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How low for how long? The fall (and rise?) of the loonie

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The rapid decline in the value of the Canada dollar relative to the U.S. dollar has been cause for serious concern. If current trends are not reversed, both public policy options and prospects for private sector outcomes will be dramatically reshaped. A low dollar is caused by, and will entail, many painful and costly transitions in the structure of the Canadian economy. If it stays low for long, the benefits could ultimately outweigh the costs. But how long will the dollar stay low? I made some of the following comments today at the Senate Committee on Banking, Finance and Commerce.

Why is the loonie so low? A perfect storm of reasons

Declining global demand -- driven by the slowest growth in China in 25 years -- is propelling a downward spiral in demand as companies respond to slowing sales with further cuts to cut costs. What makes sense for one company is self-defeating at the economy-wide level.

Commodity supply gluts continue to accelerate. Demand for oil, iron and other commodities is not falling, but it's not growing as fast as the growth in their supply, leading to downward pressure on commodity prices. A 20-year commodity supercycle linked the exchange value of Canada's dollar increasingly to crude oil prices, in particular. But what's happening now is not just because the markets treat the loonie as a petrodollar, for shorthand.

A relatively stronger U.S. economy has sapped some of the loonie's strength too. In the U.S., unemployment is now below 5 per cent. The central bank raised the benchmark interest rate in December for the first time in almost a decade, triggering a capital flight to the US. Whereas the Canadian dollar benefited from the international "flight to safety" after the 2008 crisis, as the U.S. economy continued to crater, today economic fundamentals in the U.S. are now relatively more attractive than in Canada for foreign investors looking for a place to park their money.

Economic positives of a low Canadian dollar

More exports: Things produced in Canadian dollars and sold in U.S. dollars (commodities like oil and beef, but also auto and wood products, as well as services) see higher margins when the loonie is low relative to the greenback. This offsets the impact of falling commodity prices, and provides windfall profits to Canadian producers of goods and services whose U.S. price has not been cut.

More U.S. consumers: The U.S.-Canada exchange rate now boosts American purchasing power by almost 40 per cent. This will draw more tourists to our vacation spots and sports events. If the dollar stays low, expect a bigger than usual crowd at this year's Pride Parade; and tickets to TIFF (Toronto International Film Festival) may get harder to buy. The low dollar reverses the direction of cross-border shopping -- estimated to have sent as much as $11 billion Canadian to the U.S. in 2012 -- which could strengthen some Canadian retailers' volume. It will also lead to some repatriation of capital that migrated south with snowbirds who purchased $92 billion in U.S. real estate from 2009 to 2015.

Greater investment potential: A lower dollar means lower relative wages. Some American businesses will produce more in Canada. For example, Hollywood North expands when the exchange rate falls. The film industry was worth over $1B in Toronto alone in 2014. Advanced manufacturing is already seeing a boost from foreign investors (thanks to numerous innovation clusters throughout Canada but particularly in Ontario, where Waterloo, Toronto and Ottawa are all buzzing centres of cutting-edge R&D). And remember, when the Canadian dollar is this low, it's like our real estate is on sale. So are our corporations, for that matter. If the dollar stays low, auto producers tempted by Mexico may well take another look at reinvesting in their facilities here. Finally: Canadians import one-third of GDP. The vast majority comes from the U.S. (China is in a very distant second place, accounting for 7 per cent of merchandise imports.) A low-for-long loonie could trigger some import substitution. The old marketing adage "Why pay more?" may result in investments that see Canadians producing more of what they consume over time.

Economic negatives of a low Canadian dollar

Lower purchasing power: Consumers are paying significantly more for imports now. Hardest hit are the pocketbooks and health of low-income households, as fresh fruit and vegetables are mostly imported from the U.S., and their prices are soaring. (This is due to the combined effect of higher American prices due to a drought of over four years in California; and the weakening exchange rate.) Businesses that import intermediate goods for their production are also paying almost 40 per cent more. The lower loonie is like a pay cut for consumers, and a profit cut for many businesses.

