Proceedings of the Standing Senate Committee on
Foreign Affairs
Issue 18 - Evidence, October 8, 2003
OTTAWA, Wednesday, October 8, 2003
The Standing Senate Committee on Foreign Affairs met this day at 6:08 p.m. to examine and report on the Canada- United States of America trade relationship and on the Canada-Mexico trade relationship.
Senator Peter A. Stollery (Chairman) in the Chair.
[English]
The Chairman: Honourable senators, I apologize to our witnesses for this delay. The committee tabled the first volume of its review of NAFTA in June. It has led us to this series of meetings in which we are taking more evidence. We had received a great deal of information from some good witnesses that the exchange rate is a major factor in Canada-U.S. trade — which should not come as a surprise to anyone. We were reminded of the fluctuations in the exchange rate from 1988 to 2000. Our exports, to some extent, follow those exchange rates.
Our first witness today is Mr. Michael McCracken, who has been before the committee many times before. We will also hear from Mr. Ted Carmichael and Mr. Jim Stanford.
Mr. McCracken, please proceed.
Mr. Michael McCracken, Chair, Informetrica Limited: I have handed out a PowerPoint summary of points, but my testimony, I think, will actually serve for what you want. I apologize for not having this available in both English and French. I just completed it this afternoon.
Let me set the scene, if I could. It strikes me that the first question that would be helpful for me to answer would be what we know about exchange rates. In essence, it is fairly clear, and we have lots of evidence that exchange rate changes affect export prices, import prices. We also have learned that these changes take time; they do not happen instantaneously, in all markets at least. Once you start changing prices in a modern economy, other prices also respond to those — wage rates, prices of domestically produced goods — and so very quickly the cat gets out of the bag and you have a much more complicated set of changes to think about.
If that were not enough, when prices change, particularly relative prices, you begin to get real changes in the economy. People make decisions to lay off people, or to hire people, or to invest, or to slow down their investment, or to buy cars or not. When you ask questions about the effect of the exchange rate change, you are, in some sense, very quickly moving into having to answer a question of what happens in the total economy. When you face that question — as always with almost any kind of a shock to the system — there are effects that are positive for some people and negative for others, and for businesses, regions for levels of government, and so on.
Also, when you ask the question about exchange rates, a good economist — and we have nothing but that here — would ask you a supplementary question: What kind of a monetary policy rule is being pursued by the central bank? Is the bank just going to sit there and watch it and do nothing, or is it focusing on inflation? If inflation, for example, with depreciation is substantially higher, will the bank react to it by raising interest rates? Or, in the more recent period, will the appreciation of the Canadian dollar lead to lower prices or the anticipation of lower prices, and will that lead to lower interest rates? Or will the bank use something even more sophisticated — some sort of a monetary conditions index, where a certain amount of appreciation can be traded off with interest rates changes?
If you were to ask the central bank, of course, the bank would probably say that it never comments on the exchange rate; however, were they to search their hearts, they would also point out that they would really like to know how persistent this exchange rate change will be. It is one thing if it jumps half a cent in one day, as it did yesterday; however, if that persists for five years, the story is different. Or will it be reversed in the next two days, in which case, they might say, it was there but then it left and we are not going to respond.
There is also a question that we worry about in terms of bankers, particularly, central bankers, and that is whether they react symmetrically. If the dollar depreciates and pushes up inflation, and they take a series of moves to raise interest rates, would they do the same in the opposite direction if there were an appreciation of the dollar of the same amount? If not, then you run the problem that your economy can be buffeted or pushed to one extreme or another.
You would also like to know whether they would react differently to small changes versus large changes. Will they react to a one-cent change in a very modest way but get not just five times but ten 10 time more excited if they were facing a five-cent appreciation?
Why we are asking this question now? Where were the hearings two years ago when we faced a depreciation of 35 per cent? We could have dug in and wrung our hands — which would have been more appropriate. It is interesting that only after something has changed a lot do we want to talk about it. Of course, that usually is the time it reverses and goes in the other direction, because we have begun to look at it. With the recent appreciation that has occurred, this may be the peak that we are meeting at to wring our hands about. I do not know.
In fact, both things are happening out there. We have had a large depreciation of the Canadian dollar in nominal and real terms, against the U.S. dollar since the early 1990s. We have had a recent appreciation since the beginning of the year that is quite substantial. Perhaps another reason we want to talk about this is that we are hearing from our trading partners, particularly the U.S., their concern about the Canadian dollar not appreciating enough. Indeed, I can recall a group of U.S. senators coming up here in the mid-1980s to express their concern about our low dollar. Of course, between the time they arranged their meeting and the time they actually came up, the dollar had bounced back up about two or three cents. As near as I can find out, they showed up, but I could not find them to meet. They all said they sere someplace over in Hull.
I get stuff from U.S. economists saying that we have been taking advantage of the U.S. with our low dollar over the last few years and it is time it stopped. Is there anything there or not? Of course, they are beating up on China at the same time; in fact, we have been joining in on that effort to some extent — with some question in my mind as to why.
It could also be that we are worried about our manufacturing and resource sector being too strong and that we want to cool it down a little bit with this appreciation. It was helped, perhaps too much, by a lower dollar and has been perhaps getting a little sloppy on the productivity front, so there is nothing like a good appreciation to stimulate them to higher objectives.
The changes you know about — you have been hearing about them. The kinds of numbers that will get tossed around are something on the order of a 15 to 18 per cent appreciation of the Canadian dollar since the beginning of the year — something on the order of a 37 or 38 per cent depreciation of the dollar from 1991 forward. We are now sort of about halfway back. If you want simple numbers, think of it as 30 per cent depreciation, of which about half has been offset by the recent strengthening of the currency.
I mentioned the interconnections within the Canadian economy when we start juggling the exchange rate, but we must realize that Canada is just a box in a global economy and that we are connected to what is going on in the U.S. economy — which will affect our exchange rate independent of what we are doing here. The Canadian economy has its feedbacks. The U.S. economy affects the Canadian economy and, indirectly that way, also the exchange rate. It is an interconnected system; and in thinking about why there has been a change, we will want to follow up on that story.
Very quickly, let us assume we had — and if not, you can correct me and I can switch the signs — but let us say we are talking about a 20 per cent appreciation of the Canadian dollar that sticks. In other words, let us assume that we stay at 75 or 77 cents for the foreseeable future — up from something in the mid-60s on average in the 2001-2002 period. How will that unfold over the next few years in terms of its effect on the economy — is that right direction to go, Mr. Chairman?
The Chairman: We are relatively focused on what effect the dollar has on our trade with the United States. Our terms of reference are Canada-U.S. trade, and the committee is interested in what the effect of all of this has been, and will be, on Canada-U.S. trade.
Mr. McCracken: I will try to keep it limited in that way, although you will quickly find that we have to spill over to some other issues.
If we have an appreciation, export and import commodity prices will rise — and some immediately by almost the full amount, or 20 per cent. A good example would be oil. We have chosen, rightly or wrongly, to price our oil in Canada at the world oil price and to adjust daily to that world oil price. Other prices in the energy field also link into that decision and adjust quite quickly as well. Other basic commodity prices — metals and fibre products, for example — are also linked into international commodity prices. By and large, these will respond almost instantaneously to higher prices or lower prices as landed in Canadian dollars.
Some export-import prices will not change quite as much. Someone may decide that a price change would make its product too uncompetitive in the eyes of the buyers of the product. In that case, the foreign price is not adjusted by the same amount and will be offset to some degree by adjusting to a greater or lesser amount, as the case may be. Think of declines of full amount at 20 per cent for the market products and perhaps 10 to 15 per cent for some of the others.
These price reductions will reduce corporate profits and will also lower the consumer price index, the CPI. It will also then get picked up in other import competing prices. Wages will probably increase less, may or may not drop, most likely not, and machinery and equipment prices will go down. One of the major effects of an exchange rate change is that an appreciation of the Canadian dollar is essentially a transfer of income from the corporate sector to the personal sector. It is akin to removing a tariff on imports and stopping the subsidization of exports. That is another way of seeing an exchange rate appreciation or depreciation the other way. It is like having a tariff on all imports and a subsidy on all exports.
