G7 Books Canadian Dollar Chaos by William B.Z. Vukson

Canadian Dollar Chaos
Canadian Dollar Chaos. Copyright 2001 by William B. Z. Vukson. All rights reserved. Printed in Canada. No part of this book may be used or reproduced in any manner whatsoever without written permission except in the case of brief quotations embodied in critical articles and reviews. Published by G7 Books First published in 2001
Books by Vukson, William B. Z., 1958Canadian Dollar Chaos 2001 Political Structure and Technological Change 2001 The Pound Sterling Chronicals 2001 The Regal Dollar 2001 World Money Guide 2001
ISBN 978-0-9809085-0-3
G7 Books Toronto, Ontario, Canada g7research@eol..ca
CONTENTS
Foreword . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .4 Canada and the Dollar . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .8 The G7 and Exchange Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .13 Markets over Politics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .17 The Northern Peso . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .21 Two Crises: The Peso and the Northern Peso . . . . . . . . . . . . . . . . .24 Trapped in Asia! . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .32 First Quarter: March 21, 1992 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .34 Second Quarter: May 21, 1992 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .36 Third Quarter: July 24, 1992 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .38 Fourth Quarter: September 11, 1992 . . . . . . . . . . . . . . . . . . . . . . . . . . .40 First Quarter: December 15, 1992 . . . . . . . . . . . . . . . . . . . . . . . . . . . . .43 Second Quarter: March 19, 1993 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .45 Third Quarter: July 16, 1993 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .48 Fourth Quarter: October 12, 1993 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .51 First Quarter: 1994; December 18, 1993 . . . . . . . . . . . . . . . . . . . . . . .55 First Quarter: February 14, 1994 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .58 Second Quarter: April 22, 1994 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .62 Third Quarter: September 25, 1994 . . . . . . . . . . . . . . . . . . . . . . . . . . . .65 First Quarter: January 5, 1995 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .69 First Quarter: February 10, 1995 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .74 Second Quarter: March 30, 1995 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .78 Second Quarter: June 6, 1995 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .83 Third Quarter: July 26, 1995 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .88 Third Quarter: September 24, 1995 . . . . . . . . . . . . . . . . . . . . . . . . . . . .93 Fourth Quarter: November 25, 1995 . . . . . . . . . . . . . . . . . . . . . . . . . . .97 First Quarter: January, 1996 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .101 Second Quarter: April, 1996 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .105 Second Quarter: April 28, 1996 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .109
Third Quarter: June 18, 1996 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .113 Third Quarter: August 7, 1996 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .118 Fourth Quarter: October 2, 1996 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .122 Second Quarter: June 3, 1997 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .127 Third Quarter: September 29, 1997 . . . . . . . . . . . . . . . . . . . . . . . . . . .129 First Quarter: January 30, 1998 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .131 Second Quarter: June 19, 1998 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .133 Third Quarter: September 20, 1998 . . . . . . . . . . . . . . . . . . . . . . . . . . .135 First Quarter: January 16, 1999 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .137 Second Quarter: May 9, 1999 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .139 Fourth Quarter: October 8, 1999 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .141 January/ February, 2000 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .143 March/ April, 2000 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .145 May/ June, 2000 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .147 July/ August, 2000 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .149 September/ October, 2000 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .151 November/ December, 2000 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .153 November/December, 2000 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .155
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FOREWORD
The G7 Report Project came about unexpectedly. After having spent many years in academia, trade and merchant banking, I felt that a new communications forum was needed that would bind together an inter-disciplinary approach to the new developments and challenges faced in this emerging new decade, the 1990s. As things turned out, the past decade proved to be one of the most revolutionary periods in the twentieth century, with an unprecedented combination of global markets and technological invention. All of this called for a fresh new start in media, research and documentary journalism that yearned for direction from a unique type of leader; perhaps one that brought to the table a rare combination of both academic and theoretical grounding, combined with unequalled practical know-how. To be an effective leader or strategist in the 1990s, it was not enough to just be a specialist within a narrow area of expertise, nor was it sufficient to rely on just many years of experience within a particular sector of the economy. In this respect, the academic approach to economics and world business was deprived of what John Kenneth Galbraith once termed as practical good sense evident in great abundance throughout the revolutionary 1990s. Even within the confines of the new high tech economy a great deal is lost in trying to understand the longer term trends that are in play, let alone in predicting the rise and progress of this new high tech world. Very few Economists in the