Dodge expects credit problems to persist

The Bank of Canada believes the risks to the Canadian economy have increased over the past couple of months because of continued problems with global credit markets and the volatile Canadian dollar.

In what was in all likelihood his last public appearance in front of the Standing Senate Committee on Banking, Trade and Commerce before he steps down early next year, BoC governor David Dodge said threats to the Canadian economy have increased since the release of the Bank’s most recent Monetary Policy Report Update in October.

“The Canadian economy continues to operate above its production capacity. Given the strength of domestic demand and weak productivity growth, there continue to be upside risks to the Bank’s inflation projections,” Dodge said. “However, other developments since October suggest that the downside risks to the Bank’s inflation projection have increased. Difficulties in global financial markets, related to the valuation of structured products and anticipated losses on U.S. sub-prime mortgages, have worsened since mid-October. These difficulties are expected to persist for a longer period of time than previously thought.”

Dodge says this has led to a tighter lending environment, increasing bank funding costs, and has furthered weakened the U.S. economy, which could have a negative impact on exports.

“In these circumstances, bank funding costs have increased globally and in Canada, and credit conditions have tightened further. There is an increased risk to the prospects for demand for Canadian exports since the outlook for the U.S. economy — particularly, the U.S. housing sector — has weakened,” he said. “All these factors considered, the Bank judges that there has been a shift to the downside in the balance of risks around its October projection for inflation through 2009. In light of this shift, the Bank decided to lower the target for the overnight rate at our fixed announcement date on Tuesday.”

Members of the senate committee wanted to know how the credit problems associated with structured products could continue to persist. Dodge responded that the lack of transparency and the complexity of structured products, like asset-backed commercial paper, make it very difficult to assess the risk they pose to both the Canadian and global economies.

Dodge said there is currently about $40 billion in assets related to structured investment products of which approximately $10 billion are of the “plain vanilla” variety and $30 billion are “highly structured.” He says the lack of transparency in the latter makes it difficult to assess their value. He did note the current market value of structured products is likely not indicative of its true long-term value.

“If you take the value of these from the marketplace, those are fire-sale values far below their long-term value,” he said. “In the long run, the cash flow that’s going to come from this stuff will not justify the fire-sale price from which it’s currently trading,” he said.

With regard to credit issues, the Senate also asked Dodge if he thought there would be any spillover effect from U.S. President Bush’s proposal to freeze sub-prime mortgage rates. Dodge said the liquidity problems with the Canadian-owned ABCP were related to their underlying U.S. assets, but the White House’s proposal would have a minor effect on the Canadian market and would primarily impact the U.S. housing market.

Dodge also expressed concern about the volatility of the Canadian dollar. He says its behaviour in November was unprecedented.

“We’ve just never seen it before. We’ll have to go back and analyze [what happened],” Dodge said.

One of the senators then asked if the BoC should consider a monetary union with the U.S. to prevent future volatility. Dodge rejected this idea. He says historically monetary unions follow political unions.

In order for a North American monetary union to work, Canada and the U.S. would have to have a common market with open cross-border flows of goods and labour, and he doesn’t see that happening anytime soon.

Filed by Mark Noble, Advisor.ca, mark.noble@advisor.rogers.com