Depreciation Of The Candaian Dollar Essay, Research Paper

Scott Christiansen

December 10, 1999

Economics 335 Section 01

Final Paper

The Depreciation of the Canadian Dollar

Canada has been increasing its prestige as a high-tech, industrial, society since the end of World War II. In many ways it resembles very closely its southern North American cousin, the United States. Some of those similarities are residing in its market-orientated system, pattern of production, and its high standard of living. Most years following the war up to the present, Canada has experienced some kind of continued growth as a prosperous and developed country. However, during the year of 1998, Canada experienced an unexpected large depreciation in their dollar relative to the United States. Late in August of that year, in fact, the value reached an all-time low. During this paper, I will try to present some of the possible economic factors that may or may not have led to this change in Canada’s exchange rate. I will also examine some additional analysis and theories as to why the trend possibly occurred.

Exchange Rate

As the year 1998 approached, the trend for the Canadian dollar was on a steady decrease in value in relation to the U.S. dollar. With each passing year the dollar lost some value as the table below demonstrates.

Year 1990 1995 1996 1997 1998

Exchange Rate 1.16 1.38 1.36 1.38 1.48

*All data tables extrapolated from the Cambridge Forecasts Country Report, unless otherwise noted.

It took an exceptional hit during the year, moving the rate from 1.38 U.S. dollars to 1.48 in U.S. dollars. The plunge is better exhibited in Appendix 1, with the sharp decrease of the dollar illustrated graphically and more specifically, with Appendix 2 showing the drop throughout the year of 1998 alone.

Growth Rate

In terms of growth rate, the years leading up to the exchange rate drop in 1998 showed very typical numbers. There was nothing out of the ordinary, or anything to hint at a sharp decrease in the value of the Canadian dollar. As highlighted below, up to 1998, the economy was growing at a slow but steady rate each year. Both the Total Gross Domestic Product and percentage of GDP real growth were increasing overall.

Year 1990 1995 1996 1997 1998

GDP (bill. of U.S. $) 573966 584044 611602 631193 603978

Year 1990 1995 1996 1997 1998

GDP Real Growth (%) N/A 2.3 1.6 3.7 3.1

However as the numbers for 1998 indicate, the depreciation of the dollar definitely took a significant chunk out of the Total Gross Domestic Product, dropping it below 1996’s levels. This is to be expected as a depreciated currency would effect the value of the products, however as pointed out before, nothing in growth rate eluded to the depreciation that took place in 1998.

Inflation Rate

Similar to the growth rate, the inflation rate also had nothing to offer in terms of an indication of the lowering exchange rate. In fact, as highlighted below, the inflation rate was steadily declining as 1998 approached. A trend usually linked to a healthy economy overall.

Year 1990 1995 1996 1997 1998

Consumer Price Inflation N/A 2.2 1.5 1.6 1.0

Even the figures from 1998 indicate, the inflation rate seemed to be unaffected by the depreciation of the Canadian currency. “…that (increase in) performance (of Canadian companies), is due almost entirely to the depreciation of the currency and, to a much lesser extent, to the lower inflation that Canada has experienced during the last decade…” Therefore using the inflation rate as an economic indicator in this case is not always conclusive to the ideal that the dollar should have been in good shape, with a thriving economy.

Dollar Reserves

Again, looking at the numbers of dollar reserves, no significant trend seems to point in the direction of increased weakening.

Year 1994 1995 1996 1997 1998

Dollar Reserves (mil of U.S. $) 392 -2710 -5498 2392 N/A

The fluctuations in the numbers seem to be quite normal and constant throughout Canada’s time of both economic prosperity and slowdown.

Trade Balance

The trade balance however starts to show a different story. The numbers up to 1997 look very healthy with the amount of exports far outweighing the imports. 1997 spelled a big decrease in the trade balance and the numbers from 1998 show much of the same.

