Exchange rate hampering Bank of Canada's ability to slow growth in household debt

TORONTO, Dec. 17 /CNW/ - CIBC (CM: TSX; NYSE) - The growing appeal of Canada to foreign investors, including central banks, may be overheating the value of the loonie, further hurting an already battered Canadian manufacturing sector and making it difficult for the Bank of Canada to raise interest rates to slow growing household debt, finds a new report from CIBC World Markets Inc.

While Bank of Canada Governor Mark Carney recently warned of a "death grip" on the U.S. dollar, given that over 40 per cent of America's trade is now with countries with managed exchange rates against the greenback and more than a dozen countries seeing double-digit growth in their reserves, the report notes the Canadian dollar may also be in a "death grip" of its own.

"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. "Precise data on such flows aren't available, and much of the foreign ownership of Canadian bonds is likely in private sector hands. But a significant share of the growth of late, and it's been massive, appears to be linked to central bank reserves and other sovereign funds."

The CIBC report found that 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 entire federal and provincial deficit. The majority of that has been in Government of Canada issues, the favoured vehicle for central bank reserves.

Canadian dollar central bank holdings are lumped into an "other" category in IMF data that would also include the Australian dollar and a few others, with most emerging economies not reporting on the composition of their holdings. Mr. Shenfeld believes these non-reporters are following a similar allocation. Using a reasonable estimate of Canada's share of that "other" group, he estimates central banks might be accounting for a third-to-a-half of the net new foreign buying, which is also in line with anecdotal evidence from market participants.

"Those central banks are not, of course, trying to control their currency's cross against the Canadian dollar, since the bilateral trade flows that would be affected would be modest," adds Mr. Shenfeld. "Nor are they directly aiming at driving the loonie up against the U.S. unit. But that is still the outcome."

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. A CIBC Economics analysis in the report shows that Canada's current debt load is not problematic, but if maintained, the present pace of borrowing could put a squeeze on household finances five years out.

The Bank can't move to raise interest rates to deter additional borrowing for fear of sending the loonie even higher and putting further drag on exports. Already, the Canadian dollar's appreciation has contributed to Canada losing more than a quarter of its 2001 share of the U.S. import market.

While many are now looking to the federal government to put the brakes on household borrowing, the report suggests Bank of Canada Governor Mark Carney has another option.

"There is one weapon yet to be touched: fighting fire with fire," says Mr. Shenfeld. "Canada could match foreign central bank intervention in favour of our currency with an offsetting intervention, selling an equivalent volume of loonies. That would simply move back to market determined exchange rates, and would loosen the death grip on the Canadian dollar."

Mr. Shenfeld notes that while global policy makers have devoted a great deal of time and effort to developing financial sector reforms based on the lessons from the past economic crisis, Canadian policy makers may want to pay a little more attention to the impacts of an imbalance in trade tied to misaligned currencies, another key factor in the recent troubles that tripped up the global economy.

The complete CIBC World Markets report is available at: http://research.cibcwm.com/economic_public/download/sdec10.pdf.

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