early years of this decade predicted what has transpired via the internet, nor has the profession been too adept at charting the long term trends that have been emerging in global stock markets, not to mention the currency markets. In fact, on the latter point, most have dismissed trends in currency markets as belonging within the sphere of the random walk. Asked where the dollar-yen parity may be tomorrow or one month from now, the quick reply would have been the same as where the relationship has stood at the close of business today. Asked where it would stand one or two years from today, the answer would amazingly have been the same. Yes, the new orthodoxy in the 1990s was the random walk. Under this method of analysing currency markets, there was no way to predict the short term daily or hourly parities between two currencies, nor was there any strategy to pursue long term risk management of fluctuating currencies. The name, The G7 Report, was derived from an international monetary economics course that I attended and which was taught by Professor Michele Fratianni, an expert on exchange rates and interest rates and former Chief Economist of the European Commission in Brussels and a member of the Council of Economic Advisors in Ronald Reagans Administration, not to mention a good friend of mine. Of interest was how both fiscal and monetary policy was formulated within the industrial grouping of the most powerful economies in
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the world, the interaction between them, and the effects a particular direction would have on the emerging market group of countries that border these powerful G7 nations. In simple English, if all of the members of the G7 were expanding fiscal spending or lowering interest rates in concert with one another, the disruption as reflected via fluctuating exchange rates would be kept to a minimum. This would be of particular benefit to all parties transacting international business, since strategy and planning within organisations find it most difficult to hedge the effects of gyrating exchange rates. On many occasions, the serious financial press is full of reports of disappointing earnings results due to financial hazards that have impacted subsidiaries in various parts of the world. The initial attempts to co-ordinate official demand-creation activities within the G7 have been motivated to a large extent on purely trade grounds. Liberalised capital mobility and the burgeoning herd-mentality lead by some well known hedge-funds is a phenomenon that arose in the early 1990s, through George Soros glorious victory in ejecting the pound sterling out of the European Exchange Rate Mechanism, which was the prelude to the present day single currency- the Euro. However, in the mid 1980s, the hey-day of G7 policy co-ordination exercises, it was trade concerns which were at the forefront of the policy debates. After Francois Mitterrands Socialist Party took power in 1981, politicians in France broke with their G7 counter-parts in order to pursue a massive re-inflation which ultimately proved very short-lived. To break from the pack in such a manner, the French franc nose-dived in global currency markets as inflation skyrocketed upwards. The Mitterrand government quickly learned that individualistic approaches to policy were dead ends, and that the short-lived expansion quickly made the exchange rate attractive to foreign buyers, but that the ensuing price increases, or inflation, choked off the gains that buyers would have had from the lower franc. In short, the Mitterrand experiment exacted great inefficiencies on fellow member G7 nations and had limited real impacts on the domestic French economy. Mitterrand quickly retreated from this approach and agreed to become a team player thereafter. Not only were such policy directions between the worlds most powerful economies vital in understanding how business cycles interact between these countries, but a collective decision to increase spending or to lower interest rates exacted a real impact on the global economy, and the emerging market countries in particular. During the transformation of Russia and the former communist countries of central and eastern Europe, many have argued in favour of a concerted G7 expansion in spending and their creation of a more global demand that would in turn assist in the transformation to a market system. This criticism remains valid as trade and investment flows from the G7 to the newly emerging
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market economies and vice-versa, has been disappointing, hence prolonging the transformation process and creating more hardship than what would have been otherwise necessary. The G7 Report project was not just about economics and business, but was a new vehicle that introduced a number of journalists and commentators unfamiliar to the readers of the daily news in major North American cities. We retained some leading contributors over the years, such as Harvard Professor Benjamin Friedman, Belgian Senator and leading international trade Economist Paul De Grauwe and compliance and regulatory expert Dr. John Pattison, but also introduced numerous writers that would normally not have had the opportunity in the commercialised or market-driven media to express their views and communicate with our readers. We became known as a media that was made available to some leading European based journalists such as Italian based organised crime expert, Antonio Nicaso, and to his counterpart in Canada, Mr. Lee Lamothe, the former head of the crime section of the Toronto Sun daily newspaper. The G7 Report project attained a small niche circulation in major North American cities such as New York, Boston, Miami, San Francisco, Los Angeles, Toronto and Montreal, but was never able to develop a following in places such as Vancouver or Atlanta. Moreover, throughout 1995 and 1996 we were also available over the retail newstrade in the City of London at selective newsagents. Furthermore, The G7 Report project was not something that was developed by marketers residing in New York, Toronto or Los Angeles. In fact, I would be the first to stick my neck out and say that this