Is The Canadian Dollar Caught In A "Death Grip"?

The Canadian dollar has kicked off 2011 in a position of strength. It is above parity with the U.S. dollar and trending at historically high levels against other major currencies such as the euro and the British pound.

At the end of its first week of trade for the new year the Canadian dollar was buying about US$1.01, 78 euro cents and 65 British pence -- all stronger than average levels. But what is driving this strength in the loonie?

Canada's economic strength compared with the rest of the world has attracted a lot of private investment in Canadian denominated assets. But Avery Shenfeld, chief economist at CIBC, says there is more to the high exchange rate than meets the eye. Mr Shenfeld says central banks around the world are also very interested in Canadian dollars in a bid to diversify their assets at a time when the U.S. dollar has lost purchasing power. This additional demand for the loonie may be overheating its value and crippling the Bank of Canada's ability to raise interest rates and curb rising consumer debt levels.

Mr Shenfeld says that BOC Governor Mark Carney's recent warning of a "death grip" on the U.S. dollar could also apply to Canada. Mr. Carney was referring to the fact that over 40% of U.S. trade is now with countries with managed exchange rates against the greenback and more than a dozen countries seeing double-digit growth in their reserves. Mr Shenfeld's use of the term applies to a slightly different situation: one where central banks around the world are filling their reserves with large amounts of Canadian dollars and thus pushing the value of the currency to artificially high levels.

"Precise data on such flows aren't available, and much of the foreign ownership of Canadian bonds is likely in private sector hands," he says. "But a significant share of the growth of late, and it's been massive, appears to be linked to central bank reserves and other sovereign funds."

A CIBC report has found that foreign investors added more than $72 billion to their Canadian dollar bond holdings in the past 12 months, nearly enough to finance last year's entire federal and provincial deficit.

Mr Shenfeld says the high level of the loonie has "hamstrung" the Bank of Canada in its efforts to stem the rapid growth in consumer debt through interest rates hikes. While household debt is not yet at a critical point, recent increases have been alarming and could reach harmful levels if left to fester.

The problem is that the central bank cannot raise interest rates at present for fear of sending the loonie even higher, Mr Shenfeld says. Currency or bond investors generally like higher interest rates because of higher yields. CIBC says the appreciation of the Canadian dollar has already resulted in Canada losing more than a quarter of its U.S. import market compared with 2001.

"There is one weapon yet to be touched: fighting fire with fire," says Mr. Shenfeld. "Canada could match foreign central bank intervention in favour of our currency with an offsetting intervention, selling an equivalent volume of loonies. That would simply move back to market determined exchange rates, and would loosen the death grip on the Canadian dollar."

While this is certainly an option for the BOC it is one they will likely try to avoid if possible. This is because such a move -- known as currency manipulation -- could cause friction between the BOC and other central banks and undermine Canada's criticism of countries that manipulate their currencies.

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