Mr. Thiessen discusses global uncertainties and the Canadian economy  (Central Bank Articles and Speeches, 23 Sep 98)
Central bank: boc | Type: speech | Date: 1998-09-23

Mr.

Thiessen discusses global uncertainties and the Canadian economy Remarks by the Governor of the Bank of Canada, Mr. Gordon Thiessen, to the St. John's of Trade in St. John's, Newfoundland on 23/9/98.I am delighted to have been invited to speak to the Board of Trade on occasion when the Bank of Canada's Board of Directors is meeting here in St. John's.This past year, we have had to deal with the implications for our economy a currency of increased global uncertainty and pressures arising from the problems that in Southeast Asia.

I am sure that the effects of these developments, especially o commodities, such as oil and nickel, are already very familiar to Newfoundlanders.To understand what is going on, we need to look at the nature of the forc are currently affecting our economy.

We also need to correctly identify cause and effe comes to the decline in the external value of our currency over the past 12 mont commentary on this subject has not always been helpful.I would like to start my presentation with a quick review of intern developments, focusing on the extent to which the problems in Southeast Asia have persi spread.

Next, I will discuss the implications of these developments for the Canadian and give you the Bank's latest assessment of the outlook.

I can tell you now that I bel key trends in our economy remain positive.

Lastly, I will talk about the decline in t value of the Canadian dollar and about the response of monetary policy to that decline.

## The world around usFor over a year now, volatility and uncertainty have been the main traits international environment in which Canada operates.The financial crisis started in Southeast Asia in the summer of 1997, then to

South Korea, and in turn exacerbated the domestic economic difficulties that Ja already facing.

Recently, Russia has been added to the list of afflicted countries, an countries in Latin America are under pressure.As with the crisis in Asia, the financial problems in Russia have rever around the world through foreign exchange, stock, and bond markets, touching off conc still further contagion.It is certainly easier now, with the benefit of hindsight, to see the exte many investors from industrial countries were attracted to higher-yield investments in market countries, without fully appreciating the risks involved.

When investors substantial losses in certain markets, they sought to reduce their exposure to emergi more generally.

But this rapid withdrawal of funds brought to the surface areas of we some of these economies, making investors still more nervous.

The recent events in Russ prime example of this process.The apparently contagious nature of these developments has led to s pessimistic predictions of recession in the world economy.

How concerned should we be this?While the international environment has turned out to be more difficult tha people had thought earlier, let me reassure you that it is certainly not all negative.To be sure, the situation in Japan is worrisome - not only because of that economic importance but also because of its strong trade and financial links with othe Asian economies.

But, and this is an important but, Japan has the capacity and the wherewithal to turn its situation around.

With resolute action to speed up the impleme measures to deal with its ailing banking sector and to kickstart its domestic economy, concerns would dissipate.More importantly, economic activity in the United States has been very robu is expected to remain healthy.

In Canada, too, and in Europe the situation is positi certainly not insignificant, for North America and Europe together account for more tha world output.

And recent declines in medium- and long-term interest rates to record l are helping to sustain domestic spending in all industrial countries.With this as background, I would now like to turn to the impact of international developments, and of the associated uncertainties and pressures in markets, on Canada.

## How is our economy faring?The international developments of the past year have affected our economy than previously anticipated.

And there is no doubt that those Canadian industries and r depend on the production of primary commodities are facing considerable difficulties.To appreciate this particular link between recent international developmen the Canadian economy, let me point out that Asia, including Japan, absorbs between 30 per cent of the world output of certain key primary materials.

So it is not surprisin commodity prices have been hit hard by the Asian crisis.

The recent events in Russia, w major commodity producer, have added to the uncertainty about the outlook for the world and prices of primary commodities.Because of all this, the US dollar prices of commodities that are impor Canada have fallen by about 15 per cent over the past 12 months.

While commodities ar important to us than they used to be, they still make up about 30 to 35 per cen merchandise exports.Although Canadians have to deal with these difficulties coming from abroad, important to remember that, overall, our economy is still in good shape.

This is, foremost, because some basic aspects of our economic situation have improved markedly last few years.

We now have a low rate of inflation, a fiscal surplus, and a declining high) public debt-to-GDP ratio.

