Can the canadian economy continue to grow if the loonie goes to par with the U.S. dollar?

Montreal-based National Bank Financial Ltd. thinks so. It’s forecasting an even-steven exchange rate by the fall of 2007. But it does not think that will throw Canada into recession. Canadian growth will be a sluggish 2.4% in 2007, but not because of the Canadian dollar reaching new heights. It’s because U.S. growth will slow to 2.3%.

Nor is NBF alone. Toronto-based Scotia Capital Inc. expects the C$ to average US96¢ in 2007. It, too, sees the economy continuing to chug along — in its case, at 2.7%, the same pace as that of the U.S.

Canadian companies have surprised economists in the way they have adjusted to the high C$. Although firms have been helped by strong U.S. and global demand for their products and lower prices for inputs purchased in the U.S. —especially machinery, equipment and information technology — their ability to cope has been remarkable, says Warren Jestin, Bank of Nova Scotia’s chief economist.

Ironically, the adjustment may have been made easier by the increasing competition from low-wage developing countries. That has forced Canadian companies to figure out where they fit in global supply chain by identifying what they do well — and hiving off what they don’t do well. Jestin is particularly impressed with the approach small and medium-sized companies are taking. This will probably produce surprisingly strong productivity numbers in Canada over the next five years, he says.

Clement Gignac, chief economist and strategist at NBF, reinforces his position that companies will be able to cope with parity by pointing to a KPMG study of 27 business costs in 2006. It shows that even with the C$ at US85¢, Canada had the lowest costs among the G-7. For Canadian costs to equal U.S. costs, the loonie would have to be almost US98¢.

That is not to say that some companies, sectors and workers aren’t having problems. Manufacturing has shed 150,000 jobs in the past 18 months in an effort to remain competitive, says NBF. Tourism is dealing with what Craig Wright, chief economist at Royal Bank of Canada, calls a “double whammy”: the high C$ is encouraging Canadians to travel to the U.S., while it discourages Americans from coming here.

Furthermore, Paul Ferley, assistant chief economist at Bank of Montreal in Toronto, says there may be more impact from the recent rise in the C$ to more than US90¢ than from the earlier increase to the US80¢ range. Companies knew an exchange rate in the US60¢-US70¢ range was undervalued and were braced for a rise to the low US80¢. But they weren’t expecting it to vault above US90¢

The higher C$ is not the only unexpected development in the past few months. Oil prices have also soared and that, too, hasn’t made economists lower their forecasts for economic growth. As a net energy exporter, Canada benefits from higher oil prices. But the U.S. is an importer, so the impact there should be negative.

But the U.S. economy has likewise surprised on the upside. American consumers remain resilient despite both higher energy costs and higher interest rates. This is partly because long interest rates, including mortgages, have increased only recently, so consumers are still comfortable spending the equity they took out of their homes as housing values rose.

Most economists, however, expect some slowing in the U.S. economy in the next year or two as higher long rates finally bite. The question is: how much will the bite hurt? NBF says U.S. growth will be 2.3% in 2007, vs 3.2% this year; BMO expects only a moderate slowing in consumer spending, thanks to job and wage gains.

That, combined with strong business capital spending, leads to BMO’s forecast of 3.1% U.S. growth, down from the 3.5% it expects this year.

As for Canada, NBF expects growth to slow to 2.5% in 2007, vs 2.8%in 2006. BMO’s forecast holds steady — at 3.2% in both years.

Few economists think there’s much probability of recession. NBF puts the odds at 30%-35%. He says a drop of 5%-10% in housing prices would probably push the U.S. into recession, which would spill over into Canada and the rest of the world. A steep fall in resources prices, due to a lessening of global political tension or a severe slowdown in China, would hurt Canada and other resources producers.

