Why Does Canada have a Floating Exchange Rate Regime

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Why Does Canada have a Floating Exchange Rate
Regime?

• Farid Novin
• Senior Representative of the
• Bank of Canada

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Outline

• Overview
• The Arguments for a Fixed Exchange Rate
• Dutch Disease
• Optimal Currency Area
• Reduced Uncertainty
• Academics proposals for a fixed rate
• The Arguments for a Floating Exchange Rate
• Monetary Policy Independence
• Buffer against external shocks
• Unwinding the arguments for a fixed rate

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Overview

• Canada is one of the world's most open economies.
  
• Trade is about 68 of GDP (36 exports, 32
  imports)
• 76 per cent of our exports go to the US.
• The value of goods and services that cross the
  Canada-U.S. border every year amounts to about
  US465 billion.
• Canada has operated under a floating exchange
  rate for most of the last 60 years

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Fixed Exchange Rate Regimes

• The vast majority of countries operate on a fixed
  exchange rate system.
• Most countries prefer to tie their currencies to
  that of another trading partner and to operate
  under some form of fixed exchange rate
  arrangement.

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• Reasons
• Currency movements (whether up or down) have
  political repercussions because someone will be
  made unhappy.
• An appreciation renders exports less competitive
• A depreciation renders importers less competitive
  in domestic markets. Consumers will complain
  about higher prices.
• The exchange rate can be a symbol of national
  pride.

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Renewed Interest in Canada

• In 1999 articles by Courchene Harris helped
  resuscitate the debate
• Over the last few months Canadian academics and
  various media have again regained interest. This
  renewed interest can be explained by
• The rapid rise of oil and other commodity prices.
• Strong appreciation of the Canadian dollar since
  2002
• The downturn in the manufacturing industry
• The current situation has drawn comparisons with
  Dutch Disease

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Source Options Politiques Feb. 2008
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What is Dutch Disease?

• Term originated with Holland in the 1960s
• Natural Gas was discovered in the North Sea
• This caused a significant appreciation of the
  Dutch gilder
• This led their manufacturing sector to become
  less competitive, leading to a significant
  downturn

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The Arguments for a Fixed Exchange Rate Regime

• Optimal Currency Area
• -- originally Mundell (1990), but more recently
  championed by Thomas Courchene
• Canadas economy has become a series of
  north-south cross-border economies
• BC competes with the Pacific northwest
• Alberta with the Texas Gulf
• Central Canada with New York/ Chicago
• Maritimes with Boston and New England

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• In the presence of an external shock (ex. rise in
  energy prices)
• each cross-border region is affected in the same
  way,
• but the energy region (Alberta-Texas Gulf)
  changes relative to the other regions.
• With a floating exchange rate
• the energy shock results in an appreciation of
  the Canadian dollar
• every Canadian region becomes less competitive
  vis-à-vis its US counterpart

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The Arguments for a Fixed Exchange Rates (contd)

• Floating Exchange Rates lead to under- and
  overvaluations of the currency, movements can be
  rapid and painful
• Low labour productivity growth due to 10 years of
  undervaluation (1992-2002)
• This made the cost of labour relatively cheaper,
  so manufactures invested less in ME
• Theoretically the appreciation should reverse
  this, leading to investment and productivity
  improvements
• But the speed of the rise has led some firms to
  downsize, outsource and go off-shore
• Any recapitalization will be on a reduced
  domestic base
• Investment in some industries will remain low, or
  at least delayed

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Source Options Politiques Feb. 2008
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Main advantages of Fixed rates

• Microeconomic in nature
• Reduced transaction costs
• Conversion costs eliminated
• Reduced uncertainty
• These encourage international trade

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• Supporters point out that during Canadas last
  period of fixed exchange rates (62-70)
• Productivity growth rose faster than in the US
• It was during the Pearson era, when many social
  programs were created (so fixed rates need not
  affect fiscal policy)