As well, Canadian businesses have undertaken m restructuring and investment initiatives to increase their productivity.

Because fundamental strengths, we are now better positioned to weather sudden shocks.As for the near-term outlook, there are also a number of positive elements picture.

Economic activity in the United States, our main customer, remains high.

And Canada, the latest indicators suggest continued expansion in consumer spending and b investment, supported by higher employment and low medium- and long-term interest ratesThis year, the Canadian economy will not repeat the 4 per cent gro experienced through 1997.

But it may still expand by 2½ to 3 per cent (fourth quarter o quarter).

Clearly, a good deal of uncertainty surrounds any estimate at this juncture international situation.

For one thing, it is difficult to judge how quickly and effe will deal with its problems, and what this will mean for the rest of Asia.

The extent o from the recent spreading of the crisis to Russia and the pressures in parts of Latin also uncertain.

But, at the same time, most forecasters have consistently underesti resilience of the US economy, and may still be doing so.

## Implications for the Canadian dollarOne of the most talked-about economic events in Canada over the past year been the decline in the external value of our currency.

At its lowest point, in late the Canadian dollar had depreciated by about 13 per cent against the US dollar and by m 7 per cent against the German mark from its average value in the first half of 1997, Asian crisis erupted.

Since that low point in late August, the Canadian dollar has somewhat against the US dollar.

## What has caused these movements?Exchange rates will typically reflect developments in Canada and abroad.

Th is important to keep in mind that the recent movements in the Canadian dollar consequence of developments that have occurred over the past year.

They are not the cau difficulties we are now facing, as some of the recent commentary seems to suggest.It is also important to note that our exchange rate is the price of the dollar expressed in terms of the currency of another country, usually the US dollar exchange rate will be influenced by events affecting both countries.

If we are to interpret movements in the Canada/US exchange rate, we must also look at what has happening to the United States, not just to Canada.

And that makes any interpretati complex.Until very recently, the US dollar has been exceptionally strong again currencies.

In part, this reflected the buoyancy of the US economy.

But in the dif uncertain global environment of the past year, the strength of the US dollar also cam role as the major international currency.

After the Asian crisis, and with renewed vi days following the events in Russia, international investors sought shelter in US do Indeed, the turmoil in financial markets in late August seemed to be the result of a reassessment of risks by investors following the announcement of the Russian debt moratThus, to the extent that the depreciation of our currency reflected the app of the US dollar against all currencies, the cause was the global flight of funds into UBut that is not the whole story.

The downward pressure on our currency ove past year was also related to events that were seen as affecting Canada more specific explained earlier, one important event was the marked decline in the prices of the ke commodities we export.The drop in these prices has meant lower incomes and wealth for Canadians. profit outlook for many of our resource industries has deteriorated and product employment in those industries are likely to be affected.

And the market value of comp those sectors has reflected these developments.

Moreover, lower net export earnings f primary commodities imply, all else being equal, a larger deficit in our balance of i payments and a greater need for foreign borrowing than would otherwise be required.All these commodity-related developments have led to downward pressure on o exchange rate.

And the lower dollar spreads the wealth and income effects of falling c prices across the economy.In effect, a lower Canadian dollar means higher domestic prices for all goods that are imported and for many of the import substitutes we produce here.

For level of income, these higher prices imply a decline in living standards for Canadian Retailers who feel unable to pass on these price increases to consumers will have to ab in lower profits which, in turn, will mean lower returns for their shareholders.The bottom line is that the decline in commodity prices has made us less w than we were before.

And we have to adjust to this reality.These effects are unavoidable, even if we were able to prevent the Canadian from falling.

In fact, if the currency were not allowed to move at all, the adjustmen slower and more costly, taking place through reductions in wages which usually involve fluctuations in output and employment.

Under a floating exchange rate, the process is by some downward movement in the dollar which spreads the burden of adjustment.

Over years, this has been an important justification for a flexible exchange rate in Can adjusting through exchange rate movements to the shocks that periodically hit our e makes for a generally smoother and fairer process than adjusting through reductions i employment, and wages.But I do not want to leave you with the impression that foreign exchange ma always know the appropriate value for a currency.

They sometimes push too far once a established in one direction or another.

