Dollar Parity Possible – But Then What?

(Stephen Poloz — Export Development Corporation)

Many have begun to contemplate the possibility that the Canadian dollar might reach parity with the U.S. dollar. Since the vast majority of export sales are conducted in U.S. dollars, a 10 per cent rise in the Canadian dollar would clip C$3-4 billion per month from export revenues – a serious matter.

Dollar parity is obviously possible. After all, we had it 30 years ago. Plus, the dollar has risen by nearly 30 cents since 2003, so another 8-10 cents is not out of the question. But the deeper question would be, first, what would cause it? And second, what would happen next?

One route to parity would be a speculative bubble. Canada looks attractive in the context of high commodity prices, low inflation, a strong fiscal situation and a trade surplus. Economic history is littered with periods of exchange rate volatility that cannot be explained by economic models.

The story would not end there, though. A rise in the dollar to parity in the absence of an accompanying strengthening of Canada’s economic fundamentals would slow the Canadian economy significantly. Monetary policy would ease and the speculative bubble would pop.

Another route to dollar parity would be a further big ramp-up in prices for commodities, particularly oil. According to EDC’s model for the Canadian dollar, a rise in the price of oil of $10 translates into a currency appreciation of 3 cents. Given current conditions, a rise in the price of oil to the $100-110 range would take the Canadian dollar to parity. This is clearly possible.

Again, though, the story would not end there. The global economy would slow significantly, prices of other commodities would retreat, oil prices would probably retreat as well, monetary policy would ease and the Canadian dollar would reverse some of its gains.

The third route to parity is through productivity gains here in Canada. The reason why models of the Canada/U.S. exchange rate point to a natural value somewhere between 75-80 cents is that Canadian business productivity levels are on the order of 80 per cent of U.S. productivity levels. This reflects a steady erosion in Canada’s relative productivity performance during the past 20-25 years. That means that a level of the dollar in the 75-80 cent range levels the playing field for manufacturing in the two countries, making costs of production about equal.

Narrowing that productivity gap would lead naturally to a higher Canadian dollar over time. This began in 2005, when manufacturing productivity rose 5.4 per cent in Canada and 5 per cent in the U.S. We expect Canada’s outperformance to continue, but it will take many years to close a 20 per cent gap and move the natural level of the Canadian dollar up to parity. The good news is that such a gradual move would be sustainable, because improved fundamentals would be driving the dollar’s rise.

The bottom line? The Canadian dollar can clearly reach parity, but under current conditions it would prove short-lived. Rising productivity is the surest route to a stronger currency. And even if the strong currency comes first, higher productivity is the best cure for the accompanying stress.