That will increase real disposable income consumption and will probably, almost inevitably, increase imports, as a result. Exports in real terms may go up, depending on how people have adjusted and what kind of income effects are seen. I will open the door to the recognition that when you start down this road you have to look at the flip side of what is happening. Keep in mind that the change in the exchange rate in Canada of an appreciation is a depreciation of the U.S. dollar against the Canadian dollar. That depreciation of the U.S. dollar will have effects in the U.S. It will move income from consumers to business. It will generate some additional economic activity in the U.S. Some of that, as we know, will spill over and create additional demand in Canada. The question becomes one of what the net force of these activities is.
In the same way, if the consumer is stronger in Canada, the influence of that may be an increase in demand in Canada for automobiles, for example — even though they may be losing demand on the export side because of higher priced cars as seen in U.S. dollars in the south.
That is what needs to be considered — what else changes, inflation and interest rates. You should also keep track of federal government balances. An appreciation, as I mentioned, hits corporate profits. The federal government receives the biggest hunk of its revenue from corporate profits; the provincial governments receive much less. On the other hand, provincial governments pay out a great deal of money for wages, salaries and transfer payments, some of which are indexed. Therefore, at a lower inflation rate, they benefit. Thus, government balances will be affected modestly. The big difference is that with an appreciation the federal government pays more, have a larger deficit or a smaller surplus, and the provinces have an improved fiscal situation. The figures would be roughly of the same magnitudes. That is another twist to give you an idea of how this reallocation happens.
What has been happening in the case of this appreciation recently? There are three stories floating around, and the truth, I suspect, is some combination of those three. It is a complex story. One story says that the U.S. is finally depreciating against major currencies such as the euro and the yen, and Canada is following along with that depreciation but more slowly, or less in magnitude. The net result is that the Canadian dollar inevitably must appreciate against the U.S. dollar. However, you did not hear me mention anything about what is happening inside Canada and Canadian policy — and so we could call this story the ``sideswipe story.'' Canada's currency does not qualify as one of the major currencies, although that may shock some of you. The big moves are taking place between the U.S. dollar and the euro and the yen. That is part of what has happened over the last 10 to 15 years, in many people's opinions. The U.S. dollar has appreciated against all the major currencies and we appreciated with them but not as much. We show up with a depreciation of the Canadian dollar vis-à-vis the U.S. dollar.
The second story is that you look inside Canada and see that the fundamentals are wonderful. We have had great inflation, somewhat better than the U.S. economic performance over the last few years, and it is finally coming through in the exchange rate. In spite of some people believing that these markets are perfect and adjust daily to the latest piece of news, sometimes they forget that story and it lags and takes a few years to come through.
The third story element that you will hear is that this is all due to special factors. I will come back to that in a moment.
If you believe the first story, or if want the elements of the first story, you have to understand why it is a U.S. depreciation. One view is that they have an unsustainable current account deficit. It is large at $400-$600 billion, with no sign in the future that it will be reversed quickly. For some reason, people are willing to accept U.S. dollars and willing to accept them at the current exchange rates. That interest may be waning because U.S. interest rates are low and there is increased international friction that can lessen the desire for some countries to hold U.S. assets. Even more recently, people wonder about California and question whether they want U.S. dollars in their portfolios.
On the Canadian side, I mentioned relative inflation performance, whether that be the GDP deflator or CPI. We have higher Canadian interest rates than in the U.S., at roughly 175 basis points. We expect growth to be at or perhaps higher, although that has come down a bit. Most people are beginning to think that the U.S. may be in recovery and that world commodity prices will pick up. Typically, that is good for Canada, relative to the U.S. Canada is a large net energy exporter and the U.S. is a large net energy importer.
We are also running a strong positive current account surplus and long-term capital flow balance. It is much stronger than it is in the U.S. These elements should suggest a persistent pressure for appreciation, at least from the Canadian side.
Finally, in the third story there are special factors. Some would say that Quebec's separation threat is less today than two to six years ago. There are new opportunities coming out the woodwork, for example, lower Churchill, the Alaska Highway gas pipeline and British Columbia gas discoveries. Some would credit this to the hypothetical new prime minister in the wings. We also have a reversal of negatives. SARS is over, mad cow is no more, and the blackout was not of Canadian origin, or at least we hope not.
All of those things are in play and all those stories are in play. The government's problem at this point is this: What do we do about it, if anything? My suggestion to them has not changed in 20 years — and they have been ignoring it. My suggested is to lower interest rates, encourage investments, expand export opportunities where you can find them, try to get these other opportunities to happen rather than just chatter about them, encourage employment and, to the extent you get fiscal dividends from lower interest rates — that is, if the central banks follow up with lower interest rates, as they should with this kind of appreciation, and if the lower inflation helps you on your fiscal balances from less growth and wages and indexed payments — put those out there. That is particularly directed at the provincial governments, who should see a particular improvement in this environment.
On the trade side, a fundamental explanation might well be the fact that we have put in place the FTA and NAFTA. Those have resulted in substantial improvements. Canada certainly is a country that is committed to free trade rather than simply being involved in it, as is the U.S. In that context, it has been working. We certainly see it in the accumulation of growth, as well as a combination of diversity of employment occurring.
It may well be that what you are finally seeing is the payoff. There was a big debate at the time of the FTA, particularly in the early 1990s, as to whether we had the thing screwed up. Could you imagine taking this broad trade stimulus issue and, at the same time, purposely putting the economy into a deep recession. Raising interest rates did not strike me at the time — nor does it today — as the wisest move that had ever been made. Nevertheless, that is now history.
Finally, you are getting the payoff. An interesting debate occurs from time to time when talking about NAFTA, namely, are all of the effects of NAFTA over? In other words, have we realized it? It was an agreement. We have made the adjustment, and wherever we are now it is a new plateau. That is one view.
Some would take the view that whatever it was it was small and not to get excited about it at the beginning. Others say that these things take a long time. They do not take five years but 10 or 15 years to restructure industries and investments. You are only halfway there. Whatever you think you have had out of NAFTA or FTA, positive or negative, you may want to multiply it by two before the end of the day in order to know what you will face. It may well be that what you are now seeing are the seventh and tenth year and the twelfth and the fourteenth year of the effects coming out of the FTA and NAFTA, not something else totally different.
My guess is that much of the NAFTA/FTA effects have been transmitted and that we are in a world now where the only continuing positive benefit we may be getting out of NAFTA and the FTA is a bit of a reluctance on the part of the U.S., given those agreements that are in place, to take strong protectionist steps against us.
Senator Austin: Coming from British Columbia, I should like you to define ``strong.''
Senator Di Nino: Softwood lumber.
Mr. McCracken: Softwood lumber was never in the agreement to start with, which is why they get away supposedly with that effect.
The Chairman: But the dispute settlement mechanism was, and it has not worked.
Mr. McCracken: We are still trying to see how well it will work. Time will tell. It is better than what we had. I was of the view that, in 1986, we would get a good benefit out of talking about the FTA at that time and avoiding trade actions between 1986 and whenever they implemented it. It was less the implementation side but, rather, the fact that you tied them up in terms of moving to further protection when the spirits at that time, if you recall, were very much a move toward protectionism in the United States. I am straying from the exchange rate issue.
The Chairman: I will have to stop you there and give Mr. Carmichael a chance. The committee is pretty focused on the FTA/ NAFTA question because we have held extensive hearings. I think we are pretty knowledgeable about it.
Mr. Carmichael, please proceed.
Mr. Ted Carmichael, Economist, J.P. Morgan Securities Canada: I should to start by drawing a distinction between the near-term issue that we face today with the Canadian dollar appreciating very strongly over the last nine months or so and the long-term issue of whether fluctuations in the Canadian dollar up and down are a good thing for the Canada-U.S. trade relationship and a good thing for the Canadian economy. At the moment, if you pick up the newspaper, all of the attention is focused on the near-term issue. The near-term impacts of the sharp rise that we have seen in the Canadian dollar, which, as Mr. McCracken has said, probably is better characterized as the sharp fall we will have seen in the U.S. dollar against currencies everywhere, is not really a Canadian dollar story that we have been playing out over the last nine months but the U.S. administration backing away from the strong dollar policy they have had for years basically because there is no job growth in the U.S. and the current account deficit is an increasing concern for them.
