Proceedings of the Standing Senate Committee on
Foreign Affairs
Issue 19 - Evidence, October 21, 2003
OTTAWA, Tuesday, October 21, 2003
The Standing Senate Committee on Foreign Affairs met this day at 6:00 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 wish to welcome, from Export Development Canada, Mr. Stephen Poloz, Chief Economist; from the Centre for the Study of Living Standards, Mr. Andrew Sharpe, Executive Director; and from RBC Financial Group, Mr. John Anania, Assistant Chief Economist.
Gentlemen, you will be aware that the committee tabled in June Volume 1 of our review of the Free Trade Agreement. That raised the question of to what extent exchange rates affect Canada-U.S. trade. We have already had some very interesting evidence on that. We are delighted that you could take the time to appear here this evening.
The subject is not only interesting but also very timely because the U.S. dollar has dropped quite dramatically over the last six months.
Mr. Stephen Poloz, Chief Economist, Export Development Canada: Thank you very much for having us at your committee today, Mr. Chairman. I provided a written brief to the committee 10 days ago. I will not repeat that material in depth. I would rather highlight the main points to provide time for discussion.
The question before us is how the exchange rate affects Canada's trade and, therefore, how it affects economic growth in Canada. The question is deceptively simple for economists. To put it concretely: What is the effect of the recent 15 per cent rise in the Canadian dollar? Theoretically, this is a pretty simple question. An appreciation of the Canadian dollar reduces Canadian exports and boosts Canadian imports, therefore reducing our trade balance and lowering our GDP growth rate.
The rule of thumb economists would generally use for Canada is an elasticity of point 3. To translate that, a 15 per cent appreciation would mean something like 5 percentage points, less economic growth, in the following year.
Economists are famous for adding a qualification to that answer, that being, assuming that everything else is held equal. Everything else being held equal is a crucial assumption and is, of course, one that fails every time.
Almost any disturbance in the domestic or global economy can be shown to affect the exchange rate in some way. Those disturbances also affect Canada's exports, trade and economy. That means that an exchange rate adjustment will affect the economy in different ways depending on what is causing the exchange rate to move. What other things are happening at the same time? It is very possible, for example, to see a rising Canadian dollar with rising exports or a rising Canadian dollar with falling exports. Each of those two things can happen as easily as the other, depending on what else is occurring at the same time.
In the real world, there are lots of things happening at the same time, which makes it fundamentally impossible to answer this question in the way it is normally posed.
I am talking about things that affect both the exchange rate and the Canadian economy such as interest rates; economic growth, either here or in foreign economies; changes in fiscal policies, either here or in foreign economies; fluctuations in world commodity markets — a very important driver; and, changes in perceptions of risks in various economies, including our own. There is a long list of such variables.
The question is much more complicated than it looks. This would be true even if the world had not changed in the past 20 years. However, the world has changed a lot in the last 20 years, and that bears on the question you asked.
The economists' theoretical model of the exchange rate effect on the economy assumes also that Canada's exports are priced in Canadian dollars. In the real world exports are usually priced in U.S. dollars. That means that when the Canadian dollar appreciates, the U.S. dollar price of those exports is still a fixed number. It is in the contract. The textbook assumes it is the Canadian dollar price, therefore, it automatically moves when the Canadian dollar moves. However, in the real world, the Canadian company has agreed to a U.S. dollar price. When the Canadian dollar appreciates, it means that the Canadian company — the exporter — receives fewer Canadian dollars in exchange for that contract.
The foreign buyer does not see a change in price — not automatically. In that case, the exporter has the option of changing the price with that foreign buyer. He decides how to react to the appreciation. To assume, as many do, that a rise in the Canadian dollar will reduce Canada's exports, is to assume that Canadian exporters automatically raise their U.S. dollar prices when the Canadian dollar rises, in the way I have just described. That is not what the companies that I talk to tend to do. Instead, they price to their marketplace, keep their U.S. dollar price as unchanged as they can to continue to do that transaction with their foreign buyer, and then, their profit margin is squeezed by that higher Canadian dollar. They then look for ways to try to restore their profit margin over time. They may be able to negotiate a slightly higher U.S. dollar price when the contract comes up for renewal. More likely, they will look for ways to cut costs to restore their profit margin through better investments or through other ways of organizing their business.
That is the first thing that has changed in this world, Mr. Chairman. The second important bearing on this question is that the world has become globalized in its supply arrangements. Not only do we sell our products and services all around the world, we also draw various elements of supply from all around the world. Global companies think of their products not as single item but rather as a collection of components. Some of those components are more cheaply and better made in other countries. The result has been a globalized product that has components imported from other countries.
The implication of this is that Canadian companies find themselves on both sides of the exchange rate issue. When the Canadian dollar goes up, it is true that they receive fewer Canadian dollars for that sale. However, the cost of the imported components that they must put into their product is falling at the same time. For some companies, it may be six of one and half a dozen of the other. For other companies it is more skewed in one way or the other way. It varies dramatically across the Canadian economy. On average, just over 60 per cent of the value of our exports is Canadian. The remainder is imported.
Sectors such as tourism or engineering services have high Canadian content. Manufactured items such as electronics have a much lower Canadian content — well below 50 per cent, in many cases. Therefore, the exchange rate effect is different from one company to another because of this. Additionally, an important input into our company's businesses is investment in machinery and equipment. Most of the machinery and equipment that is bought in Canada has been imported. The price of that falls as the Canadian dollar rises.
For those two reasons, the simple answer that economists give is changing dramatically through time. It changed a great deal during the 1990s and, in particular, since the Free Trade Agreement, when much globalization took place.
Given all of this, let us ask how to interpret the recent rise in the Canadian dollar and its effect on the Canadian economy. First, not everything was equal. Things have changed at the same time. The context is that the world economy has not been in balance since 1996. Since that time, we have had a series of crises that have pushed the U.S. dollar up and the Canadian dollar down, which is a natural phenomenon. Now that the world appears to be getting back on track towards a more balanced place, we see that the U.S. dollar is coming back down, more to where it belongs around its 1996 levels, and the Canadian dollar has returned roughly to its 1996 levels. That is a natural process that was expected by economists and by many Canadian businesses.
The gist of this analysis is that the rise in the Canadian dollar, to a large extent in the last year, is a symptom of a return to a healthier global economy. A healthier global economy is good for Canada, which is trade dependent and, therefore, the ultimate net effect on Canada is positive. That is why economists are not predicting a major recession or even a slowdown in Canada next year as a consequence of the stronger dollar. There are offsets — positives — in the mix that come with the stronger Canadian dollar. We will have more trade and more economic growth because of the stronger world economy and we will have a stronger Canadian dollar as a symptom of that.
