The soaring Canadian dollar may discourage foreign companies from locating operations in Canada. It may also result in Canadian companies deciding to relocate or expand their facilities elsewhere rather than expand domestic production.

Fortunately, costs are not up as much as the loonie, which has risen more than 16% since the beginning of 2007 and has reached parity with the U.S. dollar. Some costs, such as machinery, equipment, commodities and transportation, fall with a higher C$. In addition, corporate income taxes tend to decrease the after-tax effects of exchange rate movements.

Nevertheless, Canada has lost the overall business costs advantage that it has had since 2002 and is now even with the U.S., according to KPMG LLP.

But because Canadian business costs are still not higher than those in the U.S., US$ parity “does not appear to be an economy killer,” says Stéfane Marion, assistant chief economist at National Bank Financial Ltd. in Montreal, in a recent report.

Despite this, Marion is concerned: “We are now at the point at which improving our productivity is of paramount importance to guard against further erosion of competitiveness.”

At parity, the C$ is way above its US81¢ purchase power parity (PPP) rate. PPP compares the cost of a specified basket of goods and services in two countries and determines the exchange rate at which the goods and services can be purchased in each country.

Marion expects the C$ to remain high. Although he expects it to move down to around US96¢ by the end of this year, he thinks it will be back at parity when 2008 draws to a close.

Even if the high C$ isn’t an economy killer, it will probably slow Canadian growth, says NBF senior economist Yannick Desnoyers in another NBF report: “When the C$ trades higher than its PPP value, Canadian exports tend to grow far slower on average.”

And the impact of a high C$ will probably be worse if the U.S. goes into recession. As Desnoyers points out: “U.S. recessions have always caused Canadian exports to fall.”

NBF currently puts the odds of a U.S. recession at 50% — a real risk, in its view. And even if a recession is avoided, NBF expects U.S. growth to be very slow next year, at 1.5%.

Fortunately, the effects of a U.S. slowdown or recession could be somewhat offset by a drop in interest rates and other fiscal stimuli. The Bank of Canada has room to manoeuvre if it needs to lower interest rates, Desnoyers points out. He also expects the Canadian federal government to cut taxes in its next budget. IE