The U.S. dollar is now actually being talked down by the U.S. administration. They want it to move down and they want Asian currency to move up. However, in the type of sideswipe story that Mr. McCracken mentioned, all currencies are moving up against the U.S. dollar. The Canadian dollar in fact has moved pretty much the same amount as the euro has moved. The difference is that 85 per cent of Canada's exports go to the U.S., whereas the U.S. market, while important for Europe, for Japan and for other parts of the world, is not 85 per cent. It is not the lion's share in the same way. We have this short-term issue that will attract our attention for a while and people will wonder what the Bank of Canada will do about it next week. It is an issue and it is worth talking about, but there is probably a bigger issue in the context of your overall hearings — that is, are these fluctuations up and down in the Canadian dollar over time beneficial for increasing Canada-U.S. trade, making Canada-U.S. trade more stable over time and adding to the ability of the Canadian economy to create wealth, jobs, increase productivity, and so on? Those are two different questions. We can debate the short-term question for a long time about what the Bank of Canada should be doing about this at the moment, but I would like to indicate that I think the longer-term question is one that we should continue to consider as well.
If you turn to page 2 in the blue handout, you will see the U.S.-Canadian dollar exchange rate from 1987 to 2003. We could start out at the beginning of this period, in 1987, which, in the context of your hearings, was about the time we were beginning to reach an agreement on Canada-U.S. free trade that was implemented in 1989. Mr. Crow was the Governor of the Bank of Canada. Interestingly, we started this period with a 75-cent Canadian dollar. During Mr. Crow's period we had some inflation issues. We had a real estate boom. We had very tight monetary policy from the Bank of Canada, with interest rates in Canada four to five percentage points above those in the United States. The Canadian dollar hit its high of 89 cents in 1991 — 14 cents above where it started. Following that, there was a steady downhill move.
Mr. Thiessen took over in 1994. We had the Mexican peso crisis in that period. The Canadian dollar tumbled. Credit-rating agencies downgraded Canada's credit rating because we had a big budget deficit at the time. The Bank of Canada, despite better than 10 per cent unemployment, had to dramatically hike interest rates to try to protect the Canadian dollar. It stabilized for a while, but if you let your eye travel to 1998 on the chart there was much turbulence in the world. There was the Asian crisis, culminating eventually in the Russian default. The Canadian dollar fell to what at that time was a record low. The Bank of Canada again hiked interest rates 100 basis points, despite the fact that there were concerns about the economy at the time. The Canadian dollar recovered slightly.
Mr. Dodge took over as Governor of the Bank of Canada. Canadian interest rates were below those in the U.S. We fell to an all-time low of around 61 cents — interestingly, 14 cents below that 75-cent point. Therefore, the range has been 75 cents in the middle; 14 cents higher to 89 cents; 14 cents lower to 61 cents. In the last nine months or so we have gone back from near the lows up to 75 cents.
What is all the fuss? We are in the middle of the range. This looks okay: not too hot, not too cold, just right.
That is not the way everybody is feeling now because we have gone from near the low to the middle of the range. We have moved up to 15 to 20 per cent that Mr. McCracken mentioned in a very short period of time.
For those of you who have watched the Canadian dollar for a long time, and some of you may have watched it longer than I have, this is the biggest, fastest increase in the Canadian dollar against the U.S. dollar that I can remember and that I think that one could document over the last 75 or 100 years.
Does that matter? Is it good for Canada-U.S. trade? Does that make our trade with the United States in some way more stable? It probably does not. I will not go through every slide in the handout, but I want to start out with the notion that we should question whether or not swings of up to 89 cents, down to 61 cents and back to 75 cents are a good thing or not a good thing.
If Mr. Thiessen had come before you, as he may have done at some point in a previous hearing, he would have talked about the shock absorber role that the Canadian dollar has played. It sounds good because it means that, if you get a shock from outside, somehow or other the Canadian dollar will cushion that shock. It will move in a way that will help us. During his term in office, the case in point that he often referred to, particularly when there were discussions about a common currency with the United States, was the Asian crisis. During the Asian crisis, Canadian commodity prices fell dramatically. The Canadian dollar went down with them. That drop in the Canadian dollar helped cushion the impact on our resource producers of the big drop in the commodity prices. He was absolutely right. In that instance, the floating exchange rate acted as a shock absorber for the Canadian economy.
I want to suggest that at times the Canadian dollar can also impart quite serious shocks to the Canadian economy. That is exactly what we are experiencing right now.
This is not because David Dodge is running a bad monetary policy here in Ottawa. As I mentioned before, it is more because the United States has decided to shift its emphasis away from the strong-dollar policy that it was pursuing before to encouraging the U.S. dollar to weaken against all currencies, and the Canadian dollar is going down along with it.
Is it a good thing for Canada to have this type of sharp movement in the Canadian dollar? My suggestion is that while a fluctuating or floating exchange rate does absorb shocks at times and has helped us out at times, at other times a high Canadian dollar or a sharply appreciating Canadian dollar — or a depreciating Canadian dollar, for that matter — has destabilized the Canadian economy, either because the Bank of Canada has responded with sharp movements in interest rates or because the currency movement itself has been so great that it caused real problems for Canadian industry.
I would like to move along and take you to the chart on page 5, which is the core chart in my presentation. It will take some explanation because I have not walked you through all the charts to get here.
This is a chart of unit labour costs for Canada and the United States. Unit labour costs are basically the cost in Canada of producing a unit of output. There is a red line for Canadian unit labour costs in Canadian dollars; the blue line in the chart is U.S. unit labour costs in their currency; and the green line is the one that makes these lines comparable. We take Canadian unit labour costs and convert them into U.S. dollars.
When we look at Canada's relative cost competitiveness with the United States, the two lines we should focus on are the green line for Canada and the blue line for the United States. Those are in a common currency. That is the way, in my opinion, businesses take a look at Canada. They will say this: ``Let us look at apples against apples. In a common currency, how are the labour costs in the two countries?''
In the early 1990s, when Mr. Crow was Governor of the Bank of Canada, Canadian labour costs even in Canadian dollars were rising more quickly than U.S. unit labour costs. However, with the very strong U.S. dollar that we experienced at time, partly because of that very tight monetary policy, you can see what happened to the green line relative to the blue line. It shot way up. That means that Canadian costs moved up very substantially relative to U.S. costs. We became very uncompetitive through that period.
The net result of that was a longer, deeper recession in Canada than was experienced in the United States. The Canadian dollar fell very sharply and the green line by 1995 comes back down to the blue line. We are back to where we were in 1987 when this chart starts, more in line with U.S. costs. We stayed there for several years, until we got into 1998, when the Asian crisis and the Russian default happened. The Canadian dollar fell to an all-time record low. What happened then was that Canadian unit labour costs fell substantially below U.S. unit labour costs and Canada opened up a substantial cost advantage relative to the United States.
From that point forward, Canadian employment growth exceeded U.S. employment growth. That continued right through last year. That was because, throughout that entire period, while there were many other things happening in the world. China was taking up a bigger share of world trade, Mexico was taking up a bigger share of NAFTA trade, and Canada was so competitive relative to the U.S. that we managed to hold on to our market share in the U.S. market and we were a very attractive place to expand business.
That culminated in 2002, when the Canadian dollar was still down in the low 60-cent type level, with 600,000 jobs being added here in Canada, while about 600,000 jobs were being lost in the United States.
What has happened since then? The Canadian dollar has appreciated very strongly. Our productivity growth has been poor over the last several years. U.S. productivity growth has been strong. U.S. unit labour costs are coming down while ours have shot up. The cost advantage we have had since 1998 has disappeared in the space of nine months.