One of the side effects will be that we will have more investment in that machinery and equipment that is imported, which is another stimulus to the Canadian economy that will enhance productivity as we move forward. Therefore, it has a very positive aspect.
Therefore, with all those things considered, I believe the Canadian economy will see a solid growth next year and it will see increased international trade in spite of and because of the rise in the Canadian dollar.
The Chairman: Thank you, Mr. Poloz. Mr. Sharpe, please proceed.
Mr. Andrew Sharpe, Executive Director, Centre for the Study of Living Standards: Mr. Chairman, I appreciate the invitation to be here today. Given the mandate of the Centre for the Study for Living Standards to monitor trends in living standards in Canada, I thought it was appropriate to base my presentation on an analysis of the impact of the exchange rate on the living standards of Canadians.
By ''living standards,'' I mean GDP per capita. That is a narrow concept and it is narrower than economic well- being and quality of life, but we can measure it fairly well.
To understand the impact of the exchange rate fluctuations on living standards, we need to understand which variables affect living standards. I will highlight three particular variables: the first one is productivity growth, which is output per unit input, generally labour productivity. In the long run, that is the only way to have sustainable increases in our living standards. The second one, in the short to medium term, is our employment growth from lower unemployment or from increased labour participation. The third one is inflation. If we have lower price increases for given nominal incomes, we will have higher real income gains.
I want to look at the impact of exchange rate fluctuations on those three variables. I will turn first to the impact of the exchange rate on productivity. There are four channels one could identify whereby changes in exchange rate affect productivity. The first is the exchange rate sheltering hypothesis. The argument is that lower exchange rates increase cost competitiveness, reduce the need for businesses to stay competitive and, therefore, less effort is made to improve productivity. This is also known as the ``lazy manufacturers' hypothesis.''
A second mechanism whereby exchange rate fluctuations can affect productivity is the ``factor price hypothesis.'' This means that the exchange rate could affect the relative price of labour and capital and, if those prices change, then there are changes in the substitution of capital for labour in the production process. That has effects on labour productivity. The best example is if the exchange rate depreciates, then the price of capital goods goes up, firms substitute labour for capital, the capital/labour ratio increases at a slower pace, and labour productivity does not increase as quickly.
A third mechanism is the ``productivity investment effect.'' As was mentioned, exchanges in exchange rates can affect the profitability of Canadian businesses — particularly those that sell their goods in U.S. dollars. When the exchange rate depreciates, profits and investments increase, and investment is good for productivity gains.
A final mechanism is the ``foreign investment effect.'' Exchange rates affect the attractiveness of investing in Canada and the attractiveness of Canadians investing abroad. For example, with a lower exchange rate, Canadian assets become more attractive for foreigners and if those foreigners invest in Canada, they may buy a business and build a new plant and equipment. That can result in strong productivity gains. Of course, that is affected to the degree to which we have multinationals operating in Canada and to the degree to which they base their decisions on the relative competitiveness of the different countries. These four effects that I mention will vary greatly by sector and by region, so I am speaking in very general terms.
The second effect of exchange rates on living standards is the effect of exchange rates on employment. A key factor here is whether the economy is fully employed or not fully employed. Unfortunately, in recent years the Canadian economy has not been fully employed. We have had an unemployment rate above that of full employment. Currently, the unemployment rate is around 8 per cent. If you are at full employment, you cannot increase your employment.
The first mechanism here is the cost competitiveness mechanism, which we have already mentioned. The exchange rate effects the relative price of goods and exports and appreciation will make our exports more expensive and imports cheaper. That affects the demand for labour, which results in increased or decreased income, depending on the movement. If we have unemployed labour and depreciation of the currency, employment, income and standard of living will increase. If we have an appreciation — as we are experiencing right now with unemployed labour — we have the opposite effect on living standards.
In terms of employment, you can also have a foreign investment effect, with changes in exchange rates that can affect again the relative attractiveness of Canadian assets. This affects foreign employment and living standards.
The final effect is that of exchange rates on inflation. Again, depreciation raises the price of imports, which results in lower rates of increase in real incomes. Again, appreciation has the opposite effect. We do not often have a full pass- through and therefore, we do not see a one-to-one relationship between these variables, because of changes in profit margins.
What has been the effect of exchange rate fluctuations on the living standard of Canadians? I distinguish two periods here. The first period is from the second half of the 1990s and the first three years of this decade, when we have seen a lower exchange rate relative to the Canadian dollar. During that period, the Canadian economy has been characterized by strong employment growth and acceleration of productivity growth, strong investment, low inflation and rapidly rising living standards. There are multiple effects at work here. All the factors and mechanisms that I have mentioned are at play. Therefore, the task is to basically calculate the relative importance, which is very complicated.
I will just tell you what is at play and give my bottom line on what the effect of the exchange rate has been on the living standards.
The weak exchange rate of the period in the late 1990s and early years of this decade had a positive impact on living standards, through the increased cost competitiveness of our industry and therefore the strong inputs in employment; through the increased profits in investment; and also through the increased attractiveness of foreign investment in Canada. Therefore, there have been three positive effects in the exchange rate.
During that period, the weak exchange rate had a negative effect on the living standards through this factor price effect, which is the increased price of capital goods. That resulted in very low rates of growth in our capital-labour ratio, which had a negative effect on labour productivity growth. The higher inflation, because of the exchange rate depreciation, had an effect on prices; however, that was pretty well offset by other factors and overall inflation was very low. Arguably, there was a little effect of the sheltering hypothesis, although I would not put a lot of emphasis on this sheltering hypothesis of lazy manufacturers. There may be some examples of it.
The exchange rate depreciation in recent years has had a strong positive effect on the real incomes of Canadians, because of this great underutilization of labour in the Canadian economy. It put more people to work and that was very positive.
Turning now to what has happened in 2003, we have seen a 20 per cent appreciation of exchange rate since January. This exchange rate has had a negative effect on the living standards of Canadians through: lower cost competitiveness and, therefore, lower exports; lower profitability and investment; and the reduced attractiveness of foreign investment flows to Canada.
On the other hand, the exchange rate is currently having a positive effect on our productivity and living standards, through cheaper capital goods and lower inflation for any given increase in nominal incomes and less exchange rate sheltering.
I would argue the net effect on living standards is currently negative, because again we have 8 per cent unemployment. That effect is more important than the other effects.
I will quickly turn to the question of how important exchange rate effects are for living standards. There are other factors that are more important for living standards than the exchange rate effects I mentioned. I will mention three of them.
