Gordon Thiessen: Why a floating exchange rate regime makes sense for Canada
Speech by Mr Gordon Thiessen, Governor of the Bank of Canada, to the Chambre de commerce du
Montréal métropolitain, Montreal, Quebec, 4 December 2000.
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Why a floating exchange rate regime makes sense for Canada
As I near the end of my term as Governor, I find myself looking back more and more, focusing on the
broad, longer-term trends in our economy and in financial markets and on what those trends may
imply for the future.
One of the issues that has often surfaced over the years is the exchange rate for the Canadian dollar.
Indeed, over the past couple of years, it has been a topic of considerable public discussion. That
discussion has revolved around such questions as: Should we continue floating, or should we peg our
currency to the US dollar? In fact, should we even keep our own currency, or should we adopt the US
currency?
That there is such interest in our exchange rate is hardly surprising. Some of the more recent attention
no doubt stems from public concern about the relatively low value of the Canadian dollar in
comparison to the US dollar. But the fundamental reason for this interest is that the exchange rate is an
important price in an economy, particularly in one as open as ours. Exports represent about 40% of
total Canadian output. And if we add imports, this proportion doubles to 80%. In addition, more than
80% of this trade is with the United States. So the value of our currency in terms of the US dollar has
always been particularly important for us. But we must be careful not to exaggerate this point, because
when it comes to exports, we compete with many other foreign countries for a share of the US market.
And so the exchange rates of those currencies relative to ours also matter a great deal.
In 1950, after the Second World War, Canada became the first major country to adopt a floating
exchange rate. In 1962, we went back to a fixed exchange rate only to float our currency again in
1970. In all, the Canadian dollar has floated for 42 out of the past 50 years. No other major country
has had as much experience with a floating exchange rate.
This does not mean that our floating exchange rate regime has somehow outlasted all its critics! For
the most part, though, the debate over the years has been about the market value of the Canadian dollar
- whether it has floated too high or too low, especially from the viewpoint of certain exporters and
importers.
More recently, however, and certainly here in Montreal, some of the discussion has focused more on
whether a floating currency is the right exchange rate regime for Canada. This particular debate has
been kindled by the advent of the euro and its adoption by 11 members of the European Union at the
beginning of 1999.
I entered that debate early in 1999, arguing that the introduction of the euro was a remarkable
achievement, but that it did not provide a useful role model for Canada and for our position in North
America. Since then, with increased interest in the subject internationally, there has been considerable
discussion of exchange rate alternatives for Canada and for other countries.
In Canada, the debate about exchange rate regimes has been mainly among academic economists. But,
with the decline of our currency against the US dollar through the 1990s, the exchange rate has also
been raised as a concern in the business community when comparing our less-impressive economic
performance with that of the United States.
Outside Canada, the debate on exchange rate regimes has also become more active, especially in parts
of Latin America that have had a long history of high inflation and exchange rate crises. Indeed, in
some of these countries, commentators have argued in favour of the outright adoption of the US
currency.
Today, I would like to return to the issue of the right exchange rate regime for Canada. Having again
considered the advantages and disadvantages of our current arrangements, I can tell you at the outset
that I remain convinced that a floating exchange rate continues to make sense for us at this stage of our
history. I propose to examine the different sides of the argument with respect to a floating currency in
as simple and straightforward a manner as possible.
The transactions costs of a floating currency
When the amount of cross-border trade and financial transactions is as large as ours is with the United
States, the need to exchange currency raises the cost of such transactions. Moreover, if the currencies
involved are floating, so that the future level of the exchange rate is uncertain, there is also a foreign
exchange risk to consider and to hedge against. For example, investors and borrowers must take into
account not only the level of interest rates in Canada and the United States, but also potential
movements in the exchange rate over the term of their investment or loan. So, yes, there are certain
transactions costs in having a separate currency.
A fixed exchange rate between the Canadian and US currencies, such as we had from 1962 to 1970,
does not do away with all these transactions costs. Conversions between the two currencies would still
be required. Moreover, a fixed exchange rate does not eliminate currency risk. If there were any
perceived risk of a future devaluation of the fixed rate for the Canadian dollar, the result would be
persistently higher interest rates in Canada than in the United States to compensate for that risk.