What does that bode for the future? It bodes a massive adjustment for Canadian businesses now to become more competitive or to hold on to the market share that they have in the U.S.
I will return to my original theme. Is it a good thing for Canada to have the Canadian dollar effecting these big swings in the relative competitiveness of Canadian industry? It feels good in the weak-dollar periods. We can generate more jobs. Even if we have lower productivity growth, it does not seem to matter; our economy keeps booming along. However, if our currency adjusts upward, as it is doing now, we will have to go through a painful adjustment.
In a common currency, we have no movement in the exchange rate. If the U.S. dollar were appreciating or depreciating against the Euro or the yen, the Canadian dollar would be moving right along with it. That would not have any impact on our competitiveness with the United States.
I guess the message I am trying to get across is that, as the chairman said at the beginning, the exchange rate is important to Canada-U.S. trade because it has a heavy impact on our competitiveness with the United States. Right now, the near-term issue is that we have blown away the cost advantage that we had from a low dollar from 1998 through 2002, and our industries will have to adjust to it.
I finish by again agreeing with Mr. McCracken's comment that this will show up in lower Canadian corporate profitability. That will mean lower government revenues, in exactly the fashion that Mr. McCracken said. Lower corporate profitability will mean an end to the hiring boom that we had in Canada over the last several years.
For Canadian companies now facing a 75-cent dollar or, if the forecast comes true, an 80-cent dollar in the next year or so, dramatic productivity improvements will be required, and the way you increase productivity is by investing more heavily and actually downsizing your labour force. This is not a good development in terms of the near-term economic prospects for Canada.
A U.S. recovery is good news; the higher Canadian dollar is bad news. The two will balance themselves out one way or another. I think what you should expect for the Canadian economy for the next while is that after outperforming the U.S. last year, being the sort of miracle economy in the G-7, this currency movement will turn us into an under- performer relative to the United States.
This will leave open a question that kind of disappeared as the currency came back. When the Canadian dollar was at 62 cents heading for 61 or 60, there were many articles in the newspaper wondering whether we should have a common currency, because the next stop was 50 cents. My point to you is that this issue of whether we should have a common currency is as relevant today at 75 cents as it was when we were at 61 cents, because these movements in the currency are destabilizing for trade and the economy. If we have thrown our hats into the ring in North American free trade, then we should follow through, in my opinion, by trying to seek, with Mexico and the United States, a common currency that would reduce these fluctuations that have very dramatic impacts on Canadian business and on the performance of the economy.
The Chairman: Thank you very much, Mr. Carmichael.
Mr. Jim Stanford, Economist, Canadian Auto Workers (CAW): Honourable senators, thank you very much for the invitation to appear before you. I also want to congratulate you on your prescience in scheduling this hearing on the impact of the dollar to occur the day after the dollar reached its seven-year high.
The Chairman: We almost did not make it.
Mr. Stanford: Perhaps I could talk with the chair about how you knew that was going to happen, and perhaps we could make some good investments together on future opportunities that you could forecast with equal accuracy.
I will address a few of the charts and graphs you received in your information.
First, to reinforce the remarks that my two colleagues set out earlier, a huge portion of the incredible and unique prosperity that the Canadian economy enjoyed in the second half of the 1990s and the first few years of this decade is clearly attributable to the fact that our exchange rate was low and undervalued in the traditional sense that economists measure that. That undervalued currency contributed to a situation where our job growth was faster than that of our trading partners, and our standard of living grew more quickly than that of our trading partners. We made up many of the losses in our standard of living that we had experienced earlier in the 1990s, and our government revenues and fiscal situation improved as a consequence of that. In short, things got a heck of a lot better when our currency was weak, which leads us to challenge the traditional idea that your currency is the barometer of your economy. In fact, in many cases, it is quite the opposite. Our economy, by virtually every real indicator you can imagine, improved by leaps and bounds since the mid-1990s, and the fact that our currency was at low levels was a crucial part of that.
I have given you one indication of that with this first graph titled ``The Dollar and Industry.'' The top line is an index measuring Canadian manufacturing employment levels relative to American manufacturing employment levels. Since 1995, we created about 450,000 new jobs in manufacturing, an expansion of over 20 per cent, while the U.S. industry was shrinking, losing over 2.5 million net jobs. Our share, if you like, of total North American manufacturing employment grew by something approaching 50 per cent over this period, an incredible accomplishment in a short period of time.
I have little doubt, given that I deal with companies in a wide range of manufacturing sectors, that the strong cost competitiveness of the Canadian location, which was largely attributable — not solely attributable, but largely attributable — to the value of our currency was a key factor there. Those exchange rates changes, as my colleagues mentioned, clearly dwarfed, again whether positive or negative, going up or going down, the impact of all the free trade agreements we have ever signed on tariffs. Obviously, the scale of the impact on relative prices from exchange rate fluctuations of that scale is quite in another dimension.
In the first years after the Canada-U.S. free trade agreement, we went to great lengths to negotiate some reductions in tariffs on our products, and then we shot ourselves in the foot by increasing the exchange rate by three or four times as much as the tariff reductions that we had gone through such contortions to try to negotiate. We did the opposite starting in the mid-1990s, but in the matter of a few months, we had basically applied an 18 per cent self-imposed tariff on all our exports by virtue of the exchange rate appreciation. Hopefully, that will not be a permanent, self-imposed tariff.
Mr. McCracken went over the potential theories about why the Canadian dollar has appreciated. I differ from my colleagues in placing most of the responsibility for what has happened not just in the current period but in the longer- run period on domestic policy levers over which we have some influence, in particular, the monetary policy issue.
My chart on the dollar and interest rates on the second page shows what I think is a fairly strong link between the Canada-U.S. short-run interest rate differential and the level of our dollar. As that interest rate differential reached peak levels in the early 1990s, obviously our exchange rate appreciated to peak levels. As that differential eased off after the shift in monetary policy that accompanied Governor Thiessen's appointment, the dollar eased off. As we ended up in a tough situation, a near recession in the mid 1990s, the Mexican peso crisis, the effects of fiscal drag from spending cutbacks, we actually cut our interest rates below U.S. levels for the first time in years, and our dollar sunk accordingly. Clearly, that does not explaining everything.
Mr. Carmichael is correct in pointing out the impact of international instability on our dollar and so on, but the fact that interest rate differentials are now back up to their highest level in several years is an obvious and immediate and self-controlled explanation for why our dollar has risen up to the highest level in several years. Our interest rates are now almost two points above U.S. levels, and in the financial world, if you can make two points additional interest on short-term investments on one side of a line drawn across a continent rather than the other side, then you know where people will put their money, and that inflow of financial capital is driving the exchange rate up.
I do not accept the mumbo jumbo arguments that Canada's strong fundamentals have finally been recognized by world financial markets. These guys are paid big bucks to stay on top of developments on a moment-to-moment basis. It does not take them seven years to figure out that we have balanced our budgets. I do not attribute this appreciation to the fact that our fundamentals have improved. I see it as a more direct and immediate consequence of the decision by our Bank of Canada to attack inflation aggressively earlier this year. In retrospect, that has been proven to be a false alarm. Inflation has eased off faster than they and others have expected.
The consequence of that decision to move away from U.S. rates as aggressively as they did is with us today. The bank has eased a couple of times since then, although ironically, on September 3, they cut the rate another quarter point. They gave with one hand but took back with the other, because the bank signalled quite clearly to financial markets that that was it for rate reductions, which is a decision I do not understand. Since then, of course, the dollar has swung back up another three or three and a half cents. I am concerned that the Bank of Canada reconsider its approach here before more damage is done.
The next chart, ``The Dollar & Auto Investment,'' is my way to address a frequent hypothesis that is often called the ``lazy manufacturers hypothesis.'' It is the idea that the low dollar we had in the late 1990s coddled Canadian-based manufacturers into doing business in unproductive way. We did not hold their feet to the fire and they were able to compete in international markets, thanks to the dollar. They did not worry about labour-saving investment, productivity changes or technological advances. That hypothesis is untenable, theoretically. The level of competition amongst Canadian manufacturers is incredibly intense — there is no gentlemen's club where they sit down together to talk about the economy. They are out to eat each other's lunch. Moreover, anyone can come to Canada and take advantage of those relative low prices with a low dollar and still use new technology and new productivity to improve their profit margins. Theoretically, it does not make sense.
