Hands off the dollar

Seven reasons why calls for Bank of Canada intervention in the currency market are misguided

by Eric Lascelles and Shaun Osborne

Markets and newspapers alike have recently been abuzz with speculation that the Bank of Canada might begin intervening in the currency market, after a long hiatus. Inaction at the Bank of Canada’s most recent rate decision poured a teaspoon of cold water onto the notion, but the speculation continues.
We do not believe it would be wise or fruitful for the Bank of Canada to intervene on behalf of the Canadian dollar in an effort to temper its recent strength. There are seven main reasons why.

It is not possible for any country to have perfect control over its currency and interest rates simultaneously. One most float or the whole enterprise is doomed as investors will elect to arbitrage interest rate opportunities between countries, and the resulting tsunami of capital flows overwhelms either the fixed exchange rate or a central bank’s monetary policy independence, if not both.

The Bank of Canada is too small to have the desired effect on the FX market via intervention. Canada’s currency reserve ranks only 33rd in the world, and there are 20 times more Canadian dollars transacted over the foreign exchange market each month than the value of the reserves. To have a substantial influence, Canada would have to either print tens of billions of dollars in money or issue tens of billions of dollars in bonds to finance the operation. In the present context, both are equally unpalatable. And to truly achieve traction, the effort would have to be paired with further rate cuts (mathematically impossible) or quantitative easing (seemingly not in the cards).

The Bank of Canada was unsuccessful in its last effort in 1998 to corral the Canadian dollar over a decade ago. Despite deploying roughly $18B, the Canadian dollar continued to fall and the effort was eventually halted due to its “ineffectiveness.” This experience left such a sour taste in the bank’s mouth that the intervention policy was subsequently changed for use “only in the most exceptional of circumstances.”

While the Canadian dollar is likely a tad overvalued by conventional measures, it is hardly egregiously so. Purchasing power parity argues that the loonie is about 10¢ too rich, while TD Bank models suggest overvaluation in the range of 1¢ to 7¢. In the grand scheme, these differentials are not especially large, and in the case of purchasing power parity, the Canadian dollar has actually spent two-thirds of the past decade at least 10¢ off “fair value.” It is thus not clear why the Bank of Canada’s appetite would be sufficiently ravenous as to warrant a rare currency intervention.