However, with an inactive fiscal and

monetary policy, the best it will be able to do is 0.72 to 0.75 to the dollar.


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Canadian Vehicle Production and Sales (Table I)

Year Units Produced Units Sold1990 actual 1,947,106 1,314,118

1991 actual 1,887,572 1,287,056

1992 actual 1,950,646 1,227,841

1993 actual 2,237,733 1,188,992

1994 forecast 2,200,200 1,284,167

1994 scheduled 2,301,365 1,296,001 (tracking)

1995 2,500,000 1,401,783

1996 2,500,000 1,501,351

1997 2,500,000 1,528,495

1998 2,450,000 1,517,195

1999 2,400,000 1,449,000

All vehicles include both automobiles and trucks

Source: DesRosiers Automotive

Consultants Using Industry Data

Percent Changes in Manufacturing Unit Labour Costs (Table II)

Country 1991 1992 1993

Canada -2.6 -2.2 -2.9

France 2.1 0.5 1.5

Germany 4.3 4.8 1.4

Italy 13.4 5.5 4.2Japan 4.4 8.7 4.5

US 1.3 1.0 -1.9

Source: Bank of England Quarterly Bulletin. August, 1994

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$financial markets anticipate February 1995 budget

$rising real interest rates threaten large debt levels

$US rate increases pose challenge to Canadian recovery

$historical spread on US and Canadian rates narrows

$foreign debt at 44% of GDP used to finance consumption$current account deficit to attain 2.5% of GDP

$reduction in 1995 immigration quota by 12%

$consumer prices register a 0.2% rate of deflation

$industrial restructuring causes labour input to fall by 20%

$automotive industry expected to generate record profits

After scoring a post-election dividend in the aftermath of theQuebec elections in September 1994, the dollar found itself on thedownside once again, challenging 0.70 US in the fourth quarter of 1994. The popular opinion in Quebec continues to show overallsupport for the Canadian federation, however, the immediate

euphoria in financial markets has been replaced by resurgent reservations aboutthe abilities of the present Liberal government to carry out the promised reduc-tion in the deficit for 1995-1996.

Finance Minister Paul Martin Jr. has announced that the February, 1995 budget will contain draconian fiscal measures, designed to reduce the presentdeficit of some $40 billion to $25 billion, or 3.5% of GDP. If accepted at facevalue, there still remains the possibility of provincial gridlock, as both Quebecand Ontario (two of the wealthiest provinces) resist the trend to lower debt lev-els, despite the fact that credit agencies continuously deliver downgrade after downgrade. At this very moment, the government is showing tremendous faith inthe natural recovery, as recent life exhibited in the economy from pent-updemand in the automotive industry has generated some $5.0 billion extra in rev-enues over the second half of 1994.

Success in such a strategy of patiently waiting out the current budget-ary impasse, may prove to come out short. As the present cycle of recovery will

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First Quarter: January 5, 1995



prove to be far more shallower than in the past. A recent report commissioned bythe Paris-based OECD has concluded that the period 1989 to 1993 witnessed the

most severe restructuring in the industrial base since the Second World War.Evidence presented indicates that costly Canadian labour supply has beenreplaced by technology and machinery in the production process. In fact, it wasreported that the manufacturing industry uses 20 percent less labour now, than ithad prior to 1989. Moreover, it continued by asserting the view that the “joblessrecovery” is expected to continue, as some 80 percent of the income generatedin the present upturn is derived from a more efficient deployment of the existing pool of workers. Only 20 percent of the growth in income can be attributed tonew workers absorbed in the production process.

Monetary policy continues to be inactive, as the Bank of Canada isforced to side with foreign investors by maintaining artificially high real interestrates. As the US Federal Reserve has raised its short term administered rate by0.75 percent, the Bank of Canada has found itself in a position where it mustraise real rates under a condition of domestic deflation. Since foreign investorsexpect the historical yield spreads between US and Canadian financial instru-ments with similar risk profiles to be maintained, any narrowing of this gap is notexpected to be tolerated for too long, before Canadian securities are dumped on

international capital markets. A situation which has not been too far off the mark most recently.

By having to defend the value of the Canadian dollar constantly, thedomestic economy is being deprived of a more beneficially active monetary pol-icy. This argument may very well be refuted by current commentators on theCanadian economy, who cite the fact that growth has been on a recovery trendand that Canada is expected to be one of the fastest growing among industrialisedcountries in 1995. However, with consumer price deflation being the present

condition, and with continuing long term rates at about 8 to 9 percent, the breadthof the present recovery is being supported solely by pent-up demand. Any ter-mination in this cycle of pent-up demand could produce disastrous results, plung-ing the Canadian economy back into a state of heightened recession.

The lingering problems that are re-surfacing on Canada’s internationalaccounts present an alarming signal for all investors exposed to Canadian dollar denominated certificates of investment. A backdrop to the entire problem is thefact that much of Canada’s foreign indebtedness, amounting to some 44% of

GDP, has been directed to financing an artificially inflated standard of living. The prime example of which is the battered real estate sector, which continues to losereal value, and which by some conservative estimates is still some 50 percentovervalued.

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Despite operating under a merchandise trade surplus, the overall inter-national exposure is faced with continuing deficits, as interest payments on the

stock of foreign debts are causing the need for continuing capital inflow fromforeign investors.

With the US economy nearing its peak in performance, the imbalanceon the Canadian international accounts is bound to get even more serious. Sincemost of the merchandise trade surplus is with the US and Mexico in the auto-motive trade, an end to pent-up demand could cause even more pressure on thealready high real rates to increase even further. Since yields that transcend thehistorical Canada-US spreads become indispensable in attracting much-needed

foreign capital.

The alternative of having a further devaluation in the Canadian curren-cy can only go so far, before investors rush to dump their Canadian securities.The current danger is that if the upcoming February 1995 budget does not cur-tail the bloated deficit, causing capital to accelerate its outflow, a surplus on theinternational trading account would be the only alternative. Causing unprece-dented pressures on the social welfare system.

The most likely developments will ensure that the Bank of Canadamaintains high real interest rates, and that the Federal government delivers acombination of higher taxes and lower regional and industrial subsidies. Major reductions in social spending should not be anticipated at this point in time.Overall, investment spending on new plant and equipment will suffer only to theextent that existing pent-up demands may lead to higher levels of production.Higher taxes will work to reduce disposable incomes further, curtailing spendingon consumer goods and imports.Presently, as was reported above on several occasions, pent up demand arising

out of the automotive sector has been the pillar of the improvement in econom-ic fundamentals. The duration of the expansion is expected to continue until1998, the basis of which has been aging vehicles and the North American FreeTrade Agreement, which has resulted in two vehicles being produced for everyone sold in Canada .

Although the likelihood of Quebec separating is very small, the rheto-ric leading up to the referendum will have an effect on the dollar. However, the

most pressing concern on the minds of Canadian citizens and investors alike, isthe substance in the all important federal budget promised in February 1995. Upto now, the ruling Liberals have only hinted at a combination of tax increases andminor social program re-allocations, along with some symbolic cutbacks to the


71



military. The tactic seems to be entirely based on faith in the growth of the econ-omy, through the performance in the auto sector, hence increasing the tax

receipts collected. Moreover, the tight money policy together with the prevailinghigh real rates of interest has been tacitly accepted by politicians without resort-ing to criticism, through necessity. The government is fully aware that the mas-sive foreign debt exposure of some 44 percent of GDP poses a major constrainton domestic policies. Although adversely affecting most citizens, an inactivemonetary policy, implemented by an independent Bank of Canada has becomesomewhat of a blessing to the government, when the precarious state of the inter-national accounts are considered.

Yet still, it will be difficult to convince many investors that Canada hasreached the end of its historically stable place in the world. However, most willstill look to achieve some spread over comparable US denominated securities, asis expected. The danger being that Canada has missed out on the two solid yearsof economic growth in the US. And should the Federal Reserve continue its pro-gram of higher short-term rates to quell the record strains experienced on US pro-ductive capacities, the Bank of Canada will have no choice but to follow suit.The flipside of which would cause a severe devaluation in the dollar, and evenlead to greater problems as investors bail out of their “cheapened” investments.

Whether the budget will deliver the much anticipated result is any- body’s guess. However, with current account deficits being mainly a structural problem, and with taxes on Canadians already at their limits, cutbacks in theupcoming budget are not expected to be deep enough in order to give a further boost to the merchandise trade surplus. In that respect, the dollar is expected totrade within the 0.69 to 0.73 cents range to one US.

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Canadian Automotive Trade (Millions)

Exports Total 1992 Total 1993 %ChangeAssembled Vehicles 28,352 36,006 27.0

Vehicle Parts 10,227 12,454 21.8

Total Exports 38,579 48,460 25.6

Imports

Assembled Vehicles 15,378 16,483 7.2

Vehicle Parts 18,398 23,375 27.1Total Imports 33,776 39,858 18.0

Balance

Assembled Vehicles 12,974 19,523 50.5

Vehicle Parts -8,171 -10,921 33.7

All Auto Products 4,803 8,601 79.1

Source: DesRosiers Automotive Yearbook


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$attention focused on all important budget due in February1995

$budget impact expected to last until the second quarter of1995 as investors continue to evaluate impact

$ indications that Finance Minister Paul Martin Jr. expectedto aggressively bring down deficit

$current deficit of $40 billion expected to fall to $26 billionfrom $7 billion in tax increases & $7 billion in cuts

$current growth in automotive assembly & parts sectorbegins to spread to related industries

$real GDP grows by 5.0 percent in 1994 representing thehighest in six years

$pent up demand beginning to show positive effects inemployment growth

$2.7 percent decline in real disposable incomes & growthin consumer spending financed by savings shortfall

$personal savings fall by 6.7 percent to their lowest level in23 years

The Canadian dollar has hit new lows vis-a-vis the US dollar, and for avery brief moment crossing to the psychologically important 0.69 cent level. Theseverity of the Mexican Peso crisis prompted vigorous attacks on the dollar bycurrency traders, using any excuse, even if completely irrational, to drive downits value. The crisis has caused many investors and commentators to re-evaluateCanada’s economic performance, by placing recent developments under far greater scrutiny than usual.

In his budget, Canadian Finance Minister Paul Martin Jr. must convincenot only the international financial markets, but an increasingly restless citizen-ry that his government has full control of the situation. The timing for a largescale reduction in the deficit could not be more opportune than in the prevailing

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First Quarter: February 10, 1995



climate. The Finance Minister’s window of opportunity will be closed if he isunable to deliver major reductions in spending. For this task the current climate

is favourable, and he is aided by a number of unrelated factors:

• the Mexican Peso crisis could not have been better timed for the task that awaitsthe Finance Minister. The crisis and fall-out from this has brought to the atten-tion of the Canadian public, just how fragile international markets have become,and just how vulnerable the domestic economy is to events that happen in anincreasingly inter-related global marketplace.

• current record Canadian growth rates driven by pent-up demand in the manu-

facturing sector and falling unemployment, are providing a climate that isfavourable to budget austerity measures.

• recent successes in reducing spending by Premier Ralph Klein in the Provinceof Alberta has established a precedent and provided early evidence that austeritycan be a possible option.

• the current rhetoric out of Washington D.C., with the newly-elected Republicanmajority in both houses of Congress has promised smaller government, which

may have some spill-over effect in Canada.

According to leading Canadian economist Jayson Myers, the govern-ment is determined to deliver a balanced budget towards the end of the decade,with a possibility of exceeding the self-imposed 3 percent to GDP deficit guide-line. Any back tracking at this point would definitely send a signal that the gov-ernment is not in control, causing further uneasiness in financial markets.

Myers asserts that the key issue that faces the entire nation, as well as

most other industrialised countries, is how can a government practice austerityand grow at the same time? Up to this time, most industrialised countries have been attempting to do so by either encouraging exports to non-industrialisedcountries throughout the world, or have resorted to, either by design or default,to devaluing their currency. The current export promotion trip by Prime Minister Jean Chretien to Latin and South America and to China is a perfect case in point.The fact of the matter is that an inactive monetary policy over the years, willshortly be joined by an inactive fiscal policy. Solely relying on pent-up demandconsiderations to drive domestic economic activity. This seems to be the chosen

path of most industrialised countries, leaving the all important question: how canwe cut and grow at the same time? , at the centre of political debate over thecoming year.


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After all is said, the consensus scenario for the upcoming budget,according to Myers, will most probably lead to some balance between raising

taxes and reducing spending. A reduction of $14 billion, from the current $40 bil-lion deficit, to $26 billion over a time period of two years, will see a saving of $7 billion per year. This represents about a 1 percent reduction, out of a totalCanadian Gross Domestic Product (GDP) of $750 billion in each year. In other words, a forecast of 3 percent growth over the next two years, will result in anoverall net growth of 2 percent after the implementation of the cutbacks.

At this moment, every move that Finance Minister Paul Martin Jr.makes will be under the scrutiny of financial markets. If the expected cutbacks

are not delivered, or if they are by a far larger increase in taxes, the dollar willcome under speculative attack. Any tax increase, must be balanced by a corre-sponding cutback in expenditures. The prevailing sentiment is that a dollar increase in taxes, must be accompanied by a corresponding two dollar reductionin spending, for the budget to be deemed as being credible to the markets.

In spite of the upcoming presentation of the budget, the real economy isshowing continuing improvement, primarily driven by the pent-up demand beingexperienced in the automotive sector. The fact that the North American Free

Trade Agreement has helped in producing two cars in Canada, for every one solddomestically, has figured prominently in the recovery. However, the currentMexican Peso crisis will undoubtedly have a major impact. This may cause theforecast growth in economic activity to drop, as foreign imported automotive products into the domestic Mexican market become prohibitively expensive.

The negative real disposable income posted in the third quarter of 1994,is an indication that some of the current recovery in consumer spending has beenexclusively financed by a fall in personal savings. Except for the automotive sec-

tor, many others in the services and government are in a mode of retrenchment.With wage and salary roll-backs being the present norm, the consumption component that drives economic activity can not be relied on to assist in recovery.Personal spending is expected to suffer further from the impact of the Martin budget.

A positive development that places upward pressure on the dollar is theimproving current account (international account) balance. Record levels of mer-chandise trade exported out of Canada has resulted in a reduction some $10 bil-

lion from the second to third quarters of 1994. It remains to be seen what impactthe recent trade promotion trips by the prime minister will have on exports, andconversely, what negative impact the Peso crisis will have on automotive partsexports to Mexico.

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The Peso crisis has affected the dollar to the extent that investors now

perceive both to be part of a “soft currency” club. The budget is expected to sever this relationship, and once again inject credibility to the currency. Consequently,the dollar will recover to trade within the 0.72 to 0.75 cent range, shortly after the presentation of the budget. A sustained rally will be dependent upon howquickly the domestic economy can restructure, to provide for sustained growthunder austerity.

Economic IndicatorsIndicator 1992 1993 1994:Q1 1994:Q2 1994:Q3

Current Acct. Balance 26.5 -30.7 -29.8 -30.2 -20.5

Percentage of GDP -3.8 -4.3 -4.1 -4.1 -2.7

Real Disposable Income 1.0 0.8 8.0 2.1 -2.3

Profits Before Taxes -1.9 20.3 73.6 43.4 58.4

Unit Labour Costs 1.8 0.3 -1.2 -0.6 -1.3Unemployment Rate 11.3 11.2 11.0 10.7 10.2

Prime Interest Rate 7.48 5.94 5.75 7.17 7.25

Source: Department of Finance


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$budget presented by Finance Minister Paul Martin Jr.received well by markets

$13.6 bn. reduction in spending over next two years isthe largest in Canadian history

$long bond yield spread differences with USsecurities stabilise at 1.4%

$Moody’s credit rating agency places Canada on itssurveillance list despite budget

$support slides for Quebec independence

$residential property prices continue downwarddecline

$Canadian military confronts Spanish trawlersaccused of over-fishing

$rail strike incurs shortages in the automotive sector

$automotive sector expected to slow down in 1995with business conditions rising in 1996 & 1997

$successes in computer & industrial export marketsfor Canadian companies

Finance Minister Paul Martin Jr. has presented a historic budget docu-ment. It calls for historic expenditure roll-backs on programs ranging fromdefense to business subsidies. The notable exemption has been any increase in personal income taxes, although excise taxes on petroleum products haveincreased.

In short, Martin has delivered to investors a budget that they have beenwaiting for. However, judging by the response in the Canadian dollar, it has not

been as positive on the up side as what many have expected. Why?

For one, problems affecting the dollar extend to factors beyond the simplereduction of the Federal deficit. Not only must the fiscal position of the federal gov-ernment be taken into consideration, but more importantly that of the provinces.

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Second Quarter: March 30, 1995



Although progress on the deficit and debt has been forthcoming by thegovernments of Alberta and New Brunswick, the two major economies of

Ontario and Quebec have not indicated that debt and deficit reductions areexplicit goals in their agenda as yet.