Year 1994 1995 1996 1997 1998

Exports (mil of U.S. $) 228,167.10 265,333.90 279,891.80 301,381.40 322,262.40

Imports (mil of U.S. $) 207872.50 229936.50 237917.20 277707.80 303399.70

Trade Balance 20294.60 35397.40 41974.60 23673.60 18862.70

*Data extrapolated from CANISM, Statistics Canada’s online statistical database

But as Appendix 1 indicates, 1997 was the beginning of the gradual decent of the Canadian dollar, until it reached it’s low in August of 1998. This translates to the relatively more expensive foreign products (imports), as Canada’s ability to purchase and make good on its domestic products (exports) being sold overseas decreases. In other words, the cost to buy foreign products rose while the amount of money taken in on imports when converted to their currency fell. This is again demonstrated as you look at the amount of exports. It continues rise, but not as quickly due to the lower exchange rate. Couple that with higher prices paid for the imports equals a significant decrease in the trade balance. The balance in 1998, in fact, was lower than the balance in 1994.

Interest Rates

A final economic indicator that helps us to explain the reasons behind the exchange rate drop is to look at a few of the key interest rates in the economy in and around that time.

Year 1995 1996 1997 1998 1999

Bank Rate 7.31 4.53 3.52 5.1 4.91

Prime Business Loan Rate 8.65 6.06 4.96 6.6 6.43

Consumer Loan Rate 11.88 9.19 8.75 9.27 10.18

*Data extrapolated from CANISM, Statistics Canada’s online database

As exhibited with the figures, there is serious decrease in all of these interest rates from 1995 to 1996. “1998 started off well enough, but by mid-year the optimism was being abruptly clouded by a decreasing currency, which seemed to be related to the low rates of interest being charged.” This decrease demonstrates a strong economy at this time, but with them being too low, it causes a capital inflow to the country, in turn making the currency’s value depreciate as more of it is supplied and demanded. The trend in 1997 and 1998 indicates that the interest rates are starting to climb again with hopes to regain the original strength the dollar.

Other Factors

Besides these basic economic indicators two other main factors influenced the depreciation of the Canadian dollar. The first of these resting in the hands of the Federal government’s action, or as some would put it, lack of action. The Prime Minister and finance minister did nothing in terms of trying to stop this devaluation of the dollar. In fact, they encouraged it. Their thinking was that a weakening dollar would reduce the labor costs of many companies, therefore increasing the amount production and increasing margins. The opposite occurred. With the lower value of the dollar, companies were less motivated to innovate and reduce costs because they were so sheltered by the strong foreign competition. The weaker dollar also raises the price of machinery and equipment, which of it, 60% is imported. With these factors comes a decrease in competition with the foreign firms and overall decrease in the health of the country. Jeff Rubin, an economist at CIBC World Markets agrees that this depreciation in the currency has also had a “huge erosion in competitiveness.” Mr. Rubin also agrees that the lack of action taken by the government has hurt competitiveness. “…the protective aspect of the a weak dollar is to blame for the plunge in competitiveness and that the currency’s devaluation was engineered by the Bank (of Canada).” Yet another source has the same opinion, “The dollar’s decline was intensified by the Bank of Canada’s benign neglect through early August (1998) and the apparent indifference expressed by the government.”

Some would also argue that tied along with this deterioration in competitiveness, is the influence the Asian currency crisis had on the Canadian dollar. The depreciation of the dollar was one of the most visible impacts that crisis in Asia had on Canada’s economy. The crisis over there demonstrated a lower demand and prices for commodities, not to mention the perception of Canada being able to compete in the global market. It also caused other countries to question its other policy and structural issues that take away from the country’s attractiveness to investors.

Conclusion

To conclude, the depreciation of the Canadian dollar had many influences hinging upon it. Some of the key economic indicators were unfazed by the devaluation, while others were heavily affected. These and the outside factors of the Canadian government’s ignorance of the problem and the Asian currency crisis all added to the already confusing mix of speculations. A quote in the article by Janet Matthews ties it altogether best, “…if we have learned anything from the last 18 months, it is that only the longest of perspectives is likely to be of any use when looking a Canada’s economy. This period since May 1998 has been characterized by so many ups and downs that it is easy to jump to conclusions when looking at economic performance statistics.” Many economists did. They believed that this depreciation would cause a long term economic slowdown for Canada but as current facts indicate, the dollar has regained some of its strength and contrary to predictions, the economy is again growing and improving at a steady rate.