The Canadian government seeks to have a positive balance of payments with the United States. This is, in effect, a wealth transfer. Tracking the balance of payments vs. The exchange rate, we can see the impact of exchange rate shifts on the BOP. The Canadian balance of payments in 2004, when the exchange rate ranged from 1.17 to 1.37, was $29.8 billion. In 2008, when the exchange rate was between 0.97 and 1.29, the balance of payments was $8.1 billion. Tracked against the forex chart, the trend holds for the interim years as well -- when the Canadian dollar is strong, the balance of payments shrinks. This reflects the reduced competitiveness of Canadian goods in the U.S. market when the Canadian dollar's value is high. It also reflects the increased value of U.S. imports. In the U.S.-Canada trade relationship, however, there is an offset, which is oil. Increased strength in the Canadian dollar in recent years has typically reflected strength in crude oil prices. While this reduces the value of Canadian non-oil exports to the U.S., it increases the value of oil exports. The demand for oil in the U.S. has low price elasticity, in contrast to other Canadian exports. The increase in oil price elasticity and increased volatility in oil markets have contributed to the increase in influence that oil prices have on the USD-CAD price fluctuations.
Recent years have seen a seismic shift in the demand drivers for the Canadian dollar. In the long-run, the strength of the U.S. dollar has been the most important driver, with a secondary driver being the monetary policy of the Canadian government, which has for several decades been designed to support Ontario and Quebec-based exporters to the U.S. An analysis of recent data shows that these factors have been less important in recent years. The defining moment for the Canadian dollar in this decade came when analysts realized that advances in technology and rising oil prices had made the oil sands economically viable. This propelled Canada from a minor oil nation into a major oil nation. This in turn shifted the balance of influence on the Canadian dollar. Prior to 2003, the Canadian dollar's value vis-a-vis the U.S. dollar was relatively stable. After, it grew significantly in strength. In the past couple of years, volatility has increased as the value of the Canadian dollar has become increasingly tied to the prevailing price of crude.
The balance of payments is affected, however. Canadian exports to the U.S. decline significantly as the Canadian dollar increases in value, despite the increase in value of oil exports. This in turn causes a political problem in Canada. The Bank of Canada, which has traditionally held the value of the Canadian dollar lower in order to facilitate that nation's export business is now faced with a situation where the high price of oil is causing a steady erosion in the balance of payments. The coming years will be a test for the USD-CAD relationship. Oil will likely remain high. This means that the Canadian dollar will likely remain high. There will be negative impacts on the balance of payments as a result, and this in turn will affect the two major long-term factors that influence the USD-CAD exchange rate. Americans will buy fewer Canadian goods as the price of those goods increases. The Canadian government will be less able to manage the exchange rate via traditional levers such as interest rate policy. As a consequence, Canada's balance of payments will be far less favorable in the past. If, however, the long-run trends hold and Canadian monetary policy is able to effectively counteract the impact of fluctuations in the price of crude on the CAD, then the paradigm we have seen in the past will hold. More likely, however, we will see a continuation of what the past few years have represented -- a new paradigm for the price relationship between the USD and the CAD, along with corresponding changes in the economic structure of those two nations.
Currency chart adapted from www.dailyfx.com
Fed Funds rate from U.S. Federal Reserve. Retrieved June 28, 2009 from http://www.federalreserve.gov/fomc/fundsrate.htm
Canadian bank rate from Bank of Canada. Retrieved June 28, 2009 from http://www.bankofcanada.ca/cgi-bin/famecgi_fdps
Canadian oil production statistics from the National Energy Board. Retrieved June 28, 2009 from http://www.neb.gc.ca/clf-nsi/rnrgynfmtn/sttstc/crdlndptrlmprdct/stmtdprdctn-eng.html
Coulling, Anna. (2009). USD to CAD -- Daily Chart. FX Street. Retrieved June 28, 2009 from http://www.fxstreet.com/technical/forex-strategy/currency-trading-majors-pairs/2009-06-22.v04.html
Walsh, Campion. (2003). Canada's Oil Reserves 2nd only to Saudi Arabia. Dow Jones Newswires. Retrieved June 28, 2009 from http://www.rense.com/general37/petrol.htm
Oil production statistics from Energy Information Administration. Retrieved June 28, 2009 from http://tonto.eia.doe.gov/country/index.cfm
No author. (2004). Monthly Policy Report: October 2004 Summary. Bank of Canada. Retrieved June 28, 2009 from http://www.bank-banque-canada.ca/en/mpr/pdf/mprsumoct04.pdf
Balance of Payments statistics from Statistics Canada. Retrieved June 28, 2009 from http://www40.statcan.gc.ca/l01/cst01/econ01a-eng.htm