Further, the problem on the international accounts has not been on thetrade side. In fact, a balance of trade surplus has been the norm for quite sometime, a typical example of which has been the 2:1 production to sales ratio (1:1is the minimum required by Nafta) in the Canadian automotive sector. A good portion of the excess vehicles produced are being exported to the US andMexican markets. However, the problem exists more on the capital side of the

international account. Here, payments to foreigners account for most of the over-all deficit, when factored in. In fact, with over 40 percent of Canadian debt heldexternally, any payments in Canadian dollars must be dumped on the foreignexchange markets and converted to the bondholders’ domestic currency of choice. This does not exist in the cases of Belgium and Italy, two other industri-alised countries with above average debt positions, whose foreign holdings of debt merely amount to 10 percent of the entire outstanding.

From the point of view of economic fundamentals, the current decreas-

es in the Canadian deficit by $13.6 billion over the next two year period, asannounced by the finance minister only reduce the growth in the stock of debtoutstanding. The current budget, although a step in the right direction concern-ing the fundamentals, does not retire any of the debt stock outstanding and held by foreign investors. All that it does is reduce the amount of bonds that will beoffered on international debt markets over the coming two years.

In that respect, the amount of dividends paid out periodically, will onlyhave their rate of increase fall, but will continue to rise, although at a slower pace.

On the real side of the economy, the automotive parts and assembly sidehas provided most of the business activity, however, there are initial signs thatsmall to medium sized specialty computer manufacturers are poised to play a bigrole in the export markets. Services have also been in a state of recovery, withthe photographic and film industries now beginning to attract attention in thecapital markets. Overall, a very different profile from the business conditionsexisting only four years ago. No longer are real estate and construction-related projects the preferred destinations for finance capital.

Although the shift towards creative services has accelerated, it remainsto be seen if they can endure cyclical slowdowns as well as traditional manufac-turing. The industrial growth pattern in Canada over the recent past, very muchresembles that of the UK. Services are gaining in prominence, while Nafta con-


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tinues to ensure that for every one automobile sold in the Canadian marketplace,one is produced in Canada. Although the UK does not have a formal trade agree-

ment with the automotive sector, it has become the third most important countryof manufacture within the European Union.

Aside from the good performance in the automotive assembly and partssectors, there exists optimism that the sector will continue its current level of business activity, based only on the expected scrappage of automobiles over thenext two years. The fact of the matter is that the current atmosphere of restraintwill not overcome the need for new automobiles, as the current stock of auto-mobiles aged 10 years near the end of their useful life. These automobiles com-

pose the majority under ownership at this point in time.

Politically, Quebec separatism seems to be a dying cause at this point intime, although sentiments may very well pick up, if Parti Quebecois leader Jacques Parizeau manages to turn the recent budget against the Federal govern-ment. Other than the Quebec referendum, the domestic political environmentremains subdued, except for the current fishing impasse on the Grand Banks of Newfoundland, as a fleet of Spanish fishing trawlers using illegal nets continueto plunder the already diminished stocks of fish.

The depressed regions of the Atlantic fisheries have already rallied behind the actions of the Federal government. The fishing issue may very well become an issue that will unify a fragmented country. The popularity of Prime-Minister Jean Chretien is at an all-time high. As the Spanish fleet gets larger, andthe confrontation escalates, the European Union is urged on to do what it does-n’t wish- impose trade sanctions against Canada. Already, the EU SpanishMinister’s action to impose Europe-wide sanctions has been dismissed by amajority of European ministers. President Jacques Santer has opted to publicly

pursue a negotiated settlement over the issue, much to the dismay of Spain’s rep-resentatives in Brussels.

However, if the confrontation continues to build, and if Canadian mar-itime patrol boats attack the illegal fleet, it could be the badly needed issue for Canada to unite over.

The risk of having the dollar fall below 0.70 cents US has greatly dimin-

ished. The combined effect of a budget friendly to foreign capital and a far less-er chance of Quebec separating from the rest of Canada, have once again instilleda degree of confidence in the foreign exchange and bond markets.

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However, the possibility of systemic market risk hangs over the dollar,as now it has attained the status of an international “soft currency”, grouped

together with the likes of the Italian lira, Belgian franc and ironically, the Spanish peseta.

The problem that this association exerts can be seen by the recent seriesof crises that has plagued the Mexican peso, and continues to do so to this day. Not only has the peso problem encouraged sales of the Canadian dollar, but hasalso brought down with it the once invincible US currency.

With perfectly mobile international capital, what happens in Mexico

City or Milan, will affect the financial markets in Toronto or Montreal. With anincreasing tendency towards volatility for the remainder of the decade, especial-ly in the European sphere, towards the Maastricht intergovernmental conference,speculation against some of currencies of the “latin core” group in the EU,should the concept of a single currency fail to progress, will exert some sort of afall-out on global markets.

The only way in which the Canadian dollar can uncouple itself from theupcoming events in the EU, would be for further reductions in the budget

deficits. Not only reductions for their own sake, but reductions that go together with a powerful re-development in the private sector. One cannot occur withoutthe other. For the time being, the Canadian dollar is comfortable in its currenttrading band of 0.70 to 0.74 cents to one US dollar.


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Budget Summary

• deficit set at $37.9 bn. in 1994-95 & $32.7 bn. in 1995-96& $24.3 bn. in 1996-97

• personal income taxes will not increase

• excise taxes on petroleum products to rise by 1.5cents/litre

• privatisations to continue with Petro-Canada & CanadianNational Railways & the air navigation system

• $560 mn. annual subsidy under Western GrainTransportation Act (Crow rate) eliminated

• federal civil service to reduce 45,000 positions or 14% ofworkforce

• provincial transfer payments reduced by $2.5 bn. in1996-97 & by $4.5 bn. in 1997-98

• Corporate taxes rise by $1.0 billion over 2 years

• special tax on banks set at $100 million

• general business subsidies to be reduced by 60% over 3years

• foreign aid spending to be reduced by 21% over 3 years

• defense budget cut by 14.2% by 1997

• deferment against capital gains tax eliminated afterJanuary 1, 1999 & treated as realised & subject to tax

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$ business activity declines by 0.1% in February 1995

$ export growth shows early signs of weakness

$ Province of Ontario regional elections called for June 8,1995

$ equity markets over-inflated due to surplus pool ofcapital

$ Province of Ontario becomes largest non-sovereignborrower in international capital markets

$ real estate sales collapse by 45% in most major urbanmarkets from 1994 values

$ stock markets continue to be severely over-valued

$ upcoming recession in US to transmit to Canadianmarkets

$ dollar recovery as uncertainty over Quebec separatismbegins to fade

$ manufacturing sector in continuous depression asoutput falls by 0.3% in February 1995

Canada is awash with investment capital that cannot seem to find a proper home. As large players increasingly pull out of the stock market, smallmutual fund investors continually pick up the shares at grossly over-inflated prices. In addition, numerous investment funds are scouring the Canadian land-scape to finance viable investment projects, but little up to now has surfaced,causing large scale channeling of capital into paper assets in the stock and bondmarkets.

The evidence is everywhere, as Provincial government bond premiumshave narrowed considerably. A symptom of capital that is restricted to the geo-graphical confines of what investors term as “Canadian” investment. In short,indebted Provinces benefit from this captive capital.

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Second Quarter: June 6, 1995



The fact that such a surplus of cash hangs over paper assets usually trad-ed in very “thin” markets, is an unfortunate consequence of a chronic long-term

disease affecting Canada. As innovation and a manufacturing base was allowedto slip deliberately over the past decade, and as property development has cometo a resounding halt, perhaps never to recover again, a very serious situation con-fronts the policy makers of the day. How can policy effectively re-channelresources into viable projects that are not in the traditional property development,resource extraction and automotive parts manufacturing industries? Up to thismoment, the good performance of the automotive parts and assembly industrieshas saved Canada. Admittedly, it has been generated solely on pent-up demandconditions, the most basic way that an economy can progress, but nonetheless, is

the only thing that is happening at this point in time business-wise.

The unfortunate situation that presently exists, where too much moneyis continuously chasing too few ideas, is a deep-rooted problem of the Canadian business and cultural establishments, which are most important issues thatrequire a great deal of thought, and which are central to the current imbalanceexperienced in Canadian financial markets.

Most major business activity remains depressed. As manufacturing con-

tinues to slide and as early signs of an impending downturn become visible in theautomotive sector, real estate equity values edge on the negative. The slide in res-idential property values over the last four years, and with the current drop of some 50 percent over the spring-time sales in 1994, have instilled a feeling of general panic. As personal equity positions of individuals continue to erode withevery fall in housing values, retail activity is directly affected, further depressing business conditions.

As recession once again grips Canada’s major market; the US, it will

not be long until reduced business activity from the US will be directly trans-mitted to Canada. This, when the pent-up activity up to now has fallen far shortof most people’s expectations of what a normal level of recovery ought to be.Certainly, by having experienced inactive policy over the past four year period,unemployment and business conditions have both suffered. Unfortunately, theupcoming recession will tend to harm the presently devalued asset positions of Canadians even more. When the recession arrives, the lower level of businessactivity will reveal severely devalued real-estate assets, and what is more dan-gerous, pressure on the security held by the banking system.

The immediate danger of banks lending money on only property, andnot on good ideas that may generate cash-flow is fully indicative of the conser-vative financial institutions that currently operate in Canada. Not only have the

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underwriting policies of these banks held back creativity and innovation, butlending practices that take assets as security such as property, are in the current

deflationary climate left exposed.

For instance, a default on a loan that is backed by greatly devalued property, will cause the financial institution to withhold the asset from thedepressed marketplace, as is currently happening. In turn, there develops a severemismatch between what depositors are owed, and what liquidity the financialinstitution may salvage from the depressed property asset held as security. Theultimate result is an erosion of the capital base, leading to further practices of conservative lending to compensate for the initial default. A situation all too

familiar, but one that stifles the development of badly-needed innovation inCanada.

The Provincial election in Ontario (largest Province) is expected to reignin a new political party, one that will be alot friendlier to business than the current New Democratic Party has proved to be over the past four years. This should putan end to the re-patriation of foreign investment capital, and add value to the dol-lar immediately. Over the past four years, Provincial borrowing patterns have con-tributed to Canada’s position as a debtor country. It has become a very well known

fact that the Province of Ontario has become a valued customer in theEuromarkets. This transformation has been a common experience, with countriessuch as the US and UK, and is the underlying long-term cause of dollar weakness.The question at this point in time, is whether or not this can be reversed?

In an era where the importance of raw materials and the extractionindustries has been steadily eroded in significance, it will be most difficult for acountry to sustain good business based only on the automotive sector. Somethingmust be developed in order to supplement the importance of the automotive partsand assembly factories. Although there has been initial signs of a push towards

the “new” economy industries, such as various forms of computer electronics,assembly and communications industries, the jury is still out on whether thesecan be categorised as “good business.” Or if the other members of the G-7 indus-trialised economies, also consider the new electronics industries as somethingthat is desired?

Three months after the presentation of Paul Martin Jr.’s austere budget,the prospect of recession transmitted from the US, may cause the level of aus-terity in the Canadian economy to be unbearable throughout the downturn.

Whether it causes any back-tracking remains to be seen.

The positive political fall-out that the election in Ontario is expected to bring, will however, be offset to a great degree by the impending downturn. This


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will have even greater negative effects, should it be pre-dated by some form of financial crisis and fall-out in the equity and bond markets. The signals are in

place for the stock markets to experience a correction. The current conventionalwisdom, used to justify the stability of most stock market indices is one thatargues in favour of the “soft-landing” hypothesis. Under this scenario, also believed to be presently applicable to the US economy, equity markets justifiablyincrease, or hold on to existing value.

The argument that a soft-landing will encourage independent central banks not to raise interest rates, will in turn maintain stocks and bond valueswithin the current trading range, and not produce a flight of capital to money-

market instruments. It may be true that interest rates will not cause a flight out of stocks and bonds, but what may do more damage is the further erosion of prof-itability in the industrial sector. Pent-up demand can only go so far in addingvalue to stocks.

Since longer term capital flows have had direct effects on currency val-ues most recently among the industrialised countries, the upcoming dollar valuewill be primarily determined from two offsetting effects. The defeat of theSocialists in one of the most economically important Provinces in Canada-

Ontario, should reverse the flows of foreign profits. This will be countered by therecessionary fall-out, which will inevitably lead to a much-reduced official bank rate over the short-term.

Which effect will dominate? Under present circumstances, an exchangerate that exceeds 0.78 cents US to one Canadian dollar, deems Canadian indus-try uncompetitive in US export markets. Likewise, the longer-term trend of Canada becoming a debtor nation mitigates any permanent rise in the dollar over the medium-term.

As the results of the Ontario election are reported, investors can cometo expect the Canadian dollar strengthening vis-à-vis the US dollar only margin-ally. With the current trading range of 0.72 to 0.74 cents US for one Canadiandollar, the positive political fall-out may push the currency up to a range of 0.74to 0.76. Should the recession be of a greater intensity, and of a greater durationthan what is experienced in the US, the Canadian dollar will dip back to a trad-ing range of 0.69 to 0.72 cents US. After all is said, a level near 0.78 cents USwill be difficult to sustain.

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Provincial Debt Positions

Provinces Tabling Balanced Budgets For 1996• British Columbia• Saskatchewan• Manitoba• Newfoundland• Prince Edward Island• New Brunswick

Provinces With Large Imbalances• Ontario• Québec

Capital Flows

Suppliers (%) Users (%)Japan 53 US 27

Switzerland 8 UK 9Taiwan 6 Canada 8Netherlands 6 Mexico 6Germany 5 Saudi Arabia 6Hong Kong 5 Spain 5Belgium 4 Italy 5China 2 Australia 5

Other 11 Other 30Source: IMF, FT


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$Ontario Conservative leader Michael Harris tablesfar-reaching spending cutbacks

$austerity measures introduced across mostCanadian provinces save Québec

$spending reductions in Ontario to be matched by a30 percent reduction in provincial income tax rates

$stronger dollar presents opportunity to Bank ofCanada to lower short term rates

$automotive retail sales slide into recession whileproduction maintains pace

$Bank of Canada draws down gold reserves in favourof the US dollar

$reductions in government transfers in Ontario shiftsburden on business to create employment

$housing sales continue to stagnate at levels notseen for over a decade

$GDP falls by 2% in second quarter of 1995

$sentiment over dollar reverts back to the spreadoffered over comparable risk-weighted US securities

Under a climate of over-valued stock markets, excess supplies of credit andnegative economic growth, newly-elected Ontario Premier Michael Harris tabled a“back to basics” economic statement after only four weeks in office. The shift towardsa more investor-friendly climate in Canada’s largest province should set a trendlinefor the entire country over the remainder of the decade.

Specifically, the Ontario Conservatives have reduced program spending bysome $1.9 billion initially, with some $6.0 billion still expected to be cut from businessactivity in a planned mini-budget that will be detailed in October of 1995. With some500,000 inhabitants relying on some form of welfare transfer payment from the

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provincial government, out of a total population of some 7.5 million in Ontario, theannounced reduction of 21.6 percent will spin-off and reduce the general level of

business activity in the provincial economy.

However, as equally as troubling as the reductions in social expenditures,is the effect on small and medium sized businesses that reductions in various capitalspending programs on rapid transit, road and infrastructure spending, will all have onthe overall economy, despite the promise of a 30 percent reduction in personal incometax rates later in the year. In addition, some $71 million in business grants andguarantees will hit the very vulnerable sectors of the economy that have beenhistorically marginally profitable. Altogether a very dangerous set of aggregate

circumstances for Ontario-based businesses. The question at this point in time, iswhether the loss of purchasing power generated by the budget and on-going recession,will be offset to any great extent by the “presumably” favourable investment climatecreated by the Harris budget?

It has been argued that the costly social infrastructure in Ontario, has causedmany businesses that traditionally re-invested their profits to re-patriate the surplusearned, back to their parent companies that were resident in another country. This wasa common pattern during the tenure of the previous socialist government of Bob Rae.

However, a precondition for a return to business investment in Ontario, must be theexistence of a robust domestic economy that shows high potential for expansion andsustained levels of good business activity. Certainly, any move to withdraw purchasing power through restricting spending, will bring into doubt the possibility for profitableinvestment opportunity.

Not only has the current philosophy over the role of government began togrip most Canadian levels of government, it has most vigorously been advocated bythe right-wing revolution in the United States led by Congressional Representative

Newt Gingrich. Although it is far too early to judge what effects on purchasing power and business conditions budgetary cutbacks can be directly accountable for, the contrast between the US and Canada may end out to be the most worrying aspect. In the caseof the US, government has never fully taken on a role as the main generator of businessactivity. However, the Ontario economy has historically had far greater inclination torely on centralised purchasing power. Although from an accounting perspective,deficits may be bad and immoral, they nonetheless, provide a good deal of spin-off income that helps sustain the small and medium sized business sector. Consequently,a move to import the current “revolution” in government from the US, may see a

large divergence in the growth of business activity between the two countries. Alldepends on how quick Ontario-based business sectors respond to the incentive-based programs that the Harris government is offering.