First, the overall state of aggregate demand is key for the economy. That is linked to government spending, consumption and investment, and is affected by interest rates and consumer confidence. That is what is driving the economy. Second is the state of foreign demand, particularly income growth in the United States. Third is the underlying trend in productivity growth, which is linked to investment and technological change.
Those are the three factors that are fundamental to our living standards. Exchange rate has an effect, but it is not as dominant as these three factors.
In conclusion, given the high unemployment rate in Canada, the appreciation in the Canadian dollar is not a positive development for the Canadian economy and our living standards, but it is by no means disastrous. Other developments can more than offset the negative effects of Canadian exchange rate appreciation. The Bank of Canada should keep interest rates and interest rate differentials with the United States as low as possible to put downward pressure on the dollar. However, if the exchange rate appreciates because of foreign developments such as the deterioration of the fiscal position of United States or positive developments like the falling debt to GDP ratio in Canada, we should accept these developments and not be overly concerned.
The Chairman: Thank you very much. Mr. Anania, would you like to proceed?
Mr. John Anania, Assistant Chief Economist, RBC Financial Group: My colleagues have already given much detail about the topic at hand tonight. I would like to focus on one subject that has already been discussed in brief by my colleagues, which is the nexus or link between the Canadian dollar trade and productivity in this country.
I do many briefings in Toronto and Montreal and I find both clients of the Royal Bank and employees are concerned these days about the rise of the Canadian dollar. That is understandable because the Canadian dollar is probably the most important price in the Canadian economy. It is a small open economy, and it will have some resource allocation impacts in Canada. Basically, we are talking about an allocation of resources away from industries that are dependent or more reliant on foreign sales as opposed to industries reliant on domestic sales. That means employment opportunities will be better in those industries. There may be a rise in frictional unemployment in Canada because of this. However, it should prove to be temporary.
It is not all bad news, obviously. There is some good news to the Canadian dollar story, particularly if it is sustained at the levels we are seeing today, or even if it appreciates from this point forward into 2004 and into 2005.
I am talking about the causal impact of the Canadian dollar on productivity. The others talked about the fact that we import in this country roughly 70 per cent to 80 per cent of the machinery, equipment and software in which businesses invest. Basically, that comes from the U.S. It is an important factor. When the Canadian dollar depreciates relative to the U.S. dollar, the cost of capital in this country, relative to labour, increases. IN the past, we have found that Canadian companies tend to depend a little bit more on labour than capital. That has key implications relating to labour productivity. The larger your capital stock, the more productive your labour force will be.
The opposite is true when the Canadian dollar appreciates. Obviously, the cost of capital goes down relative to labour. Businesses might invest more, your capital stock will be higher and your productivity might be higher because of that.
Before I go any further, I should say that we prepared a study — I hope the honourable senators have a copy — on the hidden benefits of the Canadian dollar. I will refer to some of these charts in just a moment.
I must refer to the empirical relationships. Many people have studied this topic. We are looking for a causal relationship between the Canadian dollar and investment in this country. So far, I must say that empirical evidence is just not there. We have yet to find conclusive evidence that a move in the Canadian dollar has an impact on investment in Canada.
It could also very well be that the arrow points the other way, where productivity increases for other reasons in this country; it attracts capital into Canada and boosts the Canadian dollar.
This is a complicated issue, but I believe that there is compelling anecdotal evidence that suggests that a rise in the Canadian dollar would be good for productivity in this country.
I would like to refer to two of the charts in the study I have distributed on the hidden benefits of the Canadian dollar.
I will turn now to page two where two of the charts go a long way to explaining the anecdotal evidence to which I referred.
The first chart shows the cost of capital relative to labour in Canada compared to that of the U.S. It is plotted here against the Canadian dollar. The Canadian dollar is on the scale on the right side. This is an inverse scale, so an increase in the line represents depreciation in the Canadian dollar. The scale on the left is the index of the cost of capital to labour in Canada relative to that of the U.S. The point of the chart is that, relative to the U.S., our cost of capital to labour is dependent on the value of the Canadian dollar. You can see that there.
More important, if you look at 1981 and follow up to 2002, you can see that the depreciation in the Canadian dollar over that period drove up the cost of capital relative to labour in Canada compared with that of the U.S. That is important. I hope I was clear in explaining that chart. Perhaps I can refer to it again later during the questions. That is important, especially if you look at the next chart, chart four.
I was quite surprised when I saw this chart and also puzzled when I looked at some of the details behind it. First, the capital stock to GDP is plotted for both Canada and the U.S. The dotted line is for the U.S. and the solid line is for Canada. Over time, especially in the 1970s, the capital stock to GDP in the U.S. increased relative to that of Canada. That shows that that, in the U.S., they use more machines, equipment and software in their production mix than Canadian companies do. Part of that can be explained by the fact that the Canadian dollar has depreciated over time. That is not the only explanation.
There are some problems in comparing the capital stock between Canada and the U.S. in terms of measurement because the inputs in measurement are sometimes different between Canada and the U.S. Statistics Canada indicates that this can explain some of the gap, but not likely all of it. The important point here is that they use more capital in the production mix in the U.S. than we do in Canada. Perhaps that is why their labour productivity over time has trended over and above that of Canada's.
I had a question when I looked at this chart. If you look at chart three and at the period between 1986 and 1991, you will notice that the Canadian dollar appreciated over that period of time. We went from close to 71 cents to 89 cents in about four or five years. You would expect that, on the back of that, Canadian companies would have increased investment relative to labour over that time and that the capital stock in Canada would have increased and, perhaps, boosted productivity. However, that did not happen. That is because this relationship does not operate in a vacuum. There are many other factors involved in business decisions to invest.
During the period 1986 to 1991, uncertainty was high for businesses. Inflation was still a problem. The Bank of Canada had yet to adopt inflation-targeting bands, government balances were not as good as they are today and were probably pushing up interest rates and the cost of capital.
If you look at real interest rates over that period of time, they were averaging 5.3 per cent. Today, real interest rates are averaging a much lower 1 per cent and probably will go modestly higher, to the 2 per cent or 3 per cent range over the next one and a half to two years.
There were other factors as well. The Free Trade Agreement was being discussed and it was signed. That also imparted some uncertainty.
Finally, with these combined factors, it is understandable why businesses did not capitalize on the fact that the cost of capital relative to labour had gone down because of the Canadian dollar appreciation.
This time, the increase in the Canadian dollar is also accompanied by some positive fundamentals in Canada. There are good reasons to believe that if the cost of capital relative to labour in Canada drops and if the Canadian dollar appreciation is sustained — and we think the Canadian dollar will appreciate a little more — we should see an improvement in the use of capital relative to labour. The capital stock in Canada should increase relative to GDP, and perhaps labour productivity will finally start to catch up to what we are seeing in the U.S. That will be a benefit to all Canadians.
