by: Issues: March / April 2004. Tags: Strategy. Categories: Strategy.

For Canadian companies, smart currency management has never been more crucial. It’s likely to become even more crucial, to the point where it may make or break some companies. An executive must do more than just keep his eye on the U.S. dollar. A good start is to take the suggestions offered by this regular contributor.

For an economist, there are no more perilous waters than the outlook for a currency. Every currency is one happening and one second away from a complete and total reversal. Our dollar is no exception, but it is so important to Canadian business and so vulnerable to today’s events that it’s worth taking the plunge. Angels do rush in where fools fear to tread, or at least something like that. Apologies to Alexander Pope.

My view is that the Canadian dollar is likely to strengthen against the U.S. dollar over the next while. Do not rule out an exchange rate of 81 to 83 cents (U.S.), but if you make decisions based on this view you are on your own. It is a view, not a promise.

What I know for sure is much more important! Forecasting any currency is such a mug’s game that wise executives will do everything they can to inoculate their enterprises against untoward currency movements. Mitigating and offsetting what you cannot control is always good business advice, and applies especially to currencies. No currency inoculation is 100-per-cent perfect, but my strong hunch is that many enterprises can do much more than they are doing currently. Making money in business is tough; throwing it away on a dumb currency bet is just plain stupid. On stupidity, executives should heed Oscar Wilde: “There is no sin except stupidity.”

Our dollar trades against more than 100 currencies in the world. Every Canadian business has its own exchange rate specifics, but for all practical purposes only a handful of currencies matter and at the head of that list by a country mile is the U.S. dollar. The Canadian dollar/U.S. dollar exchange rate is an enormously important factor in the Canadian economy’s performance. Few Canadian enterprises are not materially affected in one way or another by the U.S. dollar. The same applies to Canadian consumers.

Why the U.S. dollar matters so much to Canada is straightforward. Canadian merchandise exports to the U.S. are $350 billion annually. Weaken the Canadian dollar and those exports become correspondingly more competitive with comparable goods sourced elsewhere; strengthen the Canadian dollar and the reverse occurs. That $350 billion is 30 per cent of our economy and 83 per cent of our total merchandise exports. Add in the rest of the economy, including services, and U.S. exports push 35 per cent of our economy and 88 per cent of our total exports. It is incredible, but only about six per cent of our economy is dependent on non-U.S.-based trade. The enormous flow-through effects of the U.S.-dollar exchange rate on Canadian jobs, growth and investment are obvious. In particular, too big, too fast a move up in the dollar and a lot of Canadians have good reason to worry about their jobs.

For an exporting business, you just cannot beat a low dollar. The trouble is a low dollar can lull an undisciplined business into a false sense of its own capability and competitiveness. Nothing makes an uncompetitive export business look great like a currency well below its proper value for a lengthy period of time.

The same applies at the level of an economy. Governments that keep their currencies low to get short-term growth and job benefits over time do no one any favours. There is no surer route to deep-rooted national uncompetitiveness than a persistently low currency. The signposts are chronically weak relative productivity and chronically high relative unit labour costs. Alas, years of our currency in the 62- to 70-cent (U.S.) range have left Canada showing clear symptoms. Canadian business, especially exporting manufacturers, struggle with anything over 75 cents (U.S.)

The import side of our economy tells a similar story of our dependence on the U.S. dollar, but the effects are reversed. We import over $250 billion in merchandise from the U.S. and about $100 billion from the rest of the world. Strengthen the U.S. dollar and everything from California fruits and vegetables to North Carolina furniture to Nashville country music becomes accordingly more expensive, lowering our standard of living. Whether a currency-induced rising price for Shania Twain or Garth Brooks CDs really reduces standards of living, I will leave for wiser souls to decide. Weaken the U.S. dollar, and Shania and Garth get accordingly cheaper.

The case for a stronger Canadian dollar

The case for a strengthening Canadian dollar against the U.S. dollar is compelling. Paradoxically, it does not have all that much to do with Canada or the Canadian dollar. What makes exchange-rate forecasting so difficult is that every time you forecast an exchange rate, you are forecasting two currencies and by extension just about everything to do with two economies. Small wonder economists often take the Fifth when it comes to exchange-rate forecasting. “Give them a rate but never a date” is the best advice I ever heard on forecasting exchange rates.

The U.S. current-account deficit is at the heart of the U.S. dollar’s difficulties. The current account measures the difference between what a country sells to other countries and what it buys from other countries. It includes inflows and outflows for merchandise, services, dividends, interest, reinvested earnings and transfers. By definition, a current-account deficit must be offset by an equivalent foreign capital inflow; a current-account surplus by an equivalent domestic capital outflow. Foreigners finance a current-account deficit by buying the deficit country’s treasury, debt and other securities. Each year’s current-account deficit adds an equivalent amount to the deficit country’s accumulated foreign debt.

The U.S. current-account deficit is a $550-billion, five-per-cent- of-GDP annual horror show. Net U.S. obligations to foreigners are about 25 per cent of GDP and growing at five per cent a year. Foreign investors in U.S. securities are quite rightly wincing. As the U.S.’s foreign obligations inexorably mount because of the current-account deficit, the holders of the offsetting financial instruments worry more and more about getting paid as contracted and/or expected. They express their worry by selling U.S. securities, putting downward pressure on the U.S. dollar. Every day about $1.5 billion (U.S.) must find an international home, and at today’s interest rates and exchange rates, foreigners increasingly prefer non-U.S.-dollar currency investments. That’s why the U.S. dollar has lost ground against the euro, the pound, the yen, the Canadian dollar and the Australian dollar.

