The Canadian Dollar and Canada’s Trade with the United States:

Recent Developments

byJohn Murray

Bank of Canada

Presentation to the Standing Senate Committee on Foreign Affairs

Ottawa, 7 October 2003

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Introduction

• Renewed interest in exchange rate volatility and trade

• Four major messages in my presentation:

1) the recent moves have not been that unusual

2) fundamental and unavoidable forces are probably at work

3) there is an up side to a stronger dollar

4) a floating exchange rate is still the best option for Canada

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Putting the Recent Appreciationin Perspective

• Sharp appreciation of the Cdn. dollar in the spring of 2003 (Graph 1)

• Part of a more general appreciation against the US dollar (Graph 2)

• Similar to other movements over the 1975-2003 period (Graph 3)

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Putting the Recent Appreciationin Perspective (cont’d)

• Cdn. dollar typically more stable than other floating currencies (Graph 4)

• Real vs. nominal movements and Canada’s competitiveness (Graph 5)

• The importance of the bilateral Can-US exchange rate to Canada

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Possible Causes of the Appreciation

• A strong Canadian economy, rising world commodity prices, and an improving outlook for the global economy

• Broad movements in the Cdn. dollar are usually driven by fundamentals

• The Bank’s exchange rate equation and four critical variables -- interest rates, inflation and two commodity prices (Graph 6)

• Unsustainable trade deficits in the US and a need to rebalance the global economy; Asia as an importance challenge (Graphs 7-10)

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Canada’s Trade with the US

• The importance of trade for the Canadian economy, and greater integration of the North American economy post-NAFTA (Graphs 11 and 12)

• Structural differences between the Cdn. and US economies, and the importance of commodities

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Canada’s Trade with the US (Cont’d)

• Steady improvement in Canada’s trade balance and net foreign investment position since mid-1990s (Graphs 13 and 14)

• Factors that have contributed to Canada’s strong external position (and recent weakness)

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Effects of an Appreciation on Canada’s Trade

• Canada’s net exports and movements in the real exchange rate (Graph 15)

• The uneven impact across industrial sectors -- exports and imported inputs as a share of production, and import competition

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Effects of an Appreciation on Canada’s Trade (cont’d)

• Machinery, electrical and electronic products more exposed, while food, beverage and refined petroleum products are less exposed

• Advantages of a stronger Cdn. dollar -- an improvement in our terms of trade; cheaper imports and potential productivity gains

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Pros and Cons of Alternative Exchange Rate Regimes

• The advantages of a flexible exchange rate – policy independence and (partial) insulation from external shocks

• The limited costs of short-run exchange rate volatility

• The costs of pegged exchange rates and other semi-fixed arrangements -- increased vulnerability to financial crises

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Pros and Cons of Alternative Exchange Rate Regimes (cont’d)

• New research on common currency arrangements -- Europe and the euro as an interesting experiment

• Border effects and the (un)importance of separate currencies

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Conclusion

• The exchange rate typically moves in response to broad fundamental forces

• Some rebalancing of world trade and economic activity in Canada is necessary and desirable

• It is important to take a broad perspective on trade and exchange rate developments, and not view the exchange rate in isolation

• Alternative exchange rate systems hold little attraction for Canada at the present time

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Canada’s Main Trading Partners : 2002

(using current dollars data on merchandise trade)

Share of Exports Share of Imports

United States 83.75% 71.52%

United Kingdom 1.51% 2.89%

Other E.U. 3.98% 7.26%

Japan 2.48% 3.29%

Other O.E.C.D. 2.98% 5.52%

All Other 5.30% 9.52%

Total 100.00% 100.00%

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Structure of Canada’sMerchandise Trade : 2002

(using current dollars data)

Share of Exports Share of Imports

Agriculture 7.46% 6.11%

Energy 11.96% 4.64%

Raw and industrial materials 25.93% 20.20%

Machinery and equipment 23.49% 29.70%

Automobile products 23.42% 22.85%

Other 7.74% 16.50%

Total 100.00% 100.00%

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