I look forward to your questions.
Senator Carney: I wanted to thank the witnesses for an update in our economic education. This is a topical issue right now.
I do not know which one of you wants to answer this question, but I want to ask about the effect of the U.S. budget deficits on exchange rates, in particular, the Canada-U.S. exchange rate.
The experience of Vietnam was that the increase in the budget deficits in the U.S. led to inflation, which had a major spillover effect here in Canada. We are facing huge U.S. budget deficits now. Can you explain that to us?
Mr. Anania, your textbook analysis is great, but at some point looking down the road at the increase in the Canadian and the effect on U.S. dollar, we will have some problems. Will you identify those problems for me?
Mr. Poloz: The conditions that Senator Carney has described in the late 1960s and early 1970s demonstrate a clear case where a budget deficit led to inflation, which led to weakness in the U.S. dollar and strength in the Canadian dollar when we freed up from the fixed exchange raid.
The current situation is different in many ways. Most importantly, I would ask you to consider the context in which the U.S. fiscal deficit has emerged. During the last four years or so, we can hardly consider the world to have been normal. It has been weak in some areas of the world.
The Chairman: You said this before. What is ``normal''?
Mr. Poloz: Normal would be a world in which all economies grow simultaneously in a synchronized fashion. Developing markets grow faster than developed markets. Interest rates are stable and inflation is not an issue. Exchange rates are stable. The last time we were in a normal situation like that was in 1996. Then we saw the Asian crisis, the Russian crisis, the Brazilian crisis, 9/11, and so on down the road.
Throughout that process, we had many major adjustments. One of those in the past two years has been a sluggish United States economy. That is a period during which any country's deficit will increase. Layer on top of that the effort in the war against terror and you have a structural element to that deficit. This only plays into exchange rate determination if it then goes to the next stage, which is the stage you described before, when the Vietnam War became an inflationary problem.
We see no signs of that becoming an issue here. It would become an issue if global investors suddenly decided not to buy U.S. debt. We see signs that people are losing their appetite a little, and that may be one of the reasons behind the U.S. dollar's decline. However, it is it not a reason to expect the U.S. dollar to fall dramatically. We see it as an influence — I would say it is more like icing on the cake rather than the big picture.
The big picture is that the U.S. dollar went up because of all the imbalances in the world, and now the U.S. dollar is coming back down as those imbalances disappear. That return to global health has a symptom of exchange rates going back to ``normal.''
Mr. Anania: Will mounting federal deficit in the U.S. have an impact on the exchange rate going forward between Canada and the U.S.? We think so.
I will try to simplify the issue. Together right now, American consumers, businesses and governments are spending more than they earn. That is the problem down there. In you think of what they earn as being equal to what they produce, then you find they are consuming more than they produce. Obviously, that is their current account deficit; imports have to increase more than export. To finance that, Americans have to borrow on international capital markets. The U.S. government is one of the reasons.
What you find these days is that investors around the world are no longer satisfied in subsidizing or financing that deficit. Stock markets, for instance, are rising right now in the U.S., but they are rising overseas as well, perhaps even more in other countries. Interest rates — this is key — in the U.S. are much lower all across a yield curve relative to other countries, like Canada or the Euro zone — maybe not Japan.
You can see the problem. Americans have to borrow; governments are borrowing; foreign investors are no longer interested in blindly financing the current account deficit in the U.S. Something has to give, and, in the balance, that is the U.S. dollar. It has to depreciate to attract that capital into the U.S. right now. We think this problem will take some time to be rectified. However, in the coming years, the fact that the U.S. dollar is depreciating will promote exports and take away from the desire to import in the U.S., so the demand for capital should drop in the U.S. and you will find that at the end of the process the U.S. dollar will be trading in a lower range.
The short answer is that it should have an impact going forward.
Senator Carney: My second question concerns your remarks about increased labour productivity and the ratio of investment relative to labour and the increase in labour productivity. Normally those are code words for displacement of labour by the shutting of jobs by increased capital spending.
Given the fact that we are in a skills short market and the demographics may help alleviate that, at what point — Mr. Anania raised this but Mr. Sharpe might speak to this — does this trade-off between increase of labour productivity and investment start showing up in unemployment figures?
Mr. Sharpe: In the long run I do not think there is a trade-off between productivity increases and employment growth. In the short to medium term, there can be but it is largely conditioned by the context of aggregate demand. That means you will be shredding labour in certain sectors for certain reasons, but if there are strong demand conditions, many of those workers can be re-employed in other growing sectors of the economy. Some will not be and you must have adjustment programs to retrain them or to give them income support if they leave the labour force.
Overall, if we have the right policies in place we do not really have to worry about this trade-off between productivity growth and unemployment. We should be able to handle that problem.
In the second part of the 1990s, we saw a decline in the relative price of labour compared to capital in Canada. It was linked again to the increased price of investment goods because of the depreciation of the dollar. It was also linked to our larger output gap. We had higher unemployment in Canada and that cheapened the price of labour. The rate of wage growth in Canada was lower in the second half of the 1990s than it was in the U.S.
We saw a massive increase in employment in Canada, particularly in manufacturing relative to the U.S. That has continued in recent years. The U.S. has lost a large number of jobs in manufacturing. We have not. That has been positive overall for the Canadian economy. It has increased living standards but it has resulted in a lower rate of manufacturing productivity growth compared to the U.S. We still have had about 2 per cent labour productivity growth in manufacturing and the U.S. has had around 4 per cent. If we had not had that depreciation of the dollar, we probably would have been much closer to what it is over there.
Senator Carney: I want to note that there are clearly regional impacts in terms of resource industries and other kinds of interests. Maybe at some point in the questioning some of my colleagues might want to explore that because this world is a little too rosy from where I sit on the West Coast.
Senator Grafstein: I am interested in the fact that one of the issues governments have been talking about for a while is competitiveness and productivity. It seems to me that on the balance a stronger Canadian dollar will, in most sectors, increase productivity and competitiveness. Is that a fair statement?
Mr. Sharpe: Yes, I think that would be a fair statement. The key is that that can be bad for employment, but if we have full employment then absolutely, an appreciation dollar will result in improved productivity and improved living standards.
Senator Grafstein: We are very much export-oriented. Our international competitiveness is based on our ability to export increasingly. We do have a large surplus with the U.S. We do have a deficit; for instance, with another major trading block, which is China. Could you give us a view about the impact of a stronger dollar as it applies to the Euro market vis-à-vis exportation, and with respect to the Asian market, particularly the Chinese market? We have a deficit with the Chinese market, and I would be interested to know whether or not a stronger dollar enhances our ability to trade or export into those two markets.