Whither the U.S. dollar?

How far will the U.S. dollar slide? The honest answer is, who knows-but history is instructive. In the mid-1980s, the U.S. current-account deficit got to the 3.5- per-cent range. International agreement was reached in the so-called Plaza Accord to weaken the U.S. dollar. By the time the current account approached balance, the U.S. dollar had lost close to 40 per cent on a trade-weighted basis. Given where we are today at a five-per-cent-and likely climbing-current- account deficit, and taking account of currency adjustments to date, the U.S. dollar would seem to have a good way to go yet before balance is restored. A current-account deficit declines with a declining currency because imports cost more (reducing imports) and exports cost less (increasing exports); both effects reduce a current-account deficit.

So the Canadian dollar should strengthen, not because the Canadian dollar is so strong, but because the U.S. dollar is so weak. A rising tide lifts all boats, and the rising tide of the U.S. current-account problem will lift most currencies, including ours. We do, however, have some things going for us that should also help the Canadian dollar: currency investors like the fact that Canada’s federal finances are in balance while the U.S. deficit is at five per cent and growing; spreads between Canadian and U.S. short-term interest rates make Canadian-dollar investing relatively attractive-every marginal dollar invested in Canadian-dollar instruments enhances the Canadian dollar’s value; the U.S. does not have an inflation problem, resulting in a low chance of a currency-strengthening U.S. interest rate increase anytime soon; the Canadian current account is in healthy surplus which, on its own, points to a stronger Canadian dollar; currencies develop a momentum of their own-in the U.S. dollar’s case, the momentum is down, while the Canadian dollar’s is the reverse; finally, the Canadian economy is performing quite well.

Smart currency management

At the end of the day, the Canadian dollar will go where it goes. What executives do control is how they position their enterprises. Wherever the Canadian dollar goes, smart currency management can make and/or save a lot of money.

For openers, executives should determine how exposed they are to the ups and downs of the Canadian dollar. This is a complicated quantitative exercise involving assumptions, probabilities, forecasts and simulations. It is important to develop a range of possible exposures with likelihoods of occurrence attached. This type of analytical exercise is not cheap, but no enterprise can determine what it should do about the Canadian dollar without a clear and accurate understanding of its exposure. Intuition and preconceived wisdom are usually early casualties of solid quantitative analysis. My guess is, some enterprises will be flat-out shocked at just how exposed they actually are. In this case, shock is good. It may drive action. Obviously, the degree of exposure should drive the effort to protect.

There are three things enterprises can do to protect themselves against an uncertain currency. First, having said currencies go where they go does not mean that over time some people and some techniques do not forecast better than others. Enterprises with serious currency exposure should consider investing serious money in the currency forecasting function. Currency forecasting is like many other things: you get what you pay for. It is also important to treat currency forecasting as a continually rolling exercise rather than a once-a-year event.

Second, currency movements hurt enterprises because cash inflows and outflows are not matched by currency over time. If your inflows and outflows in a given currency match perfectly day by day, that currency’s movements will not have an impact. This puts a premium on the proper forecasting of cash inflows and outflows by currency. It also puts a premium on doing things like financing foreign assets in the appropriate currency market. Currency exposure is much like interest rate exposure: match everything and you will not go far wrong.

Running your business so you match inflows and outflows is a so-called natural hedge. The natural hedge is very difficult for any enterprise to effect perfectly. Too many assets, too many liabilities and too many cash flows have to be coordinated across too many currencies, too many maturities and too much time. Third, an alternative to the natural hedge is to use financial derivatives such as futures, options and swaps to “artificially hedge” what cannot be naturally hedged. A future is a firm commitment to buy or sell a given currency or security on a given day in the future. An option gives you a choice. A swap is a firm commitment to exchange financial obligations. For example, an enterprise with a million U.S. dollars firmly coming in in 30 days can sell one million U.S. dollars in the futures market today for delivery at a fixed price in 30 days. Whatever the U.S. dollar does-over the next 30 days, the enterprise knows exactly where it is.

The derivatives markets are a great way to offset currency risk, so long as you clearly understand your situation, clearly understand the transactions you have entered into, and only deal with top-notch counterparty financial institutions. Derivatives hedging is costly but can save considerable financial heartache.

Using derivatives markets to speculate in currencies is a whole different issue. That is a high-stakes game most enterprises are not equipped to play properly. Enterprises that find they are making large amounts of money through derivatives transactions should investigate why. Probably they are speculating, and those chickens always come home to the roost. Enterprises with large foreign currency cash flows should assure they are making optimal use of derivatives techniques.

Whither the Canadian dollar? If I knew I would be a very rich man! I think, up. Many Canadian enterprises have a big-time exposure to the dollar. It is an exposure worth precise quantification and mitigation. Executives should carefully monitor the dollar file. With the dollar, you can sleepwalk your way into a financial disaster.

About the Author

John S. McCallum is Professor of Finance at the I. H. Asper School of Business, University of Manitoba, and former Chairman of Manitoba Hydro. Contact