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The real-estate market still has not bottomed out, while the automotive sector at the retail level is beginning to show visible signs of weakness. With two of the most

vital sectors to the Ontario economy showing signs of stagnation, the oversupply of creditis continuously being channeled into the stock markets. With a good deal of pension andinstitutional money withdrawing from equities, the support levels have recently beensustained on the backs of small retail investors, entering at the tail end of the bull market.

The timing of further increases in stock prices will all depend on the speedat which the promised reductions in income taxes will become legislation. Consumer spending will benefit business conditions, should the promised 30 percent reductionin income taxes become law. At the front end of the beneficiaries of the tax cuts, will

be luxury imports ranging from automobiles to jewellery and vacations. It is hopedthat such a tax cut will revive the terminally depressed high-end retail sector, sincemany well-named boutiques still breach the thin line of bankruptcy by the hour.

Should a general reduction in tax rates only affect one small segment of the population, it will not add much to overall consumer confidence, thereby resulting ina harmful reduction in the trade surplus adding downward pressure on the dollar.Regardless of the offsetting effects in the upcoming policy debates, one thing thatwill clearly be evident, is the harmful effects that the new policies in Ontario will

have on low income earners. It is vital that the newly-elected government not alienatethe lower income segment of the population. Only well-rounded tax-incentive basedmeasures will ensure a level playing field, and only until this is achieved can theHarris government claim any degree of success.

However, as of this moment, knowing only the negative impact of spendingcuts, consumer spending is bound to get worse. Already burdened by the great lossof wealth caused by the bursting of the 1980s property bubble, a situation not uniqueonly to Canada; any correction in the grossly over-valued stock markets will ensure

that a continuous relapse at the retail level will persist over the next quarter.

Although business investment flows into the province are front and centreto the current cutbacks, they will also depend on the improving state of domestic business conditions. Deregulation without adequate demand for the goods and services produced, will not provide for the full effects that the policy originally intended. Inthat case, a repeal of restrictive social legislation can only result in positive investmenteffects over a longer period of time. For the next quarter, both consumer and businessspending will continue to be depressed, while the export markets will continue to act

as “safety-valves” in generating the badly needed purchasing power in the Canadianeconomy.

In many respects, the coming year should provide yet another opportuni-ty to test how well a derivative of the Reagan inspired supply-side economics can

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work. On a comparative basis, the original Reaganomics of the 1980s consisted of two elements: a reduction in taxes and the unprecedented spending on military-

industrial projects. The latter of which is excluded from the Harris budget and moreor less a function of a completely different geo-political era. It does, nonetheless, present an ideal comparative framework. Should the tax cuts in the Harris budget,not result in a rejuvenation of purchasing power in Ontario and only benefit a selec-tive few luxury importers, then spending increases as in the case of Reagan’s mil-itary build-up, will be considered as the more vital policy element by default.

The way in which a depressed consumer sector responds to the Harris budget in Ontario, and the way in which business investment behaves both domes-

tically and from foreign investors will be closely watched over the next severalquarters. If it is the case that the business community does not take up the challenge presented, or if the tax cuts favour only a select few luxury importers, then a con-sensus will quickly build towards the importance of spending, that may once againcreate the all-important purchasing power needed to power business opportunities.

A general respite from the turmoil in international currency markets ben-efitted the Canadian dollar. From a frenzy of pressures in the early part of 1995, thedollar firmed to a point where it was trading at 0.74 US cents. Despite the fact that

the fundamentals were further weakening, the firmer dollar allowed the Bank of Canada to lower its short-term administered rates, feeding into the entire bankingsystem. The wild-card on the horizon is still the referendum planned on Quebec’sseparation from Canada in September. Although highly unlikely at this point intime, it still may give investors an excuse to dump Canadian paper in the upcom-ing quarter.

Although the presentation of the cost cutting measures in Ontario had noimmediately noticeable effects in Canadian financial markets, any signs of further

deterioration in purchasing power and domestic growth rates will put investors onalert. In general, since the business community generally applauded the initiative, theemergence of positive signs in private investment initiatives by industry, should placeCanadian investment paper in a desirable position with foreign investors. Likewise,any recovery in consumer spending from the current depressed state that its in, willalso support the Canadian currency at higher levels.

Although no visible effects from the budget will result over the immedi-ate quarter, it would not take much positive news to raise investor euphoria. For

one, the continual easing in US short term rates, will ensure that the dollar willtrade within the 0.73 to 0.76 US cents range.


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1995-96 Spending Reductions in Ontario

$millionsProgram Spending Cuts

Operating: 850Capital: 307

Ministry Spending Reductions

Operating: 500

Capital: 187Public Debt Interest Savings 40

Total Spending Reductions 1,884

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$ Province of Québec calls for referendum to be heldon separation on October 30, 1995

$ budget austerity adopted by provinces leads to arecovery in foreign investor confidence

$ Canadian chartered banks report record profits forthe third quarter of 1995

$ consolidation continues to affect insurance sectoras Manulife Financial & North American Life merge

$ slight recovery detected in new homes market forsecond quarter

$ paper industry plans $4 billion investment in newplant & equipment

$ capacity utilisation falls in most sectors with theexception of paper manufacturers

$ stock markets continue to rise on expectations oflow inflation

$ dollar recovers relative to most G-7 currencies

$ US investors perceive Canada as not meeting hereconomic potential

All eyes have focused on the Québec referendum campaign, its after-math, and the likelihood that Québeckers will be able to set a firm foundation for their destiny by voting “yes” or “no” to the following question: “Do you agreethat Quebec should become sovereign, after having made a formal offer toCanada for a new economic and political partnership, within the scope of the billrespecting the future of Québec and of the agreement signed on June 12, 1995?”.

What bill respecting the future of Québec? What agreement signed onJune 12, 1995? From an international investors perspective, such a questioncould only be understood by the staunchest of Québec separatists. Unfortunately,

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Canadian internal political affairs do not normally attract too much attentionamong international investors. Perhaps this time around they should.

If the current referendum campaign is placed in a historical perspective,one may be able to argue that the separatist tendency of Québec follows a cycli-cal pattern. When Réné Lévesque led the campaign in 1980, the argument in support of separation was based on the traditional historical resentment thatQuébeckers had over English Canada’s domination over cultural issues. Québecdid not separate in 1980, but the economic costs were very high, as most corpo-rations shifted their headquarters to Toronto, in response to the political uncer-tainties created.

The prosperity of the booming 1980s discouraged any moves to evenconsider separating from Canada. Swept up in a lengthy period of economicexpansion, the concept of separation continued to be an abstract ideal that was best left to some future decade. The return of Jacques Parizeau and the PartiQuébecois, once again asserted a timetable for the ultimate vote.

Although there has always been historical constitutional tension between the Federal government of Canada and Québec, there may also exist an

economic argument for provinces to become separate. For this, parallels betweenCanada and the program for a single currency that is currently on the receivingend of large doses of political capital among the European community, providefor informative case studies.

Viewed in relative terms, the European Union is an economic area thatattempts to tie numerous “culturally diverse” countries economically. The Treatyof Rome in 1957 established a framework that would create similar conditionsfor the conduct of business over a grouping of culturally diverse countries. At

that point in time, political leaders and the electorate of France, Germany, Italy,Belgium, Luxembourg and the Netherlands viewed some form of co-ordinationin economic and commercial policies essential for stability and prosperity. Thefuture addition of the UK, Spain, Portugal, Ireland, Denmark and most recently,Austria, Sweden and Finland, also represented culturally-diverse states thatdeemed it beneficial for one reason or another to join the EU. The benefits of sharing a common external tariff, standardisation in cross-border commerce, acommon agricultural policy and a central mechanism to monitor monopolistictakeovers and mergers, were all functions that could best benefit a close eco-

nomic area through some type of central control mechanism.

The degree to which member states consider being part of the EU essen-tial, will vary according to the policy in question. In the opinion of many diverse

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European politicians, the current program that will take the economic area under a single currency will not be effective over the longer term. Aside from the usual

cries over the loss of sovereignty in countries such as the UK and Denmark, theeconomic reasons are even more compelling.

A currency can at times be viewed as a substitute to fiscal policy.Deliberate devaluations act to stimulate the export sector and to import goods athigher prices, adding to domestic inflation. Moreover, such a policy can only beeffective under certain conditions, one being that a country’s economy is suffi-ciently large and that any attempts at devaluation be co-ordinated among major trading partners. In addition, it is also true that “surprise” devaluations work the

best in stimulating the domestic sector. Devaluations also tend to work wellunder deflationary situations where business conditions tend to be depressed for a very lengthy period of time. Both Italy and the UK have benefitted their respec-tive industrial sectors by being dumped out of the fixed exchange rate mecha-nism in 1992.

Likewise, Canada is a very large economic space composed of twelvediverse provinces. As with the European Union, all provinces have benefittedfrom co-ordinating various expenditures in a central government. They have also

all been a part of an enduring currency union tied under a single money calledthe “dollar”. Under such a regime, vast differences in regional economic andindustrial development existed among the provinces. This has been exacerbatedin the slow growth and unstable 1990s. By tying 15 European countries under one currency, the same problem will surface in Europe, as it has in Canada.States like Spain, Portugal, southern Italy and the UK are recipients of regionaldevelopment transfers, which will only escalate under a single currency.

The European Union in its experiment of a single currency need look no

further than at the Canadian situation for guidance. Under a period of slowgrowth, regional development transfers have dried up, causing vast standard of living differences among provinces. Although very difficult, Québec’s introduc-tion of its own currency would create stimulus within the province, provided nohostility and bad feelings would arise from the rest of the country.

Ironically, Jacques Parizeau and the Parti Québecois have rejected the benefits accruing from their own currency, but have reiterated their preferencefor the continued use of the Canadian dollar. A stance that may lead the margin-

al separatist, or the separatist that looks forward to an independent Québec for economic reasons to reject separation. Clearly, time has come to re-examine theargument that favours an independent province of Québec. On economicgrounds, at least, the Parizeau plan comes up far short of what is required to stim-


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ulate the prolonged recession. Fortunately for Canada, it may be too late for theParizeau government to realise that the majority of Québeckers intend to vote on

a sound economic agenda. Central to which is the introduction of their own cur-rency.

Political jitters before and after the vote in Québec will cap the progressof the dollar. US investors have voiced their impatience over yet another politi-cal upheaval in Canada. Although only the impulsive will shift short term fundsout of Canadian dollar denominated financial products, the attempted separationin Québec is not expected to be successful.

Already, investors are taking the referendum vote as a foregone conclu-sion, judging by the risk premia on offer in the bond markets. The dollar will con-tinue to hold its ground within the 0.72 to 0.77 US cents range over the next quar-ter. Despite the vote in Québec, the dollar is continuing to attract positive senti-ments in the markets, with recent austerity programs adopted by various provin-cial governments that will reduce large debt levels. However, despite suchefforts, the dollar is a recipient of positive natural sentiments emanating frominvestors that view it as the best alternative, next to growing instability in Japanand various parts of Europe.

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$ Québec referendum results show narrow Federalistvictory

$ leader of separatist Parti Québecois JacquesParizeau tenders resignation

$ leader of separatist campaign Lucien Bouchardfavoured to assume role of Québec premier

$ dollar trades within narrow range as Québecgovernment intervenes to support a floor

$ Prime-Minister Jean Chrétien attacked for pursuingan indifferent campaign in favour of unity

$ investors fear shift in political agenda away fromreal economic & competitiveness issues

$ decision in favour of unity prompts surge in dollar &fall in official discount rate shortly after referendum

$ Progressive Conservative leader Jean Charestemerges as spokesman for the Federalists

$ economic conditions deteriorate as raw materialprices weaken on world markets

$ early evidence of slowdown in retail sales asconsumer debt reaches record levels

Despite the victory for the Federal side in the Québec referendum onsovereignty, entrepreneurs have been leading an exodus out of the country. Their choice to leave behind an increasingly fragmented and regionalised country, is mademore on the basis of what the government is choosing to retreat from on the spendingside, rather than on any resurgence of political uncertainty.

True, the Canadian political architecture is more deeply in doubt now thanin any time since confederation. However, what is preoccupying the minds of mostmembers in the business community is the negative impact that cutbacks in spendinghave produced in Ontario. Premier Mike Harris’ strict insistence on balancing the

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Fourth Quarter: November 25, 1995



The performance of Jean Chrétien, as the leader of the Federalists in the1995 referendum, has come under severe attack. After sustaining a comfortable margin

of 59 to 41 percent in favour of the Federalists throughout the early months of summer past, when the referendum was still deemed to be a “non-issue”, it quickly became acrisis after the entry of Bloc Québecois leader Lucien Bouchard. What seemed as aninsurmountable lead for the Federalists, ended up as a 50.6 to 49.4 percent margin.After the quick resignation of Parti Québecois leader Jacques Parizeau, there is a verygood chance that Lucien Bouchard will resign as leader of the Federalist BlocQuébecois separatists, to take over the leadership of the provincial Parti Québecois.Such a development would only lead to further instability, as the prospect for another referendum on separation could become linked to a renewed mandate for the Parti

Québecois under the leadership of Bouchard. In all, a very unattractive prospect tocommitted free-market business people, and to the longer term committed investmentcapital in the Canadian economy.

As matters presently stand, a scenario that would likely occur, should Bouchardassume the leadership of the Parti Québecois, would result in a referendum linked to a provincial election victory. The mere prospect of such a coupling would solicit howls of protest from the Federal establishment, and would certainly cause long term committedinvestors to question their roles in the Canadian economy in a serious manner. The

remainder of the decade is likely to rattle the remnants of the traditional Canadian politicalarchitecture, which will ensure that a climate of uncertainty prevails well into the earlyyears of the twenty-first century.

In the immediate cyclical economy, business conditions point to an endingin the growth experienced from the revival of pent-up demand in 1994. The fall incommodity prices that has engulfed the manufacturing sectors in the second quarter,is now very visible. Steel, and most importantly, paper prices have reached their elixir,only to initiate a lengthy period of price reductions that will likely begin to affectmargins very early in the cycle. It is safe to say, that for the most part, the manufacturing

boom of 1994 is now coming to an end. With the likely negative impact on investment plans affecting the rate of unemployment. This, despite the fact that Canadian financialinstitutions are currently awash with investment capital, left to be recycled once againin the steeply over-valued Canadian stock markets.

Personal finances are deteriorating even further, as negative equity has become a familiar phenomenon, just as it is in France and the UK. Housing priceshave reached depression status, with no real prospects of a turnaround in sight. Inaddition, debt repayments are showing signs of liquidity strain, as the familiar net

30 day term, is now more commonly associated with a term of 60 to 90 days for repayment, if at all.


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The problems that are being witnessed on the personal financial side, canonly call into question the quality of the assets of most Canadian banks and financial

institutions. Given that the five chartered banks have virtually retreated into being primarily domestic savings and mortgage banks, the underlying quality of securedresidential properties for which most mortgages are based on, must come into question.It is no secret that the global ranking of Canadian banks in terms of asset volume hasdropped by 50 percent. For a variety of reasons, Canadian financial institutions havechosen to slowly retreat from the active lending market, save residential mortgages.A category for which they are bound to pay very dearly in the coming years.

Before any form of banking panic ensues, we must remember that fee-driven

activity is coming to play a very important role in Canadian banking. Despite the factthat lending has become an activity in decline, fee-driven services will serve to offsetany problems that may arise from the continuing property shake-out. However, coupledwith the overhang of political uncertainty, investors would be advised to pay moreattention than usual to developments in banking.

With the US government on the verge of defaulting on its interest payments,and with a general climate of a slow-down in growth, the traditional Canadian exportmarkets south of the border will contract well into 1996. Add the presidential election

campaign, and a rise in trade friction is bound to surface. This may become a veryhot issue, even among traditional business partners, should the Mexican peso comeunder continuous pressure. Afall-out over the rhetoric connected to the North AmericanFree Trade Agreement (Nafta) in the context of a growing trade deficit with Mexico,as cheap imports pour into the US, will generate some fall-out with their traderelationship with Canada. In all, conditions in the traditional US export market willact to further depress domestic business conditions.

At the height of referendum jitters, the Canadian dollar maintained its value

within a narrow range of 0.725 to 0.74 US cents, despite massive intervention byQuébec’s powerful pension fund, to offset some of the short-term outflows. Evidenceof a 0.65 cent dollar surfaced in US border towns, as panic-stricken Canadian citizensmoved to convert their savings into US funds.

The narrow victory, however, eliminated the risk premium and the immediate panic from the referendum. On fundamental grounds, the dollar should not move toofar above the 0.75 cent level. However, should problems surface in Europe over thesingle currency project (always a risk), or should more political fall-out afflict the US budget, then a level above 0.75 cents is likely.

