Our Neighbor to the North

November 21st, 2012

by Eric Schaefer

While addressing the National Press Club in Washington, D.C. in March 1969, the then Canadian Prime Minister Pierre Trudeau uttered his famous observation about his nation's relationship with its neighbor to the south. Trudeau observed, "Living next to you is in some ways like sleeping next to an elephant. No matter how friendly and even-tempered is the beast…one is affected by every twitch and grunt."

Suppose the elephant, instead of having an insatiable appetite for peanuts, has an unquenchable thirst for oil. Furthermore, suppose its neighbor just happens to be well endowed with the commodity. [The Energy Information Agency (EIA) estimates Canada, with 174 Billion barrels ranks third in the world — behind Saudi Arabia and Venezuela in proven reserves.] And, let us assume the neighbor is willing to drill, dredge and dig up the oil as fast at it can. If so, you then have the makings of a spectacular oil boom with far reaching ramifications for the rest of the economy.

Canadian bond, equity and currency movements over the last decade reflect the extent of the oil (and timber, iron ore, nickel, gold, silver and wheat among other commodities Canada has in abundance) boom. Over the last decade, Canadian share prices (measured by the MSCI Canada Index) rose 14.1 percent per annum in US dollar terms. In contrast, the corresponding MSCI country index for the United States rose by a less spectacular 7.1 percent per annum. In part, the spread reflects the dominance of energy and basic materials companies on the Toronto exchange.

But the euphoria for all securities Canadian is not limited to the equity markets. Canadian government debt has enjoyed a similar bull market. In the ten years ending October 2012, the Citigroup Canadian Government Bond Index advanced 10.6 percent per year measured in US dollars (versus a 4.9 percent return for US Treasuries). There are a variety of reasons for this disparity. A key element is the Canadian fiscal picture. Along with Australia, Canada is one of the few developed, industrialized nations not confronting a fiscal crisis from rising government debt. Canadian federal government debt is approximately 33 percent of nominal gross domestic product (GDP). In comparison, US Treasury debt now exceeds 100 percent of US nominal GDP. In a world tiring of ongoing and unresolved debt crises, Canada merits only positive headlines in the financial press.

These factors explain the steady appreciation in the Canadian dollar (or, the "loonie" among currency traders) versus the US dollar. Ten years ago one US dollar bought 1.58 Canadian dollars; today, it buys just over one Canadian dollar. This flip in the relative values of the two currencies is mirrored in cross-border shopping excursions. A soaring loonie has spurred Canadian day trippers to head south to the United States in search of bargains.

Booms — and this one is no exception — are seldom without their costs. In 1977 The Economist magazine coined the phrase "Dutch disease" to describe the impact of a commodity boom on a country's manufacturing sector. The origin was the discovery in 1959 of extensive natural gas deposits in Groningen Province and the North Sea. The find caused the Dutch guilder to appreciate versus the West German Deutsche mark. Since Germany was its largest trading partner, Dutch exports suffered inducing a secular decline in the Netherlands' manufacturing base.

Canada faces a similar dilemma. Ongoing negotiations between GM and Chrysler and the Canadian Auto Workers (CAW) union illustrate the unattended costs of the oil (and, commodity) boom. Without significant changes in shop floor practices and a re-structuring of wage scales, both auto makers are threatening to shift production from Ontario back to the United States. Between them, the three automakers (including Ford) employ more than 21 Thousand Canadian workers. As the loonie soars, the inevitable question is how much higher before the economy is singed?

Notes on Sources and Methods:

The MSCI Canada Index (with dividends, net of applicable withholding taxes, reinvested) is a free-float adjusted market capitalization weighted index which tracks the share price performance of Canadian equities. The MSCI USA Index is similarly constructed.

The Citigroup World Government Bond Index series is a collection of fixed income benchmarks for the 23 major government bond markets around the world. Each market must be at least $50 Billion in size with a minimum credit quality of A-/A3 (as determined by S&P or Moody's). Issues with at least one year to maturity are included. Security weights are based on outstanding issuance. The country indices for Canada and the US are similarly constructed.

The government debt to nominal gross domestic product (GDP) ratio is the ratio of the country's debt issued by its central government to the size of its economy. GDP is a widely used measure of the total goods and services produced (consumed) by a nation over a period of time. Nominal GDP reflects the value of the aggregate goods and services at current price levels.

Exchange rates reflect the closing price defined as the number of Canadian dollars received for one US dollar.

(Sources: Bank of Canada; Lipper; and, AIFS estimates.)

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