Devaluation is now the preferred tool to reinvigorate slowing economy. On a traded-weighted basis, the US dollar is at its highest level in over a decade. Resource-based countries have seen their currencies tumble by as much as 25% and manufacturing-based economies as much as 20% in the last 12 months.
The Japanese yen, the Russian ruble, the Brazilian real, the Chinese yuan and other Asian emerging economies have all adopted a policy of allowing their currency to float downwards, principally to stimulate exports. There is a race to the bottom as nations no longer can rely on monetary policy to promote growth–the last resort is devaluation of one's domestic currency, Seeking Alpha reported.
As Sherlock Holmes famously said, 'The game is afoot'.
Canada joined the crowd when it cut its bank rate, for the second time this year, signaling that the loonie was overvalued and needed to find a much lower level to stimulate growth through exports.
Since July 2014, the loonie has depreciated nearly 25% against the US dollar, appreciated slightly against the euro, and has weaken against the British pound.
Balance of Trade
Canada's trade balance went from a healthy surplus of over C$ 2.2 billion ($1.66 billion) in July 2014 to a deficit of over C$ 3.3 billion in May 2015. The progressive widening of the trade balance is very worrisome to a nation that relies on 30% of income from international trade.
As a major commodity producer, Canada was hit hard with the drop in world oil prices, accompanied by price declines in natural gas, non-metallic minerals, metals, forest products and basic agricultural products. Manufacturing, especially auto vehicles and parts, play a large role in Canadian exports. Canada's position in the North American auto industry has also declined.
More troublesome is that Canada's terms of trade have progressively weakened over the past year. The terms of trade is defined as the ratio of export prices to import prices. The terms of trade are heavily influenced by exchange rate movements. While globalization has resulted in lower import costs, the terms of trade continue to go against Canada. This suggests that real issue concerns the declining value of Canadian exports. Should oil prices continue their decline, the terms of trade will further weaken, putting additional downward pressure on the loonie.
Exports
Canadian exports to the US are very narrowly confined to two broad sectors. Oil and gas dominate natural resources exports, while automotive vehicles make up the bulk of manufacturing exports.
The International Energy Agency expects the oil supply glut to extend well into 2016. Global supply will exceed global demand by 1.4 million bbl//day and prices are expected to remain below $50. No price relief is in sight for Canadian producers. Moreover, the US has now almost doubled its domestic production to 9.5 million bbl//day and just last week authorized crude oil exports to Mexico. Given these market conditions, Canadian exports are unlikely to exceed the current level of 3 million bbl//day.
Looking at the longer term, Canadian production is "landlocked" in two respects. First, Canadian producers are not able to expand significantly into the US, without the approval of the XL Pipeline. Secondly, Canadian producers have no means to export oil to Asian markets.
Auto Sector
Normally, one would expect that a depreciation of 25% would boost manufacturing export volumes significantly as has been the case in the past.
Canada is the 9th largest vehicle producer in the world. It is the single largest manufacturer employing directly and indirectly 550,000 workers.
The rise of the Mexican auto industry is a large part of the story of how Canada's share of the continental auto market fell from 19% to 14%–the lowest level since 1987. This decline was significant, given that both Canada and Mexico experienced a depreciation of their respective currencies.
The loonie/peso exchange was largely unchanged all the while Mexico increased its share of the North American auto market. Mexico was able to exploit its low-wages and proximity to southern US markets. The Mexican auto industry has received $7 billion in new plant and equipment, while only $750 million has come to Canada in recent years. It is unlikely that Canada can recapture its lost market share in the auto sector.
As long as the terms of trade continue at these levels or below, the balance of trade will be negative, necessitating the inflow of capital to balance international payments.