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$OECD warns over heavy debt burden and suggeststhat large public sector debts prevented gains fromlow inflation

$economic activity heavily dependent on investmentin export-intensive sectors

$substantial gap still exists between actual andpotential production output

$federal Finance Minister Paul Martin Jr. proposesfurther budget cuts prior to 1996 budget address

$Lucien Bouchard becomes premier of Quebec whileinvestors expect early provincial elections

$Ontario Premier Michael Harris’ plan to reduce

spending raises prospects of widespread user feecharges

$Federal government system of transfer payments indoubt as reallocation of Ontario budget likely

$retailers face prospect of 1995 being the worstChristmas season in a non-recession year

$ large domestic Canadian banks report record profit

performances based on retail service charges

$venture capital industry under attack for investingmostly in safe and secure treasury bills

Business Outlook

The year 1995 ended in an anticlimax, as one of the most important periods

for retail sales fell flat. Leading up to what has become termed as "the worst Christmasin a non-recession year" were record high personal debts, the Qu6bec referendumon sovereignty and evidence throughout 1995 that went against the official viewsthat "recovery had taken hold."

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First Quarter: January, 1996



If one was forced to proclaim that something positive occurred in theCanadian economy in 1995, it must have been the record breaking run that the Toronto

Stock Exchange registered. On the real side of the productive economy, it was thecontinuing search by talented new technological small and medium sized companiesworldwide, for interested buyers that would match their enthusiasm for their products.Consequently, most business investment was made in those sectors that were mainlyoriented towards the export markets.

On the surface, the events above may be deemed as being positivenewsworthy items, however, in actuality, they are mirror reflections of the depressedstate of domestic business activity. In the case of record breaking stock exchange

indices worldwide. Financial research has commonly established the view that whathappens on the Dow in New York, will also happen in Luxembourg, Brussels, Paris,Prague, Zagreb and Toronto.

An initial impetus that the New York Stock Exchange is able to deliver toworld markets, indicates the high level of correlation that exists in global financialmarkets. As such, stock markets even more remotely mirror any real economicfundamentals within individual countries themselves, than they have on any occasionsin the recent past. Just because the Toronto Stock Exchange is continually pointing to

record high activity, does not at all mean that things are going well within industry,and especially in the small and medium sized business sectors.

What is more, the record breaking market in Toronto has captured the peculiar behaviour of the Canadian banking system, which has just been able toregister record levels of earnings, by behaving most unlike the way in which bankersought to behave. In Canada, lending activity is virtually absent in the sectors thatgenerate most of the dynamic growth- the small and medium sized companies andrecent start-ups that have been around for a period of less than two years. Instead,

credit decisions are usually made on the basis of the size of the recipient. MostCanadian bankers are domestic in orientation, with a large propensity to take as littlerisk as possible. Very often, large amounts of money are allocated to companies thatreally do not need the financing, and have committed themselves to raising fundsthrough such things as commercial paper and stock issues.

The dynamic of the Canadian banking system is a very interesting one, if followed in its entirety to its final conclusion. Credit decisions that are made on the basis of size, compete with a flood of capital that is readily available, but only to a

select grouping of multinational organisations and governments. Herein lies what istermed as the "Canadian Growth Trap", as the process of credit intermediation bypassesthe small and medium sized sector, or those companies that have the highest propensityto create growth and deliver employment opportunities.

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The intermediation process that has become most identifiable with thelarge domestic banks in Canada, runs along the following lines. A government

raises money by issuing savings bonds or treasury bills. Spending occurs tofinance the public service and outlays are advanced to various public institutionssuch as universities, hospitals and entitlement programs such as pensions andwelfare. By their very nature, public sector workers are risk-averse, and themoney transfers that are not spent on the necessities of every day life, are com-monly placed in savings deposits with the banking system. In turn, the Canadian banking system re-shuffles deposits to those very same institutional organisa-tions that have raised money at the outset: hydro utilities, public corporations andthe various levels of govemment themself. This circular process continues to spi-

ral around, while some money is channeled to small and medium sized compa-nies that service only those necessities of everyday life, invariably such things asgrocery shops, laundromats and garages.

Recently, it was revealed that the last hope for the financing of innova-tive small and medium sized export companies, was also caught up in this"Canadian Growth Trap." Instead of having the massive capital of thelabour-sponsored funds go into dynamic job producing companies, it wasrevealed that they were all caught up in the game for searching for the "big deal."

In essence, the labour- sponsored venture capital funds were trying to play therole that the domestic Canadian bankers currently perform.

More specifically, it is becoming a well-known fact that 75 percent of these labour- sponsored venture capital funds, that were supposed to have beenreserved for growing the dynamic small company sector, have instead beeninvested in such things as treasury bills and even “risk-free” stocks. In essence,the intermediation spiral has enticed the very organisations that were supposedto have been created to assist the small and medium sector, not able to be active

participants in the spiral of capital themselves.

Although very profitable at this moment, the entire banking system inCanada has become a burden in achieving the required level of business activityand income growth. In a period of government spending cutbacks, this mustchange. It is now more vital than ever, that capital be channeled to dynamicgrowth industries. Companies that have endured over a period of fifteen to eight-een months of operation, but have primarily cash-flow and receivables to offer as assets, must become "financeable" entities by the Canadian banking sector, if

there is any hope at all for better business and employment conditions in Canada.With the retreat of the public sector, the private sector must have the means bywhich it can assume the role of the previous public entities.


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In 1996, the cutbacks announced by the Ontario provincial governmentof Michael Harris are expected to filter through the economy. What is more, the

spending cuts announced in the economic statement of November 1995, areexpected to be followed up by even more cuts in the upcoming budget. In all, ageneral retreat in the public sectors of Canada will that were supposed to have been reserved ensure a completely different composition for growing the dynam-ic small company of the economy. The withdrawal of spending such a greatextent may further erode the ability of the Federal government to manage region-al disparity througout the country. As an overall reduction of transfer paymentsfrom the most prosperous province of Ontario, will agitate further divisions innational unity. Not only will Qu6bec deliver yet another round of voting for sep-

aration, but remote provinces such as Newfoundland and Saskatchewan, will become increasingly regionalised and unable to relate to the central powerswhich bind the entire country together. Evidence is everywhere, that the effec-tiveness of the Federal government is continuously being eroded.

Severe structural changes in the Canadian economy, will serve todepress any hopes that consumer spending will lead a durable recovery. The dan-ger is that the recent display of restraint during the Christmas shopping period,may continue well into 1996. Continuous cutbacks in the public service, will

ensure that some 3.0 million residents of Ontario will continually lack confi-dence to commit to the purchase of big ticket items. Moreover, a retail sector shake-out, the second time in five years, is expected to impact retail distributionthroughout Canada. Small retailers will find it increasingly difficult to continueto trade, while large discount stores from the United States will continue toexpand their presence within the Canadian market.

Currency Forecast

The seriousness under which all levels of government have displayedwill to balance budgets, will have a positive effect on the dollar. Investors willtake note that Canada is a willing participant within the G-7 group of industri-alised countries, that has made a commitment to leading the general trendtowards less public involvement in its economy. An orderly reduction in the pub-lic sector in Canada, countered by turmoil in France and Germany, will further benefit the dollar.

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• Ontario plans to cut back civil service erupts in labouraction

• record number of bankruptcies recorded in January1996

• residential property prices continue to slide as bank-offered mortgages fall to historic lows

• 1996 federal budget delivers spending cuts and noadditional tax increases

• defense sector scaled down even further as budget cutback by $600 million

• incentives for labour-sponsored venture capitalcorporations reduced

• federal budget to be balanced by 2000 at the currentpace of program cutbacks

• mergers & acquisitions activity in 1996 is expected tosurpass the levels of 1995

• a dormant mortgage market and a surplus of capitalprompts Canadian banks to reconsider leveraged buy-outs

• slowdown in US market encourages Canadiancompanies to search for alternative markets

Business Outlook

Business sentiment has experienced a reversal of fortune as a record number of bankruptcies were registered in January of the new year. The deflationary

environment in most regions, encouraged through spending cutbacks in Ontario andmost western provinces, together with the federal government's goal of balancingthe budget by the year 2000, all create a dangerously unstable environment.

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Second Quarter: April, 1996



Behind the broader trend towards depression, are subtle signs of unrest anduncertainty. The environment on most Canadian university campuses is one

of high anxiety. With very few employment opportunities in the private sector, publiccutbacks have caused a virtual collapse in the traditional professions. Teaching positions in both universities and secondary schools, along with candidates trainedfor medical practice and legal work are all finding the current period extremelydifficult. Moreover, the technological revolution continues to place the Canadianwork environment on the vanguard of change among most of the G-7 countries. Ahallmark of the changing environment is the effect that the computer has had on theToronto Stock Exchange. Recently, stock equity traders have been made redundanton the floor, while those trading futures and options await similar destinies over the

next year or two.

The pace of technological change has been so revolutionary, that onlyservice-sector employment opportunities are what remain. Such uncertainties havecreated a great deal of anxiety and displacement, and have resulted in chronicallydepressed levels of consumer confidence. This has in turn depressed the housingmarket so much, that one can conceivably purchase a home through a common creditcard.

A tight fiscal stance by both the federal and provincial governments, hasto some extent been countered by historically low interest rates on mortgages andloans charged to the best corporate customers. Recently, federal Finance Minister Paul Martin Jr. presented a document that will lead to a balanced budget by the year 2000.

Specifically, he committed his Liberal government to reducing the fiscaldeficit to $24.3 billion or 3 percent of GDPby 1996-97, from its current $32.7 billion.Moreover, he went on to present a plan to continue with the progress and hold the

deficit to $17 billion or 2 percent of GDP by 1997-98.

It is interesting to note that while the Democrats and Republicans in theUS have been arguing over balancing the budget within either 7 or 10 years, Canadamay achieve the goal in a matter of 4 or 5 years. Despite the presentation of such ascenario, the dollar did not show any reaction as of yet.

While the business environment continues to undergo very revolutionarychanges, the T o r o n t o S t o c k Exchange (TSE), has continued to set new records

in step with the Dow Jones Industrial Average.

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Money & Bankin

A brief summary of the status of the Canadian financial system continuesto reveal a large surplus of investment funds. On top of this large surplus of funds,is a drying up of mortgage demand for house ownership in the consumer sector,along with subdued interest in borrowing for consumption purposes. The purchaseof a new automobile, or some household item also rank very low down the list.

The break-out of a computer price-war in the personal computer marketamong most of the major brand names, is signalling a temporary saturation pointfor the sales of computer and high tech products in the consumer marketplace.

All of these trends underscore the low demand for capital financing in a lowgrowth environment.

Financing of the small business sector with turnover of $500,000 isalmost non-existent in Canada. The traditional banking system is not showingany interest in this sector since the time and money that it takes to consummatea deal with a small player, a far higher rate of return can be achieved by doing avery large deal. The problem is that there just are not that many large deals in theCanadian market. Consequently, a situation exists where far too many financial

institutions -domestic and foreign are going after the same deals, and crowdinginto an already overcrowded market.

The combination of low rates of return for savers and a lack of willing-ness to intermediate in the small companies sector, has led to the record run-upin the Toronto Stock Exchange index. As with the Dow Jones, The Toronto Stock Exchange has been the recipient of capital flows driven by the concerns that it isthe "only game in town" at the moment. Meaning that only the stock market candeliver the returns far and above what are being offered from the intermediation

process in the real economy, via the mortgage or small business loans markets.

Privatisations

Several foreign merchant banking presences have been establishedrecently to advise all levels of government on selling off public assets. TheOntario government of Michael Harris is expected to decide on the privatisationsof the state-controlled liquor control board (LCBO), Ontario Hydro and severalother smaller functions that could be assumed by the private sector.

Likewise, Qu6bec Premier Lucien Bouchard will most likely move toreduce the provincial deficit by privatising several state-controlled assets, shouldthe domestic political climate be right.


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Mergers & Acquisitions

Acquisitions activity in 1996 is expected to break the levels seen in1995, and move closer to those in 1994, according to managing editor of Mergers& Acquisitions in Canada, Mr. Paul O'Brien. Accompanying this acceleratedactivity, will be Canadian banks' willingness to once again engage themselvesactively in the leveraged buyouts market (LBO). As an additional outlet for thesurplus capital that is available, the LBO has been available to several ver largedeals in the Canadian mark e t p I a c e . Specifically, this form of financing wasoffered by the large Teachers' Pension Fund in two transactions recently. One of which was the emergence of a $2.7 billion bid by Belgian based Interbrew SA

for Canadian brewing and entertainment group JohnLabatt Ltd.

In contrast to the LBO situation in the US, LBOs are somewhat morelimited in Canada. In Canada, financing must be in place before a bid is tendered,whereas the US only requires a communication through a press release.According to Mr. O'Brien, the LBO in the US is enjoying a resurgence, as LBOfunds have been able to raise over $10 billion in 1994, with new funds recentlylaunched by specialists Kohlberg Kravis Roberts & Co. and Goldman Sachs.

What is less common in Canada, as opposed to the recent market for acquisitions in the US, has been the use of an all share transaction. The prefer-ence for a combination of share and cash offerings is consistent with the smallCanadian marketplace, since a targets acceptance of the shares of the bidder aredependent upon the upside potential of the stock after the acquisition has taken place. This is only common when two companies decide to merge in a spe-cialised industry sector, such that economies of scale are immediate. The grow-ing use of cash in Canada may indicate that such tie-ups have been exhausted for

the time being.

Currency Forecast

The Canadian dollar has been steady after the passage of the 1996 budg-et and the Qu6bec referendum in 1995. Overall, the dollar is one of the better cur-rencies among the members of the G-7 grouping of countries on fundamentalgrounds. The prospect of a balanced budget, should add even more value to thecurrency.

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$consumer bankruptcies continue to increase as overalleconomy continues to depend on exports

$auto sales show slight recovery in first quarter of 1996 asproduction share continues to grow from transplants

$employment shows marginal increase in serviceindustries & contraction in manufacturing & financialservices

$Canada’s net foreign debt declined as did the rate ofincrease in 1995 individual net worth

$corporate debt to equity ratios decline as the corporatesector becomes a net lender to the Canadian economy

$consumer debt rises even though a borrowing slump

takes hold

$number of jobs in the financial sector continues todecline as technology introduces new innovation

$property prices continue downward trend despite shortrespite as mortgage quality issue resurfaces

$ Québec Premier Lucien Bouchard becomes determinedto halt continued decline of the city of Montréal

$ selective group of Canadian based companiesparticipate in acquisitions activity in both US and Europe

Now that the element of political risk has disappeared for the time being,Canada has continued to register a slow, but consistent improvement trend in business conditions in line with most members of the G-7 group of countries. Theunspectacular, but steady level of growth in business conditions, is in fact, directlyin contrast to the worsening conditions in France and Germany. In fact, it may also be accurate to admit to the fact that the Canadian recovery may be just as good asthe prevailing business climate in the US, if not better.

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Second Quarter: April 28, 1996



Although the automotive sector has been coasting on an unspectacular rate of growth for a consecutive eighth month, February has shown some early

signs of the continuation of an upward trend. In fact, new vehicle sales haveincreased by 3.4 percent in February, offsetting somewhat the 4.5 percent declineregistered in January.

An interesting development in the automotive sector has been theincreasing share of production attributed to Japanese transplants. The market sharefor vehicles manufactured at these plants has tripled since February of 1993.

The slow growth climate in the domestic Canadian economy, no different

from most other re-structuring industrialised countries, has shown an increasingmerchandise trade surplus. Since the middle of 1993, the divergence solidly infavour of a surplus in merchandise trade has been clearly evident. In that respect,the Canadian situation is remarkably similar to the prevailing conditions among businesses and consumers in France. What is very clear, however, is the receptiveresponse in which the Canadian export industry has taken up the challenge.

Many instances are beginning to emerge of outward looking industriesin Canada. Many of the export-oriented brand-name companies such as Magna

International and transportation equipment manufacturer Bombardier, have been joined by lesser known medium sized industries with a keen interest in establishingoperations in other markets.

While on the subject of corporate export success stories, it is interestingto note the progress that the corporate sector as a whole has made in managing itsdebt structure. Overall, credit market debt which includes short term paper, loansand bonds issued, grew at a rate of 4.0 percent in 1995, compared with a 6.0 percentrate in 1994. Indicating an overall trend towards stronger balance sheets.

In 1995, corporate internal sources of funds, mainly generated by“corporate downsizing” exceeded capital expenditures, implying that they becamenet lenders to the overall Canadian economy in 1995. In short, the corporate sector,with unprecedented amounts of credit available, is currently confronted by a climateof increasing liquidity.

Consequently, the cash-rich corporate sector has increasingly little needto access bank-generated lines of credit, leading to the “intermediation problem”

of the 1990s. Not only has the rigid Canadian banking system come to rely onacting as an investment manager under current conditions, but has left itself vulnerable to the criticisms of small and medium sized businesses, that highlydesire more credit at more favourable lending rates.

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The unwillingness of Canadian chartered banks to lend to these producersof future wealth, has placed them in a very uncomfortable situation when it comes

to investing their enormous deposit base. Recent indications point to the fact thatthey have a clear preference in acting as stock brokers and investment advisers,over being traditional bankers which provides for the foundation of future wealth.

