As the loonie has fallen, what initially was seen as a boon to non-energy exporters has given way to fears that our national purchasing power is crumbling.JONATHAN HAYWARD/The Canadian Press
If a 70-cent (U.S.) Canadian dollar instinctively sounds too low, that is probably because it is. But that raises the question: What is a fair, or even optimal, level for our beaten-down currency?
"It's not a dumb question, but it's a tricky question," Carleton University economics professor Nicholas Rowe says.
The concept of where the dollar should be trading can be looked at from several different angles. From most of them, it does appear that at 12-year lows – it closed at 69.71 cents on Wednesday – the massive sell-off of the loonie has been overdone.
But maybe not by as much as you might think.
Perhaps the most common gauge of a currency's fair value is looking at purchasing power parity (PPP) – a measure that adjusts currency values to remove differences in prices in each country. It reflects what consumers can actually buy with their currency.
The Organization for Economic Co-operation and Development's latest estimates put Canada's PPP exchange rate at about 81 cents, suggesting the dollar is about 15 per cent undervalued.
But PPP does not really get at the root of what makes up a currency's value. It is fair to say that a currency should reflect a combination of a country's terms of trade (the relative prices of its exports versus its imports), which represent demand for the currency through trade; and the country's interest rates, which speak to demand for the currency in financial markets.
Both have significantly eroded over the past year.
The Bank of Canada has cut its key interest rate twice, while the U.S. Federal Reserve recently raised its rate. The Fed is likely to raise it further and the Bank of Canada is looking increasingly likely to cut again in the next few months – and divergence is a key element behind the Canadian dollar's weakness.
Meanwhile, Canada's terms of trade in the third quarter were down 8 per cent from a year earlier, according to Statistics Canada's most recent data. Commodity export prices have been the key driver, and they have fallen further since the third quarter ended. The Bank of Canada's Commodity Price Index, which tracks Canada's key export commodities, has slumped 16 per cent since mid-October. Over the same period, the currency, relative to a trade-weighted basket of currencies of its biggest trading partners, has lost a comparatively modest 9 per cent.
Nomura International economist Charles St-Arnaud has assessed the Canadian dollar using a valuation model that focuses on these factors. His model suggests that, even with the deterioration of Canada's terms of trade and its divergence with the Fed on interest rates, the loonie's fair value is about 73 cents – making it look oversold, but only relatively mildly.
The fact that the currency has dropped so far that we are now worried it will threaten consumer spending, as costs for imported food and consumer goods rise in Canadian-dollar terms, raises a question of "fair" value in another sense: What level best serves the interest of the most Canadians? Dr. Rowe refers to this as a notion of a "just" exchange rate. And while he asserts that this is "a bit of a stupid way of looking at it," it is nevertheless quite prevalent in the public discourse about our currency.
As the loonie has fallen, what initially was seen as a fortuitous boon to non-energy exporters has given way to fears that our national purchasing power is crumbling. It is easy to forget that, not that long ago, Canada's dollar was above par with its U.S. counterpart – and a lot of people bemoaned the injustice of that, too. The sustained oil-driven strong currency is widely blamed as a major cause of the decline of Canada's manufacturing sector.
So, is there a price for the dollar that we could all live with? An "optimal" exchange rate, if you will?
"I think the answer is yes, and it's a fairly wide range," says Douglas Porter, chief economist at the Bank of Montreal. Anywhere from the mid-70s to the low 90s is "a range where the most people can be satisfied," he believes.
That implies a sweet spot somewhere in the 80-85 cents area. That happens to be in line with the currency's long-term average over the past quarter-century, which suggests that the market does tend toward this sort of equilibrium over time. It is also consistent with the OECD's long-term estimates of Canada's PPP exchange rate.
But perhaps the best way to look at the fair value for the Canadian dollar is to consider how it functions in the Canadian economy. Canada's reliance on the market to set the exchange rate is a key element to the Bank of Canada's monetary policy; effectively, the exchange rate acts as a complement to the interest rate, helping steer the economy to its optimal pace of growth and inflation. Both a lower interest rate and a lower exchange rate stimulate the economy in different ways.
The question then, Dr. Rowe says, should be: "What exchange rate do we need to keep demand about right, to keep inflation steady around [the central bank's target of] 2 per cent?"
In practice, the Bank of Canada sets only interest rates, and allows the market to decide what exchange rate is appropriate at that rate. Right now, with the central bank's key rate already exceptionally low and underlying inflation stubbornly below target, it might actually be advantageous in the short term for the market to overshoot on selling the dollar – adding some extra stimulus to exports, and probably more effectively than another rate cut would.
"There is a 'right' level for the exchange rate," Dr. Rowe says. "Will the market find it? God only knows."
David Parkinson