Profile of the Canadian Dollar – Economic Overview and Monetary Policy

Profile of the Canadian dollar – economic overview and monetary policy

You will learn about the following concepts

  • Economic overview of Canada
  • Monetary policy
  • Goals and tools of BoC

Canada is the fourteenth biggest economy in the world, with a GDP (purchasing power parity) estimated $1.518 trillion in 2013. Canada closely resembles the United States with its market-oriented economic system, types of production and high standard of living with a GDP per capita of $43 100 in 2013, according to which it ranks 19th (compared to $52 800 in the US, which ranks it 14th). The country has achieved significant growth in its mining, manufacturing and service sectors since World War II, but has thrived after the signing of the 1989 US-Canada Free Trade Agreement (FTA) and the 1994 North American Free Trade Agreement (NAFTA), which included Mexico. It is a member of the Organization for Economic Co-operation and Development (OECD) and the Group of Seven (G7).

Canada-Flag-iconCanada’s economy is typically known as a resource-based economy as its initial economic development relied heavily on the exploitation and exports of its natural resources. However, more than two-thirds of the country’s Gross Domestic Product comes from its service sector, employing three quarters of the country’s labor force. Canada’s Gross Domestic Product composition by sector of origins looked in 2013 as follows:

– agriculture – 1.7%
– industry – 28.4%
– services – 69.9%

The largest employer in the service sector is the retail sector. The retail industry is mainly concentrated in a number of chain stores focused in shopping malls, although in recent years an increase in the number of big-box stores is observed, reducing employment in the retail sector. According to data from 2006, the labor force occupation by sector looked as follows:

– agriculture – 2%
– manufacturing – 13%
– construction – 6%
– services – 76%
– other – 3%

The size and importance of Canada’s service sector is partially attributed to the businesses’ practice to sub-contract a large segment of their services to other companies, e.g. a company in the manufacturing sector might outsource delivery services to a transportation sub-contractor. Despite the vast and diversified services sector, however, Canada still relies heavily on exports of commodities and manufacturing production, and especially trade with its neighboring countries.

Major partner

United-States-Flag-1-iconThe Canadian economy thrived with the depreciation of its currency against the US dollar and the signing of the so-called Free Trade Agreement (FTA) in 1989 with the United States. This accord removed almost completely the trade tariffs between the two countries, making the US Canada’s major trade partner. Canada was later further benefited by the so-called North American Free Trade Agreement (NAFTA), which incorporated Mexico to form a three-way trading partnership. The more advance treaty took effect on January 1, 1994 and removed the majority of trading tariffs between the three North American countries.

Canada has enjoyed a significant trade surplus with its major trading partner – the US, and is its biggest foreign importer of energy, including oil, gas, electricity power and uranium.

CargoShip-iconAccording to MIT’s Observatory of Economic Complexity, Canada’s top five export destinations are the United States (70%), United Kingdom (4.7%), China (4.0%), Japan (2.7%), and Mexico (1.8%). Meanwhile, its top five import origins are the United States (50%), China (11%), Mexico (5.4%), Japan (3.0%), and Germany (2.9%). Canada’s top five exported products are Crude Petroleum (16%), Cars (9.3%), Refined Petroleum (4.1%), Gold (3.8%), and Petroleum Gas (3.7%), while the top 5 imported products are Crude Petroleum (6.1%), Cars (5.5%), Vehicle Parts (4.6%), Refined Petroleum (3.8%), and Delivery Trucks (2.9%).

Canada’s imports amounted to $458.7 billion in 2013, down from $462.9 billion a year earlier, ranking it the world’s 12th biggest exporter. Meanwhile, imports stood at $471 billion, down from 474.9 billion in 2012, rendering it the 11th biggest importer.

Risks

However, Canada’s tight trading relations to the US also expose it to a significant reliance on the latter’s economic health. Thus, if the US economy falters, as it did in 2008, this would have an immense impact on Canada as exports to the US will suffer. The same, however, is also in force for the opposite scenario – when the US economy thrives, Canadian exports will benefit (thus the Canadian dollar will be on the rise).

The Canadian economy enjoyed solid growth through 2007 but was heavily impacted by the global economic crisis and fell into a sharp recession in 2008, posting its first fiscal deficit in 2009 in more than a decade. However, thanks to the Canadian banking sector’s robustness due to previous conservative lending practices and strong capitalization, the Canadian economy emerged from recession and posted moderate growth in line with pre-recession levels, boosted by commodity exports as well, and mainly oil.

oil_barrelCanada is one of the few highly developed economies, which is a net exporter of energy. Canadian electricity exports amounted to 57.97 billion kWh in 2012, as opposed to 11.39 billion kWh of imports. Canada exported 1.576 million barrels of crude oil per day in 2011, compared to imports of 770 300 bpd a year earlier. In 2010, the country also exported 1.073 million barrels of refined petroleum products per day, compared to inbound shipments of 249 500 bpd, while its natural gas exports in 2012 amounted to 88.29 billion cubic meters, as opposed to imports of 31.31 billion cubic meters.

Thus, this explains why the Canadian dollar is considered as a “commodity-based” currency. These currencies, among which are also the Australian dollar and the New Zealand dollar, rely heavily on exports of raw materials, and apart from economic data, they are heavily influenced by rising or falling prices of commodities exported by the country in question.