was among very few recent launches which went the other way around. I did not measure or test the market with this concept before launching the product. In essence, The G7 Report made and shaped its own following and market over the years. It was a leader which was embraced by a very loyal grouping of reader, that felt that we had important things to say about global trends and the rising new economy. The G7 Report project was particularly foreign to advertisers, especially among the agencies in Toronto. We counted very limited success in soliciting advertising support, and agency calls and presentations tended to border on the absurd. In short, The G7 Report was simply not a concept that was welcomed within this realm. Most of the major corporate supporters were much appreciated, yet very rare. Among this select group, we are very grateful to Ford Motor Company, the Montreal Stock Exchange, NatWest Markets and Kapital Trade as our core group of advertisers. The problem that any niche publisher must go through is retaining a core group of supporters over the long term. If this can not be maintained, then the publication either dies or gets transformed over the years. We greatly relied on the latter technique to ensure our survival. However, it was interesting to note that we did not deviate much from our core
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group of readers, regardless of the format of The G7 Report. Since 1992, we went from an academic-looking journal to an expensive full-glossy magazine, to a newsprint version and ending with the current newsletter look. We found that the constant throughout this entire process of transformation in design were our core readers over the years, and for this we thank them for their ongoing and unbending support. William B.Z. Vukson
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he 1990s have been even less kind than the 1980s to the Canadian dollar relative to the U.S. dollar. A long time ago in the 1970s, for a very short period of time, the Canadian dollar was actually a few pennies stronger than its U.S. counterpart. This occurred during the era of pegged exchange rates around 1970, just before the Bretton-Woods system was completely abandoned during the time of the Nixon administration. For most of the inflationary 1970s, Canada pursued a nationalistic economic policy, restricting foreign direct investment inflows and keeping a suspicious eye on what was happening south of its border. During this period, politics and economic policy was formed under the premise that Canada was a closed country, and that the period of rising oil prices could effectively be shielded from consumers by regulating the international market and creating what became known as a made in Canada price for a barrel of oil. The posture which the Liberal government of Pierre Trudeau opted to pursue during this time, was very much reflected by its actions in the oil and gas market. The 1970s were very much a decade where commodity-producing countries were left in a respectable strategic position, in contrast to the resourcepoor countries which needed to struggle with ridiculously high energy and commodity prices. Even local governments were singularly defeated over their pricing policies with respect to gasoline and energy. The Conservative government of Joe Clark was in power less than a year in 1979, when it introduced a budget which pushed local gas prices closer to world market prices, inciting massive protests. Ultimately, the Clark government was defeated in a non-confidence motion over gasoline, and the Liberals under Pierre Trudeau were once again resurrected from defeat.
CANADA AND THE DOLLAR
The 1970s were also an era of large-scale capital projects; such as the Alberta tar sands, which held large reserves of heavy thick oil that was difficult to refine and distribute, and the massive investments in energy exploration conducted in the northern arctic regions. The Cold War system of fragmented regions, was very friendly to large, resource-rich countries such as Canada. Investors came to view these countries as carrying a real premium, based on the high standard of living that such an abundance could bring. Often, Canada and the Soviet Union were comparable to one another from the perspective of size and resource richness during this time. During the 1980s, Canada became even more attached to the U.S. market, as exports as a component of overall income grew to about one-third, as the natural allure of a boom created by deficit spending by the Reagan Administration was very difficult to resist by most Canadian manufacturers. The
boom-time conditions after the interest-rate induced recession in 1980, resulted in the dependency ratio rising in relation to the U.S. market. More and more, as the Liberal era of Pierre Trudeau was swept aside, and politics took on a more Conservative bend, very soon there was an unstoppable inertia which swept in formal free trade arrangements with the U.S. Aside from the local rhetoric in opposition to free trade with the U.S., the Conservative government of Brian Mulroney sensed that an era of more open global commerce was upon us, and that Canada would do well in moving quickly to protect its most vital market, the United States. After the collapse of the Bretton Woods system of currency pegs in 1972, the Canadian dollar was on an unending downward spiral in relation to the currency of its most vital trading partner, the U.S. dollar. Despite constant agitation among the Senators representing border states, every administration in the U.S. understood that without easy access to their vast market by Canadian exporters, one-third of all incomes could potentially be affected in some way. In addition, Cold War strategic interests also prevailed, as the U.S. needed Canadian co-operation in order to patrol the northern reaches of the arctic for any Soviet intrusions that could threaten the United States directly. The low dollar politics took on an inertia over the 1980s that was difficult to reverse, even though many Senate leaders in the U.S. Congress constantly received opposition from their constituents who had to deal with very competitively priced Canadian exports.
