Loonie ties the hands of BoC

As dollar-parity becomes more of a floor than a ceiling, Canada continues to lose its share of the U.S. import market. As conventional measures remain inapplicable, Canadian economists are suggesting radical moves to tackle the issue of an overheating loonie.

The rapid rise in the value of Canadian dollar owing to foreign investors and central banks flocking to Canada is hurting an already battered Canadian manufacturing sector while making it difficult for the Bank of Canada to raise interest rates to curb household debt, according to a report from CIBC World Markets.

“Reasonable decisions by central banks to diversify their reserve holdings, including added weight in the Canadian dollars, may have been a key factor in driving our currency to parity vs. the U.S. unit, offsetting a large trade deficit,” says Avery Shenfeld, chief economist at CIBC. “Those central banks are not, of course, trying to control their currency’s cross against the Canadian dollar; nor are they directly aiming at driving the loonie up against the U.S. unit. But that is still the outcome.”

Foreign investors added more than $72 billion to their Canadian dollar bond holdings in the past 12 months, nearly enough to finance last year’s combined federal and provincial deficits.

The elevated value of the loonie has hamstrung the Bank of Canada in its efforts to stem the rapid growth in consumer debt through interest rates hikes. Any further rate rise would push the loonie even higher, sending already suffering exports on the skids.

Noting that the Bank is fast running out of ways to contain the loonie, Shenfeld points to a weapon that can fight fire with fire. “Canada could match foreign central bank intervention in favour of our currency with an offsetting intervention, selling an equivalent volume of loonies, says Shenfeld. “That would simply move back to market determined exchange rates, and would loosen the death grip on the Canadian dollar.”

From the investment perspective, anyone who’s investing in companies that do business with the rest of the world is going to be negatively impacted, says John Kurgan, senior market strategist at Lind-Waldock Canada, a brokerage firm with offices in Toronto and Montreal. “If investors are looking to invest in companies, (they) want to take a look to see if (the companies) have their business hedged in some way with respect to the U.S. and Europe.”

Once the loonie goes north of parity it’s going to hover around that region for a while, he adds. “I think we’re going through par and we are going to stay above par, until the second quarter of 2011, regardless of how hard the BoC tries to break away.”

The other thing that’s affecting the Canadian dollar is its correlation to the price of crude oil. And judging by the current buy signals the oil prices will continue to rise, taking the loonie along for the ride, says Krugan.

Shenfeld suggests Canadian policymakers pay more attention to the impacts of an imbalance in trade tied to misaligned currencies, another key factor responsible for the current global economic environment.