Oil and the loonie, part 1: The causes

We know the value of the loonie is affected by the price of oil. Why is the correlation so close? Daniel Schwanen of the C.D. Howe Institute explains.

Jess Morgan 18 February, 2016 | 6:00PM
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Why have oil prices been so volatile at the beginning of 2016?

Daniel Schwanen: Oil production had been climbing very, very fast in response to what were high oil prices in the mid-2000s and beyond. So [there have been] a lot of investments in oil production, particularly shale oil, much larger production than expected. So the supply went up and the demand was going up very rapidly as well until economic growth in China, which is where a lot of this growth in demand was occurring, started faltering. And there were some questions about growth in other developing economies, such as Brazil, that were growing fast and were adding to the demand very fast. So, eventually, you ended up with supply/demand imbalance: a lot of supply, and demand was less strong than people expected. Then all of a sudden, you had what was maybe an overreaction, but a sharp drop in oil prices for the time being. It doesn't cost a lot to produce oil at the margin in a lot of countries in the world. Iran is coming back on stream. A lot of countries are desperate, like Russia and Venezuela, to sell their oil because they are in such a dire economic state. So you have a lot of supply and some questions about the growth in demand going forward.

Why is the relationship between the price of oil and the value of the loonie so close?

Canada is a natural resource exporter. That's how Canadians get a lot of their income, from natural resources. When the price of oil in particular and other natural resources is high, our incomes rise. It's like getting a wage increase. We have more money to spend. People are more willing to invest in Canada and lend us money, not just for resource development but for other reasons as well. We are wealthier.

When oil prices and the price of other commodities as well drop people are saying, "Well, wait a minute; at what price am I willing to put my money into Canada?" And they are discounting our currency a little bit. It's harder to attract foreign investment. Canadians are perceived correctly as having lost some purchasing power and all of a sudden people are saying, "Well, wait a minute; are household finances government finances as strong as they were prior to the collapse in oil prices, and what does it take for me to invest in Canada? Am I going to invest in Canada at this high Canadian dollar level? No." So people are revising their expectations of Canada, and as a result their investments that they are willing to put in Canada. And as a result the Canadian dollar is valued less. There are just less people, less foreign investment, for example, coming into Canada. And Canadians are perceived as being less wealthy, and one way in which this gets translated in the financial markets internationally is through the lower value of the Canadian dollar.

Are the "eggs" of Canada’s economy really all in the "basket" of oil?

Relative to most of our peer countries –essentially, rich advanced economies – we are more intensely invested in resources. No question about that. That's our competitive advantage compared to a lot of economies in the world. Having said this, it's far from being the entire story in terms of future growth potential of the Canadian economy. Manufacturing has been really hard hit by the strong Canadian dollar since 2000 and the mid-2000s. So, we lost a fair bit of manufacturing capacity in this country. But one of the silver linings, in fact, [which is] very important for the Canadian economy has been the strong growth in high value-added services.

People often think of services as either government services or "McJobs," and that's not at all. Where our strength is in services, it's been in professional services, research and development, financial services. You've seen Canadian business, including exports in those areas, growing by leaps and bounds. And I expect that that's going to be one of the key factors going forward. Essentially the rotation that the Canadian economy is undergoing right now is towards growth that would originate in different sectors, at the moment at least in the resource sector. So those high value-added service areas in our economy are really the key. And as that becomes more clear to Canadians themselves and to foreign investors, I think that's where you'll say, "Hey, wait a minute"; you'll see a reaction that says "The Canadian economy is more diversified than we thought," which means that also there is going to be definitely a floor on how low the Canadian dollar can go because of these positive factors.

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About Author

Jess Morgan

Jess Morgan  Jess Morgan is the associate editor of Morningstar Canada’s website. She began her career as a television producer and freelance writer, often making appearances on TV and radio as a commentator on politics and culture. She holds a BA in communications from the University of Winnipeg and a diploma in Creative Communications from Red River College.

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