The difference between the two dollar parities in the period of the Cold War, when compared to the era of emerging globalisation in the 1990s, was that the Canadian dollar began to track the deflating prices of commodities in the latter period. This behaviour was not obvious during the Cold War period, especially when rising oil prices during the 1970s, resulted in a dollar which was weakening in relation to the U.S. dollar. Why did this happen and can it be explained by economic logic? If the Canadian dollar was dependent on the balance of trade during the 1970s, as many of its G7 counterpart currencies were, then it made sense only if the trade balance with the U.S. was on a long term trend downwards. However, this was difficult to imagine, since Canada was a net exporter of energy products, such as certain grades of oil and natural gas to the U.S. market, especially during the years of the OPEC oil embargo in the late 1970s. However, despite this, the activity on the capital account of the Canadian dollar worked against it, as travel to the U.S. and abroad kept a steady demand for the Canadian dollar low. Under the period of emerging globalisation in the 1990s, the collapse of Communism began to tie all of the emerging market countries together now in a single global marketplace, driven by advances in high technology and communications. This started the new decade off with a challenging dose of disinflation as Canadian commodities that were priced in international markets, were
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now being challenged by continuously lower-priced commodities of the former Soviet Union countries. Not only was world market oil and gas production now located in Alberta and the North Sea, not to mention the Arab countries, but it was also very plentifully available from Kazakhstan and Azerbaijan; the newlyemerging markets of the old Soviet Union. This was also the pattern for many other basic commodities that were traditionally mined, sending prices lower and battering the price of gold well below three hundred dollars U.S. for the remainder of the decade. As a general gauge of inflation over history, it is interesting to note how gold has behaved in the era of globalisation, as disinflation in some countries combined with outright deflation in others, to exert an overall impact on lower and declining prices in general on a basket of commodities. The Canadian dollar went down with the price of commodities, as it pushed to record low levels inviting criticism along the way from commentators, and adopting the unofficial Northern Peso label from those most critical of its recent performance. As the Asian crisis hit in 1997, it spread to Russia and the central European emerging market countries in the fall of 1998, also affecting some members of the G7 and Canada in particular. Having dipped below the important seventy U.S. cent point very briefly during the very close Qubec Referendum of 1995, the ensuing emerging markets crisis in 1997 was notable from the perspective that the Canadian dollar was taken down simultaneously with the Thai Baht, Indonesian Rupee and the Russian Rouble. History was made, and Canada was distinct among G7 countries for being the most vulnerable to such a crisis originating in the newly-emerging markets. Even an aggressive reduction in short term interest rates engineered by the U.S. Federal Reserve, could not save the Canadian dollar from its slide towards sixty U.S. cents. The slide in the Russian Rouble preceded one of the biggest financial crises that the New York banking brethren has seen, and one of the most dangerous financial risks since the collapse of Barings bank. I refer to the near collapse of the Long Term Capital Management (LTCM) fund, which was directed by a group of star nobel prize winning academics and famed New York trader John Merriwether. Nobel prize winners Merton Miller and options pricing theory guru Myron Scholes were among the partners in the speculative fund that took positions based on historical financial relationships in the markets confirmed over time. The leverage that LTCM amassed was so great, and the individuals so influential to have received so much credit backing, that a turn for the worse during the emerging market crises stood traditional relationships on their head, and at the same time created an unprecedented situation of panic. So severe was the potential impact on the U.S. and the world financial system, that Federal Reserve Chairman, Alan Greenspan, took the unprecedented step of seeking help from all major global commercial and investment banks, along with an aggressive pro-
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gram to reduce short term rates, and add liquidity to U.S. and world financial markets. Despite this crisis in New York, the consequences were felt more in the Canadian currency and stock markets in Toronto, than they were on Wall Street. The fears being that the deflation-ravaged domestic Canadian economy was about to absorb yet another dose of confidence-shattering crises. Such an event would destroy the consumer confidence that was so difficult to rebuild after the early 1990s commercial property crash, and several double-dip recessions thereafter. Immediately, the Canadian dollar followed the Rouble, Baht and Rupee downwards, much to the surprise of many investors. The crisis in Russia was particularly troubling, as many commodity exports such as oil and gas, were now far more competitive in global markets after the Roubles collapse. Furthermore, the metal-based commodities that Russia exported impacted the Canadian economy directly, calling for a lower dollar in order to compete on international markets.
