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Our Loonie Runs on More Than Oil

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Bank of Canada Governor Mark Carney recently rejected the notion that the Canadian dollar was nothing more than a "petro-dollar" relying entirely on the global price of oil to backstop its value.

"It is far too simplistic to talk about the Canadian dollar as a commodity currency, let alone a currency that moves consistent with one commodity," Carney noted during a press conference in Ottawa earlier this month.

Despite the Governor's dismissal, there is no question that the Canadian dollar is receiving support from surging oil prices and the oil-producing regions of Western Canada are reaping the benefits. Meanwhile, Canada's manufacturing base in Quebec and Ontario continues to struggle as demand from foreign markets remains well below pre-recession levels.

The strong loonie only adds to the misery of a manufacturing sector still reeling from the loss of thousands of jobs. In Ontario alone, factory employment fell to a 35-year low late last year. Little wonder, then, that Ontario Premier Dalton McGuinty told an audience that "the only reason the dollar is high" is because of rising oil prices.

Given the situation, the Premier's frustration is understandable. Truth be told, however, for much of the past three decades, the shoe was most definitely on the other foot, with the "loonie" consistently valued well below its U.S. counterpart. Ten years ago, for instance, one loonie was barely worth a paltry 60 U.S. cents and this built-in exchange rate discount gave Canadian goods a decided price advantage in foreign markets.

No one is doubting the importance of oil and energy to the Canadian economy, but the entire energy sector represents less than five per cent of GDP. The wealth this sector creates is significant, but it pales in comparison to the entire economy making the claim that the loonie is merely a "petro-dollar" seem somewhat overblown.

To fully understand the factors supporting the Canadian economy -- and by extension the loonie -- it is necessary to also consider the impact of global events.

At the top of this list is the ongoing European debt crisis and the growing likelihood that additional Eurozone countries could soon require emergency bailouts to prevent a sovereign default. To prepare for this emerging possibility, it was recently announced that the lending capacity of the European Financial Stability Fund (EFSF) would be increased from 400 billion euros to just under 800 billion euros.

Obviously, the International Monetary Fund and the European Central Bank are preparing for further funding needs. Sovereign bond investors clearly share this sentiment as evidenced by the recent increase in 10-year yields in Spain and Portugal.

As well, the U.S. economy continues to under-perform and after the U.S. suffered last fall's credit downgrade, Canada remains one of the few countries still firmly established as a top-rated, triple-A economy. As such, Canada is becoming a more attractive destination for investors looking to protect wealth and savings.

This search for a "safe harbour" has resulted in an increase in investment dollars flowing into Canada. Currency speculators are also taking long Canadian dollar positions in the expectation that the Bank of Canada will raise interest rates later this year adding further to demand for the Canadian dollar on foreign exchange markets.

Given these realities, the loonie is expected to remain well-supported. This has given rise to warnings that Canada is falling victim to its own version of "Dutch disease."

This term was first coined in the late 1970s and refers to the "hollowing out" suffered by the Netherland's manufacturing sector following the discovery of a large natural gas field. In short order, new money started pouring into the country and the economy soon became highly dependent on natural gas sales leaving it extremely vulnerable to swings in the price of natural gas.

Canada has experienced this phenomenon in the past, and the nation's oil-producing regions have suffered through several energy price cycles. However, Canada's financial make-up is more diverse than that of the Netherlands in the 1970s and energy plays a smaller role in the overall composition of the economy.

This means that while energy is important to Canada's well-being, it is only part of the story. As well, the Canadian manufacturing has proven its resilience and as of this past March, the sector recorded its fifth straight monthly gain.

Despite these gains, there is no question that some of the manufacturing jobs lost following the recession are gone forever. However, whether these jobs disappeared because of the strength of the loonie -- or, looking it at from another angle, a floundering U.S. dollar -- is immaterial.

The reality is that Canadian manufacturers must find ways to remain competitive with other jurisdictions -- and relying on an undervalued currency to maintain this competitiveness is simply not feasible in the current global climate.

Think of it as Dutch disease in reverse.