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 Board
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 this
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 and our
currency of increased global uncertainty and pressures arising from the problems that originated
in Southeast Asia. I am sure that the effects of these developments, especially on primary
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 forces that
are currently affecting our economy. We also need to correctly identify cause and effect when it
comes to the decline in the external value of our currency over the past 12 months. The
commentary on this subject has not always been helpful.
I would like to start my presentation with a quick review of international
developments, focusing on the extent to which the problems in Southeast Asia have persisted and
spread. Next, I will discuss the implications of these developments for the Canadian economy
and give you the Bank's latest assessment of the outlook. I can tell you now that I believe that the
key trends in our economy remain positive. Lastly, I will talk about the decline in the external
value of the Canadian dollar and about the response of monetary policy to that decline.
The world around us
For over a year now, volatility and uncertainty have been the main traits of the
international environment in which Canada operates.
The financial crisis started in Southeast Asia in the summer of 1997, then spread
to South Korea, and in turn exacerbated the domestic economic difficulties that Japan was
already facing. Recently, Russia has been added to the list of afflicted countries, and now some
countries in Latin America are under pressure.
As with the crisis in Asia, the financial problems in Russia have reverberated
around the world through foreign exchange, stock, and bond markets, touching off concerns of
still further contagion.
It is certainly easier now, with the benefit of hindsight, to see the extent to which
many investors from industrial countries were attracted to higher-yield investments in
emergingmarket countries, without fully appreciating the risks involved. When investors suffered
substantial losses in certain markets, they sought to reduce their exposure to emerging markets
more generally. But this rapid withdrawal of funds brought to the surface areas of weakness in
some of these economies, making investors still more nervous. The recent events in Russia are a
prime example of this process.
The apparently contagious nature of these developments has led to some
pessimistic predictions of recession in the world economy. How concerned should we be about
this?
While the international environment has turned out to be more difficult than most
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 country's
economic importance but also because of its strong trade and financial links with other troubled
Asian economies. But, and this is an important but, Japan has the capacity and the financial
wherewithal to turn its situation around. With resolute action to speed up the implementation of
measures to deal with its ailing banking sector and to kickstart its domestic economy, the present
concerns would dissipate.
More importantly, economic activity in the United States has been very robust and
is expected to remain healthy. In Canada, too, and in Europe the situation is positive. This is
certainly not insignificant, for North America and Europe together account for more than half of
world output. And recent declines in medium- and long-term interest rates to record low levels
are helping to sustain domestic spending in all industrial countries.
With this as background, I would now like to turn to the impact of these
international developments, and of the associated uncertainties and pressures in financial
markets, on Canada.
How is our economy faring?
The international developments of the past year have affected our economy more
than previously anticipated. And there is no doubt that those Canadian industries and regions that
depend on the production of primary commodities are facing considerable difficulties.
To appreciate this particular link between recent international developments and
the Canadian economy, let me point out that Asia, including Japan, absorbs between 30 and 35
per cent of the world output of certain key primary materials. So it is not surprising that world
commodity prices have been hit hard by the Asian crisis. The recent events in Russia, which is a
major commodity producer, have added to the uncertainty about the outlook for the world supply
and prices of primary commodities.
Because of all this, the US dollar prices of commodities that are important to
Canada have fallen by about 15 per cent over the past 12 months. While commodities are less
important to us than they used to be, they still make up about 30 to 35 per cent of our
merchandise exports.
Although Canadians have to deal with these difficulties coming from abroad, it is
important to remember that, overall, our economy is still in good shape. This is, first and
foremost, because some basic aspects of our economic situation have improved markedly in the
last few years. We now have a low rate of inflation, a fiscal surplus, and a declining (though still
high) public debt-to-GDP ratio. As well, Canadian businesses have undertaken major
restructuring and investment initiatives to increase their productivity. Because of these
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 in the
picture. Economic activity in the United States, our main customer, remains high. And here in
Canada, the latest indicators suggest continued expansion in consumer spending and business
investment, supported by higher employment and low medium- and long-term interest rates.