The 1990s began with a crisis at Canadas central bank, which was supposedly independent. Governor John Crow, appointed during the era of Brian Mulroneys government, was a devout monetarist and inflation fighter. He pursued an aggressive policy which was designed to enhance the credibility of the Bank of Canada, as an inflation-fighting institution. This policy was implemented by a combination of high real interest rates and an appreciating dollar, which was impacting the bottom-lines of the all too-important exporters in the manufacturing sector. The election of the Liberal government of Jean Chrtien in 1993, elevated the comments of Finance Minister Paul Martin Jr., which were very much anti-Crow and against the Bank of Canadas uni-dimensional pursuit of fighting inflation. Martin quickly orchestrated a campaign to remove Crow from the Governorship of the Bank, in favour of a mild-mannered career central banker, in the form of Gordon Thiessen. The severity of the downturn in the early part of the 1990s, was a good enough reason for the government to reject the harsh monetarist policies of John Crow, under a period where technological change would have made the entire concept of fighting inflation somewhat redundant anyhow. However, what was at stake under the Crow episode, was the entire concept of the role of an overly-independent central bank, that was too singularly focused on one thing; fighting inflation. It also brings into question the entire trend in the 1990s of independent central banks pursuing their own agendas among the industrialised and advanced G7 countries, when rapid technological changes in the latter half of the decade would have been a natural hedge against price increases anyway. In essence, to have a double dose of rigid central bank independence, as well as technological change and heightened levels of competition, combined together, was just too much to handle for some countries like Canada. Just how independent is the Bank of Canada? It is independent only up
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to a certain point, as the Liberals so vividly illustrated via the Crow affair. With an ailing economy for most of the 1990s, and with constant attacks on Canadas standard of living from abroad via the global marketplace, political expediency ruled the day. In this case, foreign investors also reacted with dismay, as the Crow affair ran so much against the mainstream investor logic on central banking independence, not only among the G7 countries, but also among the emerging market countries which so much aspired to inherit independent central banks and sound currency policies. It can be argued that the continuing structural weakness in the Canadian dollar, was also very much due to the interference that the Liberal government chose to implement against the Bank of Canada, in the early part of this new decade of globalisation.
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The G7 members including the U.S., Canada, Germany, France, Italy, Japan and the U.K., with the latter inclusion of Russia, have always been a fiscal and monetary policy information forum. Only for a very brief period of time since its creation, did the G7 actually co-operate to co-ordinate the direction of economic activity. Central to the whole concept of policy co-ordination is controlling wildly fluctuating exchange rates among the worlds major industrialised countries. Adverse exchange rate movements distort international investments, as well as strategic planning initiatives, while creating uncertainty and project delays. Based on the premise that it is good to control the fluctuation of exchange rates, a good beginning would be to co-ordinate fiscal and monetary expansions among a grouping of countries. If the G7 moved in tandem to expand money supply by ten percent, meaning that money supplies in dollars, euros, yen and pounds sterling went up by ten percent, inflationary expectations would be the same in all of the G7 countries and there would be no real effect on exchange rates. However, if the G7 decided to expand money supply by ten percent, with the exception of Japan; preferring to hold its growth to zero, then the yen could appreciate by ten percent relative to the dollar, pound sterling and the euro. This latter unco-ordinated approach would cause havoc in global currency markets, hence distorting investment and trade. In short, it should be avoided. The historical development of the G7, must be traced back towards the development of the Bretton Woods System of pegged exchange rates after the second world war, and was influenced by one of the most well known economists in modern times, John Maynard Keynes. Where Bretton Woods ended off in 1972, during the peak of the Vietnam crisis, the European Monetary System tried to take over the function of coordinating monetary policies. Both the Bretton Woods system and the European Monetary System are fundamentally different from the G7. Whereas the former two are formal agreements to coordinate monetary policies and inflation rates by fixing exchange rates, no such formal agreement exists within the G7. In that respect, the G7 is a forum that idealises the concept of coordinating policies in three different trading blocs throughout the world. However, there is no enforcement mechanism that forces its members to pursue monetary policies based on some form of pre-arranged fluctuation band for the group of currencies, and there is no assurance of success, given that no member is obliged to follow the final communiques that are issued at the yearly summits and through the more informal gatherings of Finance Ministers throughout the year.