The policy implications of the lazy manufacturers hypothesis are absurd. Government could solve the problem by simply imposing a lazy manufacturers tax on all manufacturers of about 10 or 15 per cent, to offset the savings they receive from a low dollar, thereby holding their feet to the fire. What would be the response from manufacturers if you were to do that? Alternatively, all manufacturing workers could receive an extra 10 or 15 per cent wage increase to make up for the savings they receive from the low dollar. Would that strengthen our industry? I am never one to argue against wage increases, of course, but they are unlikely to occur.
In fact, there are many cases in which the low dollar, because of its impact at improving the relative cost competitiveness of Canadian location decisions, enhanced our productivity by attracting the kind of investment — machinery, equipment and new technology — that makes us more productive. I will give an example from the auto industry. The graph before you shows machinery, equipment and structures investment in the auto assembly sector — the core of the industry. Record levels in the second half of the 1990s of over $3 billion per year, on average, were invested in fixed capital in the assembly sector. The benefits of that investment were not only jobs, production and exports but also productivity. Most Canadian assembly plants were retooled because automakers were looking at Canadian locations as highly profitable and cost effective. The result is that auto assembly is one of two or three manufacturing sectors where Canada is more productive today than the U.S. We have a 10 to 12 per cent productivity advantage in Canada versus the U.S. assembly sector. It is the only industry where that is the case. That strong inflow of investment, attracted by our low dollar, is the reason for that.
There is also a cash-flow effect. The higher dollar will reduce profit margins, which means you have less money to spend on equipment and investment because most investment is financed from retained earnings within the firm. I do not accept the idea that the low dollar harmed our productivity. In fact, I think I can make a case, not universal, that it actually strengthened our productivity.
In terms of the core issues of the committee, senators, and the impact of the dollar on trade flows, the next page of the presentation will show you some of the immediate impacts that we are experiencing with the current appreciation. Obviously, there are short-run impacts and long-run impacts of the rising dollar on our trade flows. For any commodity priced in U.S. dollars, an appreciation immediately means that the Canadian value of those exports is reduced. There is also a short-run impact on shipments from manufacturers who find they cannot profitably supply. There is a longer-run impact once the higher level of the dollar becomes integrated into the investment location decisions that companies are making. If they decide that the dollar is here to stay at 75 cents, or perhaps higher as some analysts are speculating, then they reconsider Canada as a location for those new investments.
Certainly, they were not assuming the dollar would stay at 62 cents or 65 cents over the long run. Everyone recognized that that was not a permanent result, but they certainly were not counting on it going up to 75 cents in terms of the internal planning processes of these major manufacturers.
We have already seen a dramatic impact on the sectoral makeup of our trade flows with the rapid rise in the dollar. The Automotive products sector has been the hardest hit by the run up in the dollar. We have seen a decline in the net exports of Canadian automakers — assembled vehicles and parts — of 50 per cent in the first six months of this year, compared to the levels one year ago. That is a 50 per cent decline in the net trade surplus.
The auto sector is one of the only high-value industries where Canada has traditionally enjoyed a trade surplus. In most high-value or high-technology sectors, we import more than we export. The auto sector is an exception and we have traditionally relied on a strong trade surplus to finance some of the trade deficits we have in other value-added sectors. Half of that trade surplus has disappeared. I predict that if we stay at this 75-cent level or higher we will become a net importer of automotive products — we will import more than we export within five years.
Those are worrisome implications for Canada's industrial structure. Our exports of energy products and other resources are booming, with the exception of lumber, of course, unfortunately. Our exports of value-added, or more technology-intensive products, are suffering badly. If I could perhaps paraphrase one of North America's newest politicians, this is what we would say about Canada's automotive trade surplus if the dollar stays at 75 cents or higher: ``Hasta la vista, baby.''
On the last page, we will address the matter of where the exchange rate should settle. I heard Mr. Carmichael's suggestions or comments on the troubles that the volatility in exchange rates plays. I disagree with the conclusion that, therefore, we should consider a common currency. The policy independence granted by the exchange rate, as well as the shock-absorbing features of it, are important, particularly if we were to consider a monetary union or common currency because we would lose the ability to set domestic interest rates. That would be a huge mistake.
However, if we have this independence, then we have to sensibly manage it. I should like to see the monetary authority — the Bank of Canada — pay more explicit attention to the exchange rate, recognizing the importance of some kind of sustainability and stability in the exchange rate. It does not have to be a fixed rate system, but it could be one of the policy variables that they would take into account, rather than focus solely on interest rates and inflation.
My argument is that given current nominal compensation levels in Canada and the U.S. in manufacturing — the crucial export or traded goods sector that we have — and given the continuing gap in productivity levels — auto is an exception — of about 15 per cent lower than in the U.S., we need an exchange rate of U.S 72 cents or lower so that we can maintain the absolute level of unit labour costs in Canadian manufacturing at a competitive level. When the dollar is higher than 72 cents, then there is an incentive for manufacturers to shift production back to the U.S. Below 72 cents creates an incentive to expand Canadian operations. That is exactly what we saw, to our great benefit, in the last half of the 1990s. With the Canadian dollar at U.S. 72 cents, there is an incentive to stay put.
I am not sure that tells the whole story, but that is a rough benchmark. I am hopeful that the Bank of Canada, with our collective advice in the background, will begin to think about their actions on interest rates with an eye to maintaining the exchange rate at 72 cents or, preferably, a little lower, if our goal is to expand that high-value sector of our economy.
I thank you for your interest and patience and we all look forward to the discussion.
Senator Austin: Thank you all for a fascinating set of presentations. There are so many topics raised by you — from the Chinese currency to the common dollar to the competitive test of the Canadian dollar — that it is a dilemma where to start. However, I have made up my mind where I should like to start. I wish to take Mr. Carmichael to page 4 of his blue book, because you say there something I have been taught, namely: ``Periods of poor productivity growth tend to follow periods of C$ weakness, while C$ strength has tended to stimulate productivity.''
Mr. Stanford said just the opposite, if I understood him correctly. I wonder if I could ask the two of you whether you are saying different things, or whether there is some common meeting ground in what you are saying?
Mr. Carmichael: I am not sure if there is common meeting ground. Looking back at that history on the Canadian dollar, the periods when we have seen a very high Canadian dollar, when our costs got out of line, we had to correct that. There were two ways of doing it: with a big adjustment in the exchange rate, which happened after 1991; also, with an improvement in productivity, which happened in the years following that economic downturn.
You might remember that the recovery of the early 1990s was the first time we referred to something called the jobless recovery. That was true in the U.S., and it was even truer in Canada for quite a number of years. In other words, we were still in our economy trying to adjust to that high dollar period and the dramatic deterioration in our relative cost performance that had happened. The currency coming down was part of what did that. However, we had to have a rebound in economic growth without any real employment growth for several years before we got the productivity improvement that helped us get our labour costs back in line.
The weak Canadian dollar period that we experienced from 1998 through 2002 — Mr. Stanford mentioned that this was a period of very good economic performance for Canada. It was, but it was a period that has ended with Canadian productivity being much weaker than productivity growth in the U.S. In other words, the low dollar actually encouraged more hiring and less investment in productivity-improving technologies than might have been the case if the dollar had not gone as low as it did.
What I am suggesting, looking at that chart on page 4, is that we are now going to head into a new period in Canada where the productivity line will do what it did back in 1991. After a period where it was very weak, it will now start moving up. We will probably get a convergence again back in productivity growth in the two countries. That will come about because a low dollar in the U.S. will stimulate hiring there, and their productivity growth will slow down; a high dollar here in Canada will slow down employment growth, and our productivity will pick up. That is the point that I was trying to make.
