The Pros And Cons Of A Strong Loonie

By Geoffrey Michael | January 12, 2011 AAA

Last year was a strong one for the Canadian dollar (loonie). After a 16% gain against the U.S. dollar (USD) in 2009, it added another 5.5% last year. This is the strongest it's been since 2008, and that strength is directly tied to rising prices for crude oil and commodities. Canada's vast supplies of natural resources provide solid support for the currency as prices for commodities have risen across the board in the past year. Also, the United States imports more oil from Canada than any other country. (For more, see Canada's Commodity Currency: Oil And The Loonie.)
On December 31, 2010, the loonie closed at 99.8 cents to the USD, the first time it's finished a year above parity since 2007. Additional support for the currency came in November when Russia began purchasing the loonie to diversify its foreign exchange reserves. The loonie gained against seven other major currencies during the past year. It performed best against the Danish krone (+13%) and worst against the Japanese yen (-8%), according to Bloomberg.

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History
After the loonie was floated against world currencies in 1970, it became a benchmark and global reserve currency. There has always been a close relationship between the movements of the loonie and USD, and the relative economic conditions in both countries. The link between the tandem has decoupled over the past 10 years, primarily as a result of the rise in oil and other commodity prices.

The importance of the relative strength of the two currencies can't be overstated since the countries are major trading partners. Over three-quarters of all Canadian exports go directly south of its border, and over half of Canada's imports come from the United States.

Buying Power
For Canadians, the higher loonie is a drag on exports because they appear more expensive to importing countries. If demand for gasoline in the United States was highly elastic, this would hurt Canadian crude exports. The reality is that, at current prices, gasoline demand is relatively inelastic so the rise in the loonie has not negatively impacted Canada's oil exports. Data from the U.S. Energy Information Administration shows that imports of oil from Canada averaged 1,919,000 barrels per day during the first 10 months of 2009. In comparison, an of average 1,962,000 barrels per day were imported during the first 10 months of 2010.

Canadian companies that import raw materials, machinery and other American products benefit from the stronger loonie. Retailers that specialize in American imports have the option of lowering prices and increasing sales volume, or maintaining prices and increasing margins. The reverse is true for American importers since they pay more for Canadian products.

The stronger loonie is good news for American exporters who have struggled through the recession of the past few years. Their products appear cheaper to Canadian companies and consumers, helping their bottom lines. American exporters also have the option of reducing their prices with the goal of increasing sales revenues through higher export volume. (To learn more, check out our Economics Basics Tutorial.)

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Doing Business
Canadian businesses that want to expand into the United States now get more bang for their investment buck. The stronger loonie provides them with more purchasing power for potential acquisitions. It also helps Canadian companies that do business in Canadian dollars but pay salaries in USD, such as Canadian sports franchises that operate across the border (think professional hockey teams).

Going Forward
Based on a Bloomberg survey of 29 economists, the loonie is expected to trade between parity with the USD and C$1.01 for the rest of this year. Much depends on the state of the U.S. economy, which has been battered by the implosion of a housing bubble and rising government debt. The monetary policies of the Federal Reserve are widely viewed as being inflationary, which could put further downward pressure on the USD. While the Fed could raise interest rates to fight that trend, this could stall or derail an already weak economic recovery which would likely spill over into Canada.

The Bottom Line
The key fundamentals that have strengthened the loonie are investor risk tolerance, a stable and growing Canadian economy, a good fiscal balance sheet, higher commodity prices and a search for investment currencies that will hold value in the future. (To learn more, see Why Things Are Getting A Little Loonie.)

For the latest financial news, check out Water Cooler Finance: You're Never Too Old To Work.

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