Even where countries have gone beyond a fixed exchange rate and have tied their currencies rigidly to
the US dollar - as Hong Kong and Argentina have, through a currency board - the costs, in terms of
risk premiums in domestic interest rates, have not completely disappeared.
So, in fact, the only way to eliminate cross-border transactions costs with the United States and
eliminate premiums in our interest rates for potential exchange rate risk is not through a fixed
exchange rate but through some sort of currency union with the United States. In reality, this would
mean "dollarization".
Dollarization versus monetary union
But why not a common-currency arrangement, as in Europe? Wouldn't that be better?
On the face of it, of course, a currency union would be better than dollarization. Under such an
arrangement, we would, in principle, still have some say in determining a North American monetary
policy. Presumably, we would also be able to keep some of the revenue (or seigniorage) from issuing
that common currency.
But we must understand what a North American monetary union would mean in reality. The European
experience is rather enlightening in this respect. Economic and monetary union in Europe is the
product of 50 years of increasing political and economic integration. The recent adoption of a common
currency, which was a further step on the road to European integration, was taken mainly for political,
rather than economic, reasons. And when it comes to decision-making at the European Central Bank,
the three large countries in the euro area (Germany, France, and Italy) have agreed to a "one country
one vote" rule with their other eight medium- and small-sized partners.
I do not see how we could possibly have similar arrangements in North America, given the clear
dominance of the US economy. In effect, a monetary union with the United States could only mean
that Canada would adopt the US dollar.
The advantages of a floating exchange rate
So far, I have been focusing on the costs of cross-border transactions and the exchange rate regimes
that could reduce those costs. But that is not all that matters. The real world is a more complicated
place, as I shall explain in a moment. And that is why a floating exchange rate regime makes sense for
Canada.
The case typically made for a floating rate for Canada is that it gives us the chance to run an
independent monetary policy. That is true. But these days, there is really very little difference in the
low-inflation objectives of industrial countries. The real value of a floating exchange rate for Canada
is that it allows us to have different monetary conditions than the United States - monetary conditions
appropriate to our own economic circumstances, even as we pursue the same general objective of low
and stable inflation. The significance of having this option is our ability to respond to external
economic shocks that affect us differently from our southern neighbours, or to respond to differences
in domestic economic policies.
Let me give you a couple of examples of economic shocks and policies that have reflected these
differences.
Fluctuations in world commodity prices are an important first example. Although our reliance on
primary commodities has diminished substantially through the years, such goods still account for
30 to 40% of Canada's exports. The United States, on the other hand, is a net importer of
commodities. The Asian financial crisis of 1997-98, which led to a 20% decline in the prices of the
key primary commodities that we export, was a major negative shock for Canada. In contrast, the
United States benefited from these lower prices.
The decline in the value of our currency against the US dollar at the time was in response to that
economic shock. And it helped Canadian manufacturing and other non-commodity sectors to increase
their exports to the United States. In this way, the impact of falling employment and incomes in our
primary sector because of the lower commodity prices was largely offset by greater expansion in these
other sectors.
Another example involves the fiscal restraint measures that were undertaken by our federal and
provincial governments, beginning in the mid-1990s, to deal with persistent deficits and the resulting
unsustainable accumulation of public debt. The United States also had a budgetary problem. But the
need for fiscal tightening was much greater here and so was the effect of the corrective measures on
total demand in our economy. To help the transfer of resources from the public to the private sector
and so support overall demand in Canada, we needed lower interest rates here than in the United
States. These lower rates were maintained through most of the period from 1996 to the present. In
today's globalized financial markets, such persistent interest rate differences in the circumstances I
have described are possible only with a floating exchange rate.
In both these examples, the exchange rate acted as a shock absorber between the US and Canadian
economies, helping to facilitate the needed adjustment in response to differing shocks and differing
policy requirements. Even though our two economies are closely linked, they can move in different
directions. And when that happens, the shock-absorber role of a floating exchange rate is invaluable.
