As the Yankee Dollar continues to slide and the Loonie breaks the 90-US cent barrier for the first time since 1977, all of a sudden everything that is American – from MacDonald’s hamburgers to real estate – looks darn cheap to Canadian eyes.
The $US/$CAD Noon Rate hit 0.9032 on May 5, 2006 as reported by the Bank of Canada, and the Loonie is predicted to equal the Greenback by close to year’s end. There are essentially four major key reasons for the recent surge of the Canadian Dollar vis-à-vis its American counterpart:
[ ] A substantial increase in demand for Canadian commodities, most notably oil and precious metals, from the United States.
[ ] A rising participation of American interests in the exploration and development of Canada’s natural reserves, and a subsequent increased demand for shares in Canadian companies.
[ ] A steady increase in Canadian interest rates, which are moving at a faster pace than the corresponding increases of the Feds, and which in turn attract foreign investors.
[ ] Financial leverage, which is higher in Canada than in the U.S.
This last point deserves a closer scrutiny, as it is directly related to real estate, my field of expertise and practice. Financial leverage takes the form of borrowing money and reinvesting it in hopes to earn a greater rate of return than the cost of interest. Leverage allows greater potential return for the investor than otherwise would have been available. Because real capital appreciation has been constantly more remarked in Canada than in the United States these past few years, it turns out that leverage is stronger in Canada than in the U.S., meaning the spread between real capital appreciation and cost of borrowing is higher in Canada. And this notwithstanding the fact that mortgage rates in Canada are typically nominally higher than in the States and that, in fact, wages in Canada are typically nominally lower.
The last time the Canadian Dollar was at par with the American Dollar was in 1976, just before the election in Quebec of the separatist government of Rene Levesque (1922 – 1987). Following that election, the Loonie began a long downfall, greased by weakening commodity prices and rising government deficits and domestic debt. The slide culminated in the record low of 62 cents U.S. for one Canadian Dollar in January, 2002.
The current exchange rate, therefore, represents a huge increase with drastic consequences on both sides of the border. For instance, a house priced at U.S.$350,000 would convert in CAD$564,500 approximately using the U.S.$1.00=CAD$0.62 exchange rate of 2002. The same U.S.$350,000 residential property costs a mere CAD $387,500 using today’s U.S.$1.00=CAD$0.9032. That’s a difference of CAD$177,000 in a little more than four years or, to put it differently, a price depreciation of approximately 31.35 percent in four years, or 7.838 percent p.a.
It sure beats the yield of treasury bonds, both in Canada and in the United States!
It is even easier to see how appealing has American real estate become for Canadian investors if we look, for instance, at the average rental property that would sell across the border from where I am. In 2002, rental properties would sell for an average US$80,000 in Washington State, or CAD$129,000 using the 0.62 cents conversion rate of that time. Now the same rentals sell for an average US$115,000, or CAD$127,300 approximately using the 0.9032 rate. Even though they have appreciated in value and are, therefore, more expensive for Americans, they have become actually less expensive for Canadians.
Interestingly enough, the Loonie has not been rising rapidly against other key currencies like the Euro and the Yen. A fact, this, which underscores that Canada and the United States have become mutual major trading partners, setting aside disputes and differences of opinion in the matter of salmon fishing and lumber subsidies of years past. In fact, the Canadian Board of Trade reports that over 70 percent of the manufactured goods produced in Canada are destined for the American markets, as opposed to only 25 percent in 1980. And Uncle Sam has increased his stake in Canadian holdings by 55 percent in the same period, with the latest acquisition being the purchase in December, 2005 of the entire stock of Terasen Gas, the exclusive distributor of natural gas in British Columbia and Alberta, by Kinder-Morgan LP of Austin, Texas.
There are, to be sure, some economic downsides that attach to an equal conversion rate, mostly because the two economies are significantly different. Not only is the American GDP (US$13.049 trillion) approximately 15 times larger than the Canadian (US$880 billion) – the very economic philosophies of the two countries are diametrically opposed. America’s capitalism is based on consumption and gives priority to consumerism, that is spending as opposed to saving. Canada, on the other hand, gives precedent to saving, so that Canadians are cash and equity richer, even in the instances when they actually make less money. Which, at the end of the day, makes Canada a much more stable environment.
This goes a long way to explain why the American economy is far more susceptible to interest rates variations: with a domestic debt load nearly double, the economic ripples caused by shifts in cost of lending travel twice as far in the U.S. than in Canada. A fact, this, that is also reflected in the weakness of the Greenback vis-à-vis the Loonie.
So therefore, Canadian companies stand to lose competitiveness in Trade from a situation of exchange equality or near equality, since manufacturers North of the 49th parallel have to reduce productions costs and, at the same time, apply leverage on the economy of scales to increase productivity, in order to remain competitive in American markets. But, on the other hand, an increased international demand for the Greenback caused by a surge in demand for American real estate products by Canadian investors may cause a corresponding surge in domestic interest rates, which in Finance may cause a further imbalance in the US ‘debt service ratio’ – the ratio of the mortgage payments to disposable income, already at a whopping 47 percent in the United States.