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Proposed Fixed Rate

• Courchene and Grubel have independently suggested
  that Canada move to a currency board, over the
  past few months
• Thomas Courchene (Options Politiques Oct. 2007,
  Feb. 2008 The Globe and Mail Oct. 2007
• Herbert Grubel (Financial Post Jan. 2008)
• The currency board would fix the value of the C
  to the US by buying and selling US at that rate

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The Next Step

• They suggest that eventually it will become
  politically feasible for their to be one currency
  for the US and Canada
• The North American Monetary Union (NAMU)
• There would be one central bank for the 2
  countries
• Nation specific designs (like the Euro)
• The Bank of Canada would issue its currency so as
  to maintain Canadas seigniorage
• Bank clearing would still occur in Canada
• Canada would maintain control over financial
  regulation

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Main Advantages of Floating Rates

• Macroeconomic in nature
• Monetary policy independence
• Inflation targeting
• Ability to respond to fluctuations in demand that
  are unique to the Canadian economy
• Buffer against external and internal shocks
• Nominal exchange rate adjustments can facilitate
  the transition to a new equilibrium

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AD1
AD2
SAS
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Canada Output and Final Domestic Demand (Volume,
year-over-year percent change)
U.S. Output and Final Domestic Demand (Volume,
year-over-year percent change)
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Other Arguments for a Floating Exchange Rate

• The economic structures are different in Canada
  (commodity exporter) and the US (commodity
  importer)
• Movement of labour is restricted between the US
  and Canada
• Border does matter Regions in Canada are more
  similar than Canada-US regional similarities
  (Bank of Canada study)
• A monetary union would leave Canada with only 1
  seat, the US would have 12

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• Sharp adjustments may occur when fixed exchange
  rates unravel (ex. Argentina, South East Asia)
• Rise of oil prices Nations pegged to the US
  (like the Gulf States) are seeing increased
  inflation rates
• No Dutch Disease in Canada, the Canadian economy
  is well diversified

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• Sovereign monetary policy
• We couldn't actually target inflation if we
  didn't have a floating exchange rate. We would
  have to keep that exchange rate stable. That
  would mean we would have inflation that would be,
  at the moment, very high, because we've had a big
  improvement in our terms of trade. It is
  absolutely true that the Canada-U.S. exchange
  rate, one of the most stable bilateral exchange
  rates in the world, has been more volatile.
  That's largely due to uncertainties attendant
  upon the U.S. dollar, and of course we can't do
  much about that. But the strength in the exchange
  rate means that we have been running a somewhat
  easier policy than we would run if the opposite
  were the case.
• -David Dodge, March 2005
• McLeans Magazine

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• Flexible exchange rates as a buffer to external
  shocks
• Let me put this in more concrete terms and, in
  so doing, share a valuable lesson learned from
  the Asian crisis of 1997. As a commodity-producing
  nation, we were hit pretty hard by the dramatic
  fall in commodity prices. Our floating dollar
  fell sharply and thus, helped with the
  significant but necessary adjustment. With the
  decline in the nominal exchange rate, our
  non-commodity sectors saw their competitive
  positions improve. They were therefore able to
  absorb some of the resources that were being
  quickly shed by the commodity producers. Our
  floating exchange rate allowed us to achieve a
  decline in real wages without a decline in
  nominal wages and to hold inflation near our
  target.
• -David Dodge, May 2007
• Speech to the ACI - The Financial Markets
  Association

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• On a Fixed Exchange Rate
• It would mean that, de facto, Canada would adopt
  U.S. monetary policy, despite the reality that
  the structures of our economies are very
  different and, as a consequence, often require
  different types of adjustments in response to
  global developments. We cannot avoid adjustment
  the question is simply how we adjust to global
  economic forces. With a fixed exchange rate, the
  adjustments would have to come through movements
  in overall output and in all wages and prices.
  History has shown that these adjustments are more
  protracted and more difficult than exchange rate
  adjustments.
• -Mark Carney, December 2007
• Opening statement to the House of Commons
  Standing Committee on Finance