Indeed, I believe that during this latest epi financial turbulence, markets exaggerated the commodity connection of the Canadian doll example, our exports of highly manufactured goods, apart from the important motor v sector, have grown by nearly 20 per cent over the past 12 months, and now represent a per cent of our merchandise trade.

This development seems to have been largely overlooke

## Monetary policy responseSo, what can and should the Bank of Canada do about the exchange rate in t of international financial turbulence and major external shocks?First of all, let me remind you that the objective of Canadian monetary pol hold the rate of inflation within a range of 1 to 3 per cent.

This target, jointly agre government and the Bank of Canada, reflects the conclusion that low inflation will con a stronger, more stable economic performance over time.If we are to fulfill our commitment to keep inflation low and stable, mo policy must remain focused on that objective.

The exchange rate and interest rateschannels through which monetary policy operates and they must be allowed to adjust t achieve the inflation targets.But what if the momentum of currency movements pushes the Canadian dollar beyond any level that is justified on economic grounds?

Judgments as to what is, o justified are very difficult to make, but there are times when the good economic news g the face of a persistent currency decline.On those occasions, Canadian authorities need to remind investors of the p trends in our economy.

And to reinforce the message, the Bank may intervene, on behalf Minister of Finance, to support the currency by buying Canadian dollars in the foreign market.

But we do know that this kind of intervention will be effective only if a good investors share our belief that the currency movement has been overdone.The Bank can also respond to currency declines with Bank Rate changes.

Th are two sets of circumstances in which this would be appropriate.

The first is magnitude of the currency decline threatens to push the economy off a sustainabl inflationary growth path.

Remember that a declining currency is a source of stimulu economy, because it encourages exporters and producers of import substitutes to expan activities.

That is why the Bank always puts the exchange rate and interest rates toget to measure the amount of monetary stimulus in the economy.

If a declining currency l monetary conditions that are persistently too easy and inconsistent with the inflation Bank will offset that with higher short-term interest rates.The second situation that would prompt a Bank Rate increase is when there potential loss of confidence in the Canadian dollar.

If confidence is undermined, both and foreign investors will move out of investments denominated in Canadian dollars unl are compensated with substantial premiums in interest rates.

Higher premiums, which t into higher medium- and long-term interest rates, are very costly for the economy.

It w of such concerns that the Bank responded strongly to the decline in our currency du Mexican crisis in early 1995.The recent Bank Rate increase at the end of August was also designed to cou potential loss of market confidence.

In this case, investor nervousness was exacerbat financial crisis in Russia and was reflected in a sharp decline in our currency and ris and long-term interest rates.

Since the Bank Rate increase, the Canadian dollar has rec medium- and longer-term interest rates have come down.

## Concluding commentsI have placed a great deal of emphasis on recent international developments remarks today because the implications of these developments for the Canadian economy a exchange rate are important and complex.Let me summarize my main points.For the past year, our economy has had to cope with the fallout from the crisis, which has turned out to be more widespread and prolonged than most of us had pr Although we are having to deal with these difficulties and with the ongoing global un and pressures, it is important to remember that there is still a significant positiCanada's external environment coming mainly from a resilient US economy.

And there is considerable underlying buoyancy in our domestic economy.

What's more, the improvement our basic economic foundations puts us in a better position than before to withstand t adversity.In addition to pressure from the worldwide strength of the US dollar, some downward movement in the Canadian dollar over the past year was a reflection of the im lower commodity prices on our economic well-being.

However, by early August, it appeare investors were exaggerating the importance of these effects and losing sight of th positive fundamentals in our economy.

The Bank intervened, buying Canadian dollars encourage market participants to pause and reassess their views of the Canadian economy that pause was overwhelmed by a new wave of nervousness precipitated by the events in in mid-August, the Bank raised the Bank Rate to forestall a loss of confidence in th and thus reverse a costly increase that was taking place in medium and long-term inter Since then, these interest rates have come down.Let me conclude by pointing out that, despite all the recent attention Canadian dollar because of exceptional external developments, the fundamental foc monetary policy remains on keeping the trend of inflation in Canada inside a target ran 3 per cent.

Low inflation is the best contribution the Bank of Canada can make towards overall economic performance over time.

It also provides the best underpinning for Canadian dollar in the long run.