Recently, the Canadian dollar closed below .70 USD for the first time in over thirteen years. As Canadians, we’ve seen our dollar go on a roller coaster ride over the past twenty years. From a high of 1.10 USD on November 7th, 2007 to its current value; this dramatic fall has caused many people to ask the question “why?”
This article will look into why currencies fluctuate and why the Canadian dollar is depreciating by so much. As a forewarning, this article took a life of its own and is longer than a usual post.
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Before we go into detail, we need to go over some basic concepts. The market for foreign currency is just like every other market; it operates on the principles of supply and demand. These two variables settle at an optimal point and this determines the nominal exchange rate. A simple supply and demand graph is illustrated below.
One half of this equation, the demand for Canadian Dollars, is how many people actually want to have the Canadian dollar. If more people want to have our currency, then individuals will be willing to pay more for it (assuming that supply stays the same). This then causes an increase in the price for the Canadian dollar (also known as an appreciation of the nominal exchange rate). However, the inverse also holds true and if less people want the Canadian dollar then the value will decline.
The demand for the Canadian dollar is usually generated in two ways. The first way is when foreign parties are buying Canadian goods. These buyers need Canadian dollars to purchase these goods and often will buy large amounts of currency to facilitate future trades. The second way is when foreign individuals want to buy Canadian real and financial assets. So for example, an investor may want to invest in the Toronto Stock Exchange and would need Canadian dollars to do such. Both of these ways cause an increase the amount of Canadian dollars that are wanted and therefore cause it to appreciate.
Changes in other countries can also affect the demand for the Canadian dollar. For example, if people want to invest in the United States, then the may sell their Canadian investments and move the funds to American currency. This has a double effect, the Canadian dollar will depreciate and the American dollar will appreciate!
The other side of the equation is the Canadian dollar supply in the foreign exchange markets. If the amount of available Canadian currency decreases, then individuals will be willing to pay more for it because it’s scarcer. However, if the available amount increases, then there is more Canadian currency to go around and will usually depreciate.
So for example, if the Canadian government prints a lot of extra money then there will be an over abundance of their currency in the foreign markets and this will typically decrease the Canadian nominal exchange rate.
Overall, changes in the nominal exchange rate are cause by changes in the demand and/or supply of Canadian dollars.
So What’s Happening in Canada?
The general consensus is that the Canadian dollar’s exchange rate is declining because of a weak Canadian economy and low employment growth. This is true, but this explanation only really captures the surface of the problem. If we dig deeper, we see that the biggest drag on the Canadian economy is from large drops in businesses’ investments, specifically in constructing property and buying equipment, machines and inventories. However, this overall economic drop was limited, due to a big economic boost caused by exports.
Please note that all the following data is from Statistics Canada and are for the most recent available time period, October 2014 to October 2015.
The general consensus among financial professionals is that the reduction in economic activity is directly related to falling global commodity prices, with an emphasis on the collapsing price of crude oil. I found similar conclusions after analyzing the economic data. The oil and gas extraction industry and its supporting activities had the largest drops in economic output. For example, the economic output of direct supporting roles collapsed by 47% over a one-year period!!!
Similarly, we see the largest employment drops occurring in the oil, gas and mining sectors; these decreased by 13.7% over one year. The biggest employment loss was in supportive activities, which declined by 25.5%. These declines were most concentrated in Alberta. Supportive activities are really just a mix and match of various jobs that assist with oil extraction and it’s linked activities.
So how does this affect the Canadian dollar? As mentioned, the demand for currency decreases when less people want to invest in the Canadian economy and/or buy its exports. Canada has seen a recent increase in exports, so therefore the drop in the Canadian dollar is mainly due to the sharp decline in investments. Due to our weak economy, companies are halting their investments and foreign parties are looking for more opportune investments elsewhere, e.g. The United States. Unfortunately, it seems these hurtful drags on the economy will continue for a while and these negative expectations will also decline the nominal interest rate even further.
More depressingly, the most recent data from Statistics Canada ended in October 2015. Since then, the price of crude oil has decreased further and will undoubtedly have a larger impact on the oil industry.
Is there Any Good News?
Thankfully, there are some positives effects that will arise out of this situation. We can expect our country’s exports to continue increasing and hopefully, with that a growth in the manufacturing sector. When the dollar depreciates, Canadian goods are usually cheaper for foreign countries to buy. Certain exports, like car manufacturing and consumer goods have already felt this increase of exports. If this trend continues, we will also likely draw in some large foreign investors that want to utilize our skilled workforce and easy access to American markets. Here’s wishing for the best!
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