Outlook 2005

Why the strong dollar will change Canada.

Previous projections: Outlook 2006 | Outlook 2005 | Outlook 2004

2003 was the year of the Canadian dollar. 2004 was, um, also the year of the Canadian dollar. Two factors have dominantly accounted for the loonie's remarkable reversal of fortune, unwinding the bulk of its decade-long depreciation in an economic blink of an eye. For one, people no longer want U.S. dollars–they're tired of financing an overextended economy and the unapologetic policy upon which it's been based, leaving the greenback to plunge against just about everything over the past couple of years. And two, people want more “stuff”–the insatiable demand for raw materials coming from rapidly developing economies like China has led to surging prices for the commodities with which Canada is richly endowed. Both trends look here to stay, particularly the latter, as whole swaths of the global economy chase higher standards of living. So while talk of parity with the U.S. dollar may be premature, the Canadian dollar looks likely to remain durably strong in the years ahead.

2005 will be the year of the Canadian dollar's (initial) impact. Exporters will struggle to compete, both in foreign markets and here at home, against cheaper imports. Overall economic growth will be pressured, with domestic demand increasingly needing to pick up the slack, in turn motivating the Bank of Canada to maintain a stimulative level of interest rates. Those assets particularly leveraged to rates–such as bonds and real estate–should do well, even after their decent runs of recent years. No such blanket statement can be made for Canadian stocks, where performance will depend on whether the stronger loonie hurts revenues more than it helps costs for a given company (retailers probably yes, industrials probably no), and whether the pricing power exists to offset that revenue pressure (as with resource producers). Opportunities abroad for investors and businesses alike will increasingly be found outside of the previously dominant United States.

These shorter-term economic and market impacts are the easy part of the dollar story and, I dare say, even obvious, upon a bit of reflection. Much less obvious–and more interesting–are the longer-term consequences of a durably stronger currency. Just as the Canada of recent years looks very different from the depressed, debt-laden country of the early 1990s, with the weaker Canadian dollar playing a critical role as both cause and consequence of the country's renewal, so the Canada of 2015 may look dramatically different still. The strong loonie and its underpinnings will fundamentally alter the economic, and even political and social landscape.

Canadian dollar strength reflects rising valuations of what we have (natural resources) and, perhaps to a lesser extent, what we are (not the United States). How we deal with the consequent surge in national wealth will determine how Canada will be reshaped in the years to come–and whether for better or for worse.

Most often in other countries, unfortunately, it has been for worse. So pervasive has been the tendency for resource wealth in particular to wreak havoc on economies and societies that it even has a name: the Paradox of Plenty. The trouble comes in two forms. First, windfall inflows from raw-materials exports push up the exchange rate and in turn decimate other areas of the economy, notably manufacturing. Growth overall suffers as the “easy money” resource sector crowds out more productive sectors, tending to bring overall economic stagnation and, in the limit, a country's de-industrialization. This is called the Dutch Disease, based on the unfortunate experience of the Netherlands in the 1960s and '70s after the discovery of North Sea gas.

Second, and more perniciously, when wealth is increasingly bestowed rather than earned, the friction between winners and losers often comes to dominate–and ultimately tear at–a country's economic, political and social fabric. In Saudi Arabia, the ruling elite reaps the benefits of oil riches via Wahhabi extremist subjugation of the masses. Russia's oligarchs feud with the government over the nation's vast resources, to the detriment of a broader harnessing of those riches. At the extreme are the wars of central Africa among corrupt dictators and rebel groups, vying for control of diamond wealth. All these places have among the richest natural endowments in the world; none appear on the UN's list of 55 “high human development” countries based on per capita income and more general quality of life.

Plenty doesn't have to be a paradox, however. Norway provides the key counter-example of a country whose natural resource endowment has been harnessed to promote more general economic vigour. Revenue from Norway's huge oil reserves (only Saudi Arabia and Russia export more crude) is sequestered by the government into a giant Petroleum Fund, providing for citizens' economic stability in the short term and security in the longer term. Norwegians enjoy the second-highest per capita income in the world (behind Luxembourg), and rank No. 1 on the aforementioned UN human development index.

Norway's macroeconomic success in harnessing its resource wealth and dealing with the accompanying challenges (such as a strong currency) owes, in essence, to the government's ability, with public support, to see the bigger picture, making policy for long-term sustainability in resisting short-term grab-and-squander. Taking the longer view was helped by Norway's small size, insularity and homogeneity–none of which Canada shares. But it was also due to the strength of the country's institutions, notably the established rule of law and entrenched democracy–both of which Canada does enjoy. How well Canada can adapt to its newfound wealth–learning the lessons of places like Norway, heeding the cautionary tales of other countries, and meeting the challenges unique to our country–will go a long way toward determining not just what kind of economic growth we can produce in the years ahead, but indeed in what kind of society we live.

2005 may end up being pretty easy by comparison.

David Wolf is a director and senior economist with RBC Capital Markets in Toronto.