THE G7 AND EXCHANGE RATES
In Europe, monetary policy coordination has a long history that predates the famous Schmidt-Giscard dEstaing agreement to formally establish fluctuation bands in 1978. It was as early as 1959, that the European Parliament pro-
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posed the formation of an institution patterned after the U.S. Federal Reserve system for the purpose of coordinating monetary policies in Europe. The European Monetary Agreement of 1958 strengthened the provisions of the Bretton Woods system, which was already in place and functioning. However, the Monetary Agreement of 1958, proposed that the bilateral margins of fluctuation among the EC currencies be limited to three percent. At the same time that the European Community decided to harden its commitment to monetary coordination practices alongside its commitment to the Bretton Woods system of pegged exchange rates, the Bretton-Woods system was under severe strains. The gold standard under which its central currency, the dollar was based on, began to slowly unravel in the 1960s at the height of the Vietnam war and the spending commitments made for the arms race, together with the strains of Lyndon Johnsons Great Society programs, proved to be too much for the system to bear. By 1968, gold convertibility at $35 per ounce had virtually ceased, when President Richard M. Nixon moved to formally end it on August 15, 1971.
In 1969, the French franc was devalued and Germany allowed the mark to appreciate, while a wholesale unravelling began the process that would see the eventual demise of the Bretton Woods system. In 1973, the United States itself, the anchor currency in the Bretton Woods system, announced a ten percent devaluation of the dollar, hence formally ending the international experiment of currency management which held together since the second world war.
The demise of monetary co-ordination in the 1960s, culminating with the French devaluation and the German revaluation, put enormous strains on the European Community, which considered monetary coordination a vital element in furthering the twin goals of political and economic union. After the crisis with the franc, mark and dollar began to appear, German Chancellor Willy Brandt, put forward an idea for monetary union at the summit of the European Council in the Hague in 1969. This lead to several attempts to coordinate exchange rate fluctuations, resulting in the snake agreement in 1972. However, this was short lived, as the O.P.E.C. oil embargo and the general inflationary environment during the 1970s, caused severe fluctuations in exchange rates, chaotic policy initiatives and desperate political manoeuvring in Europe, to cope with the rising energy costs. In 1978, German Chancellor Helmut Schmidt and French President Valry Giscard dEstaing, created a new initiative that would establish the enduring European Monetary System and a formal Exchange Rate Mechanism (ERM), which would govern fluctuations among European member currencies tied to fluctuation bands of 2.25 percent on either side of the central parity for some countries, and six percent trading bands for other countries that were not considered to have a good inflation record. This was the final solution that eventually yielded a single currency and one European Central Bank.
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The G7 has at its core this incredible accomplishment among its European members, that moved a loose framework for policy coordination, into outright monetary union. Certainly, the G7 never moved to replicate what had existed in the Bretton Woods framework of pegged exchange rates prior to 1969. For whatever reason, the G7s agenda was a far more informal mandate to loosely exchange information and to act only when periodic financial crises arise in the global financial system. In essence, the G7 has admitted that what has worked among its European members, can not necessarily be extended to include countries located among three diverse trading blocs around the world. The glory period for the G7 culminated in the Plaza Accords, negotiated in New York in 1985, and formalised two years later in the Louvre summit in France in 1987. The growing trade deficit in the U.S. automotive accounts with Japan, required a revaluation of the yen and Deutsche mark and the devaluation of the U.S. dollar, which lead to a new trade equilibrium in this turbulent period. Never again has such a high level of cooperation been noticeable, as the new era of globalisation presented an interesting new set of challenges. With deflationary conditions prevalent in the early 1990s, the Anglo-saxon grouping of countries that included the U.S., Canada and the U.K. were experiencing a sharp adjustment and a severe downturn, while the continental European members were experiencing a boom from German reunification. Under such a period of structural change, it was difficult for these two groupings of G7 countries to be on the same point in their respective business cycles, hence unwilling to pursue any coherent form of policy coordination that made any sense.
The 1990s have become a decade of open capital flows, budgetary surpluses and less active monetary policies. The role of the G7 is now more important than it was ever before, during the closed economic era of the Cold War. Speculative pressures are now far more prevalent than at any time after the second world war, and many respected world leaders have called for some form of control in global currency markets. Many have even called for a reinstatement of the old Bretton Woods system, that would be much more far-reaching than the European Union was in establishing the Euro. The difficulty with any such
For example, if the Anglo-saxon group of countries had argued for an expansion in the money supply or in fiscal spending, it would be, and was countered with a negative response from the inflation-conscious German Bundesbank. The fact that globalisation brought naturally diverging responses in the 1990s, made the whole mandate of the G7 somewhat redundant. How could policy be effectively coordinated in light of each country being at opposite ends with respect to its business cycle? Moreover, there did not seem to be any room for any compromise or middle ground either, which was probably the most disappointing part of the failure to take an active role in policy coordination among the members of the G7 during this period.
