The fall of the loonie against the U.S. dollar is less alarming than it appears

By JOHN HELLIWELL

f you put a waterfowl on your currency, you should expect it to take the occasional dive. That's one way--the proper way--to think about the loonie and its plunge to record lows against the U.S. dollar. By the end of last week it had bobbed upward again, at least a bit, but not to impressive heights. Is the loonie about to crash?

Before anyone calls for help, a review of the record is useful. Over the past 12 months, the Canadian dollar has fallen about 6% relative to the currencies of the U.S. and Britain, and about 2% to 3% relative to those of France and Germany. The loonie has also risen about 20% relative to the currencies of Japan and Australia and 50% compared with those of South Korea and Malaysia. The loon may not be doing as well as the eagle, but the comparisons make you wonder where all the talk of the plunging Canuck buck is coming from.

Are there good reasons why the Canadian dollar should be climbing less quickly than the U.S. dollar? Sure. Asian turmoil has depressed the world prices of raw materials, and export volumes of these have fallen most for countries like Canada and Australia, which are big providers to Asian markets. That the Australian, New Zealand and Canadian dollars should have fallen, relative to the currencies of more manufacturing-based countries like the United States, Britain, Germany and France, is thus no surprise. Lower exchange rates for resource-dependent economies cut their demand for imports and increase their exports, thus helping cushion these countries from some of the effects of falling resource exports to Asia. Canada is less resource dependent, and less Asia reliant, than Australia and New Zealand, and the Canadian dollar is correspondingly stronger than their two units of exchange. Besides, the strong U.S. dollar helps lure Americans to replace the missing Japanese skiers and golfers at Whistler.

Is the Bank of Canada likely to rescue the loonie? No way. First, as we've just seen, the news of the loonie's decline has been greatly exaggerated. But there are other reasons, having to do with the way the Bank of Canada thinks about its role today. In the new world of central banks with independence, transparency and agreements with governments about what they should be doing, it is getting easier to guess what these powerful institutions will do. The main reason why no intervention is likely is that the bank is focused on something else entirely than the international value of Canadian money, and that something is inflation.

The Bank of Canada has a target inflation range, and the inflation rate--1.1% over the past 12 months--has regularly been in the bottom half of the bank's range, sometimes falling below it entirely. Throughout the 1990s, Canada's growth and inflation rates have generally been lower than those in the U.S., while investment and labor-force growth have been fairly high, so inflation is not an immediate risk. Canadian government budgets are balanced, and the government debt is shrinking, putting further downward pressure on interest rates and on the value of the dollar. Imports from the United States are slightly more expensive because of the higher U.S. dollar, but those from Asia are cheaper, and there is still enough spare manufacturing capacity in Canada to stop import price increases from being passed along to consumers.

With the low inflation rate, Canadian cost levels would have been pretty attractive even if the loonie had climbed to the same heights as the U.S. greenback. But since it has not risen to those levels, Canadian firms are finding it easy to maintain their domestic markets and find new ones in the U.S. and Europe while Asia is on hold.

I'd better admit, however, that I would not have been surprised if the Canadian dollar had risen higher. With all the concern about the quality of investments in the wake of Asia's troubles, some of the pronounced international move to U.S.-dollar assets could have gone to Canadian securities instead, which would have kept the loonie rising. Government budgets are expected to remain balanced, inflation remains lower than in the U.S., and Canada has lots of things that seem to be missing in Asia--stable banks, securities regulators and good accounting standards. (Oops, we mustn't forget Bre-X.) To be sure, Canada's national unity, while increasingly accepted and assumed, is still not a settled issue. But if portfolio managers really believe what their models tell them, that you should not put all your eggs in one basket, you might expect to see the much vaunted flight to quality heading for several different destinations. And it still may.

In other words, the trash talk about the loonie is daffy. What of the future? Don't look for Canadian interest-rate increases to raise the loonie's value, but don't be surprised if it gradually drifts up anyway against the U.S. dollar and European currencies, mainly because of Canada's low inflation rate and cost levels. So relax and enjoy the summer. The loonie's world is not coming to an end.

John Helliwell is a widely published professor of economics at the University of British Columbia.