The Chairman: May I just remind you, Senator Grafstein, that the term of reference of our meetings are Canada- U.S. trade. We are not involved in Asian trade. There is trade with everyone, but these meetings are being held to review the Canada-U.S. trade arrangements.
Senator Grafstein: Mr. Chairman, I understand that, I am just interested in a short comment about that and I will come back to my final question.
The Chairman: Just keep that in mind, please.
Mr. Poloz: The question is a good one in the sense that many of our trading relationships are multi-dimensional in nature and involve Europe and Asia at the same time as they involve the United States. The question you pose is extremely complex.
In general, though, exchange rates matter less to Europe as a whole than they do to us. Their trade penetration — total trade compared to the size of their economy — is, like the United States, around 20 per cent to 25 per cent, whereas for Canada it is almost 90 per cent. There is much less sensitivity there. Therefore, bigger exchange rate fluctuations have less of an effect on them. Nevertheless, they have big effects on some companies in those countries.
More important, I would return to my original theme, which is that in the last six to nine months we have seen that exchanges rates are going back to a more normal zone. That is a sign that things are becoming healthier.
I should like to add one last thing, which is about the Canada-U.S. comparison: The U.S. economy, during this strong U.S. dollar period, since 1998, lost 3 million manufacturing jobs; that is, in a nutshell, the productivity gain. However, they also created 7 million service sector jobs during that same period. That growth comes from the context of better incomes and lower prices for manufactured goods give more spending power to the population. I would imagine we would see the same sort of transformation occur in Canada over the next two or three years.
Senator Grafstein: Therefore, give us a fast view about the overall impact of foreign investment by Canadians with the stronger dollar — good, bad or indifferent?
Mr. Poloz: The foreign direct investment is a key ingredient to our trading relationships. The global supply chain notion, which I discussed earlier, costs serious money to set up. When the Canadian dollar is stronger, it is less expensive to do that, and it will generate more trade of components through the system. We trade now before we make our product, and then we trade our finished product. Those investments that are crucial to that process will cost less in a stronger Canadian dollar world. Therefore, I think it will be trade generating.
Senator Di Nino: I was somewhat intrigued by Mr. Poloz's description of the 1996 time frame as ``normal.'' I am not sure we all agree with that, but he defined it, so I will accept it. I think we have longer periods of time with many competing factors than we do harmony in the business world.
There have certainly been some strong suggestions that the United States has deliberately driven the exchange rate play from a strong dollar to a weak dollar. I would like to know whether you feel that is the case.
Mr. Poloz: There is no question that those kinds of utterances by senior officials have a catalytic effect on markets. However, economists were calling the U.S. dollar extremely overvalued for a long time. We were calling for a rise in the Canadian dollar for a long time. One never knows what is the catalyst that gets the ball rolling. It seems like nothing follows the textbooks. However, they move suddenly and exchange rates tend to move all at once rather than in the nice straight lines that we see in our models. When there is a need for an adjustment, sometimes markets get stuck there, and then someone says something and it goes. That shift in sentiment was important, I think, to getting this adjustment going. Nevertheless, the adjustment was fundamentally desirable.
Mr. Sharpe: I wanted to mention a concept that I did not have time to mention in my presentation, and that is purchasing power parity. This is the price at which a basket of goods would cost the same in a common currency in Canada and the United States. Economists believe that, over the long run, exchange rates gravitate towards this level. According to Statistics Canada and the OECD, the current purchasing power parity value of the Canadian dollar is about 84 or 85 cents U.S., and economists believe that over time we will gravitate towards that level from when we were down to 62 cents. Nothing is inevitable, but it is extremely probable that the dollar would appreciate from its low of around 62 cents towards a much higher level. We may not make it to purchasing power parity, although it is possible we will. From that perspective, we cannot say that the U.S. deliberately provoked this development. It was largely through market forces.
Mr. Anania: In respect of the question that was just posed, I agree with Mr. Poloz on this issue. The United States dollar is moving in line with where market forces dictate it should go. It was kept artificially high through intervention in the markets by such institutions as the Bank of Japan, which was interfering to slow the fall of the Japanese yen. It is mostly market driven at this point.
Senator Di Nino: Recognizing the fact that 87 per cent of our trade is with the U.S., and with the appreciation of the Canadian dollar, has the Canadian government responded appropriately, or is there something else it should be doing? If so, what is it?
Mr. Sharpe: Overall, the response has been quite good. I do not think that the Bank of Canada in particular should be targeting an exchange rate. They are basically targeting inflation. They have some control over exchange rate over the interest rate differentials, a small amount, and they could bring those down a little. Even if they did bring interest rate differentials down to parity with the United States, we would not see a major depreciation of the dollar. Overall, we should not react to these changes. We certainly should not go to a fixed exchange rate. That would lose the degree of freedom in adjustment that we have right now. Overall, I do not think it has been a major policy failing of the government.
Mr. Anania: I think it was a tough decision by the Bank of Canada recently, but ultimately they probably made the right decision.
A number of factors are at work that suggest that the Canadian economy will improve in 2004 and toward the end of this year. Sure, the rise in the Canadian dollar might have some short-term negative effects and cause dislocations in the labour market, but if you look at what is happening south of the border right now, the U.S. economy is improving quite dramatically. It grew by as much as 6 per cent or 7 per cent in the third quarter ending in September. More importantly, it looks like it will be sustained in that the fourth quarter in the U.S. will be good as well, and above-trend growth will extend into 2004. That will perhaps offset the rise in the Canadian dollar as far as our exports are concerned.
In respect of the elasticities that Mr. Poloz discussed earlier, the rise in the Canadian dollar has been tremendous. Typically, though, exports are more sensitive to demand conditions in the States than to the Canadian dollar.
The Chairman: I am looking at Canadian exports. I have a list here. There is no mystery. Agriculture is about 7.5 per cent of our exports. I am not certain how price-sensitive agriculture is. I would think the Americans need energy, so I suppose those exports will continue their world prices. Raw and industrial materials, which comprise 26 per cent of our exports, are a question of demand. Everyone we have heard on this subject has said there was big demand in the 1990s, and so naturally, our exports of raw and industrial materials went up. Automobile products are 24 per cent of our products. That is the Auto Pact, not the Free Trade Agreement. That started in 1968. It has become extremely integrated. The ``other'' is interesting; it is 7.75 per cent. For example, we discovered that the fourth largest furniture manufacturer in North America is in Winnipeg and that they were large before the Free Trade Agreement.
