Luc Vallée is chief strategist at Laurentian Bank Securities.
On Jan. 7, during his first speech of the year on the topic of policy divergence, Bank of Canada governor Stephen Poloz said the U.S. dollar's rise "may be causing a moderation of U.S. GDP growth through higher imports and lower exports, but it is not causing a softening in U.S. demand. Rather, the stronger U.S. dollar diverts some of the growth in U.S. demand outward, boosting growth in other countries."
So, the rising U.S. dollar does not stifle global growth, he said – "it redistributes it."
While this is true in principle, large currency moves are not quite that co-operative in practice. And by this, I mean that the redistribution of growth does not happen magically, disappearing from the United States and reappearing elsewhere, like teleported Star Trek characters. The end result may disappoint or, worse, be disruptive.
Let's illustrate why, using a simple example of two countries, A and B, selling similar products at similar prices.
One day, country A's currency appreciates. Obviously, consumers living in both countries should now want to buy less from A and more from country B, where goods are now cheaper, taking into account the currency exchange. Demand has not changed; it has been diverted from A to B.
But will B deliver? Firms in B will have to expand operations if they don't already have the excess capacity. For that, they must access credit – not always an easy task. They will then need to build expanded facilities and hire and train workers, which takes time. Firms must also learn how to export their products, how to market them in A and make sure they satisfy standards and regulations there; for many firms, this will require new expertise, managing new risks and cost money.
Moreover, customers will have to pay for the extra shipping cost and deal with customs, making buying goods from B less appealing for residents of A. More important, firms in B have to be certain that the appreciation of A's currency will be permanent; otherwise, they could be pouring money into pointless investments.
Meanwhile, in A, workers are being laid off as firms are curtailing their own expansion plans and are making less profit. They may soon have idle assets to liquidate, sometimes with very little resale value, forcing them to take a capital loss. Demand in A, where jobs are being lost, will most likely fall before it increases in B, where new workers will eventually be hired.
Complicated enough? Yet, it is even more intricate than that in real life, with technology fast improving, tastes constantly evolving and regulation and taxes changing without warning, forcing firms to endlessly adapt. All this is without taking into account the competition that could arise from somewhere else and ruin the expansion plans of businesses located in B. It could be years by the time we get the full supply response we expect from B. Even then, the final results may only be partial, costly for both countries and likely to hurt unemployed workers in A and importing businesses in B.
Such realities go a long way toward explaining why the U.S. economy is growing below our expectations and why, despite the appreciation of the U.S. dollar, Canada's exports (and those of Europe and Japan, for that matter) are not picking up as fast as anticipated.
From 1995 to 2005, when the Canadian dollar was weak, half a million jobs were created in Canada's manufacturing sector. All were lost in subsequent years when the loonie appreciated while oil prices hovered around $100 (U.S.) a barrel. Since the middle of 2014, when the loonie started to fall again, Canada has added only 50,000 new manufacturing jobs – just 10 per cent of the jobs gained in the earlier episode! Granted, it took 10 years to get there before. But how long will it take this time?
The game of snakes and ladders is different today. Canada is larger, the planet is more globalized, manufacturing requires more technology than labour and we have competition in our backyard that we did not have in the 1990s. Mexican firms have had years to benefit from the North American free-trade agreement and China joined the World Trade Organization in 2000. Both are now well established in the United States and will be difficult to dislodge. The Mexican peso has kept pace with our currency's depreciation; against them, Canadian firms are no more competitive than they were last year. It could take a very long time before we regain our footing – if ever.
The World Bank also estimates that increased reliance on global supply chains by manufacturers, such as Apple and Cisco, has weakened exports' response to currency devaluation by as much as 40 per cent. A global supply chain is a multiple-stage process in which inputs from one or several countries are imported to another country to be marginally transformed or assembled before being exported to yet another one, where similar operations are performed again. The gain in competitiveness from one country's devaluation is limited to the small share of the value its local firms add to their products.
So commentators who are concerned about the potential impact of a stronger U.S. dollar on global growth are right to worry. Contrarily to what Mr. Poloz's reassuring words would lead us to believe, the transmission of exchange-rate variations is uncertain, imperfect, lengthy and disruptive. Its final effects are undeniable in the long run: Currency appreciation reduces growth in the country with the appreciating currency and favours growth elsewhere. However, nobody knows how long it takes for this outcome to emerge and nothing guarantees that it happens at a ratio of one-for-one, or that what happens in the process is even worth it in the end.
So why are we letting the U.S. dollar appreciate? An answer is that floating exchange rates adjust automatically to changing economic circumstances and not much can be done about it. Another is that there is often a disconnect between the framework that economic policy makers use to guide their actions and what is happening in the real world. Systematically, policies are deployed in the hope that the real world will conform to these oversimplified views, even though we now know that they mostly don't.
Rather, we should recognize that large and rapid currency devaluations are indeed potentially disruptive to global growth, as they have to be digested through the bowels of the real economy and financial system before they bear their fruits. Too much disruption can generate irreparable damage and end up being counterproductive, even if the end outcome may appear to conform to policy-makers' expectations.
In other words, policy-makers may correctly predict the nature of the desired income shifts, but the rarely resolve the issues around whether they are worth it in the first place, and how to optimize the process that brings us to the preferred outcome. These are the most difficult policy questions, yet the most relevant.
It's a lesson that we should have learned from the financial crisis of 2008-09 and integrated into our policy-making, but we seem to have already forgotten it and moved on to new challenges. Deregulation of the financial sector was supposed to be good in the end, according to policy-makers. But the process created a mess much bigger than its anticipated benefits. Today, eight years after the financial crisis, we certainly appear to be still picking up the pieces from a shattered world economy on life support for the indefinite future.
So what next? Some would argue that, given these constraints, the Canadian dollar should be allowed to fall even further. However, the Bank of Canada should resist the temptation of lowering its policy rate next week, which would precipitate such devaluation.
Given the risks identified in its last monetary policy report, the bank would be totally justified in lowering rates. But such a move would probably succeed only in putting downward pressure on the dollar without encouraging much creation of credit. Resorting to extreme relative price variations to settle our problems could thus be unproductive. For now, at least, it would be best to hope for the exchange rate to stabilize and give markets the time they need to work through the proper adjustments. Further devaluation would only add to the uncertainty.