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moves, however, has to do with the divergence of interests of members in terms of where they are in their respective business cycles. As in the early 1990s, Germany wanted to see a decrease in spending, while most other recessionplagued countries called for an expansion. This kind of coordination is redundant in the world of growing global capital flows, which would create severe speculative pressures on currencies if such an imbalance were allowed to proceed at the policy end.
The hope that remains in coordinating business cycles, is the expansion of the information economy, even in countries on continental Europe which have realised that the rigid labour structures that have come to define this region, will inevitably need to disappear over time. These are the kinds of structural impediments which make co-ordination of policies very difficult, but which have the potential to lay a framework for a successful G7 agenda over the next five to ten years.
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MARKETS OVER POLITICS

Interview with: Directed by:
Rising International Influence of the Montreal Exchange Gerald Lacoste, President & CEO, Montreal Exchange
William B.Z. Vukson
When we talk about foreign investors, we are mainly referring to products that are traded in our derivatives section, which are our three month Bankers Acceptance contract (BAX) and our contract on ten year Government of Canada bonds (CGBs). These contracts are useful for any pension fund managers in Canada or elsewhere to ensure that they properly manage their portfolio risks via hedging or specific investments. These would be our primary products on offer along with access to our stock market, where we have a listing of most of the large Canadian public corporations, and an impressive number of smaller Quebec-based companies. Does the Montreal Exchange have some kind of comparative advantage over other North American exchanges with respect to these two derivative products? These two specific products are traded only on the Montreal Exchange, although there was an attempt last year by the Chicago Board Options Exchange (CBOE) to trade a similar kind of product. This was eventually de-listed, because the market was already well-established in Montreal. What would you say would be the comparative advantage that Montreal has as a financial centre in North America? It is a modern exchange that is well equipped with the most state of the art technology to start with. Moreover, it is an exchange in a city where there is quite a good expertise in trading and portfolio management. In addition, it is a multi-cultural milieu, where people have a very good quality of life. Montreal has a very good infrastructure from a social basis, with good universities and a high quality telecommunications network. Have you tried to model the Montreal Exchange on any other exchanges in the world, or is it a unique type of institution that is very specific to itself? It is unique in the sense that we have three unique markets all under one roof. We have the stock market, an options market and the futures market. This
Why would the Montreal Exchanges products be interesting to foreign investors or fund managers?
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is quite unique, since in most of the other financial centres in the world these are usually operated quite separately by different exchanges. This adds multiple trading activities and generates enormous synergies on the Montreal Exchange. Traders are able to move with great ease between each of the three markets and are able to combine strategies between the three. Moreover, a similar regulatory environment exists among the three making it very conducive for cross-market trading strategies among the traders in Montreal. Has the Montreal Exchange made any moves towards formalising co-operative ventures with any of the other exchanges throughout the world? We are making some very loose arrangements with other exchanges in different time zones. This would allow our products to be traded in these differing time zones irrespective of the time of day in Montreal. Conversely, the products of other exchanges will be traded in Montreal. These plans are all currently being discussed, and are in progress. Have you considered any joint efforts with the Matif in Paris?
I dont think that the cultural similarity or proximity is a good reason for moving towards such arrangements, since it depends more on the type of products that are on offer. It also is a question as to how much Canadian debt is being managed among the participants and members of these exchanges? These economic and financial considerations are far more important in deciding any joint venture projects across exchanges, than are any issues that relate to cultural similarities. The exchange is a privately owned organisation that is held by its members. It is regulated by the government through a quasi-judicial body, which is the Securities Commission. In that sense the government does not have any say with respect to the affairs of the exchange. In that sense, the answer is no, but it is an answer that does not in any way relate to any policy initiatives which the government may have advanced. Overall, I think that the current and past governments have been very supportive of our initiatives. A very good example of this came at the end of the 1970s, when the Lvsque government at the time, created a stock saving plan for all Quebeckers. The plan was proposed to the government by the Montreal exchange and was supported by a task force made up of various officials. This plan together with all of its regulatory aspects was created by the securities industry, which is a good example of government assisting the development of the exchange. Most if not all of the past Quebec provincial governments have been very supportive of further developing the Montreal exchange. Has the new Bouchard government done anything in particular to advance the transparency of the Montreal exchange?