When I look at the list, it seems to me that the one that is most sensitive to exchange rates — and this is what I think, and my question is, what do you think — would be the second one that comprises 24 per cent of our exports, which is relative to the Auto Pact. As you have said, I am sure they are priced in dollars because the same companies on both side of the border move the parts back and forth, and there would be an effect there, I am quite certain, and also on the 7.75, which would include that furniture business in Winnipeg.
There is a lot of demand these exports — agriculture, energy, raw materials. Are they very price sensitive? In other words, what percentage of our exports are actually price sensitive in the sense of the exchange rate? They cannot all be. I would not have thought, for example, that our oil and gas exports were particularly sensitive to the exchange rate.
Mr. Poloz: You are correct. In general, the resource sector faces prices that are determined in global markets in U.S. dollars, whether it is wheat, lumber, nickel, et cetera. Those prices are taken as a given by a Canadian supplier in U.S. dollars. That means that when the Canadian dollar rises, they get fewer Canadian dollars for that same contract. You will read in the newspaper that their profits are being squeezed. You read in the newspaper just last week that Inco's profits were lower than they otherwise would have been because of the soaring Canadian dollar. The article failed to mention that the global price of nickel has risen by 70 per cent over the last 12 months. That means 70 per cent more U.S. dollars; 20 per cent fewer Canadian dollars in exchange for the U.S. dollars means 50 per cent more revenue. That is not a bad equation.
Some resource sectors are behind that curve and others are ahead. It depends on the sector. You are quite correct that it is not sensitive to the Canadian dollar, but the profits of the companies will be, all other things equal. That is about 40 some-odd per cent of our export picture. The balance consists of half cars or auto sector, and half machinery, equipment and ``other.'' This, of course, is where the manufactured products have the most sensitivity. By the way, services are another thing I want to mention before I stop. However, the auto sector has the lowest Canadian content of all of our exports. A car made in my hometown of Oshawa has 35 per cent Canadian content. The rest of the content is from the United States, Mexico, Asia and Europe — it comes from all over the place. Therefore, its sensitivity is actually quite low to this. The parts sector is more sensitive because it has something like 60 per cent or 65 per cent Canadian content. Even so, there is an important imported content, as I mentioned earlier.
Machinery equipment depends on the sector you are in. The sensitivity is like a spectrum. Everyone will give you a different answer depending on their sector, but they will all say that when all other things are equal, they would rather have a weak Canadian dollar because they will get more Canadian dollars for their contract. Therefore, we must be most careful about the influence of ``all other things being equal.''
The most sensitive of all are the very high Canadian-content sectors, particularly services. Tourism has almost 100 per cent Canadian content. Engineering services or other business services produced by our firms represent something like 14 per cent of our total exports today. The services area gets very little attention from us.
The Chairman: It is not even on my list.
Mr. Poloz: Correct. It is growing much more rapidly than the average growth in goods; it is 80 per cent of our economy. It is the future driver of growth in trade. Therefore, I urge you not to forget those things, and to remember that those are the most sensitive. A Canadian analyst who sells his report, which has 100 per cent Canadian content, across the border gets dinged by the rising dollar.
The Chairman: Would anyone else like to comment?
Mr. Anania: I should like to focus on what I was talking about in terms of productivity; I also have two charts in the back of the study, ``The Hidden Benefits of the Canadian Dollar.'' They look at the M&E investment of industries as a percentage of the value of their output. You find that it is not only manufacturing that uses a lot of capital in their production mix. Other industries also stand to benefit, some of which are in the services sector.
If you look at the second chart, perhaps most surprisingly, education and related services is very high. That is because of all the computers and things of that nature that are brought into the classroom nowadays. Service industries such as finance, insurance, real estate have high investment. They stand to benefit as well from the Canadian dollar appreciation.
Senator Massicotte: Mr. Poloz, Mr. Sharpe expressed the fact that if we are not fully employed, it is in our Canadian best interest relative to the economy to have a cheap dollar for greater employment and so on. Therefore, he mentioned that he was very interested in interest rate policy. Mr. Sharpe mentioned that, as you know, the Bank of Canada has as its policy to focus on inflation only and openly says it does not care about the level of the Canadian dollar. Of course, the level of the dollar affects inflation indirectly.
Would your opinion be that the Bank of Canada should continue to target inflation or become more sensitive to the dollar fluctuations affecting the American economy?
Mr. Poloz: The Bank of Canada has the situation just about right. The real issue here is that the timing looks odd. Things never happen all at the same time.
If we could look ahead to next year — I will come back to my definition of normal — I expect 2004 to be the first ``normal'' year for the world economy since 1996. Canada will have a strong year; unemployment will not be high, but it will probably be steady; and, inflation will be low, et cetera. That is what we need.
What exchange rate would be consistent with that? Exchange rates move ahead of time, which is what they have done over the last few months. Next year we will look back and see that exchange rates have gone about where they belong — thank you very much. However, it is the fact that they happen early in the process that may make it seem like it is too soon for the hypothesis that Mr. Sharpe has laid out. That is, we have high unemployment and it would be nice if it decreased faster, and a weak currency does promote that extra growth. That is to say that next year, if we are expecting 3 or 3.5 per cent growth in Canada, if somehow, magically, the dollar could have stayed at 65 cents — which I do not think we could have managed — then we would have, say, 8 per cent growth next year.
Senator Massicotte: I am not worried about the circumstances that exist today. My issue was more policy-oriented. The policy of the Bank of Canada does not focus at all on the level of the dollar. It just concentrates on inflation. Is that a good direction or policy?
Mr. Poloz: It is exactly right because it is what is feasible. It does not leave the economic performance up to question. If the economy were persistently weak, that would put downward pressure on inflation and it would make sense for the bank to act in such a way as to get the economy growing more quickly, thereby preventing inflation from falling.
In essence, the two are not separate. Getting the economy to a stable inflation rate means also getting output to a full employment level over time.
Senator Massicotte: Mr. Sharpe, Mr. Anania said that when the dollar is high, the costs of importing equipment and software is obviously cheaper. However, your basic hypothesis is that if we do not have full employment, a lower dollar benefits our country. You also made passing reference to debunk the theory of the lazy manufacturer. Yet, three or four years ago, every newspaper article in every business section suggested that the Canadian dollar is far too low, that we are getting lazy and inefficient, and that was the major explanation why productivity was so low.
Will you comment on that? Obviously, you say it is not applicable, but could you expand upon that?