The problem in the intermediation process may become resolved to acertain extent. Recently, the push by some global banks in Canada such as HongKong Bank, NatWest Markets and Citibank, prompted the government to consider changing the bank act. Currently, the “subsidiary” status of these global banksoperating in the Canadian environment, imposed restrictions on their activities to

the amount of their Canadian capital base, as presented in their balance sheets inCanada. Any ruling that would allow these banking operations to allow the full backing of their parent’s capital base, would bring immediate pressures on themargins that have been traditionally generated by the Canadian chartered banks. Not only would the fierce competitive climate add pressures to the overall pricingscheme, but, it is hoped, that a far better process of intermediation would beavailable to the credit needs of Canadian businesses. Specifically, the credit needsof the neglected small and medium-sized enterprises, by which the future wealthof the country is generated.

If not, then the financial assets available over the stock markets and bondmarkets, would become even more valuable by virtue of the fact that there willnow be even more financial institutions chasing the too few investment outletsthat have been on offer for so long. Somehow, financial innovation must comeabout.


Some of the more prominent international activity, occurred in the precious metals, consumer products and automotive parts sectors. In the goldmining sector, Placer Dome Inc. has entered into negotiations with US based Newmont Mining Corp. to explore the possibility of acquiring an interest in adevelopment. At issue is the Indonesian based Batu Hijau gold property that is 80 percent controlled by Newmont. Recent activity in the world gold markets andsteady consumer demand in some far eastern emerging markets, continues togenerate interest in precious metals.

Automotive parts producer Devtek Corp. has acquired UK basedAutomotive Components Dunstable Ltd. The $22.4 million purchase price will befinanced through a combination of cash and a 1.3 million Devtek common stock


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exchange. The deal is an example of exceptional European opportunities for well-managed automotive parts producers in Canada.

In a transaction that is still subject to regulatory approval, US basedagricultural products producer Archer-Daniels Midland, through its Canadiansubsidiary, plans to acquire Maple Leaf Mills Inc. from owners Maple Leaf FoodInc. and ConAgra Inc.

Overall, it is expected that merger and acquisition trends will continueover the next quarter. This co-incides with an abundant supply of acquisition financefor larger deals, and attempts to take advantage of economies of scale in specific

sectors. More and more, the well-managed firms with a good deal of financial backing will prefer to look for acquisitions outside of Canada, and may evenconduct a strategy of export replacement. The push towards new markets willoffset the exceedingly depressed conditions domestically.

Concentration

In an interesting study conducted by Statistics Canada, corporate

ownership remains very concentrated, despite the passage of the North AmericanFree Trade Agreement and a greater openness to capital flows and direct investmentin the world.

Canadian corporate concentration is still led by the Edper Group owned by Edward and Peter Bronfman. The top 24 enterprises in Canada encompass some2,574 corporations. Of the corporations that are resident in Canada, some 80.8 percent are Canadian controlled, while 9.9 percent are US controlled and the UK and Japan control 2.0 and 1.0 percent, respectively. In a surprising revelation, the

study noted that the government of France controls 59 corporations in Canada inthe banking and aluminum sectors, ranking behind the governments of Canadaand Québec when government ownership is at issue.

Currency Forecast

The Canadian dollar has averaged 0.734 US cents over the last quarter.With a good deal of the political uncertainty in Québec gone, the upward movementof the dollar has been limited by very weak fundamentals in the domestic economy.

The only reason that the dollar has not challenged even lower levels is that mostother industrialised countries in the group of seven, are showing even weaker fundamentals. Export growth will add upward pressure.

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$unemployment rises in manufacturing and constructionindustries

$passenger car sales reach lowest level in more than 25years as consumers prefer minivans & sport vehicles

$“big 3” auto sales climb as imported vehicle salessuffer

$house prices decline for the 22nd consecutive month asbuilders cite competitive market conditions

$raw materials price index falls by 1.5% in May 1996 asmineral fuels drop by 8.6 %

$export based industries suffer sluggishness in theirmarkets

$manufacturing capacities fall to 82.7 % from a peak of86.0 % reached in the first quarter of 1995

$reduction in capacity utilisation in wood industry signalslarge correction in paper prices

$further austerity measures enacted by the Ontarioprovincial government begin to hear protests frombusinesses

$banks continue to report record profits from stock broking and trading activities

Canadian business conditions have deteriorated since the first quarter of 1996,and continue to steadily worsen from one year ago. Depressed demand conditionsdomestically, have been joined by worsening prospects in export markets. Theunderlying trend for the remainder of the second quarter, and leading into the thirdquarter is the possibility of more sluggishness and recession.

The evidence in Canada’s most important export market, the United States,is further contraction leading to an easing of the pent-up demand conditions that havefueled the US recovery in 1994 and most of 1995. Consequently, the most significant

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declines have been registered in the production levels of export-based firms in Canada.The reductions came in the form of the strike in US automotive brake parts, which

ultimately affected the assembly of models based in Canadian plants that were destinedfor the US market.

Further, recent decreases in the demand for newsprint and paper productshave caused a great deal of panic in the pulp and paper sector, as over investment over the past six quarters has created excess capacity in production. Producers are expectedto reduce supplies and prices in order to clear out their large inventory positions.

Overall, Canadian industries have reduced their use of production capacity

for the fourth straight quarter, or 82.8 percent in the first quarter of 1996, comparedwith 82.9 percent in the fourth quarter of 1995. The surge in production throughout1994 was mainly driven by pent-up demand conditions and successful exporting activity joined by record increases in business investment. Currently, business has recorded a11.2 percent decline in profits of non-financial corporations in the first quarter.

Brake on New Cars

It can be argued that the automotive parts and assembly sector is Canada.Without the Auto Pact and the two consecutive free trade agreements, Canada wouldhave a difficult time convincing anyone that there was anything resembling amanufacturing industry at all. Likewise, the fortunes of manufacturing and mostindustrial activity are mainly determined by the success of this industry, especially inOntario and Québec.

For the first time in over three years, evidence of a downturn in the auto sector has surfaced. The overall level of vehicle sales has fallen by 89,833 from March 1996,or by 6.5 percent. Sales in April were well below the monthly average of 97,000 vehiclesrecorded throughout 1995.

Despite signs of a setback in domestic vehicle sales and falling exports, theoverall sector is expected to rebound, as most aging fleets of vehicles in the Canadianmarket will be replaced over the next several years.

Despite this upbeat scenario in the industry, there are some existing disturbingsigns for the overall passenger car market. Sales in April 1996 have recorded their lowest level of sales in more than a quarter of a century, as the growing popularity of minivans and sport utility vehicles have captured the imagination of consumers. Theshift in tastes could have a profound impact on tooling and investment in existing passenger car plants, in favour of mini van and sport utility vehicles.

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Real Estate

Poor consumer confidence and continuing job uncertainty, coupled withthe downsizing of good paying public sector jobs has joined demographic trends indepressing most of the Canadian real estate sector. After the robust growth of sin-gle family buyers in the 1970s and 1980s, poor economic conditions have combined with falling numbers of first-time buyers to collapse the real estate market.

Recently, the new housing price index has decreased by 2.7 percent over a one year period, representing the twenty-second consecutive month of decline.Such a situation in this sector has not been experienced before in recent history,and what is more, the rate of decline in house prices has been gathering pacesince 1994. On this note, it can be argued that both demographics and the chang-ing geo-political climate in the world are both working against any upward cor-rection in real-estate prices.

Moreover, the decline in this most important sector in the Canadianeconomy has created very disturbing trends in several areas. For instance, thedomestic nature of the Canadian banking system is oriented towards servicingthe mortgage market second only to its growing reliance on incomes from stock broking and trading activities. Any downturn in the value of the assets that thesemortgage loans are based on, will affect the quality of the banking system’sassets, regardless of the usual Government of Canada guarantee on such loans.

In addition, falling real-estate values, coupled with the collapse in com-mercial real-estate will affect other domestic lending activity in the small busi-ness sector. This is already in evidence, as is the preference for the Canadian banking system to lend to large internationally syndicated projects, not to men-tion increased securities operations.


The prolonged climate of low growth, and evidence of a downturn in profits should continue to drive merger and acquisition activity. Early evidencefrom the first quarter of 1996 shows that the dollar volume of transactions wasthe strongest on record. The deal base shifted from the large to medium-sizedsector, after posting several landmark deals that included publishing groupsThomson acquiring US based legal on-line publisher West Publishing for $4.7

billion, followed by mining company Inco’s $4.5 billion offer for DiamondFields Resources Inc., after a brief bidding war with rival Falconbridge saw thequick retirement of its management strategy.


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. In a bid to gain control over the massive Voisey Bay nickel project inLabrador, Inco Ltd. has moved its stake in the mine from 25 to 75 percent, which

will boost its market share in nickel to just over 40 percent. This, the sixth largestacquisition transaction in Canadian history, will see Inco issue 51 million com-mon shares as part of the overall purchase agreement, with a provision for a buy- back of one-third of the new stock with a four year period.

In addition, original equipment automotive parts manufacturer MagnaInternational Inc. has paid $100 million in acquiring UK joint-venture partner Marley Plc. Magna will acquire six plants, along with new assembly businessfrom the likes of German-owned Rover Group Plc. and Nissan Motor Co. Ltd.

Further activity will be expected in the Canadian banking sector, as Canada’slargest bank, The Royal Bank of Canada, has responded to a recent governmentwhite paper that recommends further deregulation and a more open domesticregulatory regime to foreign competitors. Specifically, the foreign banks haverequested that their operations in Canada be treated as subsidiary operations, ableto draw on the capital base of their parent banks. In turn, some Canadian bankshave agreed to this, only if the government would allow them to merge with other fellow Canadian banks, forming large international banks that could competemore easily in the changing climate.

Currency Forecast

Clearly, the industrialised countries in the world continue to stagnate. A pervasive climate of uncertainty has been created from dramatic technologicalchanges, coupled with the fall of communism and the dramatic collapse in the property price bubble.

The industry-specific situation is not any better, as companies’ profitsare on a downswing, combined with the general de-stocking of inventories andweak export markets. The upside for the Canadian dollar under such circum-stances is limited, and may even begin to challenge its lows with respect to theUS dollar.

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New Automotive Sales (%change)

(1) (2)

New Motor Vehicles 1.2 -6.5

Passenger Cars -5.9 -5.2

North American -0.3 -4.8

Imported -30.2 -7.3

“Big 3” manufacturers -5.7 -6.5Other manufacturers -6.2 -2.9

Trucks,Vans,Buses 11.2 -7.9

(1) April 1995 to April 1996(2) March to April 1996Source: Statistics Canada


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$Canadian banking consolidation begins as CIBC andthe Bank of Nova Scotia combine on back roomoperations

$mid-market manufacturing companies continue tohollow-out as large corporations cut back on contracts

$foreign investors begin to shift portfolio investments inCanadian securities to stocks & out of money markets

$US investors increase investments in Canadian stocksto record levels

$corrections on the Toronto & Montréal stock exchanges closely follow the sell-offs on Wall Street

$companies plan to increase business investment by

2.2% in 1996 over last year

$new orders for durable consumer goods & retailtrades decline

$all levels of government begin to seriously considerprivatising various divisions

$ Conrad Black’s Hollinger Inc. gains control of the old& directionless publisher Southam Inc.

$small business liquidity continues to deteriorate asused car purchases begin to exceed new carpurchases

Just as when demographic shifts in the Canadian population base brought the country’s building and housing sector to a virtual halt, a recent sur-vey by our contributing editor and automotive expert Dennis DesRosiers revealsan equally disturbing trend in the new and re-sale automotive markets.

Stagnating incomes and consumer uncertainty have shaken the normal buying patterns in the new car market, not only in Canada but also in the UK andFrance. DesRosiers shows that of all vehicles acquired in the past year, 64 per-

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Third Quarter: August 7, 1996



cent were used and just 36 percent were new. In addition, the number of vehiclesthat are aged between six and ten years have risen to 41 percent of all vehicles in

operation today.

More and more, changing habits and tastes are combining with fallingstandards of living to raise a number of concerns in the most vital industrial sec-tor in Canada today. The automotive industry has experienced steadily risinggrowth from 1992 to 1995, while 1996 has revealed signs of deceleration fromthe levels recorded in previous years. It is expected that sales will continue to bedriven by replacement demand, as vehicles already aged from six to ten years begin to reach the end of their productive cycles.

Automotive sector performance is vital to the economic prosperity of Canada, and upon closer reading of the North American Free Trade Agreement(Nafta), the auto sector was central to the framework of negotiations. Clearly, thegrowing preference of consumers to purchase used vehicles in today’s marketplace, can also be interpreted as a sign that most of today’s vehicles are manu-factured with a high level of precision and quality in mind.

Consequently, it no longer makes any sense to habitually change a vehi-

cle after every two to three years, since the depreciation schedule has been infor-mally extended over five to even seven years. The implications of this gain intechnical efficiency are very unclear at this moment. It has been argued that thelengthening replacement schedule derived from better-made vehicles will resultin noticeably lower uses of productive capacity in the auto sector, to very opti-mistic forecasts that base their logic on the steady replacement of a very largestock of used cars stretched over a number of years, that are aged between sixand ten years.

Radical changes in the automotive sector have combined with demo-graphic and technological changes to erode overall living standards in Canada.After the spectacular collapse in commercial property values in the early 1990s,marked by the fall of Olympia & York property developments, and now withtechnology making large-scale banking redundancies inevitable in the latter half of the 1990s, the Canadian economy has undergone very abrupt structuralchanges. Not only has the level of business activity changed, but the way of doing business is very different from just one decade ago.

Foreign Investment

Recent international securities transactions have been directed towardsthe record purchase of stocks. In following the general global trend, most of the


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influx of cash has originated from US based institutional and mutual fundinvestors. What is striking is the fact that the record investment in Canadian equi-

ties has not added any new net capital inflows. Instead, the foreign purchase of stocks has come at the expense of money market financial instruments.

Overall, the first half of 1996 has registered a net inflow of foreignmoney into the stock markets. So far, over $5 billion worth of equity investmenthas been accumulated by US investors. Moreover, sales and purchases of Canadian stocks initiated by foreigners has exceeded $10 billion per month in1996.

Despite recent evidence of the short-term money-market differentialfavouring US financial products over similar Canadian based investments, the buoyant stock market activity has prevented a complete repatriation of cash, buthas instead shifted the funds into Canadian stock markets.

The attractiveness of US capital shifts into the Canadian market has beensupported by gains in Canada exceeding those available in the US on similar risk-weighted products. In specific terms, Canadian stock prices, as measured by theToronto Stock Exchange 300 Composite Index gained 11.3 percent in the first five

months of 1996, as opposed to the 8.6 percent return on comparable US stocks asmeasured by the Standard & Poor’s Composite 500 index. This difference in ratesof return favouring Canadian equity investments, have far exceeded the shortfallin the traditional spread that favoured Canadian money-market instruments.

Although equity investments in Canada by foreign investors are gener-ally “blue-chip” in orientation, they can lead to more volatility than the tradition-al short-term money-markets and bond investments driven by the 1.5 percentspread available over US instruments. Evidence of this volatility has come to light

recently, as financial outflows have driven down the value of the Canadian dollar to the high 0.72 US cents range. The general stock market “correction” that hascome in July 1996, has also spurred some US based fund investors to dump

Canadian equities, putting further pressure on the Canadian dollar.


In a move to diversify its regional Québec based banking operations, the National Bank of Canada has tentatively acquired the domestic Ontario-based

branch network of Municipal Financial Corp. The deal has been negotiated at$35.5 million which is below the Municipal book value. The deal, once approved by financial services regulators, will raise the number of National’s Ontario- based banking branches to 123 from 94. Overall, the move can be justified moreon the grounds of diversifying political risks, than it can on sound profit strate-

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gy, given the uncertainty surrounding the existence of physical branch bankingin a period of revolutionary technological change.

More in tune with the new technological environment that currentlygrips global banking, is the move by Canada’s second largest bank CIBC, to con-centrate on consumer banking opportunities that transcend the traditional physi-cal presence of branch banking. More use of electronic processing units inheavy-traffic retail operations will be central to CIBC’s overall strategy.In addition, further defensive moves in securing profitability have been evidentin the Canadian banking sector, as CIBC has combined its back office operationswith those of the fourth largest and most international of all Canadian retail

banks; the Bank of Nova Scotia.

Currency Forecast

With falling interest rates and a narrowing of the traditional spread over comparable US bond investments, the situation has become much more volatilein context to foreign financial flows. Should more volatility emerge in globalstock markets, enormous pressures on the Canadian dollar could materialise as

US funds withdraw.

