Monday, May 15, 2006

Canadian Dutch Disease?

Strong demand for Canadian commodities begets strong demand for the loonie--the nickname for Canada's loon emblazoned dollar. For foreigners to buy up Canadian oil and timber they must first convert their home currency into loonies. As demand for Canadian dollars rises, the loonie appreciates against foreign currencies. That is, the price of the loonie rises--from, say, US$0.60 per C$1 to US$0.90 per C$1.00. Notice that the loonie's rise is not-so-great news for Americans who want to buy Canadian goods and services. Before the appreciation, a loonie costs only 60 cents; after the appreciation, a loonie costs 90 cents. Canadian manufacturing and services sectors, dependent on exports to the United States, may catch the Dutch disease if the loonie continues its lunar trajectory.

Dutch disease infects countries with large natural resource sectors. Strong international demand for commodities (such as oil and timber) increases the exchange rate and effectively reduces the demand for manufacturing and services exports. A stronger loonie makes Canadian exports less attractive to foreigners, particularly Americans. The strong loonie reduces manufacturing and service exports with negative short-term consequences for the Canadians who find themselves out of work as the sectors contract. According to a recent New York Times article, the prospect of parity with America's greenback (an exchange rate of US$1.00 per C$1.00) has Canadian manufacturers and policymakers on edge. The questions below examine additional factors behind the loonie's rise as well as Canada's policy options.

1. A strong loonie reduces manufacturing exports and consequently reduces manufacturing jobs. What percentage of Canadian output do Canadian manufacturers export? Of that, how much goes to the United States?

2. According to Benjamin Tal, a Toronto-based economist, how many manufacturing jobs will the rising loonie wipe out in 2006? Which Canadian industries are simultaneously creating jobs? Is Canada experiencing a net loss or gain in job creation?

3. According to Tal, the rapid appreciation of the loonie "…is much too difficult to swallow for a manufacturing sector that has relied on this subsidy for decades." In what way is a weak loonie a "subsidy" for Canadian manufacturing exporters?

4. Why does Mr. Tal feel that the Canadian dollar will not reach parity with the U.S. dollar?

5. Canada's central bank--the Bank of Canada--can influence the exchange rate through monetary policy. By increasing interest rates, the central bank makes it more attractive for foreigners to buy Canadian bonds, increasing the demand for loonies in the foreign exchange market. Higher interest rates also encourage Canadians to substitute away from foreign bonds towards domestic bonds, decreasing the supply of loonies in the foreign exchange market. By raising interest rates, the Bank of Canada makes the loonie stronger.

Suppose the Bank of Canada reduces interest rates. Would the loonie appreciate (increase in value) or depreciate (decrease in value)?

6. The article mentions the current strength of the Canadian economy (low unemployment, relatively high GDP growth). During economic expansions central banks focus their efforts on sustaining growth without igniting inflation. Recent interest rate hikes by the Bank of Canada suggest monetary policymakers are at least somewhat concerned by the possibility of inflation.

Suppose the Bank of Canada decides to weaken the loonie in an effort to reduce the losses to the Canadian manufacturers. Will the Bank still have control over its domestic goal of low inflation?

Want to read more on this topic? Stephen Gordon, an economist at l'Université Laval in Quebec City, Canada, does not see Dutch disease in Canada. In an April 13 blog post, he points to rising output in the Canadian manufacturing sector--even as the Canadian dollar appreciates and manufacturing employment falls. In his view, rising manufacturing output and strong employment growth elsewhere in the Canadian economy explain the Bank of Canada's reluctance to reign in the loonie thus far.

Topics: Exchange rates, Monetary policy, Open-economy macroeconomics