Although these recent examples involved downward adjustments in our currency, this has not always
been the case. Indeed, there have been times when economic shocks and policy differences in the two
countries have worked in the opposite direction, leading to increases in the value of the Canadian
dollar.
It is, of course, possible to cope with unexpected shocks and policy differences under a fixed exchange
rate or a monetary union. But the adjustment process will take longer, will be more difficult, and will
cost more overall.
Imagine the adjustment in our economy that would have been required in 1997-98 in response to the
fall in commodity prices, if the Canadian dollar had not been floating. To maintain a fixed exchange
rate throughout that period, much higher interest rates would have been necessary to resist the
downward pressure on our currency from the falling receipts for commodity exports. In effect, this
would have meant a more serious economic slowdown to bring wages and salaries down to a level that
would make other industries more competitive and allow them to increase their exports.
Even under a common-currency arrangement, we would still have had to go through much the same
adjustment over the longer term. But under such an arrangement, more of the short-term pain - in
terms of declines in employment and incomes - would have been felt in the primary industries and in
regions of Canada with a higher concentration of such industries.
The bottom line is: There is no escaping the need to adjust to real economic shocks regardless of the
currency regime. But a floating-rate regime does help to facilitate and smooth the adjustment process.
Before concluding, I would like to quickly deal with a couple of common misconceptions about
flexible exchange rates.
The first one relates to the incentives for business to innovate and invest in new technology. If the
argument here is that a low exchange rate gives exporting firms easier profits and blunts their
motivation to innovate and become more efficient and competitive, I am inclined to say that this
suggests a rather serious problem of corporate governance. Surely, the job of company directors is to
ensure that management is doing everything necessary to maximize profits and stock values, no matter
what the circumstances. Any company that does not operate this way will soon find itself losing to the
competition.
Another misconception is that a relatively low exchange rate puts a country at a disadvantage in terms
of foreign takeovers. Here, I would say that if Canadian companies became more attractive in recent
years to US corporate buyers, it was primarily because of high stock market valuations in the United
States, not because of a lower Canadian dollar. High stock prices essentially provided US companies
with very cheap financing for corporate takeovers in countries where market valuations were lower.
We saw a similar process involving Canadian takeovers of foreign companies more recently, when
stock market valuations hit very high levels in this country.
Concluding thoughts
Let me summarize my main points. In view of our close economic and financial links with the United
States, I recognize the attractions of the reduced currency uncertainty and lower transactions costs that
would be part of a fixed exchange rate arrangement with the US dollar.
Nonetheless, I believe that for Canada, the macroeconomic advantages of a flexible exchange rate
continue to far outweigh the lower transactions costs of a fixed rate. As long as we remain a major
producer of primary commodities, and as long as we want to pursue separate economic policies that
are suited to our own circumstances and that require differing monetary conditions, the shock-absorber
element of a floating currency will serve us well.
Does a floating exchange rate regime mean that we are likely to have a persistently weak currency?
No, it does not.
Through the second half of the 1990s, we have seen a US dollar that is strong against virtually all
other currencies, reflecting the remarkable performance of the US economy. In the process, however,
the United States has also built up a very large cumulative deficit in its transactions with the rest of the
world. At some stage, this external deficit will have to be reversed, and a lower US dollar will be part
of this adjustment.
Here in Canada, after a slow start in the early 1990s, the fundamentals of our economy have improved.
Growth has been more robust in recent years, employment and incomes have been rising, and inflation
is low and stable. Government budget deficits have been eliminated, and the public debt relative to the
size of our economy has been shrinking. Moreover, as part of a major restructuring effort by the
private sector, businesses have been investing heavily in machinery, equipment, and technology. We
may now be starting to see the payoff of these efforts, in the form of some larger productivity gains,
which I hope will grow and continue, thereby providing the basis for improved standards of living for
Canadians in the future.
All in all, the prospects for our economy are very positive. If these prospects are realized, we will also
see a stronger Canadian dollar over the medium term.