As to how it squares with Mr. Stanford, some of this is the leads and lags of currency movements, and then the adjustments that take place in the economy afterwards. Mr. McCracken mentioned that it takes some time for a free trade agreement or a big currency adjustment to feed through. We should not be looking for the effects over the next three to six months; we should be looking over the next two, three and four years for these effects to play out. I would say that the high dollar period and the high labour-cost period we had in the early 1990s played out with very weak employment growth in the early stages of our recovery in the 1990s and that the low dollar that we had in the late 1990s played out in better employment gains here in Canada than in the U.S. through 2002. However, what we are now going to head into is a kind of a reversal of that period, now that the currency has moved as much as it has.
Senator Austin: I have always believed that the Canadian economy had to be relatively similar in productivity with the U.S. economy to maintain investment interest in Canada — and also to give Canadians, as consumer and citizens, an assurance that their net worth, their purchasing power parity, was reasonable in terms of the people across the border.
Now I should like Mr. Stanford to comment on these propositions, because what you say is very challenging.
Mr. Stanford: A couple of responses come to mind, senator. First, I think I could probably tell a slightly different story from Mr. Carmichael's graph. Again, that is where you never meet a one-armed economist; you always have to have one hand on the other hand. The strong dollar period under Governor Crow at the Bank of Canada started in 1988-89, and then ended as we were in the depths of recession in 1991-92, when they started cutting rates and the dollar came down. That high dollar period that corresponds with the falling productivity portion of Mr. Carmichael's graph.
What I consider the period of the low dollar, the undervalued dollar, I would date back to 1995, when we started increasing our share of North American manufacturing. Up until last year, on Mr. Carmichael's graph, we matched U.S. productivity growth. There is something happening to U.S. productivity right now that is hard to understand.
I will tell you one way you can dramatically increase productivity in your economy. Go through and identify the 50 per cent of firms that are less productive than the others and shut them all down. You will get an immediate and dramatic impact in productivity. That is not quite what has happened in the U.S., but it is something like what has happened there. Certainly, it has happened in the manufacturing sector, where the cost competitiveness of U.S. manufacturing has been so out of whack with its competitors, including the new competitors in the China and elsewhere in Asia, that they are shedding jobs and closing plants in a massive way — and obviously you start by closing the least productive ones. I do not think that is all that is happening in the U.S. — the productivity growth there in the last year has been spectacular, if you believe that productivity growth is the goal. Unfortunately, it is translated solely into job loss, because there is not enough demand to put those people to work.
Senator Austin: What about Mr. Carmichael's point that the next step will be an enhanced employment statistic in the U.S.? New jobs will be required in order to meet the more buoyant economy that is being developed.
Mr. Stanford: You could see some of that. Initially, that can actually translate into sustained productivity growth. If employers have a little bit more labour on hand than they really need, because they did not cut to the bone, then initially you will see the new demand being reflected in overtime and just more intense utilization. However, down the road, you should see some employment. Whether we will get a boost again in our productivity levels as we did starting in 1991-92, I suspect we might — but it might be for the wrong reasons. It might be because of the toll that we are imposing on a very large proportion of our industry.
Senator Austin: I would conclude with the observation that I would hate the message to Canadians to be that we are in a permanent lower purchasing power capacity than the American consumer in order to run our economy. That is not an easy message for a government to deliver, but I appreciate your views and I know this subject is very difficult.
Senator Di Nino: That is fascinating. This is a debate on an issue on which I suspect, if we had five or six more economists, we may get five or six more different opinions.
Senator Graham: You would need more arms.
Senator Di Nino: That is true. It certainly gives us a challenge trying to come to some conclusions on this as well.
I have a couple of questions, one in general, and I invite anyone to speak about it. Most of the discussion this evening has talked about the manufacturing and trade sector dealing with Canadian-American relationships and buying and selling products. Very little has been said about the effect that the recent changes in the Canadian dollar will have on investment of U.S. dollars into Canada — foreign direct investments and other types — in particular the trend that we have seen in the last few years of Americans and other folks from other countries, but principally Americans, buying Canadian companies. I would like a commentary on that, at least for my benefit.
Mr. McCracken: Certainly, the net effect is that, if you are buying in U.S. dollars, companies are going to be more expensive now than they were. I think you will perhaps see less of the purchases of existing assets. A lot of what goes on, and much of the foreign direct investment that we measure, is investment by foreign-owned companies who are already here in Canada. When they increase their investments here, that shows up as if it were new foreign direct investment — but in fact it is not. Indeed, it happens almost automatically, because what we do is all of their earnings are shown as having been repatriated. Then we hold on to the retained earnings and count those as having come back into the country. To the extent that this appreciation dampens down retained earnings and corporate profits, you will see some diminution of that flow.
The tough question is this: What about the translation of that financial action that we just described into real capital investment — the machines that were being talked about before? Keep in mind that the price of machinery and equipment in the U.S. is now cheaper, indeed, even cheaper than that made in Canada because they are competing against those same companies in the U.S.
We find that there is a substantial offset where we have made machinery and equipment more attractive to encourage investment in Canada. Whether it is enough depends very much on what the adverse effects on the industry are. Industry, like the auto sector, may have a tough time justifying going ahead, even though it is now cheaper with new investments because they are facing a situation in which they have lost 100 per cent, if you will, of any exchange rate appreciation in their revenue side because they are basically operating in U.S. dollars.
In other industries, though, they may find it quite attractive. Some of the service sectors and parts of the manufacturing sector, which are competing not against the U.S. but other parts of the world, may say, ``This is an opportunity for us to belly up and improve our capital equipment, now that we have 15 per cent off on all that capital equipment.''
It will be a mixed bag that you see occurring. Keep in mind that we have been appreciating vis-à-vis U.S. dollar, but depreciating against some of the other currencies — those other currencies can come in now. You may see European investment pick up in Canada. You may see Japanese investment picking up into Canada.
Those are the other directions. We are not tied into old shares or into the same sort of sources, and the magic 80-20 rule does not necessarily apply.
Mr. Carmichael: From an investment bank's perspective, we have a corporate finance group and a markets group here in Canada. The corporate finance group would see activity relating to mergers and acquisitions. What would be seen by our investment banking group is more the foreign direct investment type of flows. Our markets group would tend to see investments coming into Canada where investors are looking strictly for a financial play, a higher interest rate, as Mr. Stanford was mentioning, relative to what is available in other countries, or a play on a rising Canadian dollar. They might want to be in Canada to take advantage of that appreciation.
Over the last year, by far the most foreign interest in Canada has been either to take advantage of higher interest rates here or to take advantage of an upward ride in the Canadian dollar against the U.S. dollar. These are short-term investments that do not necessarily, and often do not at all, contribute to longer-term direct investment and productivity improvement.
On the other side of the coin, as Mr. McCracken correctly said, Canadian assets are more expensive, mainly for the U.S., who are the principal investors in Canada. Mergers and acquisitions activity fell a couple of years ago and does not show any signs at the moment of picking up.
At the moment, the kind of capital you are attracting is the short-term portfolio flows and not the longer-term flows. This is part of the adjustment to a higher Canadian dollar.
I would agree with other points Mr. McCracken made that for some sectors a higher Canadian dollar is attractive on the services side.
Senator Di Nino: Before I ask Mr. Stanford to speak, would it be correct if I used the word ``passive'' FDI, foreign direct investment, versus active FDI, passive being money that comes in on a short-term basis to buy the dollar and ride with it, or to buy some bonds, as opposed to money going into buying machinery to increase productivity, or products being produced, et cetera? Is that a good term for my own use?
Mr. McCracken: I think you would be better saying ``portfolio investments,'' looking for high returns and speculating on the dollar, and the other being direct investment. Direct investment is where you have an ownership position. You own more than 10 per cent of the company and have control. We do not know in either case whether it translates into bricks and mortar because it is a separate transaction. A company will raise the money and someone has to say, ``Order the bricks and mortar.'' That is investment of another kind that has a completely different moniker in some sense.
Mr. Carmichael: It is not just the international investors who might be looking at direct investment. It is the Canadian investors who are of much bigger importance. It is a deer in the headlights when the currency is moving up as much as it is now, as far as putting new investment into Canadian plants. Is the currency going to go back to 65 cents? Or will it go to 80 or 85 cents? If there is uncertainty about that, you will not see domestic or international investors getting into that type of long-term investment.