Mr. Sharpe: Certainly. I have done a lot of research on our manufacturing productivity performance because we have done so poorly relative to the United States. The major reason for that was not this lazy manufacturers' hypothesis but the fact that we have a much smaller high-tech sector than the United States. That sector in the United States had extremely high productivity growth compared with our sector in Canada, and of course was much larger in size. That explains most of the relatively stronger manufacturing productivity performance in the United States.
If there were a lot of truth to this lazy manufacturers' hypothesis — I am not saying it is not always true — the effects are minimal. One would see across all Canadian manufacturers worse productivity growth than in the United States. However, excluding the high-tech sector, the productivity growth in the Canadian manufacturing sector in the second half of the 1990s has done almost or equally as well as in the United States.
I am a great believer in productivity. I have done a lot of research on the topic. In the long run, it is the only way to improve our standard of living. However, let us first make sure we get to full employment and then let us focus on the productivity improvement.
I am not saying this in relation to the dollar because we do not have a lot of control over the dollar. However, from the perspective of the standard of living of Canadians, we have to ensure that jobs are available people who want jobs so their income can be as full as possible to improve the overall living standards of Canadians.
I am not by any means against productivity improvement. I am saying that the key is to get our unemployment rate down to 6 per cent or even lower.
Senator Austin: I would like to take a different approach to this subject. A lot of economic studies that have recognition today are based on behavioural study. How does the economy deal with changes in behaviour or the way in which human behaviour operates?
Let me move to a highly political agenda. We see, in the United States, political rhetoric that indicates that protectionism may be on the rise. You have talked to us about the 2004 performance of the U.S. economy. Do you see that as a check on anti-global tendencies within the U.S. polity?
With considerable interest, I watched the G7 finance ministers meet last month. All of them — including the Canadian Finance Minister — focused on the impact of China and the peg that the Chinese have had in place for some time now, I think since 1993, relative to the U.S. dollar. Yet, a number of articles have appeared in U.S. journals, as well as in the Financial Times, that indicate that the performance of the U.S. economy is relatively unrelated to the Chinese peg, and that the U.S. has its own internal problems economically and they have caused some of the problems the U.S. is dealing with.
I am curious as to why the G7 continue to put pressure on China and how it will affect the Canada-U.S. trading pattern — assuming that you see any affect at all.
These questions that focus on reasons for U.S. behaviour, both micro and macro.
Mr. Poloz: Protectionism and unilateralism seem to be on the rise. Security trumps trade. In the post-9/11 world, it costs us more to do international trade as a result of things like insurance, paperwork and waiting at the border. We think of it as having thrown some sand into the wheels of international trade. We think that is like undoing some of the trade liberalization effects that we had from the 1980s going into the 1990s.
To take that into account when we do our forecast for the world, we assume the world will trend into a slower overall rate of growth than it would have before 9/11, by something like .3 or .4 percentage points per year at a global level. That adds up to a lot of money in a ten-year period. That is kind of a tax on growth coming from all those things that I call the new age of uncertainty. It is being incorporated into our discussion. We do not think suddenly it will go protectionist, but we are not getting the same sort of traction that we had previously.
Nevertheless, we think going forward the world will be a better place a year or two from now and perhaps conditions will be more favourable for trade negotiations.
Senator Austin: Are you saying that the world is resuming the trend line after the 9/11 setback? Is that what you are saying, back to the previous trend line?
Mr. Poloz: The trend line will be forever below the one I would have imagined before 9/11. Growth might be 3.7 per cent or 3.8 per cent, on average, for the world, instead of 4 per cent or 4.1 per cent, but we will be a little below it forever.
With regard to the China peg, there is no evidence whatsoever that China's currency is undervalued. There are classic symptoms when that is the case, none of which exist. The only thing that exists is a trade deficit between the United States and ourselves for that matter and China. This is happening not because we are losing out in the competition against China but, rather, because Canadian and American companies are integrating China into their global supply chain. That means we are having subsystems, components, et cetera made there and incorporated into our products. A good example might be the shirt I am wearing. It is a Tommy Hilfiger shirt, designed and marketed in the United States. All the great white dollar jobs are still there in the United States, but the product is made in China now. They do not cost half as much as they used to. Tommy Hilfiger is making a lot of money on that.
All that disturbing that exchange rate with China will do is affect the profitability of multinational companies temporarily. More than half of China's exports are by multinational companies.
Mr. Sharpe: In respect of the trend toward protectionism in the United States, I agree. It is worrisome. One of the reasons is the lack of cost competitiveness of U.S. industry. With the depreciation of the U.S. currency, there will be fewer pressures towards protectionism in the U.S. I am optimistic on that front; it will not be as severe a problem as in the past.
I strongly disagree with Mr. Poloz's statement that there is no evidence that the Chinese currency is undervalued right now. If you look at estimates of the purchasing power parity of the Chinese currency, it is basically double the current exchange rate. From that perspective, if the Chinese currency were at its purchasing power parity, we would see much less competitiveness of Chinese goods in North American markets and there would be decreased demand for them. Basically, China would import a lot more from us.
Eventually, the Chinese will leave the peg. It would be in the interests of the Chinese population. It would definitely improve their living standards by having cheaper imported goods.
Of course, the peg has also been in the interest of the Chinese people in terms of increasing employment. We have seen a strong employment growth in China, much a result of people moving from rural to urban areas to take jobs in industry. That has resulted in living standard improvements for many Chinese.
Mr. Anania: In regard to the second part of the question — that is, the G7's perhaps inappropriate focus on the exchange rate. There are some serious issues at work in the U.S. economy. They are still working off the huge investment bubble that occurred in the late 1990s. Their employment market is terrible right now. It looks like it is improving, perhaps, but businesses are still reluctant to hire. Will their recovery be interrupted because of that?
Since the U.S. fell into recession, the one thing that has been positive in the world economy is the fact that U.S. consumers have continued spending. It is unusual that they have increased their spending on durable good during the recession. Not only that, they have continued to increase consumption of these items since.
Focusing on the currencies and allowing the U.S. dollar to depreciate will actually help the world economy. In my opinion, there is probably more pent-up demand in economies like Japan and Europe than there is in the U.S. On the net it will be a positive for the world economy to have the U.S. dollar depreciate relative to those other currencies. By doing so it will help lower interest rates in other countries as inflation concerns fade and promote local consumer spending.
Senator Mahovlich: A few years ago, when our dollar was falling and the American dollar was rising, there was talk about pegging our dollar. Personally, when our dollar was at 90 cents, it was a very good place to be. If you were to peg our dollar, would 90 cents be a good place to peg it? You have to remember that our border with the United States. We cannot avoid that. The way that American dollar goes really affects us.
