Economics When the U.S. Economy

Economics When the U.S. economy plunged into recession in the second half of 2008, there was considerable concern north of the border in Canada about the prospects for that nation's economy. The two countries are the largest trading partners in the world, and it has long been viewed that the Canadian economy depended on exports to the United States. Indeed, this relationship has driven Canadian monetary policy for decades, with the CAD being kept at low levels to facilitate the export industries.

Last summer, the CAD was at highs not seen in many years, which combined with the impending U.S. recession was cause for significant worry. The impacts of the recession, however, have not been felt as strongly in Canada as they have in the United States. The more heavily-regulated banking sector was insulated from the subprime crisis, which in turn minimized the credit crunch, but there is more to the story. An examination of the Canadian dollar's value vs. The U.S.

dollar reveals some of the differences in the economies of the two nations. These differences in turn help to explain Canada's outperformance vs. The U.S. during this crisis. This paper will examine the USD/CAD exchange rate over the past several years, and attempt to explain some of the drivers of this rate in the context of the U.S.-Canada trade relationship. The Rates Historically, the Canadian dollar has traded below $1.00 U.S. Using the 10-year chart provided by DailyFX.com, the level of the USD vs.

The CAD can be tracked. From July 1998 until January 2003 the currencies traded in a range between 1.43 and 1.595 Canadian dollars to every U.S. dollar. The next major period saw the Canadian dollar steadily strengthen to the 0.93 range in October of 2007. The most recent period has seen a general weakening of the Canadian dollar, but with a more volatile trend. The USD moved over 1.30 Canadian dollars before slipping back somewhat in recent months. The current rate is 1.1539.

Drivers The trends exemplified in these three time periods illustrate some of the drivers between the CAD and the USD. In the short run, the interest rate differential between the two countries is a driver (Coulling, 2009). Another short run driver of the exchange rate is the market's view of commodity prices, in particular oil. Oil can also be seen as a long run driver of this exchange rate, since in recent years the Canadian dollar has been increasingly viewed as a petrocurrency. The state of the U.S.

economy can drive this rate for both the short and long run, but the major trends of the past few years demonstrate strong influence of the U.S. economy on this currency pair. Another long-run determinant is the trade relationship between the U.S. And Canada, in particular how this relationship guides Canadian monetary policy. The first short run driver is the interest rate differential. The two nations have similar interest rate regimes, and often adopt similar rate moves and timing.

Thus, interest rate changes tend to be short-term drivers, especially in those instances where interest rate policy differs between the two nations. The Canadian dollar began to appreciate vs. The U.S. dollar in 2003. At this point in time, the U.S. federal funds rate was 1.25%. That rate dropped a quarter point during the year and did not begin to move up again until mid-2004 (source: Federal Reserve). The Canadian rate, however, had begun to rise in April, 2002. This contributed to the increase in the value of the Canadian dollar.

The Canadian government then reversed some of those rate increases and from November 2003 until May 2004 there was a weakening of the CAD. At that point, U.S. rates began to rise and Canadian rate increases were much slower, narrowing the spread between the two and restoring the trend of a strengthening CAD. The Canadian economy has long been driven by commodity prices. In recent years, the combination of higher oil prices and technology improvements has allowed for the development of the oil sands in Alberta and Saskatchewan.

Development in the oil sands accelerated rapidly in 2005, and oil projects off the Atlantic coast of Nova Scotia and Newfoundland also increased Canadian oil production. Overall, production increased 21.6% from 2000 to 2006 (adapted from statistics from the National Energy Board). Canada is now the #7 oil producer in the world (EIA, 2009) and a net exporter and is believed to have the second-most reserves in the world after Saudi Arabia (Walsh, 2003). These developments have turned the Canadian dollar into a petrocurrency.

As such, short run price movements in the Canadian dollar have reflected short run price movements in crude prices. The impact of these moves with respect to the U.S. dollar is amplified by the fact that not only is the U.S. A net importer of oil, but Canada is the largest source of imported oil in the U.S. Moreover, almost all of Canada's oil imports go to the U.S.

Thus, an increase in the price of oil not only increases the value of the Canadian dollar but weakens the U.S. dollar simultaneously. Much of the volatility in the exchange rate in this pairing since October 2007 is tied to volatility in the price of crude oil. In the second half of 2008 the price of oil collapsed, and the Canadian dollar lost value quickly as a result. A slight recovery in oil prices in early 2009 has likewise seen an increase in value of the CAD.

The single greatest long-term driver of the USD-CAD exchange rate is the U.S. economy. Relative strength and weakness in the U.S. economy impacts the U.S. dollar. This typically impacts not just the exchange rate with the Canadian dollar, but with other major currencies as well. Despite the numerous Canadian factors that have short-term impacts on the rate, the main driver of the rate is the United States and its economic performance. When the U.S.

dollar is strong against the Euro, the yen or the pound, it will also be strong against the Canadian dollar. There are few instances where the Canadian dollar performance has been driven by Canadian factors. For example, the rise of the Canadian dollar from the beginning of 2003 was in part driven by poor U.S. economic performance. As the U.S. government began taking on debt to fuel its war in Iraq, the value of the U.S. dollar declined sharply against all major currencies.

While the move was amplified with respect to the CAD because of the increasing importance of oil production to the Canadian economy, the broader trend was driven by U.S. weakness. The chart, however, indicates that the influence of oil on this exchange rate is becoming stronger. Thus, we are likely to see increasing deviations from this long-term trend. The recession spurred by the subprime crisis, for example, hit the U.S. much harder than it did Canada. Yet, the U.S. dollar appreciated vis-a-vis the Canadian dollar.

This runs counter to the long-term trend. That contrary move was clearly driven more by oil prices than by respective economic performance. Another long-term driver of exchange rates between the U.S. And Canada is Canadian monetary policy. Canadian politicians have long used interest rates and other levers to keep the value of the Canadian dollar low relative to the value of the U.S. dollar. The objective of this policy is to support export industries, such as automobile production, manufacturing, lumber and even the film industry.

Monetary policy revolves around interest rate control, which in turn is designed in part to keep the value of the CAD low. The ramifications of this policy have been a decades-long weakness in the Canadian dollar. This has been threatened by the impact of oil. As a consequence of rising oil prices and a corresponding increase in the Canadian dollar, many exporters expected U.S. demand for Canadian goods to fall, and in the first half of 2009 this has come to pass.

As the Canadian economy shifted more towards petroleum, the Bank of Canada predicted that a realignment of the Canadian dollar's value would have to occur and exhorted the exporter community to make adjustments for this (Bank of Canada, 2004), hinting that the Bank of Canada would no longer be able exert the same degree of control over exchange rates as it had in the past.

ASSESS HOW A STRONG CURRENCY CAN AFFECT THE BALANCE OF PAYMENTS ACCOUNT The preceding discussion hints at the impact that the balance of payments has on the U.S.-Canada relationship, in particular with respect to the exchange rate. The Canadian government takes an active role in managing the exchange rate in order to affect specific outcomes. The United States is complicit for a couple of reasons. The first is that manufacturing in Canada increases profits at a number of U.S. firms, including the influential auto industry.

The second is that American consumers benefit from cheaper goods coming from Canada. The gap in wages and costs is not so great that U.S. employment is dramatically impacted, so the balance of payments is accepted. 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. Conclusion 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.