Petro-dollars equal petro-economy

By Marcel Côté

In June, the Canadian dollar was about US91¢. After stagnating for several years at less than US70¢, it started to rise in 2003, breaking the US80¢ mark in the fall of 2005. Canada has an export-oriented economy, with about 40% of its GDP exported, mainly (80%) to the US. As a result, we cannot remain indifferent to our dollar exchange rate as it is a key driver of competitiveness for our manufacturing sector.

The value of the dollar is determined by supply and demand on the foreign exchange market. Exports are the prime determinant as far as demand is concerned as buyers must purchase Canadian dollars for their transactions. The reverse is true for imports. While foreign investors also buy our dollars, Canadian holdings in foreign countries, which require the sale of Canadian dollars, have exceeded foreign investments in Canada in the past few years because Canadians are net savers. Tourism, dividend and interest payments, and trade in services round off supply and demand, although they are less important factors overall.

Contrary to belief, the Bank of Canada has had little effect on the exchange rate, as its short-term interest rate policy is moreor less aligned with that of the US Fed. In fact, the main factor influencing the value of the Canadian dollar is the increase in our oil and gas exports to the US, which rose to $67 billion in 2005 from $22 billion in 1999. As a percentage of our exports, they more than doubled to about 14% in 2005 from 6% in 1999.

In just a few years, Canada has become one of the major oil-producing countries in the world, with the largest reserves out-side of the Middle East,by developing Alberta’s oilsands.There are two factors behind this emergence as a global oil power. First, the dra-matic rise in oil prices in the past five years to more than US$70 abarrel from US$15. Unlike previous hikes, which proved tempo-rary and were generally triggered by Mid-dle East wars, current high prices result from a structural increase in global demand fuelled by economic growth in Asia and by the slow depletion of traditional reserves. Second, great progress has been made in reducing oilsands production costs. Reserves not worth extracting 10 years ago have become profitable on a massive scale.

As long as the price of crude stays above US$40 a barrel, Canada will be a major oil-producing country. Our exchange rate will be buoyed by oil and gas exports to the US, with Canada being its main supplier.

The relative value of a currency’s purchasing power, or purchasing-power parity (PPP), is increasingly used as a benchmark. For the past 15 years, the PPP of the Canadian dollar has been US80¢ to US85¢, which means that a Canadian dollar buys in Canada what US80¢ to US85¢ can buy in the US.

PPP is used to determine whether a currency is over- or undervalued. Since 2004, the Canadian dollar has been overvalued, trading above its PPP value. The consequences for the manufacturing sector are significant. Not only is it more difficult to export to other countries because of the dollar’s high value, but US imports are less expensive. In the mid-term, the continuous overvaluation of a currency can seriously weaken the manufacturing sector of a country that is becoming a society of pensioners. Economists have labelled this phenomenon Dutch Disease, a form of economic cholera that affects everyone but the strongest.

Countries where oil exports are an important part of their economy have rarely succeeded in developing their manufacturing sector. Only Norway has avoided the pitfalls of Dutch Disease by implementing an intelligent policy to counter the impact of oil exports on its currency. This allowed it to maintain a vigorous manufacturing sector and sustain the economy of its regions that depend on it. Inflation was also maintained at 2%, the same as Canada’s. Today, the standard of living of the average Norwegian is far superior to that of a Canadian.

If nothing is done to counter the impact of our dollar’s over-valuation, our manufacturing economy will be decimated,thereby weakening the economic base of Ontario and Eastern Canada. Infrastructures such as houses, roads and cities will lose value and deteriorate. Un-employment will drive workers to oil-producing regions, where infrastructures will be rebuilt.

Will Canada react to this situation? A public debate is in order. Unfortunately, the Bank of Canada blindly sticks to fight-ing inflation, a mission appropriate for the 1980s not for the 21st century. Ottawa and the provinces must tackle the issue, which demands difficult but unavoidable choices that I will address next month.

Marcel Côté is a partner at SECOR Inc. in Montreal