Mr. Poloz: In a very fundamental way, one can peg the dollar anywhere one likes and then the economy will adjust to it, in which case we would perhaps choose one. It would be easier arithmetic to peg to that, but the economy would then adjust to that level.
However, it is more likely that we will continue to meet these kinds of shocks that occur out in the world that affect us differently than the way they affect the Americans. That is why we need a shock absorber from time to time. The rest of the time, it would be a lot easier if it would just hold still. We cannot seem to have one without the other.
For the moment, I would say the benefits to flexibility look attractive to me. When I think about what a mess we might experienced in 1998 and 1999, when were we holding a pegged currency, I think of an Argentina-style problem — it is not as big, but it similar — of a protracted recession, and adjusting to that. I think the flexibility currency really paid its dues to us during that episode.
Mr. Sharpe: With respect to your point about pegging the dollar at 90 cents, that would make the Canadian economy extremely uncompetitive vis-à-vis the U.S. economy and would result in significant increases in unemployment in Canada. It would be good for certain groups such as importers, people who winter in Florida or Canadian hockey teams that pay their players in U.S. dollars. Certain groups would benefit, but overall it would be a negative development for the Canadian economy.
If we pegged the dollar at 62 cents, it would be great in terms of employment growth but it would be very bad for all the same groups. There are winners and losers at different levels.
The bottom line is that we should not be pegging our currency at a given rate. We should use it as an adjustment mechanism to give us flexibility for external shocks.
Mr. Anania: I agree with Mr. Sharpe. In addition, measuring the appropriate level for the Canadian dollar at any given time is very difficult to do. It may appear to be a simple piece of analysis, but it is not. Mr. Sharpe was talking about PPP estimates ranging between 81 cents and 84 cents for the Canadian dollar relative to the U.S. dollar. However, that is sensitive to the price deflators used in the calculation of PPP. If you use other deflators such as unit labour costs in Canada and the U.S, measures of PPP tend to be lower in the mid-1970s as opposed to the mid-1980s. Measurement is very much an issue as well.
The Chairman: On the subject of PPP, I have never been able to understand how you compare purchasing parity between a developing country and an industrialized country. You can only compare them between countries at a reasonably similar level of development because it will not work for all kinds of reasons.
Senator Eyton: I have three questions.
First, can you advise me on — and I suppose I am talking about constant dollars — labour costs in Canada as a percentage of total output costs in the trend lines there? Thinking about it in abstract, it must be a diminishing percentage, because there is more machinery, software and other elements that make it a little more efficient. Can you tell me what kind of factor is that of total output costs?
Mr. Sharpe: It varies greatly by industry. Certain industries are labour intensive and have much greater labour costs.
Senator Eyton: I am looking nationally.
Mr. Sharpe: For all industries, you can look at labour share and total value-added. Believe it or not, that has been relatively constant over time. The CEO compensation is included in labour cost. That is considered to be part of wages and salary in Canada. Overall, the share of labour in total GDP has been relatively stable over time. It varies a bit with the business cycle. It actually goes up in a recession because profits are more sensitive to the cycle than is labour income. It goes down during an expansion, but overall it has been relatively stable.
Senator Eyton: You have not talked about the rate of change. We have come through a short period where our exchange rate has appreciated; that is, the Canadian dollar has appreciated by some 20 per cent. I have a business background. One thing is certain: Business does not like shocks. They have their budgets and their business planning, and it is very hard for them to accommodate sudden shocks or sudden changes. Most business people are not sophisticated about exchange rates. They will generally go to RBC and one or two others and will get some sort of fix. In many businesses, there is a natural hedge anyway but to the extent that there is not, they will try to cover that on some sort of predicted notion of what the rates will be over the year.
It seems to me it is a bad thing for exchange rates and for the Canadian dollar to appreciate as much as they have, as quickly as they have. That hurts business and hurts reporting and the way they manage. Can you comment on that and then indicate what is a better rate of exchange than the one we have just experienced?
Mr. Poloz: You are right that it has been more difficult. The rapidity of the change has made the adjustment seem so daunting in a short space of time. Given that it is probably at least 90 per cent necessary, it may be just as well to get it over with. I really could not formulate an optimal speed. I cannot imagine what that will be. What would be the sort of adjustment that would make it okay for companies but still having to do it? That is very hard for me to say.
My argument would be that companies have the freedom to absorb it in their profit margin and then choose their own speed to get the profit margin back. If they want to be dramatic, they can be quick. If they want to take their time, they will have to hold profit margins for an extended period. That is their choice.
Mr. Anania: There is no doubt that undue volatility in the exchange rate can be a problem for businesses, especially if it does not relate to fundamental factors underpinning the Canadian and U.S. economy. I am referring to ``animal spirits'' and ``overshoots'' in exchange rates. We have seen that many times in the past. In the case of the Canadian dollar appreciation this time around, it is more grounded in fundamentals than just pure volatility and overshoot in the exchange rate market.
In my view, it has appreciated quickly over a short period of time. The key is that we do not think it is going to fall back down. We think the Canadian dollar will remain valued at today's levels and perhaps increase in 2004 and 2005. As Mr. Poloz has said, perhaps it is a good thing it has happened so quickly.
Senator Eyton: I was thinking about the trend of Canadian companies, particularly those significantly involved in businesses that either sell in the U.S. or sell in U.S. dollars and so forth.
There is a strong trend now for Canadian companies — particularly major public companies — to convert their balance sheets and their income statements to U.S. dollars. That is one way in which they can protect themselves from the ups and downs and the adjustments to the balance sheets that sometimes occur.
Is that meaningful in terms of the exchange rate? Are there any implications? I recognize that in a perfect world, it should not make any difference at all. However, do you think it has some effect in terms of the Canadian exchange rate opposite the U.S.?
Mr. Poloz: Briefly, it may help companies in the sense of improving their transparency, their ability to see from one period to the next how to make a business plan and stay on track.
The fact remains that many of the costs of the company would be in Canadian dollars so it is not any more natural. It is not as though they are hedging themselves against the fluctuations, which are more fundamental in nature. It is a question of more of a convention: If it simplifies things for the company to express it that way, then that is a benefit.
Senator Eyton: The question is: Are there any hidden implications coming out of what is a strong trend now in senior Canadian business? I guess there should not be.
Mr. Poloz: I do not think so. However, it may mean that there is greater sympathy for, some day, a fixed exchange rate or a U.S. dollarization of our economy among the corporate sector rather than in the population at large.
Still, it is only the tip of the iceberg, I would say.
The Chairman: I want to thank our witnesses for giving us the benefit of their wisdom and I want to thank my colleagues. We will adjourn and meet tomorrow evening.
The committee adjourned.