Changing retail landscape: Slowing demand has led to the closure of giants like Target, Future Shop and many large, established clothiers. Corporate consolidation has led to fewer, bigger players. Expect more players to disappear as Canadian retailers struggle to absorb costs instead of passing them through customers, to minimize falling sales.

Stranded assets? Capital spending in oil and gas fell over 30 per cent in 2015 compared to 2014, and is forecast to fall at least another 19 per cent in 2016. Moody's estimates oil capex will fall 25 per cent globally this year. Should demand continue to fall, up to $2 trillion in scheduled projects may become stranded assets. There is some concern that the mining sector is poised for a wave of defaults.

Bigger deficits: Government budgets are being pressured more directly by falling oil prices than the low dollar, but the effects are inseparable, regionally and nationally.

Will the loonie stay low for long? Countervailing factors are at play

Bigger supply gluts on the way: Iran -- the second largest oil-producing nation in OPEC before sanctions were imposed in 2012 -- is planning to add 1 million barrels of crude a day to global production in 2016. Globally, there are already 5-2 million barrels more being pumped a day than is being consumed. U.S. production has essentially not responded to lower prices. Production is 1 million barrels more a day than two years ago, and at over 9 million barrels a day remains near record highs. (Lower loonie)

Climate change initiatives: A hard cap on Alberta emissions and a global commitment to limit global warming to 5 degrees celsius at the Paris Climate Talks means more aggressive policies to conserve more energy and generate more energy from renewable sources are on the way. EU's environmental initiatives have dropped demand by 1.5 per cent a year. A similar result is plausible here. (Lower loonie)

Global economy on a tightrope: Concerns are mounting about over-leverage and asset bubbles in China. Globally, corporations have committed themselves to $29 trillion in debt, but it is estimated about a third of companies are failing to generate a high enough return on investment to cover the costs of funding. Tensions are escalating in the Mid-East, and now large economic players like Turkey and Russia are playing a troubling game of brinksmanship. The evolution of any of these developments could trigger another global recession. (Potentially higher loonie)

U.S. monetary policy backtrack? While too early a development to be definitive, weaker than expected job growth for January caused the Federal Reserve to signal it may delay its plans to raise interest rates as frequently or as much as initially planned for 2016. If recent slowdowns in manufacturing activity continue, there is even a possibility that the December rate hike could be reversed. Longer term, the ratification of the Trans-Pacific Partnership trade deal could further slow American manufacturing and job growth. (Higher loonie)

What should be done? What can be done?

Monetary policy has limited impact on the value of the Canadian dollar in relation to the U.S. dollar. Matching our rates to U.S. increases would limit capital flight but would have deeper consequences when underlying economic fundamentals differ between the two nations, as they do at the moment.

Unlike the U.S., Canada's economy has served up "serial disappointments" since 2012. Economic outlooks have been continuously downgraded every quarter for years. Current private sector estimates for 2016 range between 0.9 per cent and 1.5 per cent at the Big Six banks. While better than a recession, slowth (slow or no growth) constrains both public policy and private investment options.

The impact of expansionary fiscal policy is also limited in this context. Running $20- or $30-billion deficits (or more, as urged by some respected Bay Street analysts) will do little to move the needle on the rate of growth of a $2-trillion economy. Large deficits could, however, send signals to markets that the government sees more, not less, public spending as the current priority, notwithstanding trends in public revenues, and thereby boost the value of the dollar. Both financial markets and global economies are desperately seeking expansion. If the private sector won't bring its "dead money" back to life, the public sector could and should.

What public policy can and should do in this context is look past this year's GDP and deficit and develop long-term strategies for building future potential. It won't be easy to adapt to slow-growth-as-far-as-the-eye-can-see and, with it, a low-for-long loonie, but there isn't much choice. Welcome to the New Abnormal. It will take the best thinking we've got to meet its challenges and unlock its opportunities.

Armine Yalnizyan is a senior economist at the Canadian Centre for Policy Alternatives, and business columnist for CBC Radio's Metro Morning. You can follow her on Twitter @ArmineYalnizyan.

*A link to the French translation of an abridged presentation made to the Senate Committee will be available soon.

Photo: Jamie McCaffrey/flickr

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