When The Elephant Falls

If America's current account deficit proves unsustainable, Canada is unlikely to escape unscathed.

Global economic imbalances are hardly a hot topic of conversation around the water cooler. But given their impact on Canada, maybe they should be. For nearly 15 years, the United States has seen its external (or current account) deficit grow on a massive scale–approaching US$800 billion in 2005. Joining the external deficit is a large U.S. fiscal deficit, resulting from the Bush tax cuts and wars in Afghanistan and Iraq. Those twin deficits can be sustained only if foreign investors are prepared to buy U.S. dollar assets. So far, Japan and China, which have large trade surpluses and foreign-exchange reserves, have provided much of the counterbalance to the U.S. deficits.

An apparent financial alliance exists between the U.S. economy and foreign buyers of its financial assets, principally in Asia. While the alliance is holding for now, indications are that it will not be sustainable over the longer term. Commercial investors in India and China are diversifying away from U.S. dollar assets. Central banks in countries like South Korea and Japan are also concerned about U.S. dollar assets that have depreciated over the past three years, and they are looking for wider diversification and better yields.

If this apparent alliance breaks, Canada would be on the front line. Our economy is deeply integrated within North America; net exports to the United States (subtracting imports used to create exports) represent about 22% of Canadian GDP. This concentration has already exposed Canada to the U.S. dollar's depreciation more heavily than our international competition. Weak exports to the States have led the Conference Board to lower its 2005 Canadian growth forecast to 2.5%, down from the 2.9% increase achieved in 2004. That reinforces the importance of aggressively seeking trade and investment beyond the United States.

We see the U.S. external deficit peaking this year, as export growth in 2005 begins to outpace import growth. The U.S. fiscal deficit, meanwhile, will be smaller than expected due to slower spending growth and higher corporate tax revenues. Nevertheless, we should not forget the concerns voiced last spring by Federal Reserve chairman Alan Greenspan that U.S. growth will be impaired without faster action to address the fiscal deficit.

How will the global imbalances be corrected? So far, the decline in the U.S. dollar has carried the full adjustment burden, with a negative impact on Canadian export growth. A better way to reduce the imbalances would be through co-ordinated action by the major industrial countries–the so-called G7, plus China as an emerging power. The other major industrial countries, however, have their own domestic imbalances. They and the United States have been unwilling, and unable, to take co-ordinated macro-economic action. China just took a step toward greater exchange-rate flexibility, although its actual currency policy is not at all transparent–and a steadily rising yuan would reduce China's incentive to keep acquiring U.S. assets.

Because global imbalances are not being addressed adequately, the U.S. currency will face added downward pressure, and U.S. interest rates will inevitably face upward pressure across the yield curve. Long rates are remarkably low today. There is little hard evidence of concern among foreign or domestic investors, but markets will adjust quickly if there is a change in sentiment. The signal that Asian investors are reducing the share of their assets held in U.S. dollars is serious. And the adjustment in the U.S. dollar and interest rates could be sharp.

Canada cannot avoid external shocks, but we can try to mitigate them. Thanks to a painful but necessary domestic fiscal adjustment during the 1990s, we have the advantage of a strong macro-economic foundation: low inflation and improved fiscal balances for most governments across the country. We will need that foundation as a buffer against external shocks to the exchange rate, interest rates and economic growth.

Should we choose, we can also use this position of strength to diversify further our global business activities. Our much-improved national fiscal position gives us the capacity to address shortcomings in infrastructure–at the border, in our cities and across the economy. We are in a strong bargaining position to influence other countries and improve international policy co-ordination. The question that remains unanswered is whether we can find the political will to act, reduce our trade bottlenecks and help create those added shock absorbers.