Hands off the dollar
Posted: July 24, 2009, 8:18 PM by Ron Nurwisah
foreign exchange, currency
Seven reasons why calls for Bank of Canada intervention in the currency market are misguided
by Eric Lascelles and Shaun Osborne
Markets and newspapers alike have recently been abuzz with speculation that the Bank of Canada might begin intervening in the currency market, after a long hiatus. Inaction at the Bank of Canada’s most recent rate decision poured a teaspoon of cold water onto the notion, but the speculation continues.
We do not believe it would be wise or fruitful for the Bank of Canada to intervene on behalf of the Canadian dollar in an effort to temper its recent strength. There are seven main reasons why.
It is not possible for any country to have perfect control over its currency and interest rates simultaneously. One most float or the whole enterprise is doomed as investors will elect to arbitrage interest rate opportunities between countries, and the resulting tsunami of capital flows overwhelms either the fixed exchange rate or a central bank’s monetary policy independence, if not both.
The Bank of Canada is too small to have the desired effect on the FX market via intervention. Canada’s currency reserve ranks only 33rd in the world, and there are 20 times more Canadian dollars transacted over the foreign exchange market each month than the value of the reserves. To have a substantial influence, Canada would have to either print tens of billions of dollars in money or issue tens of billions of dollars in bonds to finance the operation. In the present context, both are equally unpalatable. And to truly achieve traction, the effort would have to be paired with further rate cuts (mathematically impossible) or quantitative easing (seemingly not in the cards).
The Bank of Canada was unsuccessful in its last effort in 1998 to corral the Canadian dollar over a decade ago. Despite deploying roughly $18B, the Canadian dollar continued to fall and the effort was eventually halted due to its “ineffectiveness.” This experience left such a sour taste in the bank’s mouth that the intervention policy was subsequently changed for use “only in the most exceptional of circumstances.”
While the Canadian dollar is likely a tad overvalued by conventional measures, it is hardly egregiously so. Purchasing power parity argues that the loonie is about 10¢ too rich, while TD Bank models suggest overvaluation in the range of 1¢ to 7¢. In the grand scheme, these differentials are not especially large, and in the case of purchasing power parity, the Canadian dollar has actually spent two-thirds of the past decade at least 10¢ off “fair value.” It is thus not clear why the Bank of Canada’s appetite would be sufficiently ravenous as to warrant a rare currency intervention.
The Canadian dollar has managed to avoid significant overvaluation because a fair portion of its recent appreciation reflects fundamentals. The bank itself notes that commodity prices have increased, while we observe that Canada’s housing market is stabilizing, retail sales have grown in four of the last five months and the latest Business Outlook Survey reveals remarkable optimism and nary a mention of pain from the loonie. From a structural perspective, investors remain attracted to Canada given its intact housing market, sound banks, and firm commitment to inflation targeting.
A certain portion of the appreciation in the Canadian dollar is due to speculative flows. This is the sort of thing that Bank of Canada is likely hoping to oppose, but we believe it would be folly to fight these forces. The speculative portion of the appreciation has little to do with Canada specifically, and far more to do with U.S. weakness. Other major currencies have risen by just as much, and it would be very difficult for Canada to extricate itself from the shift. Moreover, we postulate that some of the recent speculative flows could eventually transform into fundamental flows if the Canadian dollar proves to be a leading indicator for commodity appreciation and the global recovery.
The Canadian economy has already proven itself impressively adaptive to foreign exchange shocks in the past. It survived at Canadian dollar levels that have varied by as much as 80% in recent years.
The timing is not right for the Bank of Canada to intervene in the currency market. The loonie is not sufficiently far from fair value for market participants to take the bank seriously. Speculators are not particularly long the Canadian dollar, nor are markets frothy enough for the bank to achieve the outsized influence that it needs.
The bottom line is that while the risk of currency intervention in Canada appears as elevated as it has been in a decade, it remains ill-advised. In turn, we continue to believe that the Canadian dollar’s recent appreciation may have some further life left in it.
Financial Post
• Eric Lascelles is chief economics and rates strategist and Shaun Osborne is chief FX strategist for TD Securities.
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