Will a weak Canadian dollar really lead to stronger exports?

September 9, 2015

A Canadian dollar coin, commonly known as the "Loonie", is pictured in this illustration picture taken in Toronto

Canada’s near two-year-long attempt to boost exports through a weaker currency so far has proved futile.

The country’s policymakers had hoped a lower exchange rate would benefit exports and in turn propel the economy.

On the face of it, that is not an odd assumption to make as a weaker Canadian dollar should make the country’s exports relatively cheaper – and therefore more attractive.

But a close look at the historic trend of exports and currency movement, as well as Reuters polls, suggests policymakers might be indulging in a pointless exercise, especially when the price of oil – a major Canadian export – has fallen so sharply.

The evidence shows that Canada’s export performance, and not just of crude oil, has been good even during periods when the dollar was strong.

That includes the global financial crisis when most other developed economies led by the U.S. collapsed, while Canada’s booming housing market and consumer spending helped it escape largely unscathed.

But the housing boom is fast fading while a near-record high household debt-to-income ratio weighs on consumer spending.

Acknowledging the risks to the economy, the Bank of Canada cut rates twice this year surprising markets on both occasions, particularly in January when no one was expecting it. That weakened the dollar.

A weaker currency, in turn, should bolster domestic demand by making it more expensive for people to buy imported products or even vacation abroad.

But what is more necessary is a significant pick-up in demand from the U.S., Canada’s biggest export market by far.

David Tulk at TD Securities takes a similar view:

The currency is only part of the story. You need to see the levels of foreign demand. There is also more structural concern that some of the weakness that we have seen in manufacturing since the start of the Great Recession means that maybe there is not the same kind of capacity to respond to an improvement in foreign demand.

Indeed, Canadian gross domestic product growth predictions for this year and next have been gradually cut by forecasters in the last several Reuters polls.

Monthly GDP data for June showed there is some hope with the economy growing at a faster pace than all forecasters in a separate Reuters survey predicted at 0.5 percent.

But going ahead, divergence in monetary policy paths between the U.S. and Canada will play a key role.

While the U.S. Federal Reserve is forecast to tighten policy, the Bank of Canada’s round of policy easing is probably over according to the latest Reuters poll, not least because at just 0.50 percent, there is very little left to cut.

Analysts gave only a 25 percent chance the Bank cuts again when it meets on Wednesday.

The divide in monetary policy between the U.S. and Canada will pressure the loonie further. The currency has already lost nearly a quarter of its value since the start of 2014, mostly after oil prices began to collapse around June-July last year.

That depreciation in the currency, however, has done little to significantly bump up exports. Although at a record high in currency terms, they are not too far above their July 2008 peak.

Historic data suggests there is just a weak correlation between a devalued loonie and Canadian export growth. U.S. demand is the key factor.

CAD and exports

Emanuella Enenajor, senior economist at Bank of America Merrill Lynch wrote:

In explaining dynamics in Canadian exports, one of the most important variables is U.S. domestic demand (spending on consumption, investment and inventories).

That variable explains about 60 percent of the variation in Canadian exports, based on an annual regression using data from 1985 to 2014. The result is unsurprising as about 80 percent of Canada’s exports are destined for U.S. shores.

The last time the loonie hit its current low of C$1.32 to the greenback was in late 2004 when the U.S. was booming and crude oil prices were on an uphill climb.

The previous dollar depreciation did coincide with a rise in exports but there hasn’t been a mutually beneficial relationship between the two since.

Canadian exports performed better in 2005-06 when the loonie was much stronger than it is currently. Exports growth began to ease only when the U.S. economy was brought to its knees during the 2008 crisis.

Yet, ever since Bank of Canada Governor Stephen Poloz – a former head of the Federal Export Agency – assumed office in 2013, he has repeatedly stressed a weaker currency will help.

The loonie slumped to a six-year low after the Bank cut rates for the second time this year in July.

But that’s not going to help when the global norm appears to be a race to the bottom with nearly 40 central banks jumping on the currency devaluation bandwagon this year.

And that is even more true when China’s central bank happens to be one of the 40.

Canadian policymakers were among the first to kick off global monetary policy easing with a completely unexpected rate cut in January.

The explanation Poloz offered for the second rate cut in July was a “puzzling” weakness in non-energy exports that should have helped offset the negative impact of lower oil prices on business investment and income.

That makes it seem like the Bank is not overly convinced about its estimate of a pickup in exports via a lower loonie either.

Historically, a depreciation in the Canadian dollar needs over six quarters to have the greatest impact on real export volumes. A 20 percent depreciation should boost export volume by roughly 12 percent, according to CIBC.

CIBC

Going by that model, there are only two quarters left to see any real results.

With additional reporting by Deepti Govind and Rahul Karunakar;

Graphics by Vincent Flasseur

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