@page_break@TD Bank Financial Group puts a 15% probability on a 4%-6% drop in U.S. housing prices but says that would result in only a shallow and short-lived recession because the U.S. Federal Reserve Board would be quick to lower interest rates. TD puts the risk of higher energy prices at 10%, the probability of a US$ crisis at 3%-5% and the likelihood of a global flu pandemic at 2%. Note that TD’s oil price forecast of US$50 a barrel by the end of 2007 is at the low end of the forecasts; NBF expects US$55 and BMO and Scotiabank US$60. TD calculates that oil at US$10 a barrel higher would take 0.3 percentage points off U.S. growth and 0.5% off global growth. TD is already expecting 2007 growth of only 2.6% in the U.S. and 2.5% in Canada.

TD pegs the probability that the U.S. does not slow down at 30%. Upside risks are often forgotten, but there is ample evidence in Canada — with the big increase in the C$ in the past few years — that they can materialize.

Other key factors that will determine economic growth:

> Inflation. Inflation isn’t a great concern because competition from low-wage countries is keeping the price of goods down, providing an offset to high energy prices. The rising loonie is also lowering the prices Canadians pay for imports, leading to forecasts of an increase in the consumer price index of 1.2%-2.1% this year and 1.2%-2.2% in 2007.

In the U.S., the sagging greenback is exerting some upward pressure, but economists expect inflation to drop to the 2%-2.4% range in 2007 from 2.5%-3.2% this year.

>Interest Rates. With inflation expected to remain tame, short-term interest rates are unlikely to go much higher. NBF and Scotiabank think they will go down, as central banks ease up to prevent a more severe slowdown. NBF expects the Canadian three-month T-bill rate to rise slightly to 4.2% by the end of the third quarter of 2007 — which is as far out as its interest rate forecast goes — from a recent 4.1%. In the same period, it sees the U.S. rate falling to 4.4% from 4.8%. Scotiabank expects the Canadian rate to be 3.8% at the end of 2007, while Royal Bank and TD are predicting 4.5% and BMO, 4.3%. Royal Bank says the U.S. rate will be 5%.

Most see 10-year Canada bonds at 4.7%-5.2% at the end of 2007, up from a recent 4.38%, and U.S. 10-year treasuries at 4.8%-5.5%, which is close to its recent 5.15%. NBF says that if long rates reach 5.5% with oil at US$70 a barrel, the odds of recession rise to 45%-50%.

>Oil. Economists have increased their forecasts for average oil prices for this year to the US$55-US$70 a barrel range from the US$45-US$60 they were expecting this past December. Most expect prices to ease off, but Royal Bank and TD see US$50-a-barrel oil in 2007; the others are in the US$55-US$60 range.

There is a one view that prices will keep climbing. CIBC World Markets Inc. is forecasting oil at US$72 a barrel this year and US$90 in 2007. Rather surprising, CIBC doesn’t think this will result in any more of a slowdown than NBF is expecting.

One reason high oil prices are not biting as much as expected is because energy use is declining. Another factor is relatively low interest rates. Even at 5%, U.S. short-term rates are in the neutral, rather than what BMO’s Ferley calls the “punitive” range, making it easier for consumers to cope.

>Exchange Rates. Forecasts for the C$ at the end of this year range from US84¢ (Royal Bank) to US94.3¢ (Scotiabank). For yearend 2007, forecasts range from US80.6¢ (Royal Bank) to around US$1 (NBF). A major reason for the wide range is that Royal Bank — as well as TD, which is predicting US85¢ at the end of both years — thinks oil prices will retreat to the US$50 range. For many foreign investors, the loonie is a petrodollar.

However, there’s also downward pressure on the US$, which NBF and Scotiabank think will continue to exert upward pressure on the C$, given Canada’s good economic fundamentals — federal government fiscal surpluses, a current account surplus and low inflation.

NBF thinks Canada may see many years of an overvalued currency, just as it saw many years of an undervalued one. BNS warns that currency markets are likely to remain very volatile, with the C$ moving up and down by as much as US10¢ in any given year. IE