This year, the Canadian economy will not repeat the 4 per cent growth
experienced through 1997. But it may still expand by 21⁄2 to 3 per cent (fourth quarter over fourth
quarter). Clearly, a good deal of uncertainty surrounds any estimate at this juncture, given the
international situation. For one thing, it is difficult to judge how quickly and effectively Japan
will deal with its problems, and what this will mean for the rest of Asia. The extent of the impact
from the recent spreading of the crisis to Russia and the pressures in parts of Latin America is
also uncertain. But, at the same time, most forecasters have consistently underestimated the
resilience of the US economy, and may still be doing so.
Implications for the Canadian dollar
One of the most talked-about economic events in Canada over the past year has
been the decline in the external value of our currency. At its lowest point, in late August 1998,
the Canadian dollar had depreciated by about 13 per cent against the US dollar and by more than
7 per cent against the German mark from its average value in the first half of 1997, before the
Asian crisis erupted. Since that low point in late August, the Canadian dollar has recovered
somewhat against the US dollar.
What has caused these movements?
Exchange rates will typically reflect developments in Canada and abroad. Thus, it
is important to keep in mind that the recent movements in the Canadian dollar are the
consequence of developments that have occurred over the past year. They are not the cause of the
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 Canadian
dollar expressed in terms of the currency of another country, usually the US dollar. So, the
exchange rate will be influenced by events affecting both countries. If we are to correctly
interpret movements in the Canada/US exchange rate, we must also look at what has been
happening to the United States, not just to Canada. And that makes any interpretation more
complex.
Until very recently, the US dollar has been exceptionally strong against all
currencies. In part, this reflected the buoyancy of the US economy. But in the difficult and
uncertain global environment of the past year, the strength of the US dollar also came from its
role as the major international currency. After the Asian crisis, and with renewed vigour in the
days following the events in Russia, international investors sought shelter in US dollar assets.
Indeed, the turmoil in financial markets in late August seemed to be the result of a worldwide
reassessment of risks by investors following the announcement of the Russian debt moratorium.
Thus, to the extent that the depreciation of our currency reflected the appreciation
of the US dollar against all currencies, the cause was the global flight of funds into US assets.
But that is not the whole story. The downward pressure on our currency over the
past year was also related to events that were seen as affecting Canada more specifically. As I
explained earlier, one important event was the marked decline in the prices of the key primary
commodities we export.
The drop in these prices has meant lower incomes and wealth for Canadians. The
profit outlook for many of our resource industries has deteriorated and production and
employment in those industries are likely to be affected. And the market value of companies in
those sectors has reflected these developments. Moreover, lower net export earnings from our
primary commodities imply, all else being equal, a larger deficit in our balance of international
payments and a greater need for foreign borrowing than would otherwise be required.
All these commodity-related developments have led to downward pressure on our
exchange rate. And the lower dollar spreads the wealth and income effects of falling commodity
prices across the economy.
In effect, a lower Canadian dollar means higher domestic prices for all those
goods that are imported and for many of the import substitutes we produce here. For a given
level of income, these higher prices imply a decline in living standards for Canadian consumers.
Retailers who feel unable to pass on these price increases to consumers will have to absorb them
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 well off
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 dollar
from falling. In fact, if the currency were not allowed to move at all, the adjustment would be
slower and more costly, taking place through reductions in wages which usually involve sharper
fluctuations in output and employment. Under a floating exchange rate, the process is facilitated
by some downward movement in the dollar which spreads the burden of adjustment. Over the
years, this has been an important justification for a flexible exchange rate in Canada -- that
adjusting through exchange rate movements to the shocks that periodically hit our economy
makes for a generally smoother and fairer process than adjusting through reductions in output,
employment, and wages.
But I do not want to leave you with the impression that foreign exchange markets
always know the appropriate value for a currency. They sometimes push too far once a trend is
established in one direction or another. Indeed, I believe that during this latest episode of global
financial turbulence, markets exaggerated the commodity connection of the Canadian dollar. For
example, our exports of highly manufactured goods, apart from the important motor vehicle
sector, have grown by nearly 20 per cent over the past 12 months, and now represent about 30
per cent of our merchandise trade. This development seems to have been largely overlooked.