Mr. McCracken: Going the other way, though, is attractive. If you were looking, hypothetically, for an insurance company in the U.S. to buy, it has suddenly gotten 10 per cent cheaper.
Mr. Stanford: For a corporation with multinational operations, and which is multinational in scope, this issue that the higher dollar makes the real capital equipment less expensive, I do not think comes into play. A company like Ford or GM will buy their equipment and they are their thinking in U.S. dollars. They will buy it from the same supplier and it is a given. The only impact, then, of a higher dollar is on their variability costs, that is, mostly the labour costs and the other variable costs of operations.
It is often stated that there is a plus and minus vis-à-vis investment. The higher dollar makes the imported capital equipment cheaper, but makes the cost of production here more expensive. For any corporation, Canadian or foreign, that is multinational in scope, it is only a negative. They have a fixed price they pay for the equipment. The only choice for them is where they will put it.
Senator Di Nino: Mr. Stanford, your dollar and trade graph paints a pretty bleak picture of the auto industry, that is, the effect that the increase in the Canadian dollar has had in the short term to the auto industry. We heard yesterday from the Bank of Canada something different. They suggested that, because the auto industry has such a large foreign component coming in from the U.S. in particular, the impact on that industry may be less than on some other industries. You are arguing the opposite. Can you comment?
Mr. Stanford: Perhaps I should invite some Bank of Canada officials to take a sabbatical and work hands on in the auto industry for a while. Senator, I honestly do not understand the logic of that. This is an industry where cost competitiveness is important, both in the short-run sense and in the long-run investment allocation sense.
To be sure, because auto is one of the industries where we have a productivity advantage over the Americans, it means that a good portion of industry could tolerate a higher exchange rate better than Canadian-based manufacturers in other industries. On the other hand, it is such an integrated industry, 90 per cent of what we produce is exported and 99 per cent of that goes to the United States. The impact of the fluctuating Canada-U.S. exchange rate is dramatic, and I think the data bears it out.
Our automotive products trade surplus in the last half of the 1990s was in the order of $20 billion per year. This year, we are looking at, perhaps, $7 billion or $8 billion. That will have impacts on our whole current account situation. It is not all attributable to the dollar. What has happened this year is important.
Senator Day: Gentlemen, I will start with Mr. Carmichael's comment that we should not be abandoning discussions about a common currency. Rather than a common currency, I would be interested in your comments on fixing the currency at a percentage and reacting to Mr. Stanford's comment about 72 cents and using the exchange rate spread to maintain that, or would you consider fixing and then using the interest rates for inflationary purposes? Basically, Mr. Stanford said to forget about the use of interest rates to fight inflation, that the spread is a more important thing. That is the way I understood the comments.
Mr. Carmichael: If I believed that we could fix the Canadian dollar at 72 cents and that it would stay fixed and be a stable arrangement, I would say that that would probably be a good idea and that we should do it. International experience, however, seems to show that fixed exchange rates, whether they have been in Canada or in other countries, come under pressure and eventually do not hold. Sometimes, they lead to exchange crises that lead to great destabilization in the economies in question.
That is even true for a country like Argentina, which adopted the U.S. dollar as its currency but became unstable and could not hold on to the peg they set. At the moment, you might say that the same thing is happening with China and with Hong Kong, that is, that their currency pegged to the U.S. dollar is something that cannot hold.
I not have a problem with 72 cents. Right now, it is a better level than 61. It is a better level than 75. If we could go there, pin it there and it would stay, that would be fine. International experience has shown that the only way markets will accept that something is really fixed is if you do what they have done in Europe — in other words, adopt a common currency and pledge yourself to that. It is still always true that a country could decide at some future point that it wants out. However, if markets have gone to a stage of converting to a common currency, obviously the problem for us is that we have one big player in the United States that is not really interested in us, or Mexico. That makes the whole common currency idea more difficult.
I still believe that just because the currency has moved up it does not mean that we should drop this whole idea of whether or not it is a good thing for Canada. In the context of your hearings and looking ahead 10 years for how Canada-U.S. free trade and NAFTA is going to play out, vis-à-vis the best arrangement for trade to be stable and a positive force for Canada we should be looking over a longer-term horizon to how we could come to some kind of agreement among the three countries to arrive at a stable exchange rate. I have a paper here that goes through some suggestions of how you might get there if all three parties thought it was a good idea. It is obviously not an easy thing to do and it will not happen tomorrow.
Mr. Stanford: Senator, I am in accordance with the consensus view among most economists that a fixed exchange rate is actually the worst of both worlds. You lose the shock-absorbing capability of a flexible exchange rate, but you actually do not gain the sort of long-run institutional security and stability in financial markets that a formal currency union would have. Therefore, I am not advocating fixing the exchange rate at 72 cents. This is just a benchmark level upon which the Bank of Canada needs to balance its targeting. Yes, by all meanings look at inflation and the state of the domestic economy, but look at the exchange rate as well as one of the factors when you make your decision. That is why I believe a broader and more flexible monetary policy rule, rather than the strict inflation-targeting thing, is actually the more pragmatic and prudent approach.
In terms of the common currency issue, the thing to remember in North America is that, first, even if there were a common currency rather than dollarization, it, in effect, is the same as dollarization. Canada and a common currency might get one seat on the Federal Reserve Board, and that would give us as much sway as the Midwest or the North Central region or California — God help us — over what happens in the U.S. Realistically though, the Americans will not cede any control over their monetary policy to foreigners.
It is really a question of dollarization — us unilaterally accepting the U.S. dollar as our currency or sticking with what we have and, again, the international evidence points strongly to the latter.
Senator Graham: Could we have Mr. McCracken's views on a common currency?
Mr. McCracken: I am more practical. If it is at parity and they are prepared to pay it, as when the East Germans got taken over by West Germany, then that is a good deal. We would all become roughly 30 to 40 per cent richer if we have assets at all.
The reality is that acceptance of a common currency is not the end game. It is a step involving integration in lots of other areas. Do not forget that in the case of Europe there is a common parliament. There are rules and regulations that spread across the entire union. There is an economic union. There is freedom of mobility of people, at least for work purposes.
There are many other aspects as well. If you want to talk about ``a common currency,'' you want to talk about whether we want to have a common Senate, for example, whether we will essentially erase the borders, with no pay adjustments, of course. Those are the tricky issues that come up and it is the kind of thing that is not done overnight. It is done overnight only when the stress is there, but it took Europe 30 years, 40 years, and it is still going on, to complete the process they are going through.
In the meantime, we ask the question, and I thought quite nicely as raised by Mr. Carmichael, we have this variance, this exchange rate jumping around. If there is one group in this country that are supposed to be wizards and that can cope with variation, it is our financial geniuses in the banks and major exporters and importers. These are all big puppies. They can sit down and make a forward contract to lock in an exchange rate — one year, two years, three years; I do not know how many years forward now they can do it. They are unhappy they did not do it in some cases at the moment, but that is their financial fault. There are big players. They can handle variation.
If out of that variation we also can get adjustments taking place in the trade flow, which means not just on our side but in other countries adjusting for what has been set up by that change in the exchange rate as well, then that is probably a rough justice or a good compromise over a situation in which we would have to take all of the heat from an external shock. I think that is Mr. Stanford's point, and most other economists are saying that we think that a flexible exchange rate system is a good shock absorber.
On given days, we pray that we would accept the U.S. monetary policy and, my God, we would sign up and run. There has to be, with hope, some other days in our future where we will be glad that we have the monetary policy that we have here, in contrast to what is there in the United States.
Stick with a flexible exchange rate. Canada led the world in that regard in the post-war period, with the flexible exchange rate from 1950 through 1961. It stood us well. We subsequently went back to it in 1970 alone. Again, it stood us well. We were forced off the fixed rate we had in the 1960s, and then the world moved to flexible rates in the 1972-73 period.
