Economy strong despite dollar’s rise

The dollar may be on the rise, but that doesn’t mean the Canadian economy is headed for disaster, according to two of Canada’s leading economists.

Speaking at a conference hosted by the Association for Corporate Growth, Don Drummond, senior vice-president and chief economist at TD Bank Financial, says the dollar’s growth can be attributed to strong commodity prices and a healthy economy.

“If we were here in 2002, and the prospect had been put to us that the dollar would be in parity, we would have predicted that the economy would have been ruined, but it’s not,” he says. “To a large extent, the dollar has been pulled up by the strength of the Canadian economy.”

Warren Jestin, senior vice-president at Scotiabank, adds that Canada should see a 2% growth in the economy next year, which is on par with most developed countries. He says industrials are strong and manufacturing is faring better than most people predicted.

But the Bank of Canada will be forced to cut interest rates in 2008, and the Canadian inflation rate will drop. That’s because the high dollar means businesses have to rethink their strategic plans, and investments and profitability estimates could be realigned. “The Bank of Canada will finally move to reduce interest rates as this trend gains force,” Jestin says.

Drummond isn’t as aggressive as Jestin on the idea of rate cuts, though he does expect one cut of 25 bps in 2008. He says lower interest rates don’t have a big impact on the Canadian dollar, so dropping rates to combat the rising buck is essentially useless.

“The thrust of debate is whether the Bank of Canada should step in and lower the Canadian dollar and cut interest rates,” he says. “But cutting interest rates has a very low impact on the Canadian dollar. Say you cut the rate by 100 bps; that only has 4% impact in the long run. This is largely in the hands of commodity prices, so there’s not a lot the central bank can do about it.”

If commodity prices remain strong — and there’s no reason to expect they won’t — the dollar could move even higher than its recent peak of $1.10 US. Jestin says we could see the dollar hit $1.12 before the BoC gets involved.

“Volatility is the keyword,” he says, “but the fundamentals suggest that after we briefly touch below parity, we’ll go higher.”

If the dollar rises, job losses will become even more a hot button issue than they are today, especially in the manufacturing sector. But Drummond says the rising currency doesn’t have anything to do with the trouble in the manufacturing industry. Rather, more jobs are moving to emerging markets. “I want to address a myth,” he says. “You can’t pick up an article that doesn’t connect job losses to the dollar, but why is the percentage reduction in the manufacturing sector larger in the U.S. than in Canada? Canada’s actually had the smallest decline [of industrial countries] at 12%.”

If anything, Canadian companies shouldn’t pull back their investment plans and instead invest in better technology and skilled labour. “In five to 10 years, [these two things] will be the characteristics of the surviving manufacturing companies.”

Still, it’s the manufacturing sector that is the biggest question mark on Canada’s economic growth. Drummond says the manufacturing sector needs to take advantage of educated immigrants, and businesses need to “ramp up” more aggressively. If Canadian companies can improve productivity, then this country could be entering a “golden era.”

“We have assets everyone is looking for,” says Drummond. “If we can drive up productivity, we can become a challenge to the emerging economies.”

The dollar wasn’t the only topic of conversation at the ACG conference. The tightening credit crunch was also on the minds of a lot of attendees. If anyone had any fears that Canada would be hit hard by tightening credit, Drummond put them to rest.

“The credit crunch in Canada is an inside-the-beltway type of issue,” he says. “Weekly loan numbers don’t show that banks have tightened their lending credits.”

While the Bank of Canada estimates that the credit crisis has resulted in a 25 bps interest rate tightening, Drummond hasn’t seen those numbers himself. He says it’s more in the 15- to 20-point range. Even the U.S. hasn’t been affected as much as some might think.

“We’re hearing every day of write-downs in the U.S., but it’ll still be the second [best] year in the U.S. banking industry,” Drummond reveals.

However, just because Canada hasn’t been affected by the credit crunch as much as the U.S., that doesn’t mean we can expect smooth sailing. The industry can expect market volatility to continue for some time, due to the fact that no one is sure who is holding the most default-prone asset-backed commercial paper.

“Markets have already discounted valuations on the presumption of certain defaults, so this is why we don’t have a disaster in the making,” says Drummond. “But there’s still extraordinary volatility because [we can expect] a constant stream of surprises.”

Filed by Bryan Borzykowski, Advisor.ca, bryan.borzykowski@advisor.rogers.com

(11/15/07)

Bryan Borzykowski