International Finance in Canada ($millions)

May/96 Jan-May/95 Jan-May/96Total Investment -168 10,467 7,462Bonds (net) -62 11,084 966

Outstanding 166 2,158 -2,473

New Issues 2,610 14,517 16,484Retirements -2,838 -5,591 -13,045Money Market (net) -2,469 1,324 1,194

Government -2,258 944 237Other -211 380 957

Stocks (net) 2,362 -1,941 5,303Outstanding 1,470 -2,375 3,346New Issues 892 434 1,957

Source: Statistics Canada


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$ Federal government of Canada will seek a legal ruling bythe Supreme Court on Quebec’s plans to separate

$ Quebec Premier Lucien Bouchard causes dissension inParti Québécois over his opposition to unilingualism

$ exports rise to the US & Japan but fall with most otherimportant trading partners in July

$ new softwood lumber agreement with the US results in aone-third rise in exports in July

$ strong demand in the US causes motor vehicle exports &parts to rise by 6.0% & 4.7% respectively

$ business investment & operating profits of Canadianenterprises falls by 3.4% & 1.6% respectively

$ manufacturing shipments & new orders increase as foreigninvestors look to acquire manufacturing base

$ increasing competitiveness in Canadian industry & budgetcontrols begin to create positive sentiment for dollar

$ political & economic uncertainties in other G.7 countriesrank Canada in best overall position by IMF & OECD

$ US steps up acquisition activity in Canada in real estate &industrial products sectors

Successes in negotiating a North American Free Trade Agreement that benefits Canadian manufacturing, together with a very competitive dollar has raisedthe interest of foreign companies wanting to acquire a manufacturing presence inCanada.

Once again, manufacturers that are in the business of exporting more thanfifty percent of their product to the United States are very profitable. Not only isthis evident in the fast-growing knowledge based industries, but is apparent in theraw materials and automotive sectors. Softwood lumber products which have been

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a traditional sore point in Canada-US trade relations, despite the existence of freetrade agreements, have responded to a recent clarification of the problem by raising

exports by one-third. Likewise, the auto pact that was since carried over into thenew Nafta agreement, has continued to perform well.

Specifically, Canada’s overall exports advanced by 2.1 percent in July toa record $22.5 billion. Exports saw increases mainly to the United States and toJapan, but decreased in most other important markets. However, imports began toincrease faster than exports. As they reached their highest level in July since Februaryof this year. Most of the main trading partners to Canada sold more industrial goodsand machinery. The increase in imports has outstripped some of the good news in

the export sectors, creating a small drop in the overall trade surplus.

The manufacturing sector began to take advantage of the very competitiveCanadian dollar. The push towards the US market by Canadian producers seems to be reaching a point of maturity. It can be said that Canadian companies are finallytaking full advantage of the emerging climate of globalisation. The initial fall of communism coupled with the tremendous technological developments together with perfect capital mobility, has been a shock initially to the overly-domesticatedmanagers of Canadian companies. Four years of a changing corporate managerial

culture, together with an aggressive push to educate the newly-emerging leaders of business in universities, seems to finally be bearing fruit for the Canadian economy.

Falling Interest Rates

Despite the successes in trade relations with the United States recently,things are not so good with the two-thirds of economic activity in Canada that isnot subjected to cross-border commerce. It is only the one-third of Canadianindustry that can be deemed to be the most globally competitive. The other two-thirds of goods and services that are produced locally, are subjected to continuingdepressed business conditions domestically.

Recently, Canadian monetary policy has been mainly shaped by theconditions that are representative of this domestic sector. Bank of Canada Governor Gordon Thiessen has made a recently unprecedented break with US monetary policy. By lowering rates for the fifth consecutive time in 1996, he has displayeda very rare degree of independence, while causing the dollar to appreciate, insteadof following recent history and coming to its defense.

Most US investors have adopted the sentiment that Canada is a verygood investment at this moment, based on its relative merits among most other members of the G.7 group of industrialised countries. In particular, this group is


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very bullish towards the Canadian dollar, as some have even voiced their opin-ions that they believe that the Canadian currency is on its way to once again

achieving parity with the US dollar (see Dennis Gartman interview in this issue).

It may be possible to conclude that these sentiments are mainly basedon observing recent Canadian trade successes south of the border, and really havevery little bearing with the two-thirds of the economy that remains subject todefensive strategies of job losses and restructuring, coupled with very high ratesof unemployment. In fact, evidence on the jobless rate indicates that it hasexceeded the nine percent point for every month for the past six year period,which is a stretch that has only been equalled since the Great Depression of the

1930s. Monetary policy has been shaped by this two-thirds uncompetitive sector,as it moves in sharp contrast to the on-going austerity measures introduced by thefederal government and the provinces. In fact, it can be said that the policies being followed by the government spending programs more closely correspondto what is necessary in the robust and competitive export sector, while monetary policy has been responding to the intensive care that is required for the batteredtwo-thirds of the economy that is the domestic sector.

Central to the problems in the domestic sector has been commercial

property development and residential mortgage sales. As with most property sec-tors in the industrialised world, activity continues to barely respond to low inter-est rates, while bankers in most countries still show a very deep aversion tofinancing any grand projects which are not very conservatively capitalised.

Recently, commercial property has shown some signs of revival in theUK market, as an almost complete cessation of building over the past four yearshas caused demand to exceed the space that is currently available. Likewise, it isin the residential side of the US market that recent activity has made the best

showing since that in 1989. This has been one of the main reasons for theincreased demand for Canadian softwood lumber exports in the summer of 1996.

With US investor sentiment going one way and Canadian monetary pol-icy the other, a window of opportunity has opened up for the continued reduc-tions seen in short term interest rates. This will hold as long as the dollar contin-ues to hold its ground and stock markets stay steady. The trend with short termrates is that they have dipped below comparable US rates in February of thisyear, and have continued to fall ever since. Currently, the historical investment

spread has been attacked, as the spread on two year bonds was about one percent,while that on five year bonds has dipped below their US counterparts. Likewise,it is expected that the prime rate of interest charged by Canadian chartered banksto their best customers will continue to hold steady, or fall even further. This will

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be evident in the consumer mortgage credit market, as record low levels of financing should spur more activity in the housing market, as debt burdens will

be reduced even more through a rise in re-financings.


Most foreign manufacturers and trading groups can sense how prof-itable the Canadian manufacturing sector has become. From the large Japanesetrading companies to medium-sized US based automotive parts producers, toEuropean engineering groups, all are in the hunt for possible acquisitions of Canadian companies that are exposed in a big way to the outside world.

Manufacturer and distributor of gas wellheads in the Emco Ltd. group,Walker Steel, was acquired by Texas-based provider of oil and natural gas fieldservices ABB Vetco Gray Inc. In the automotive parts industry, New York basedStandard Motor Products Inc. has acquired Montréal based manufacturer of brake pads Fibro Friction Inc. for $19 million in cash.

The fast changing global financial services industry saw both of Canada’s largest chartered banks, Royal Bank of Canada and Canadian ImperialBank of Commerce acquire the worldwide electronic bank payment card systemMondex International Ltd., developed by UK based National Westminster Bank.CIBC and Royal are both acquiring a five percent stake in Mondex International, joining US based Wells Fargo Bank and AT&T and a consortium of European banks, with National Westminster retaining a ten percent stake in the project. Inturn, the CIBC and Royal banks will hold the Canadian franchise rights for theMondex “smart card” in Canada.

Currency Forecast

The positive sentiments created in the US by the successes of fiscal cutbacks by the Federal government and the provinces, has joined the transforma-tion of Canadian manufacturing industry as the main reasons for the early inter-est in the Canadian dollar. Problems in Europe with recessions in France andGermany, along with the colossal Japanese banking problems, have created rel-ative sentiments in favour of Canadian investment paper.

In contrast, the politicisation of the operations of the Bank of Canadaunder the relatively new leadership of Governor Gordon Thiessen, has generat-ed some early debate within the Canadian business community.

The question at this very moment, is how much more independent canCanadian interest rate policy be from that of the Federal Reserve? The recent


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strength may come to a quick end, once the US central bank decides to raise itsshort-term rates, perhaps after the US presidential elections in November.

For the time being, the dollar should enjoy some welcomed strength andchallenge the 0.75 cents US level. Any further movement upwards will be coun-tered by the Bank of Canada’s policy of yet even more lower short term interestrates.

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Investor’s NewsFlash

• dollar continues to trade at low end with respect to USdollar

• real estate sector shows signs of revival as newcondominium projects and conversions of unused

commercial space reach impressive levels• Bank of Canada rate remains at minimally acceptable level

in support of the dollar

• Canadian banking sector begins to grow throughacquisition of US boutiques and brokerages

• federal government halts new borrowing for the first time in25 years

• no new bonds will be offered to finance operations asfinances head towards a surplus position

• as provincial debt declines the only investment in the bondmarket will remain corporate bonds evidence of whichshows an increase of $10 bn. in the past year

• bank rate climbs one-quarter of a point to 3.5% as primeremains at 5.0%

The Canadian recovery, although showing signs of maturity still hangson a very thin thread. Evidence of which is the continued spread over the primelending rate in the US of an average of 3.0 percent in favour of Canadian bor-rowers, and a continuing weak Canadian dollar.

The actions of the Bank of Canada continue to indicate reservationsabout jeopardizing the recovery in any way, through a very slow and cautious policy of gradually moving the bank rate up very slowly, and only when circum-

stances warrant the move.Although the real-estate sector is showing early signs of recovery in

Ontario, as conversions of old commercial space are brought onto the market,there still remains the fact that an unprecedented amount of space has been taken

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off of the commercial real-estate market since the recession of the early 1990s.What has not been demolished, has been successfully sold in the Condominium

market, although at the low margin end more so than at the luxury level.

The Canadian economy has become so tied to the export markets of theUS and to a lesser extent Latin America and Mexico, that the movement of thedollar upwards beyond $0.76 cents to one US dollar, will impact many compa-nies’ profit margins. This is a situation that never existed to such a great extentin history as it does now. It is as if the Canadian dollar must continue to be pegged at its historical lows with respect to the US dollar, in order to ensure ahealthy performance on the real side of the economy.

The issue more and more centres on US industry’s annoyance at the suc-cess that Canadian exporters are having in their own domestic marketplace. Thedanger being that the Canadian-US trade relationship could become similar innature to the one that currently exists between the US and Japan.

With a Japanese trade surplus that cannot seem to fall, the US has usedthe dollar-yen relationship as an outlet for policy. Since the election of theClinton administration, any rumblings on the trade deficit over an extended peri-

od of time always brought a correction in the yen upwards, making Japaneseexports more expensive to US consumers, hence shutting off any increase indemand for cars and electronic products.

There currently exist fears in Canada over a similar brand of politics, asthere already is evidence that Congress is considering a re-negotiation of someaspects of the North American Free Trade Agreement (Nafta), to address some of the competitive disadvantages that US industry is currently having againstCanadian imports.

Should there continue to be an escalation of the Canadian trade surplusto even greater levels, then the US may decide to seek a “political solution” tothe problem. It would not be surprising that the low Canadian dollar over the pastthree years would become the negotiating tool for US trade policy, just as it has become so for trade relations with the Japanese.

Although recovery is at hand in the industrial provinces of Ontario andto a lesser extent, Quebec, it remains fragile and requires the existing low ratesof interest along with a very competitive exchange rate in the US.

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• dollar continues to trade at low end with respect to USdollar

• real estate sector shows signs of revival as newcondominium projects and conversions of unusedcommercial space reach impressive levels

• Bank of Canada rate remains at minimally acceptable levelin support of the dollar

• Canadian banking sector begins to grow throughacquisition of US boutiques and brokerages

• federal government halts new borrowing for the first timein 25 years

• no new bonds will be offered to finance operations asfinances head towards a surplus position

• as provincial debt declines the only investment in the bondmarket will remain corporate bonds evidence of whichshows an increase of $10 bn. in the past year

• bank rate climbs one-quarter of a point to 3.5% as primeremains at 5.0%

The Canadian recovery, although showing signs of maturity still hangson a very thin thread. Evidence of which is the continued spread over the primelending rate in the US of an average of 3.0 percent in favour of Canadian bor-rowers, and a continuing weak Canadian dollar.

The actions of the Bank of Canada continue to indicate reservations

about jeopardizing the recovery in any way, through a very slow and cautious policy of gradually moving the bank rate up very slowly, and only when circum-stances warrant the move.

Although the real-estate sector is showing early signs of recovery inOntario, as conversions of old commercial space are brought onto the market,

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there still remains the fact that an unprecedented amount of space has been takenoff of the commercial real-estate market since the recession of the early 1990s.

What has not been demolished, has been successfully sold in the Condominiummarket, although at the low margin end more so than at the luxury level.

The Canadian economy has become so tied to the export markets of theUS and to a lesser extent Latin America and Mexico, that the movement of thedollar upwards beyond $0.76 cents to one US dollar, will impact many compa-nies’ profit margins. This is a situation that never existed to such a great extentin history as it does now. It is as if the Canadian dollar must continue to be pegged at its historical lows with respect to the US dollar, in order to ensure a

healthy performance on the real side of the economy.

The issue more and more centres on US industry’s annoyance at the suc-cess that Canadian exporters are having in their own domestic marketplace. Thedanger being that the Canadian-US trade relationship could become similar innature to the one that currently exists between the US and Japan.

With a Japanese trade surplus that cannot seem to fall, the US has usedthe dollar-yen relationship as an outlet for policy. Since the election of the

Clinton administration, any rumblings on the trade deficit over an extended peri-od of time always brought a correction in the yen upwards, making Japaneseexports more expensive to US consumers, hence shutting off any increase indemand for cars and electronic products.

There currently exist fears in Canada over a similar brand of politics, asthere already is evidence that Congress is considering a re-negotiation of someaspects of the North American Free Trade Agreement (Nafta), to address some of the competitive disadvantages that US industry is currently having against

Canadian imports.

Should there continue to be an escalation of the Canadian trade surplusto even greater levels, then the US may decide to seek a “political solution” tothe problem. It would not be surprising that the low Canadian dollar over the pastthree years would become the negotiating tool for US trade policy, just as it has become so for trade relations with the Japanese.

Although recovery is at hand in the industrial provinces of Ontario and

to a lesser extent, Quebec, it remains fragile and requires the existing low ratesof interest along with a very competitive exchange rate in the US.

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• federal government delivers balanced budget andforecasts a $5.0 billion surplus in 1998-99 and $10 billionthe year after

• Bank of Canada extends inflation target of 1 to 3% untilthe end of 2001

• federal debt to GDP is forecast to fall to 63% by 2000-01

• political stability as Jean Charest becomes oppositionleader in Quebec

• trade surplus falls to $1.7 billion in January reflectingreduced exports of machinery and forest products

• Japanese investors continue to repatriate their Canadianbased investments Trade strategy for far east falls intodisarray

• Canada begins negotiations to become member ofEuropean Free Trade Association

• more bank mergers as CIBC and TD announce intentions

• exports to Japan fall by 33%

• all economic indicators peak as commodity pressuressink dollar

Throw away the Finance Ministry and the Bank of Canada becauseCanada’s economic policy is now determined by what happens in Asia andJapan! Evidence of the ineffectiveness of domestic economic policy making isnow coming into real focus. Ever since “Team Canada” trade missions began cir-cling the globe in pursuit of contracts for Bombardier and Northern Telecom, and by equal measure escaping the small and inactive domestic marketplace in thenew era of globalisation, something even more disturbing was happening in thefar east and in Russia. The collapse of the Thai Baht, Indonesian Rupiah and nowthe yen has left the Canadian export sector badly exposed and in need of cus-

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tomers. Not only has the meltdown in Asia forced the cancellation of numerouscontracts for commodities, but the growing inclusion of Russian based raw mate-

rials on world markets has also had undesirable effects on the prices of Canadian based natural resources.

The lapse into recession of the Asian trading zone has revealed just howexposed the Canadian economy is to that part of the world. In a related way, italso indicates just how resource-based the country still is, despite the growth infinancial services and in high technology in most of its major cities. In fact, theAsian crisis is a real slap in the face, as in this new era of globalisation and infor-mation technology, Canadian resource exports are still the supreme fundamentals

that drive the value of the currency.

Consequently, the recent business slowdown in the Asian region hascaused a structural decline in the price of commodities, taking the dollar down-wards. Not only have production-based commodities fallen, but the crisis hasalso caused another relapse in the price of gold, sending stocks to challenge their lows and confirming the new lower trading range of the dollar at the bottom of $0.65 to $0.75 US.

The current climate of resource deflation has effectively sidelined anyexistence of a monetary policy, as the Bank of Canada’s refusal even to consid-er the raising of short-term rates, has unnerved dollar based investors even fur-ther. Not only has the Bank of Canada been marginalised in the collapse of resource and commodity prices, but rumours abound that the inaction of Governor Gordon Thiessen in raising rates even to support the dollar symboli-cally, have devalued the credibility of the Bank.

Canada may be faced with even more problems as the profitability of its

manufacturing and export sectors comes under further attack from the US. Withmore and more cheap imports attacking the US market, growth rates are boundto be affected, which will in turn reduce the demand for Canadian exports, caus-ing even more dollar grief.

Forecast

The deluge of cheap products that will be sent from Japan to the US andwith the real prospect of even more competitive devaluations in Asia, have alreadycaused pricing pressures on domestically-produced items. The challenge thatCanadian exporters will have is to further raise productivity to counter the price- pressures from the Asian market. Failing this, the dollar will fall even further.