Most of Canada’s oil and gas resources are situated in Alberta and the Northern Territories, but also in neighboring British Columbia and Saskatchewan. Its petroleum sector is rapidly expanding as the country ranks third in the world in proved oil reserves, trailing only to Venezuela and Saudi Arabia. Proved reserves is the quantity of crude oil which can be estimated with a high degree of confidence to be commercially recoverable from known fields and under current economic conditions. Thus this indicates the Canadian dollar will most likely retain its correlation with commodities pricing, and oil in particular.

Monetary policy

Bank-iconBank of Canada, the country’s central bank, is responsible for conducting monetary policy. It was founded in 1934 as a privately owned corporation. In 1938, it became a Crown corporation belonging to the federal government. Since that time, the Minister of Finance has held the entire share capital issued by the Bank. Ultimately, the Bank is owned by the people of Canada.

It consists of two bodies – the Board of Directors and the Governing Council. The Board of Directors oversees the management and administration of the Bank with respect to strategic planning, financial and accounting matters, risk management, human resources, and other internal policies.

The Governing Council is the policy-making body of the Bank. It consists of six members – the Governor, the Senior Deputy Governor, and four Deputy Governors. It is responsible for monetary policy, decisions aimed at promoting a sound and stable financial system, and the strategic direction of the Bank.

Prior to December 2000, the bank had no predetermined schedule to holding its policy meetings, rather was ready to act whenever circumstances required action on its behalf. However, due to the uncertainty stemming from this type of organization, the Bank of Canada moved to a system of fixed announcement dates, eight throughout the year, separated by six to seven weeks of time. Under extraordinary circumstances, policy makers may meet on a date outside of the pre-fixed schedule.

Apart from the Governing Council, which is responsible for making the interest rate decision, the other major participants in the decision-making process are the Monetary Policy Review Committee (MPRC) and the four economics departments at the Bank.

The MPRC, which plays an important role in the discussions leading up to the Governing Council’s interest rate decision, consists of the Governing Council plus five or six advisers – often supplemented by one or two special advisers – as well as the chiefs of the four economics departments, the heads of the Montréal and Toronto regional offices, and other senior personnel.

The four economics departments are Canadian Economic Analysis, International Economic Analysis, Financial Stability, which focuses largely on the activities of Canadian and foreign financial institutions, and Financial Markets, which concentrates on domestic and foreign financial markets.

Goals and tools

toolsAs in the case of each other central bank, Bank of Canada’s main goal is to secure price stability by maintaining the integrity and value of its currency, while ensuring economic growth. The foundation of its monetary policy framework is its inflation-control system, whose goal is to keep inflation in the range of 1% and 3%, and more precisely near 2%. It is equally concerned of inflation going above the mid point, as well as dropping below it, and will act accordingly.

The Bank conducts monetary policy by changing short-term interest rates. It does this by raising and lowering the target for the overnight rate (the interest rate at which major financial institutions borrow and lend one-day (or overnight) funds among themselves). Decisions to influence on the overnight rate are agreed upon at the bank’s eight fixed announcement dates.

When consumer demand is strong, it can push the economy to the limits of its production capacity. This will in term raise inflation above the 2% midpoint, so the BoC will raise interest rates to cool off the economy. Conversely, when inflation is low, the central bank will lower interest rates to stimulate the economy and absorb economic slack. Changes in the target for the overnight rate usually alter other interest rates, including mortgage rates and prime rates charged by commercial banks, which influences consumer spending, and thus demand for goods and services.

The inflation target is expressed as the year-over-year increase in the Consumer Price Index — the most relevant measure of the cost of living for most Canadians.

The BoC also monitors a set of core inflation measures, including the CPIX, which excludes eight of the most volatile CPI components. These core values allow the central bank to ignore temporary changes in total CPI inflation and to focus on the underlying trend of inflation. Core inflation is monitored as an operational guide to help the Bank achieve the broad CPI inflation target, not as a replacement for it.

Large Value Transfer System (LVTS)

money flowThe Large Value Transfer System (LVTS) is the framework for the implementation of BoC’s monetary policy. It is an electronic funds transfer system that allows financial institutions and their customers to send securely large payments in real time, with certainty that the payments will settle. These time-sensitive payments include Government of Canada payments.

This is the system through which Canadian commercial banks lend and borrow money from each other on a daily basis when they have a deficit or surplus of cash. The interest rate charged on the borrowed/lent money is the overnight rate.

BoC’s target for the overnight rate (its main monetary tool), tells major financial institutions the average interest rate the central bank wants to see them lending or borrowing at overnight. If the market rate is moving away from the target, the BoC will intervene and offer to lend at rates lower or higher than the current market rate.

The central bank operates a system to ensure the overnight market remains within an “operating band”. This band is half a percentage point wide and has the target for the overnight rate at its centre, e.g. if the operating band is 0.75% to 1.25%, the target for the overnight rate would be 1%. The top of the band, 1.25%, is the Bank Rate — the interest rate that the Bank charges on one-day loans to LVTS participants. The bottom of the band, 0.75%, is the deposit rate that the BoC pays on any surplus funds that participating institutions leave on deposit at the Bank overnight. Because the BoC always uses the two ends of the band for the interest it pays or charges, there is no reason for the participating financial institutions to trade funds at rates outside the band.