Monetary policy response
So, what can and should the Bank of Canada do about the exchange rate in times
of international financial turbulence and major external shocks?
First of all, let me remind you that the objective of Canadian monetary policy is to
hold the rate of inflation within a range of 1 to 3 per cent. This target, jointly agreed upon by the
government and the Bank of Canada, reflects the conclusion that low inflation will contribute to
a stronger, more stable economic performance over time.
If we are to fulfill our commitment to keep inflation low and stable, monetary
policy must remain focused on that objective. The exchange rate and interest rates are the
channels through which monetary policy operates and they must be allowed to adjust to help
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, or is not,
justified are very difficult to make, but there are times when the good economic news gets lost in
the face of a persistent currency decline.
On those occasions, Canadian authorities need to remind investors of the positive
trends in our economy. And to reinforce the message, the Bank may intervene, on behalf of the
Minister of Finance, to support the currency by buying Canadian dollars in the foreign exchange
market. But we do know that this kind of intervention will be effective only if a good number of
investors share our belief that the currency movement has been overdone.
The Bank can also respond to currency declines with Bank Rate changes. There
are two sets of circumstances in which this would be appropriate. The first is when the
magnitude of the currency decline threatens to push the economy off a sustainable,
noninflationary growth path. Remember that a declining currency is a source of stimulus to the
economy, because it encourages exporters and producers of import substitutes to expand their
activities. That is why the Bank always puts the exchange rate and interest rates together in order
to measure the amount of monetary stimulus in the economy. If a declining currency leads to
monetary conditions that are persistently too easy and inconsistent with the inflation targets, the
Bank will offset that with higher short-term interest rates.
The second situation that would prompt a Bank Rate increase is when there is a
potential loss of confidence in the Canadian dollar. If confidence is undermined, both Canadian
and foreign investors will move out of investments denominated in Canadian dollars unless they
are compensated with substantial premiums in interest rates. Higher premiums, which translate
into higher medium- and long-term interest rates, are very costly for the economy. It was because
of such concerns that the Bank responded strongly to the decline in our currency during the
Mexican crisis in early 1995.
The recent Bank Rate increase at the end of August was also designed to counter a
potential loss of market confidence. In this case, investor nervousness was exacerbated by the
financial crisis in Russia and was reflected in a sharp decline in our currency and rising
mediumand long-term interest rates. Since the Bank Rate increase, the Canadian dollar has recovered and
medium- and longer-term interest rates have come down.
Concluding comments
I have placed a great deal of emphasis on recent international developments in my
remarks today because the implications of these developments for the Canadian economy and the
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 Asian
crisis, which has turned out to be more widespread and prolonged than most of us had predicted.
Although we are having to deal with these difficulties and with the ongoing global uncertainty
and pressures, it is important to remember that there is still a significant positive element in
Canada's external environment coming mainly from a resilient US economy. And there is still
considerable underlying buoyancy in our domestic economy. What's more, the improvement in
our basic economic foundations puts us in a better position than before to withstand the present
adversity.
In addition to pressure from the worldwide strength of the US dollar, some of the
downward movement in the Canadian dollar over the past year was a reflection of the impact of
lower commodity prices on our economic well-being. However, by early August, it appeared that
investors were exaggerating the importance of these effects and losing sight of the overall
positive fundamentals in our economy. The Bank intervened, buying Canadian dollars, to
encourage market participants to pause and reassess their views of the Canadian economy. When
that pause was overwhelmed by a new wave of nervousness precipitated by the events in Russia
in mid-August, the Bank raised the Bank Rate to forestall a loss of confidence in the currency
and thus reverse a costly increase that was taking place in medium and long-term interest rates.
Since then, these interest rates have come down.
Let me conclude by pointing out that, despite all the recent attention on the
Canadian dollar because of exceptional external developments, the fundamental focus of
monetary policy remains on keeping the trend of inflation in Canada inside a target range of 1 to
3 per cent. Low inflation is the best contribution the Bank of Canada can make towards improved
overall economic performance over time. It also provides the best underpinning for a sound
Canadian dollar in the long run.