In its initial stages, the retreat of the Canadian dollar from parity with the U.S. greenback was treated by commentators as unambiguously positive for the Canadian economy, especially our allegedly beleaguered manufacturing sector. But as the loonie sinks below 90 cents (U.S.), doubts are starting to creep in.
The costs of a lower exchange rate are adding up. Cross-border shoppers, including on-line consumers, feel an immediate loss of their purchasing power. Surcharges are appearing on travel packages as Canadians book flights to escape an unusually harsh winter.
But the most harmful impact for most people is on gasoline prices. Because of the integrated North American market for gasoline, we pay the same price in U.S. dollars as Americans. So when the loonie drops in value, prices in Canada automatically go up. This effect was clearly evident in December's consumer price index. Over the previous 12 months, gasoline prices in the U.S. fell 1 per cent, while in Canada they rose 4.7 per cent. This differential will widen in January when the loonie's depreciation accelerated.
It is not just consumers who face higher prices. Businesses import most of their machinery and equipment, a major determinant of productivity. Faced with higher prices for these imports, firms will rein-in capital investment, which will slow the future growth of wages for workers. Even governments will feel the pinch, as their cost of servicing foreign debt rises in lockstep with a lower dollar.
Meanwhile, the benefits of the lower dollar are largely confined to the export sector, notably manufacturing. Not that manufacturing really needs much help, as demand from the U.S. auto and housing industries continues to improve. Factory sales in November increased for the sixth time in seven months, reaching $50.5-billion compared with their low of $38.3-billion in 2009. Manufacturing sales are within spitting distance of setting an all-time high, something they should do in 2014. Hardly the picture of an industry needing resuscitation.
Exporters clearly welcome the extra boost their prices and profits get from the lower exchange rate, but they will not materially change plans for output and employment. Industries doing well before the loonie's dip will continue to expand, while depreciation offers little salvation for struggling exporters like BlackBerry, whose wounds are self-inflicted. This reflects how firms had fully adapted to nearly six years of parity with the U.S. dollar.
So there is no reason to expect the trend of factory output to change significantly in 2014, but consumers increasingly will feel the pinch from higher prices as retail inventories are replenished and hedging strategies expire. The net result of demand shifting from households to exports in response to the devalued dollar will be lower growth overall.
A falling exchange rate almost always lowers living standards. No country has ever devalued its way to prosperity. It didn't work for Canada in the 1990s, and it won't work now. However, the myth that devaluation raises incomes is powerful in countries that fall under its sway. In Canada, job growth in manufacturing in the 1990s was led by low wage industries such as clothing, textiles and furniture, implying Canada bought into imitating the business model of Bangladesh. Whatever we were thinking back then, let's not deceive ourselves this time around that low-cost exports based on a low dollar will make us rich.
So why are some economists so enthusiastic about a lower exchange rate? Partly because our macro models never met a devaluation they didn't like, since the benefits for exports are easy to model but the cost from higher prices and lower investment are subtle and hard to quantify. At a conference of macroeconomists last fall, between sessions I pointedly asked several experts if this bias remains in current macro models, and the answer emphatically was yes. Macroeconomists also stress how little they understand exchange rate movements, something clearly on display in the unexpected speed and severity of the dollar's slide. One of the few benefits of the lower dollar is silencing talk about the loonie being a 'petro-currency,' since steady oil prices in recent months cannot explain the weaker dollar.
Hopefully, the lower loonie will be a temporary phenomenon. The depreciation became pronounced in late October after the Bank of Canada shifted its bias from raising interest rates to neutral. If growth in our major trading partners, especially the U.S., picks up, the Bank may quickly revert to its upward bias for interest rates, encouraged by higher consumer prices.
Philip Cross is a Fellow at the Macdonald-Laurier Institute and the former Chief Economic Analyst at Statistics Canada