We have something that is a winner. We should focus our attention more on what are the rules by which we want to conduct monetary policy. What are the objectives and goals of our society? Surely we can do better than focus simply on the CPI.
The Chairman: The common currency is a really another story.
We are trying to keep our focus on Canada-U.S. trade. With respect to the common currency issue — I know Argentina very well. Ecuador is another country that is dollarized, and it is a fiasco. It seems to work in small places like Panama, Hong Kong, Singapore, and places like that. As we all know, not every country in Europe wants to be part of the euro. The deficit problem in Germany and France may well have a negative effect on that scene. However, that is not what we are here for. In 1988, about 76 per cent of our exports went to the United States. That figure is now about 86 per cent. It has risen by 10 per cent approximately.
When we talk about foreign direct investment, the fastest growing foreign direct investment comes from the European Union, I believe. It is growing quite rapidly.
Let me just concentrate for a moment on our exports. It sounds to me that you are saying things similar to what our witnesses yesterday said. The exchange rate went up to 88 cents or 90 cents, and then went down to 64 cents or 63 cents, as low as 61 cents, but very briefly. You would expect that if that happened our exports would increase. Everyone seems to agree that they would increase. I guess the question is by how much and whether that reflects much of that 10 per cent. Is much of that 10 per cent reflected in the exchange rate? If the exchange rate starts to go up — Mr. Carmichael talked about the Americans giving up the strong dollar policy, and there are all kinds of other side elements to it — to what extent is that going to affect our exports? Not to exaggerate, but would they go back down to 76 per cent, which is what they were in 1988? Is that a possibility?
Mr. Carmichael: I will send to the committee a chart I have that looks at Canada's real exchange rate against our real net exports. I shall describe what it says. When the Canadian dollar was at its high point, at the 88- 89-cent level, Canada's real net exports were in a deficit position of about 2 per cent of GDP. When the Canadian dollar got to its low point, we were up in the 5 per cent to 6 per cent of GDP surplus. We went from a 2 per cent of GDP deficit over a period of seven or eight years to a 6 per cent of GDP surplus.
Mr. Stanford's information on the auto industry is part of this story. We have already started turning that around. We have gone from 5 per cent or 6 per cent of GDP to 4 per cent. Where we are heading at the current exchange rate level I think is down to 2 per cent. This means that this is not just a story of exports. It means that, in going from a deficit of 2 per cent to a surplus of 6 per cent, our exports were growing faster than our imports throughout that entire period. We will now go into a period where our exports will be growing slower than our imports. Imports are cheaper for Canadians. We can buy more U.S. product today with our $100 Canadian than six months ago. Hence, we will be importing more. The growth of our imports will be higher than the growth of exports. Our net trade position will deteriorate, and it really depends on how high the dollar goes. If it goes back to 89 cents, we will probably go all the way back to a minus 2 per cent of GDP real export deficit. That would act as a major drag on the Canadian economy over a period of several years, just as moving from minus two to plus five was a major boost to the Canadian economy — which is what Mr. Stanford's presentation talked about.
Mr. McCracken: If you are interested, I can send a table outlining the more precise numbers of what our models would say of an effect of an appreciation or depreciation after two, five or 10 years, and so on.
The story is a simple one. If you have a 10 per cent appreciation or depreciation, and if you think it is symmetrical, then you are going to get a change in exports down. Let us assume that we are talking about, say, a 10 per cent appreciation, you will lose something on the order of about 2 per cent on your real exports. Over time, that will be less, perhaps something in the order of 1 per cent after five or six years. Keep in mind that what is happening is that your wages are growing less rapidly, your unit labour costs are coming down, you are restoring some competitiveness loss in a period of an appreciating exchange rate.
On the import side, the much bigger story is happening. There you would see a 4 per cent real increase from a 10 per cent appreciation. If you want to see it in current dollars, as a rough rule of thumb you would get a deterioration in the current account of about 1 per cent of GDP after two or three years, about $10 billion in the current world, from a 10 per cent appreciation. If you want to flip it the other way, if you had a 30 per cent depreciation over that period, you might attribute something like 3 percentage points of the increased current account surplus to the depreciation. The balance, you could attribute, positive or negative, to the net effects of your trade agreements, because that is the other thing of course that is going on over this period, as well as a number of other factors. All we are doing here is holding everything else constant and changing the exchange rate.
We have a study forthcoming. One reason we are doing it is that we want to see the effect of putting in different interest rate rules. If the Bank of Canada acts in a sensible way, we believe that will tend to mitigate the adverse effects of the exchange rate swings. If that would be of help to you in sorting this out, I would be happy to provide it in a simple set of rules of thumb.
The Chairman: I have to make one observation. A trade agreement does not mean that we have just agreed to buy60,000 pairs of shoes. It means that it is an environment in which to buy shoes. The agreement itself does not guarantee anyone buying or selling anything.
Mr. Stanford: Your initial question, senator, was focused on the composition of our exports rather than the aggregate level of them per se. On that subject, while the current appreciation will put downward pressure on exports, stimulate imports and reduce the trade balance, ultimately into the red if it carries on far enough, I am not sure it will have much of an impact in reversing that concentration of our trade with the U.S. as our main trading partner. Structurally, in the 15 years since the Canada-U.S. free trade agreement came into effect, it would tend to be quite resistant. The fact that our dollar is rising against the U.S. dollar but not so much against other countries in and of itself will lessen the negative impact of the appreciation on our exports to those other countries.
On the whole, structurally, in terms of management outlook, the degree of integration and supply relationships, I suspect that the era in which 90 per cent of our trade is with the United States is probably here to stay, regardless of where the dollar goes.
Senator Sparrow: This relevance may be important. I cannot remember the year but the Governor of the Bank of Canada was probably Mr. Crow. We were continually, almost frantically, buying up the Canadian dollar as it continued to drop in value in an effort to boost its value. We have not done that in the last few years. What has happened? What is the change of attitude such that that does not happened any longer?
Mr. Carmichael: The most recent incident of that was in 1998. During the period of the Asian crisis and the Russia default, the Canadian dollar fell not to a record low but sharply. The Bank of Canada at that time was still intervening in the foreign exchange market by buying Canadian dollars when it was experiencing severe weakness. During the space of one month, in August 1998, the Bank of Canada used up about $5 billion of its foreign exchange reserves to virtually no effect. If there were a measurable diminution of the weakness of the Canadian dollar, it was impossible to know. They had about $30 billion in U.S. foreign exchange reserves. That would have meant that, at that rate, the Bank of Canada could have continued buying up Canadian dollars for six months. It still would not have had a great effect.
After that, the Bank of Canada put out a notice that said they would no longer intervene in foreign exchange markets to try to smooth out the value of the Canadian dollar. All of our studies have demonstrated that it is not effective and that foreign exchange markets are too large. The flows of foreign exchange markets are too big for the Bank of Canada to have a material impact.
We heard one week ago that the Bank of Japan spent U.S. $40 billion in the month leading up to September 26 to try to keep the yen from appreciating against the U.S. dollar. Similarly, it had no effect. I believe the Bank of Canada will not re-enter that game and I do not think they should.
Mr. McCracken: They have other instruments, and do not forget that they can also use interest rates. They do not use their actual buying and selling but rather they set interest rates higher in Canada than in the U.S. That will attract sufficient private-capital flows into the country to more than create the suitable upward pressure on the exchange rate. They do not use the reserves any longer because they have more effective instruments, and they do not have enough reserves.
Senator Sparrow: It does not move the interest rate as rapidly.
Mr. McCracken: The Bank of Canada can move the rate up quickly.
Senator Sparrow: Is the effect slower?
Mr. McCracken: No, I think it is quicker because they are motivating more dollars — $20 billion to $50 billion — over the transom very quickly. The sheer magnitude is that we trade several hundred billion dollars per year and capital flow movements are in the order of a $1 trillion. That is about five times the flows in both directions. All the action is on the capital flow side, and they are all seeking two, three, five or 10 additional basis points of return. It is a highly sensitive market.
The Chairman: I thank you for a stimulating evening.
The committee adjourned.