Over inflated Canadian dollar risks hollowing out the country's
    manufacturing base

TORONTO, Oct. 27 /CNW/ - The Bank of Canada should look to intervene at extreme times to keep the value of the loonie stable and protect Canada's manufacturing base, finds a new report from CIBC World Markets.

The report argues that by not intervening in the foreign exchange market when speculators are pushing the dollar to heights it does not believe are fundamentally sound, the Bank risks a hollowing out of the country's industrial base.

"Canada could consider what might be called a bounded float," says CIBC's Chief Economist Avery Shenfeld in the bank's latest Economic Insights report. "By intervening only at extremes, the central bank could help chase away speculative flows that take the currency, in its considered judgment, beyond fundamentally driven levels."

Mr. Shenfeld notes that Canada has let markets decide where the currency should trade since 1998, effectively leaving the intervention tool to gather dust in the central bank's basement. The policy of the Bank is not to target the exchange rate, but rather to take any net stimulus or drag associated with an under- or overvalued loonie into account in setting interest rates. He adds that in the current environment, that means leaving interest rates at rock bottom for longer than would otherwise be the case.

"Anyone who has watched the Canadian dollar's performance in the last 15 years would have a tough time arguing that foreign exchange markets are the perfectly rational, calculating machines that the textbooks suggest," says Mr. Shenfeld. "Clearly, it's not simply trade flows and commodity prices, but also wildly fluctuating expectations and the hot money flows they generate, that set the tone for currency movements. The Bank of Canada admits as much when it points out the dangers of recent Canadian dollar appreciation."

One of the concerns in not intervening in the rapid appreciation of the Canadian dollar is that the Canadian economy is made up of many different sectors that react very differently to changes in currency values and interest rates. "If one thinks of GDP as simply an undifferentiated lump of output, then foreign exchange bubbles would not seem to be too consequential for Canada," adds Mr. Shenfeld.

"In the current context, the drag on overall growth and inflation could be largely offset by the Bank of Canada's decision to keep rates on hold for an extended period. This month's interest rate announcement sent a clear message that to the extent that the Canadian dollar will delay re-attaining the two per cent inflation target, it will help keep rates low for longer, giving an offsetting boost to output."

While this may keep the country's GDP numbers on an upward slope, it's the composition of growth that concerns Mr. Shenfeld. "In the real world, the mix of output also matters. Putting people into larger houses because mortgage rates are lower than otherwise generates economic output in the construction industry, and leaves the economy with a larger stock of housing.

"But if the loonie is overvalued for a few years, we may be sacrificing business plant and equipment on the altar of a strong currency. Plants that close because they are unprofitable at current exchange rates might permanently relocate elsewhere. They won't suddenly come back if currency later cheapens. We are hollowing out our industrial base by letting speculative foreign exchange market forces, in effect, dictate the mix of monetary conditions."

Given this, he believes it may be time for the Bank to shift policy gears and intervene in foreign exchange markets when it believes the loonie is overvalued. "To those who say intervention never works, China has steered the Yuan exactly as it pleases, while Swiss intervention earlier this year stopped the franc's appreciation against the euro dead in its tracks. Intervention is a powerful tool for those who opt to use it."

What he doesn't want to see is a fixed exchange rate, "which forever hands over our interest rate policy to the (U.S.) Federal Reserve (Board), and fails to allow any adjustment to longer swings in commodity prices."

The complete CIBC World Markets report is available at:
    http://research.cibcwm.com/economic_public/download/soct09.pdf.

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