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• federal government delivers balanced budget andforecasts a $5.0 billion surplus in 1998-99 and $10 billionthe year after

• Bank of Canada extends inflation target of 1 to 3% untilthe end of 2001

• federal debt to GDP is forecast to fall to 63% by 2000-01

• political stability as Jean Charest becomes oppositionleader in Quebec

• trade surplus falls to $1.7 billion in January reflectingreduced exports of machinery and forest products

• Japanese investors continue to repatriate their Canadianbased investments

• trade strategy for far east falls into disarray

• Canada begins negotiations to become member ofEuropean Free Trade Association

• more bank mergers as CIBC and TD announce intentions

• exports to Japan fall by 33%

• all economic indicators peak as commodity pressuressink dollar

Throw away the Finance Ministry and the Bank of Canada becauseCanada’s economic policy is now determined by what happens in Asia andJapan! Evidence of the ineffectiveness of domestic economic policy making isnow coming into real focus. Ever since “Team Canada” trade missions began cir-

cling the globe in pursuit of contracts for Bombardier and Northern Telecom, and by equal measure escaping the small and inactive domestic marketplace in thenew era of globalisation, something even more disturbing was happening in thefar east and in Russia. The collapse of the Thai Baht, Indonesian Rupiah and now

133




the yen has left the Canadian export sector badly exposed and in need of cus-tomers. Not only has the meltdown in Asia forced the cancellation of numerous

contracts for commodities, but the growing inclusion of Russian based raw mate-rials on world markets has also had undesirable effects on the prices of Canadian based natural resources.

The lapse into recession of the Asian trading zone has revealed just howexposed the Canadian economy is to that part of the world. In a related way, italso indicates just how resource-based the country still is, despite the growth infinancial services and in high technology in most of its major cities. In fact, theAsian crisis is a real slap in the face, as in this new era of globalisation and infor-

mation technology, Canadian resource exports are still the supreme fundamentalsthat drive the value of the currency.

Consequently, the recent business slowdown in the Asian region hascaused a structural decline in the price of commodities, taking the dollar down-wards. Not only have production-based commodities fallen, but the crisis hasalso caused another relapse in the price of gold, sending stocks to challenge their lows and confirming the new lower trading range of the dollar at the bottom of $0.65 to $0.75 US.

The current climate of resource deflation has effectively sidelined anyexistence of a monetary policy, as the Bank of Canada’s refusal even to consid-er the raising of short-term rates, has unnerved dollar based investors even fur-ther. Not only has the Bank of Canada been marginalised in the collapse of resource and commodity prices, but rumours abound that the inaction of Governor Gordon Thiessen in raising rates even to support the dollar symboli-cally, have devalued the credibility of the Bank.

Canada may be faced with even more problems as the profitability of itsmanufacturing and export sectors comes under further attack from the US. Withmore and more cheap imports attacking the US market, growth rates are boundto be affected, which will in turn reduce the demand for Canadian exports, caus-ing even more dollar grief.

Forecast

The deluge of cheap products that will be sent from Japan to the US andwith the real prospect of even more competitive devaluations in Asia, have alreadycaused pricing pressures on domestically-produced items. The challenge thatCanadian exporters will have is to further raise productivity to counter the price- pressures from the Asian market. Failing this, the dollar will fall even further.

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• federal task force on financial services rules favourablyto planned banking mergers

• department store sales fall 4.9% in June for the thirdconsecutive month as domestic spending begins to fall

• GDP forecasts have been downgraded for the secondhalf of 1998 to 2.0% from the 3.7% that was registered inthe first quarter of 1998

• CIBC issues profits warning over slowdown in tradingrevenues as banking shares take a huge hit in August

• Toronto Stock Exchange TSE300 index falls to 5,600from a peak range of 7,800

• worries in financial services sector over possibility of abear market in Canadian stocks

• EU joins Japan in challenging Canada at the World TradeOrganisation over its Auto Pact tariff on importedvehicles

• dollar hits all-time low of US$0.634 as Bank of Canadaraises rate by 1%

The dollar has broken through our most pessimistic trading scenario of US$0.65 to US$0.70. It now hovers just above the low end of this range, climbingfrom its most recent low of US$0.634.

Not only has this unprecedented trend been lost in the overall global crisisthat is affecting many corners of the globe, it comes as a severe shock to most estab-

lishment commentators and analysts, who only a year ago were forecasting that thedollar would progress towards the US$0.75 to US$0.80 range.

What is even more disturbing from the perspective of foreign investors inCanadian dollar denominated paper securities, is the double effect that they have had

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to contend with recently. Not only have they been drastically affected by the unprece-dented move downwards by the Canadian currency, but they have also been caught in

a substantial correction on Canada’s main stock market index, the TSE300. Losingsome 30 percent of its value in just one month, the fall-out has mainly been caused bythe banking sector, after it issued an unexpected profits warning from a fall in tradingrevenues.

The Bank of Canada has further lost credibility by responding in a mostuntimely fashion to the dollar crisis. After hitting its all-time low, the Bank argued thatthe extremely cheap currency was viewed as a proxy for a lower interest rate inCanada. Consequently, the bank reacted to this by raising its bank rate by one per-

centage point, despite the fact that the country was caught in a severe commodities-induced deflationary spiral, and that the G7 group of countries may very soon engagethemselves in a co-ordinated general rate reduction to counter the growing globalfinancial turmoil.

Aside from the fact that the Canadian dollar has been adversely affected bythe lack of credibility coming from the Bank of Canada, many are quick to point tothe effect that the Asian crisis will have had on commodity prices.

With some 40 percent of Canadian exports being composed of commodities,a price collapse from a contraction in global demand will create a trade balance deficit.This may or may not lead to an immediate effect on the value of the dollar. However,a more compelling reason for dollar weakness can be explained by the fundamentals.

On trial by global investors has been the entire establishment and elite thatrun the country. From the politicians’ over-reaction to Quebec separation, to only ahandful of Canada’s business leaders that truly know how to compete in a global econ-omy, the dollar’s decline has been in the works for a very long time. Throughout the

1990s, the dollar has been more driven by the status of Canada’s rate of unemploy-ment, than it has by the trade fundamentals or by foreign direct and portfolio invest-ment.

What foreign investors and business people continue to focus on is howCanada is adjusting to an increasingly global economy, where the resources of Russiaand China were increasingly being tied to a market

Forecast

The dollar can only be rescued by a strong figure at the Bank of Canadathat is willing to reassert its authority.

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• economic growth slows to 1.8% in the 3rd quarter asretail inventories fall by C$4.6 billion

• Exports to the US rose by 1.4% in the fourth quarterwhile a weak dollar lowered the balance of paymentsdeficit from C$20.9 billion in the second quarter to C$17.6billion

• Canadian Government rejects the banking mergersproposed by the Royal Bank and Bank of Montreal andby the CIBC and the TD Bank on the grounds that therewould be very little competition in credit cards, retailbrokerage and retail branch banking services

• Finance Minister Paul Martin jr. warns that no furthermerger proposals would be considered from banks untila review of financial services regulation was completed

• dollar rebounds from recent lows as the launch of theEuro makes it more attractive to investors

The Canadian dollar began 1999 on a positive note, as the global cur-rency markets were undergoing a mass reconfiguration of investment strategies.The launch of the new euro currency has re-denominated most securities issued by the 11 participating members voiding their previous national denominations.

Instead of investors being presented with a choice of punts, escudos, pesetas, marks, francs, guilders and markka’s, they are now restricted in their choice of only five or six “blue-chip” industrialised country currencies. The G3composing the US, Japan and Europe will capture most of the liquidity available

on the international markets, together with the pound sterling, while theCanadian dollar, Swiss franc and the Australian and New Zealand dollars willmake up the second tier.

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The Canadian dollar will benefit to a certain degree from the launch of the euro. When a broad range of European currencies were available, investors

were preoccupied with betting on the exchange rate direction of various fixed-income and equity investments. For most of the decade of the 1990s, theCanadian dollar was not a favoured currency by foreign fund managers. Set back by political concerns over Quebec’s possible separation, and the rough econom-ic climate in the early to mid-1990s, Canada was always considered to be ill-prepared for the new global climate of competition that unleashed Russia's vast nat-ural resources on global markets to compete.

The 1990s were not very kind to commodity-based producers or to

commodity exporting countries. Supplies flooding international markets fromemerging market countries, joined technological change in oil exploration andthe automotive sectors to further depress prices and profits. Although the realeconomic prognosis remains depressed for the foreseeable future in Canada, dol-lar investors can take some comfort in the launch of the euro. With the elimina-tion of 11 blue-chip currencies, European based investors will come to re-evalu-ate the dollar as an alternative choice which will only gain in prominence andacceptance.

Forecast

As the US economy braces for a downturn, trade rhetoric is now almostas intense in Washington, as are the proceedings to impeach the president.Recently, the US unveiled a “hit list” that it hopes to use against selectedEuropean imports over the dispute concerning the EU “banana regime.”Likewise, the issue that surrounds US based “split-run” magazines in Canadaremains very fragile.

With Canada threatening to protect its cultural heritage, by preventingUS mega-media groups’ access to the Canadian advertising market via split-runeditions of US magazines, the Cultural Minister has threatened to impose vari-ous forms of tax or subsidy measures to protect the fledgling Canadian magazinemarket. The US has countered by threatening to impose broad-ranging sanctionson industrial and agricultural products.

With growing reliance on the US market, Canada needs a cheap dollar to be competitive. Trade wars instigated by the US call for a stronger Canadiandollar, just as with the yen in Japan. The launch of the euro also calls for astronger dollar over the following quarter.

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• dollar shows impressive gains in first quarter as externalfactors cause a flight to quality

• resource prices stabilise as foreign investors begin to re-consider cyclical investments

• dollar helped by war in Adriatic and by the adverseeffects that it is having on the newly-minted eurocurrency

• launching of the new euro works in dollar’s favour as lesschoices are made available to currency investors andspeculators

• seasonal unemployment heads higher while UK treasuryannounces the sell-off of 50 percent of its gold reserveshitting mining stocks

• Toronto Stock Exchange posts 3rd best gains in firstquarter among G7 members as cyclical and traditionalnon-technology shares come back into favour

• banking sector braces for far-reaching rationalisations

• inflation rises to 1 percent in March

The recent move towards US$0.70 is an unwanted event that Canadianmanufacturing interests can barely afford at this stage of the business cycle. Onceagain, the upward spike in the Canadian dollar is solely driven by externalevents, and in no way is it the result of good domestic fundamentals or manage-ment.

For most of the mid to latter half of the 1990s, it has been the manufac-turing sector of Canada, that has slowly pulled the economy out of the malaisethat culminated in the close-call referendum vote in Quebec in 1995. With a US population that is all too willing to consume imports, it has been the stimulus thatthis has provided exporters of manufactured products. Most of the job creation

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Second Quarter: May 9, 1999



that has occurred in Canada in the past two years is a direct result of the sales thatCanadian firms have been making to a red-hot US market. Times could not have

been better for Canadian based exporters, as dollar weakness combined with theUS boom to lift Canada out of its lingering recession in 1996.

As was reported in previous issues, the launch of the new singleEuropean currency would spring the Canadian dollar back into favour amongforeign currency investors and speculators. This is in fact what has been happening, as the positive effects on the value of the dollar are clearly evident nowin the second quarter. By launching the new single currency, there has been anovernight elimination of some ten “hard” investment grade currencies available

to international portfolio managers and currency traders, allowing all parties tore-position their books as well as their sentiments in favour of the Canadian dol-lar.

In addition, the weakness of the euro in the first quarter, along with the possibility of long term instability in the Adriatic over the war with Serbia, hasfurther heightened foreign interest in the Canadian currency. With growing con-cern in the instability caused by this unexpected war in the Balkans, the worldeconomic stage that has normally become accustomed to discussions over

emerging market bail-outs over the past several years, is now moving in thedirection of military strategies, with infant signs of old Cold War tensions resur-facing once again.

Should this movement relegate the global liberal market themes of the1990s to the geo-political strategic sphere once again, Canada will experience aneconomic renaissance as a resource-producing country. In short, the 1990s peri-od of global and open markets, with resources from the old Soviet countriescheaply available have not been good for the average living standards of

Canadians. In fact, Canada has a very hard time competing on the global stage,since this is something that it just is not suited for culturally. Consequently, it is

not merely coincidence, that the dollar has been weak throughout the 1990s.

Forecast

The dollar has made a comeback against the interests of manufacturingexporters, which have been the foundation for recovery in the latter half of the

1990s. The dollar will continue to benefit from a prolonged war in the Adriaticregion of Europe, but will not be expected to cross into the US$0.70 cents range.

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Toronto Stock Exchange warns over the use of creative accounting to

inflate quarterly earnings

trade surplus in July is the highest recorded since December of 1996

Gold and Oil price recovery should bring resource production back onto

international commodity markets

commercial real estate sell-offs by Royal Bank and CIBC depress sec-

tor

Dollar hit by remarks at Federal Reserve over the prospect of higher US

short term rates

recovery in commodity prices fails to lift dollar beyond US$0.68

Cross Border M&A Effects on the Dollar

Canadian companies acquiring foreign companies: 3

Capital Outflows From Canada From M&A: $3.0 billion

Foreign companies acquiring Canadian companies: 7

Capital Inflows to Canada From M&A: $10.6 billion

Net Capital Inflows to Canada From M&A: $7.6 billion

Net M&A Impact on the Canadian Dollar in Global Markets is Positive (+)

Business activity continues to rise but not to the extent of positivelyimpacting employment as well as reversing the downward spiral in interest rates.The recent pronouncement by Alan Greenspan, that the Federal Reserve hasadopted a bias in favour of higher interest rates, is not a stance that Canadianmonetary authorities share. Still, despite encouraging signs, the recovery is stillconsidered to be very fragile.

For the past several years, numerous resource based companies in gold production and oil exploration have seen their capacities reduced. The collapsein these resource prices has depressed the western and northern regions of thecountry and has contributed in some way to a depressed Canadian dollar thatfound itself trading in a historically lower range relative to the US dollar. Eventhe recent recovery in these commodity prices has not convinced investors that

141




the dollar should climb back above the US $0.70 range. Many analysts haverecently argued that the Canadian economy is far less resource dependent than

many would tend to believe. They argue that there has been a great transforma-tion over the past several years which has created a very strong high tech, serv-ices and mixed industrial sector in several major regions across the country.

This may be true, however, Canada still lags when its companies arecompared to the activities undertaken in the global economy by comparableenterprises in other G7 industrialised countries. For instance, when consideringcross border merger and acquisition activity undertaken by Canadian companies,the statistics are always at the bottom of the ranking. Only Japanese companiesfail to surpass the Canadian volumes, and data from Canada is usually compara-

ble to the data generated from Italy.

What has this to do with the changing nature of the composition of Canada’s leading sectors? Since most of the leading-edge M&A deals usuallyinvolve high technology companies, and fewer and fewer mature industries,Canada is really not a player in any significant way. The fact of the matter is thatthe export boom, mainly to the US market, has been driven by medium sizedmachine tool and traditional industrial product industries.

Moreover, although the banking system is much better from just four years ago, when it comes to financing high tech industries, it still comes up far short in relation to the environment in the US or in the UK. An “equity gap”exists in Canada just as much as it does in the UK. Most of the “venture capital”in Canada that is allocated to high tech industries, is only reserved for the minor-ity that are connected in some way with the big groups like Nortel. The generalconsensus among high tech investment bankers in Toronto is that there really isno venture capital or proper financing still to this day for adequate high techdevelopment.

Forecast

The dollar continues to trade at its all-time historical lows. The resource price increase has not helped, nor has the introduction of the Euro. In short, thecurrency is following the general long term decline in resource prices.

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• Shifting balance of power towards Capital Account will notaffect dollar despite record $270 bn. trade deficit in 1999

• Interest in establishing presence in EU countriesdeclines

• Household and Corporate debts rise by 9.2 and 11.5% in1999

• Corporate debts at 45% of GDP highest in history

• Fed raises rates to highest level in 4 years

• Venture Capital Subsidiaries account for most of theprofits of US banks

• Nasdaq ends 1999 85% higher with P/E twice the peak of Tokyo market in 1989

• Greenspan re-appointed

CROSS BOARDER M&A EFFECTS ON DOLLAR

(Data for 4th quarter of 1999)

US Companies Acquiring Foreign Companies: 25

Capital Outflows From US From M&A: $13.28 bn.

Foreign Companies Acquiring US Companies: 37Capital Inflows to US From M&A: $53.7 billion

Net Capital Inflows to US From M&A: $40.46 bn.

Net M&A Impact on US Dollar Value in Global Currency Markets is

Positive (+)

With the re-appointment of Federal Reserve Chairman Alan Greenspanto another four year term, and continuing momentum propelling the US econo-my to a record 108 months of business expansion, the dollar continues its sur-

prising record run-up against the Euro. With the Euro falling from the one-to-one parity level in relation to the dollar, many have begun to take a long a criticallook at what has been transpiring recently among Euro-zone members. With noslowdown in sight in the US, the Fed has been slowly raising short-term rates outof inflationary fears. This, despite definite signs of inversion in the bond yield

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curve as the Treasury announces its aggressive campaign to buy-up and retire 30year T-bills. Recent moves to raise short-term rates by the European Central

Bank (ECB), has resulted in greater scrutiny among investors in Euro assets.Such moves have been associated with a central bank that has been quickly los-ing sovereignty over its monetary policy. Despite stating that it does not use theexchange rate to determine monetary policy, any recent moves to raise short-termrates under a period of continuing sluggishness driven by unprecedented restruc-turing in the industrial landscape of Europe, has led to the only logical reason for the recent increase of rates by 0.25 percent. In short, to protect the Euro from fur-ther weakness, means that sovereignty over monetary policy has been relin-quished at the expense of the credibility of the central bank. Only once this cred-ibility has been re-gained among investors, can the Euro once again climb back

above the parity level with respect to the dollar.

