Currency: Tame the loonie? Not likely

Mark Carney and Jim Flaherty talk a good game, but their power is limited.

Federal Finance Minister Jim Flaherty recently suggested he might intervene to halt the dollar’s rise. Bank of Canada governor Mark Carney has made similar noises. But such talk likely exceeds what either man can deliver — and contains a whiff of hypocrisy.

Since March, the loonie has gained nearly 17% against the U.S. dollar. The appreciation makes exports more expensive for foreign customers, and many now worry falling trade could truncate the budding recovery. No wonder the posturing.

Neither man, however, has offered specifics on how they’d achieve their goal. The simplest tactic would be to sell Canadian dollars and buy greenbacks, thus altering supply-demand dynamics. History suggests that’s risky. In 1992, the Bank of England attempted to support the pound by jacking interest rates and buying sterling. George Soros correctly bet the effort would fail, embarrassing the government and pocketing a fortune.

Canada knows the hazards. In the late 1990s, our dollar traded so low against its U.S. counterpart that some compared it to the Mexican peso and Canadian Tire money. The Bank of Canada intervened by selling U.S. dollars and buying Canadian ones. It didn’t work. The bank “got run over by the markets, essentially,” says Shaun Osborne, chief currency strategist at TD Securities in Toronto.

There’s also a related tactic known as “quantitative easing.” Central banks can make money out of thin air — it’s commonly called “running the printing presses,” though today it’s done electronically. They can use it to buy financial assets, such as government and corporate bonds, from banks and other institutions. That increases the money supply and tends to drive down the currency. But it might cause substantial inflation (or other ill effects) down the road. “Currency markets can turn on a dime,” warns Stewart Hall, an economist with HSBC Securities (Canada) Inc. in Toronto, adding that the loonie’s recent gains might amount to nothing more than “market whimsy.”

The Bank of Canada might also fight the dollar’s rise by keeping interest rates low. In theory, that should dissuade foreigners from investing, thus depressing the currency. Carney has indicated he’ll maintain the key overnight rate at 0.25% until mid-2010. But it’s unlikely to have a meaningful or lasting impact. After all, Canada’s not alone in holding rates low. And there’s little room to cut them further still.

Rising commodity prices and Canada’s stronger fiscal position relative to other nations contributed to the loonie’s recent performance. But Washington’s massive deficits also made the greenback resemble a fire hydrant in a dog park. That’s caused many currencies to appreciate sharply. The New Zealand dollar, Brazilian real, Australian dollar, South African rand and Swedish krona have all outperformed the loonie since March. “It’s not like currency markets are singling out the Canadian dollar and having their way with it,” says Hall. “If the Bank of Canada and federal officials in Ottawa are inclined to intervene, there’s the very real risk it will fail.”Flaherty and Carney know that. During a recent visit to Beijing, the finance minister downplayed earlier threats of currency intervention. It wasn’t an ideal venue: Canada and other G7 nations have long harassed China over its efforts to keep the yuan low, thus making exports more attractive to foreign buyers. So for now, all talk aside, the loonie’s fate will likely be left to the foreign-exchange markets.