Friday, August 11, 2006

Canadian dollar still undervalued

According to researchers at the Bank of Canada, the Canadian dollar is still undervalued and its “long-run equilibrium value” is 91 U.S. cents. This comes from a Bloomberg report filed today. The report states that the OECD has estimated the dollar to be worth 80 U.S. cents in 1995 and the IMF estimated it to be 82 U.S. cents this year. Both the OECD and the IMF estimates are based on the Purchasing Power Parity model.

Here are some excerpts from the Bloomberg report:

Aug. 11 (Bloomberg) -- The Canadian dollar is undervalued and doesn't yet reflect the benefit to the country's economy from soaring energy exports, according to an internal Bank of Canada report written in March.

The currency's "long-run equilibrium value'' is 91 U.S. cents, central bank researchers Jeannine Bailliu and Ramzi Issa wrote in a March 27 note to Bank of Canada Governor David Dodge and his five deputies. The six-page document was obtained by Bloomberg News under the nation's Access to Information Act.

The Canadian dollar climbed to a 28-year high of 91.44 cents on May 31 before retreating to trade at 88.68 cents at 5 p.m. in Toronto yesterday. The report helps explain why Dodge raised interest rates in January and March to cool inflation even as provincial leaders, labor unions and manufacturers protested that the dollar would strengthen and erode demand for exports.

"Most of the recent appreciation of the Canadian dollar is driven by the large increase in energy prices,'' the memorandum says. "It is clear that the exchange rate has not overshot the long-run equilibrium value consistent with the current level of energy prices.''

Dodge and Finance Minister Jim Flaherty have repeatedly refused to comment on the value of the Canadian dollar, which is heading for a fourth straight annual advance against its U.S. counterpart. The Canadian dollar traded at an average of 86.6 cents during the first quarter and 89.1 cents in April to June.

"In Canada, the biggest factor in terms of the fundamental value is commodity prices,'' said Benoit Durocher, an economist in Montreal at Mouvement Desjardins, Quebec's biggest lender. He predicts the currency will reach 90 cents by the end of the year and 94 cents next year. The central bank would probably get a similar result if it did the same analysis today, Durocher said.

Even as Bailliu and Issa said the currency would benefit from higher energy prices, their equation predicted it would take time. The researchers found it historically took about five quarters for the currency to make 50 percent of the adjustment to "long-run determinants,'' which would have meant an 83-cent dollar in the first quarter.

The researchers updated the Bank of Canada's mathematical model of the Canada-U.S. exchange rate to better account for the effect of energy prices, according to the note.

"What underpins the dollar to a very large extent is the price of natural resources,'' said Jean-Francois Villeneuve, an economist in Montreal at Laurentian Bank, Canada's seventh- largest bank. He predicts the currency will trade between 87 cents and 91 cents over the next 12 months.

Bailliu and Issa dismissed explanations other than commodity-price gains for the currency's rise up to the first quarter, such as the expected discrepancy between the U.S. and Canadian interest rates or a ``multilateral depreciation'' of the U.S. dollar.
In a May 15 update to their memo, the researchers said the broad-based decline in the U.S. dollar against other major currencies had contributed to "part'' of the Canadian currency's surge in the previous six weeks.


happyjuggler0 said...

In a May 15 update to their memo, the researchers said the broad-based decline in the U.S. dollar against other major currencies had contributed to "part'' of the Canadian currency's surge in the previous six weeks.

Ha ha. I guess it depends on how you define part. Technically it will always be part. Here it is a large part.

Note that of the three charts listed, the Yen and the Canadian dollare move in "the same direction" while the Euro is inverted. I don't see a way to invert it manually unfortunately. But the trend for April til May something seems clear.

Consider: Canada US currency chart for 2006 and Japan US currency chart for 2006 and The Euro vs the US dollar

I unfortunately don't have any links to currency charts for Canada vs the Euro (or vs the Yen). If it was on the same scale as the US dollar I strongly suspect that almost all of the move that was noted is really the US dollar decline vs the major currencies rather than Canadian Dollar appreciation. If I'm right then these guys are fools.

Note: The dates can be manipulated, and one can also see the actual data ( View Data link) and see which day things start and stop for major moves.

The notion of a long term equilibrium rate strikes me as absurd. If you want to know the "proper" price for a currency if two currencies were merged into one (a la the Euro), then PPP is the way to go. Same with comparing things like GDP per capita and other data.

Freely floating currencies fluctuate according to demand. (I won't say supply and demand since the Central Bank creates the supply, in theory anyway). If one is going to say what an equilibrium rate is other than PPP, one is basically asserting an ability to claim to know where a currency "ought" to be based on (supply and) demand. I was not aware economists were bright enough to know what the "proper" price for anything was, let alone a currency which has a mindbogglingly large number of diverse supply and demand components to it.

true dough said...

Yes, I got a kick out of the word “part,” too. To be fair, perhaps the memo (which was never intended to go public) was casually worded and passed to and fro via paper airplane. A corollary to the Access to Information Act is that the media can take things out of context and leave readers guessing.

First, just because the exchange rate calculated by an alternative equation deviates from the PPP, doesn't imply that they claim the dollar is undervalued by X amount. Perhaps the journalist overlooks the purpose of the memo.

Perhaps the memo reflects the research they're doing on alternative models of exchange rate determination, trying to capture price shocks in Canada's commodities.

I agree with you when you say that such a model implies the understanding of a “mindbogglingly large number of diverse supply and demand components.” Maybe the BoC's researchers justify themselves by saying that we're a small economy driven by two major forces: the U.S. and commodities (I'm curious what equation other major commodity-exporting countries use). In the name of monetary policy, they have an interest in knowing if appreciation is a reaction to the US dollar, or if Canada's strong commodities are the driving force. They would react differently to each. By the way, I don't have graphs of the CDN/YEN or CDN/EUR eitther, unfortunately.

Regarding your last point, I thought you might be interested in knowing that the BoC currently uses a variation of The Amano-van Norden equation (AvN) as explained below. I found this in a report cowritten by Bailliul, one of the authors of the memo:

“The Amano-van Norden equation (AvN) is based on a simple, error-correction specification. The dependent variable is the real Can$/US$ exchange rate (RFX), defined as the nominal exchange rate deflated by the gross domestic product price indices for Canada and the United States. Two world commodity prices—one for energy (ENER) and another for non-energy commodities (COM)—are used to generate the long-run equilibrium value of the exchange rate, while a third variable—the spread between Canadian and U.S. 90-day commercial interest rates (INTDIFF)—is used to capture the exchange rate's short-term dynamics.

The long-run relationship that was identified between the real Can$/US$ exchange rate and the two commodity variables has considerable intuitive appeal, since Canada is known as a major commodity exporter. It is important to enter these variables separately, however, as they seem to affect the Canadian dollar in very different ways. While higher world prices for non-energy commodities typically cause the Canadian dollar to appreciate, higher world energy prices are associated with a weaker currency over most of the sample period.”

I wonder how messy it really is. And thanks for the links – I've never met FRED before.

true dough said...

In case you thought I wasn't long-winded enough....
Another article sheds more light on The Memo:

“Both the recent increase in oil prices and an upward shift in expectations of future oil prices have likely contributed to the recent appreciation in the Canadian dollar....Markets appear to have become more sensitive to the issue of global imbalances and sentiment toward the U.S. dollar has turned negative,” the researchers say.

That's from:

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