The yen, however, has encountered some recent weakness in trades withthe dollar. Continuing weakness in the domestic Japanese economy, together with record bankruptcies and re-structuring activity, has spoiled the strength thatthe currency has been exploiting from a tight monetary policy that has been exe-cuted by an ever more credible Bank of Japan. After living through a decadeaftermath from the “bubble” years of the late 1980s, the Bank of Japan has keptits word to never again re-inflate the financial system so as to re-create the con-ditions of a bursting “bubble” again.

FORECAST

Despite a historically high trade deficit, the dollar market has becomemainly dependent on cross-border acquisitions and portfolio investments.European companies are showing high levels of interest in establishing a US presence via a buy-out of a US firm, and as long as the soaring high tech stockscontinue to drive up the benchmark indexes, the dollar should remain in a strong position.TOP NEWS STORIES AFFECTING THE DOLLAR

Equity risk premiums impact currency values • the lower the risk premium or the more international a stock is the greater will be its effect in the currency mar-kets • savings rate rises from 1 to 1.4% in January • Greenspan warns of further rate rises after quarter point rise to 6% in February and warns bankers not toassume current boom represents a normal state of affairs • trade deficit widens to$28 bn. from $24.6 bn. in December/99 • FTC asserts presence in large cross bor-der M&A deals • venture capital quadruples in fourth quarter of 1999 • LBOs atall-time low while high-yield debt losses are at highest since 1991

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CROSS BORDER M&A EFFECTS ON DOLLAR

(Data for January/February of 2000)US Companies Acquiring Foreign Companies: 16Capital Outflows From US From M&A: $24.37 bn.Foreign Companies Acquiring US Companies: 22Capital Inflows to US From M&A: $45.23 billion

Net Capital Inflows to US From M&A: $20.90 bn. Net M&A Impact on US Dollar Value in Global Currency Markets is Positive (+)

Alan Greenspan has once again pushed up short term rates by one quarter of a percent to six percent, hence re-establishing the significance of a yield spreadthat continues to power the dollar at record highs relative to the euro. However,this relationship completely breaks down when the yen enters into consideration,as the paradox of the Bank of Japan’s zero interest rate policy becomes ever more

apparent against the surging short term US rates. Notable developments that have affected the progress of the dollar have been the short term rate inertia and the absence of any clear variables that areaffecting the dollar/yen relationship. Furthermore, there currently exist senti-ments of a “soft-landing” which investors are confident that the Fed will be ableto engineer via its incremental interest rate policy.

Developments in the short term have been in contrast to the fallinglonger term yields on the benchmark thirty year Treasury, and to a lesser extenton the ten year bond. Inflationary expectations seem to be at bay at the currentmoment, as the recent move in short term rates by the Fed have combined with

an aggressive repurchase program that has been instigated by the surging surplus position of the US budget, which have pushed inflationary expectations over thelonger term lower. This, in addition to the recent turmoil on the Nasdaq marketset off by the FTC’s ruling against Microsoft’s monopoly position on the inter-net browser issue, has caused fearful investors to seek the security of Treasury bonds.

Without a doubt, inflationary expectations are on the way down asaccelerated competition in product markets is a good substitute for any further action by the Fed. In fact, recent moves on short term rates are bound to bereversed as soon as convincing signs of a slow down have begun to set in. Any

adverse sentiments reflected through a prolonged stock market correction willlead the Fed into an accelerated reversal in its stance on rates and beliefs that cen-tre on an overheating economy.

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March/ April 2000



FORECAST

The dollar is bound to head lower relative to the euro once signs of lower infla-tionary pressures begin to set in in the US economy. A lower euro has begun to positively affect the balance of trade in the EU, and has created a risk of higher prices based on the cost of imported oil. The European Central Bank (ECB) is poised to raise short term rates, despite the opposition of the GermanBundesbank to such a move. A narrowing of the short term spread on dollar andeuro assets will lend more support to the euro. In the case of the yen, a slowdownin capital repatriation will cause the dollar to gain ground.

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• Investor Warren Buffet warns that the internet will createno more wealth than a chain letter and that it is a netnegative for capitalists

• S&P company profits are still up by 20%

• FTC investigates online anti-trust issues

• value of all M&A in 1999 is set at $1,100 billion

• private investors regain appetite for Latin Americanstocks

• LBOs surge among old economy firms taking themprivate once again

• Investors still not making commitments to emergingmarket economies

• IPO underwriting at second highest in first quarter

• 65% of mergers fail to benefit acquiring company

• dollar sentiment begins to fall


(Data for March/April of 2000)


Capital Outflows From US From M&A: $22.87 bn.

Foreign Companies Acquiring US Companies: 22

Capital Inflows to US From M&A: $73.22 billion

Net Capital Inflows to US From M&A: $50.35 bn.


Positive (+)

Judging by the actions of several prominent currency hedge funds, thedollar’s days as the strongest currency among G7 countries is numbered. Despitethe stability in yen markets over the past several quarters, most funds are mak-ing very large bets on the Euro, which has been severely oversold. This, combined with a heightened state of risk in the US economy after the Federal

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May/ June, 2000



Reserve has opted to aggressively raise interest rates, could propel the US econ-omy into a sudden recession far faster than most investors are prepared to admit.

Any correction that is unexpected among the leading high tech stocksand the top Dow Jones performers, could reverse the record capital inflows intothe US. This, combined with a stubborn trade deficit, will divert attention fromthe positive fundamentals that have been so prevalent over the past several years.Sentiments have favoured the US economic performance so much, that funda-mentals such as the record trade deficit have been overlooked as well as sub-merged under the record investment flows that have been favouring dollar basedassets.

This time around, it is the US economy that may easily fall under scruti-ny, should there be an about face in investor sentiment spurned on by the unexpected aggressiveness in Fed policy. No longer are dot.com investments and hightech stories so irresistible, after the Fed has pegged risk free rates to levels thatcan no longer be overlooked by investors. With a Euro zone that is reaping the benefits of a record low currency and which is enjoying record low prices in thecredit and money markets, a turn around in the region’s economic fortunes is justaround the corner. This time, it is the lofty valuations of US stocks that will deter-mine how far the dollar will correct should there be a puncture in the stock mar-kets by the Fed.

FORECAST

Go long the Euro. The European single currency has hit bottom- final-ly! Current parities between the old German mark and the US dollar have not been so out of line since the early to mid 1980s, under Ronald Reagan’s presi-dency. After realising the imbalance in the mid 1980s, the Plaza accords negoti-ated among G7 Finance Ministers, revalued both the Deutsche mark and theJapanese yen relative to the dollar. At that time, the dollar was overvalued based

on the persistent and growing current account deficit in the US. This situation isonce again being played out, yet this time around the current account deficit has been smothered by the inflows from portfolio as well as longer term directinvestors that desire an exposure to the US economy. In short, the makings areonce again in place that signal the need for a reversal in the value of the US dol-lar relative to the Euro.

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• FDI at record level of $282.9 billion in 1999 or 31.4%higher than 1998

• FDI is three times higher now than in 1997

• FDI flows were driven by the high tech sector

• anti-trust issues arise in UAL’s acquisition of USAirwaysas merged company will control about 27.4% of availableseat miles in U.S.

• Internet sales jump by 1.2 % in first quarter

• Manufacturing slows in May

• Fed not expected to raise rates in election year any further

• Internet companies will have trouble raising funds

• Junk bond issues rise ten fold in May• $165 billion of international contracts affected by bribes

to public officials over past 6 years


(Data for May/June of 2000)


Capital Outflows From US From M&A: $17.47 billionForeign Companies Acquiring US Companies: 24

Capital Inflows to US From M&A: $65.98 billion

Net Capital Inflows to US From M&A: $48.51 billion


Positive (+)

Alan Greenspan is convinced more than ever before, that productivitygains from the new information economy are irreversible. In its official report,

the Fed sees more high tech driven expansion in the west, with high tech gainscontinuing to drive house prices higher in California, Oregon and Washingtonstate. In addition, the productivity gains generally from high technology are vis-ible in reduced inventories which companies keep, as well as in information thatis generated in order to better meet consumer demand and serve the marketplace.

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July/ August, 2000



Further, Greenspan admitted that rate increases may be coming to a nat-ural end, despite the political manoeuvring in an election year, as competitive

pressures in the economy are creating uncertainty in the job market. Now, morethan ever before, the internet economy seems to have carved out a marginal holdover consumer buying patterns in the U.S. This, despite the fact that we are stillin some sort of high tech overshoot correction in the stock market, the evidencenonetheless points to slow marginal gains when it comes to online sales. The prime internet companies such as AOL Time Warner and Yahoo, will reportincreased earnings, while others such as Amazon.com will attract attention fromreports of continuing losses and cash flow burn-out. Some internet companieswill collapse, while the merger of the weaker will ensure that the high level of venture capital investment that was committed to these companies, will be pre-

served in some way by continuing the business in a restructured form.

The Nasdaq high tech market which was close to falling into the high2,000 range, has recovered back near the 4,000 level. It is an indication of uncer-tainty, as cash burn-out rates are continuing for some second-tier companies suchas CDNow and Buy.com, only to be contrasted by the above expectations resultsthat were generated from Yahoo. As the good internet companies begin to absorbthe weaker groups, the Nasdaq may be expected to rise further, given that therestill exists a surplus of funding capital that is looking for alternative investments.

The downturn in the economy will come from the enormous competi-tive pricing pressures, and will ensure that disinflation will become the real prob-lem over the second half of the year. The Fed should be thinking of a rate reduc-tion at this point to engineer the highly desired “soft landing.” in the U.S.

FORECAST

The dollar continues to trade high relative to the Euro, despite a recentattempt to break out of its trough. It is relatively stable with respect to the yen.With rates expected to decrease, the Euro should see some life return to its trad-ing pattern. The yen will remain strong at its current level.

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• Bank of Canada Governor Gordon Thiessen steps down

• UK Competition Authorities launch investigation over AirCanada’s takeover of Canadian Airlines • Reports ofintensifying capacity pressures

• DeBeers focuses on diamond exploration in Canadaspending $28.5 million

• Nortel Networks becomes most profitable multinationalcompany in the world

• Hollinger to sell most of its community newspapersacross Canada

• Bank of Canada moves to raise central bank rate in stepwith Fed

• Speculators attack dollar over rate hike fearing thatrecession is inevitable





Capital Inflows to Canada From M&A: $900 million

Net Capital outflows from Canada From M&A: $3.75 billion

Net M&A Impact on the Canadian Dollar in Global Markets is Positive (-)

The recent increase in US short term interest rates prompted the Bank of Canada to match the half percent increase. The red hot tech economy of theUS which was behind the move to raise rates, was only lukewarm in Canada at best. Since the increase, many have stepped forward to criticise the move, based

on the fact that the Canadian economy has not experienced the rapid growth thatis based on productivity gains driven by technological advances. Sure, there have been a few global success stories that have come out of Canada; most notable of which have been Nortel Networks and telecoms group BCE. Although they makeup nearly thirty percent of the market capitalisation of the Toronto Stock

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Exchange, they are not necessarily representative of the broader Canadian econ-omy.

To a very large extent, the broader economy in major cities is fast becoming dependent upon a growing retail sector. A sector which is notable for experiencing severe price competition. In this area, large US retailing groupscontinue to expand in Canada, driving out their much smaller competitors basedon price competition on purely economies-of-scale grounds.

In that respect, the broader Canadian economy has experienced veryuneven growth rates throughout the 1990s, including the “booming” latter half.There are areas that mirror the high tech boom of the US, but they are not repre-

sentative of the overall composition of the economy. To an even larger extent,Canada’s over-reliance on retail growth means very severe price competition anddisinflation. Add in the commodity argument, and the overall picture begins tolook very different from the case being made south of the border.

Based on this view, a matching of the rate increase by the Fed is notwarranted, and may tip the Canadian economy into a recession in the third quar-ter of the year. Investors fear that should a recession be manufactured domesti-cally, then a weaker dollar will be the only way out of the situation. Already,manufacturers are lobbying for an even weaker currency as the US market beginsto slow somewhat. The recent rate increase may have gone just a little too far.

FORECAST

The dollar challenged the US$0.69 level for a very brief period of time.Since the rate increase, it has come back down to US$0.66 and risks falling below this resistance point. The performance of the economy will come under even greater scrutiny over the next quarter for signs that growth has come to anend. The fears that are beginning to grip many investors are that growth can onlymaintain its pace at the expense of the dollar.

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• Royal Bank of Canada moves to acquire US regionalsecurities house Dain Rauscher for $1.46 billion

• Trade surplus registers C$4.2 billion in July falling belowexpectations

• Gold and banking stocks perform well after stronggrowth in the second quarter

• Hollinger seeks buyer for the Jerusalem Post

• Of the “Big 5” banks only the Bank of Montreal hasreported disappointing results for the quarter

• TSE300 index begins to retreat as high tech stocks likeNorthern Telecom begin to experience consolidations

• Cross border acquisition activity suppresses dollar as arecord net capital outflow ensues






Net Capital outflows from Canada From M&A: $45.90 billion

Net M&A Impact on the Canadian Dollar in Global Markets is Negative (-)

Recently, the trade surplus has been slipping, but remains positive over-all. However, net capital outflows of some $46 billion have worked against theCanadian dollar in global currency markets. Several large acquisitions involvingtelecoms group JDS Uniphase, have exerted enormous down pressures on theCanadian currency, while capital inflows from acquisitions activity have result-

ed in an inflow of only three billion dollars.

Just as the cross-border mergers and acquisitions account is not infavour of the dollar, the portfolio investment side remains convinced of therecord performance in the Toronto Stock Exchange. Therefore, with both the

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trade account and portfolio investment favouring the dollar, investors can see justhow powerful the erratic acquisitions flows can be. The recent evidence in

Canada can be called a perfect “case study” of how a mega-deal directed towardsthe U.S. market, can destabilise the Canadian dollar and cause it to drift down-wards.

If we factor the acquisition effect out, and try to measure the risks of reversal in the portfolio investment accounts and the trade surplus, then whatcould be a possible scenario for the dollar? For one, the risks of an imminent U.S.economic slowdown is foremost on the minds of trade dependent manufacturersin Canada. Likewise, any reversal in the fortunes of the TSE300 stock marketindex, would require a severe setback and correction in high technology stocks.

Both of these events would be evident in the U.S. first.

To begin with, a downturn in the U.S. economy is inevitable, as is cur-rently being witnessed in the all-important auto parts and components sector.This is where the Canadian trade surplus could really be hit hard, and the risksfor a setback can be considered as being quite high.

Any setback in the TSE300 index would require a substantial high tech-nology meltdown, affecting the infrastructure-driven stocks such as Nortel Networks. This is not expected to occur so that foreign investors would be soturned off of the Toronto stock market. However, mega-deals of a cross-border nature are not expected to hit the levels seen over July and August in terms of capital outflows. They may have a reverse affect, with a foreign group making alarge play for a Canadian based asset.

FORECAST

The dollar is expected to regain some of the lost ground made over the past several months, as the cross-border effect works itself out. The only danger from here is the impact of a protracted U.S. economic slowdown on the all-vitalcomponent of Canadian exports.

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• Liberals propose a C$100 billion five year package ofpersonal and corporate tax cuts

• TD Bank moves to raise provisions against loans to thetelecom and media sectors

• TSE300 index challenges the 9,000 level after being as

high as 11,000• Nortel Networks loses some $200 million in market value

since its peak in July 2000

• TSE300 index is left with a gain of just 5% for the yearafter peaking at 35.7% in September

• dollar dips to a two year low of US$0.6424 nearing its all-time low of US$0.6311 Canadian investors send $39.1

billion to foreign securities in first ten months setting anew record

Cross Border M&A Effects on Dollar





Net Capital inflows to Canada From M&A: $0.14 billion

Net M&A Impact on the Canadian Dollar in Global Markets is Positive (+)

Many analysts and business persons feel more optimistic over the prospectsof the Canadian economy than they do about the US. The US was greatly buoyed bythe dot.com revolution, which at this moment has suffered a serious setback, as mostsuccessfully financed companies are now finding it enormously difficult to attractfurther funding, after going through very high burn rates in their cash reserves.

The revolution in internet financing did not play a big role in Canada. Surethere were a few leading-edge high tech groups such as Ballard Power Systems and Nortel Networks, but the venture capital scene was never in step with what washappening in the US.

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g7 books canadian dollar chaos by william b.z. vukson

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