The Canadian dollar’s fair value

Aside from Greece, the Canadian financial press is all about the strength of the Canadian dollar, which hovers around parity with the American greenback.  One of the most interesting aspects has been the increase in the estimates of fair value for the Canadian dollar, from around .87¢ in 2006 to the U.S. dollar to near .93¢ today.  

                     CAD Vs. USD 2002-2010

It has been nearly 25 years since I really though about economic theory, and currency was discussed in one class only – Money and Banking taught by Bill Watson (at McGill U.) so I had to hit the books again to look beyond the Big Mac Index (made famous by the Economist) and look at the BoC and FEER models [FEER dates back to 1994 – Williamson et all].  The question with the CAD dollar approaching parity with the US dollar what’s the fair market value for the CAD?

Toronto Dominion Bank published a report: Has the Canadian Dollar gone too far too fast? [2008/Q1] Which makes a valiant attempt at generating a reasonable answer.  Between June 2002 and September 2007 the Canadian dollar has risen from 0.65¢ all the way to 1.10¢ to the USD a 70% rise in 5 years… returning the Canadian dollar to the level it averaged in the 60s and 70s (yes Dorothy the CAD trades “above” the USD for many years).  A subset of the FEER model, the Behavioral Equilibrium Exchange Rate: 

E_t (q_t)-q_t = r_t - r_t* + λ_t 

Basically:  Value of the real exchange rate [E_t(q_t)-q_t] should be equal to the difference in interest rates [r_t - r_t*] Plus a risk premium for the country risk (this is largely how futures are priced by the way).  This translates into the BEER function which says that the correct exchange rate is a function of the real interests rate spread (between two countries), the terms of trade (tot), the relative price of traded good (tnt), net foreign asset position (nfa), and the ratio of fiscal deficit to GDP(def):

BEER = f(r-r*,tot,tnt,nfa,def) 

This gives us a reason for the increase in the fair market value of the dollar, whereas today the differential between Canada and America’s interest rates is negligible, the terms of trade over the past 4 or five years are important:

This shows that Canada has been operating with a trade surplus for several years (despite the reversal of  2009), the trend is well established, so that there is an imbalance between Canada and the U.S., the last two factors are the more important, where the relative price of goods have been in Canada’s advantage, although completely exogenous to Canadian cost of extraction (Metals, energy etc…).  Finally, over the past two years the important factor has been the ratio of fiscal deficit to GDP, where Canada’s ration is going from 78% to 69% (by 2014) the U.S, situation is the reverse – from 85% to nearly 100% today and estimated to be 108% by 2014.

These are the factors that explain the rise in the fair value of the Canadian dollar from .83¢ to .87¢ to .93¢ today.  If Copper, Aluminum, Oil & Gas, and other export material continue their price rise, it is fair to estimate that Canada’s fair value exchange rate will continue to rise.  Apparently, the Bank of Canada uses a different model which puts more emphasis on trade; in fact, the BoC maintains that terms of trade account for 90% of the Canadian dollar’s fair value…

There you have it, the reason the fair value of the Canadian dollar has been rising is due to prudent fiscal policy (ok don't want to over do that one), and Canada trade balance, due to the increase in price of the natural resources produced in Canada!