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What would you say is the single most important direction for the Montreal Exchange over the next five years that you would like to see develop?
I would like to see the Futures achieve a much higher level of volume to the extent that it could become a far more mature market. Currently, about 10,000 BAX contracts are traded daily, but we would need to double this volume in order to reach that level of maturity. This level of achievement would immediately attract more fund managers and investors. Derivatives markets tend to develop over a number of years, especially when there exists some kind of complicity between governments, industry participants and financial officers and exchanges. This collaboration is very much in place now, but we must create a habit and educate potential users of the benefits of our products that are available. We must remember that this type of Futures market is only about 20 years old and has a very long way to go yet. I am confident that we will be able to successfully develop new products that will come along. There is no official relationship, but we have been together with the Montreal financial community over the years, involved with emerging markets in terms of support of information and training. We frequently see people from Montreal travelling to these markets for these purposes. More importantly, we are operating through a legal system of civil law in Quebec, in an anglo-saxon context of business law and we have been able to successfully make a junction between these two systems and cultures. This probably makes our consultants far better in tune to the cultural challenges that these countries may pose. I think this is an asset that we make very good use of. What is unique about the financial culture in Montreal? We have a lot of enthusiasm in what we are doing. It is a closely knit community with a very open relationship with people more based on trust and confidence. Exchanges in the world are essential to communities, because they represent entry points to the global marketplace. All of the Exchanges in the world are regional exchanges except London and New York, even Tokyo cannot be considered as a global exchange due to its restrictions and difficulty for foreigners to operate in. All of the regional Exchanges play an important role in channeling capital to their respective companies operating within the region. They are a gateway for their respective companies that operate in their regions, to even Is the Montreal Exchange an important fixture to the Montreal economy? Is there any kind of relationship that the Montreal Exchange has with exchanges in emerging market economies? How do you plan to attract such volumes?
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larger pools of international capital in New York and in London. As a company grows into an even larger entity, it requires larger levels of capital and liquidity that the regional Exchanges may not necessarily be able to meet. When one of our companies achieves such a status, we dont view it as a loss, but instead, we try to regain an important part of their trading activity. With technology advancing the way that it is, will there not be one global Exchange in the not too distant future? There is a global market, and you have to make a distinction between the market as such and marketplaces. Finance is a human activity and involves interrelationships among people. This is why we have so many exchanges in the world, because they are all reflections of this human activity at work. What we may see, however, is a network of inter-activity between all of the Exchanges. Over the years this global market will be better organised, as tendencies to protectionism and impediments in a regulatory sense will be overcome. What do you not like about the development of world stock Exchanges? It is going a little too slowly, which frustrates me.
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THE NORTHERN PESO

Alan M. Rugman
A Vote For Separation In Quebec Will Create Another Peso Effect

The Mexican currency crisis of December 1994 devalued the peso by some 40 percent until promises of loan guarantees from the United States of $40 billion stabilized the peso-dollar exchange rate. One new and unexpected development of the peso devaluation was a run on the Canadian dollar. It fell below 70 cents US for a time and has depreciated over 20 percent against the US dollar since 1991.
For the first time the Canadian dollar was sideswiped by a Latin American currency crisis. Thanks to the North American Free Trade Agreement (NAFTA), Canada and Mexico are now linked in the international currency markets, such that problems in Mexico now draw attention to Canadian problems. International investors have shown a preference for the US dollar against either the peso or Canadian dollar in times of a currency crisis.
The parallels between Mexico and Canada are disturbing; both have economics-based debt problems and politically-based separatist regimes. Since there is a significant amount of political risk in Canada - especially given the volatile situation in Qubec - the wrong series of events could make the Canadian dollar a northern peso.
In terms of economics, after NAFTA, the Mexican current account deficit was spurred by a surge in consumer imports not compensated by increased exports. Due to NAFTA, major readjustments are underway, especially in Mexican manufacturing, but these will take several years to turn around its trade deficit. In 1994 the Mexican inflation rate of seven percent was well above US and Canadian rates as were increases in its unit labor costs. Mexicos interest rates were as high as 18 percent after its April 1994 devaluation of 8.5 percent. After the Christmas 1994 currency crisis, Mexican interest rates went to 40 percent. In Canada, the federal debt has been increasing at the rate of Cdn. $3040 billion a year for the last decade and provincial deficits, especially in Ontario (under a socialist government for over four years) and Qubec (now under a socialist and separatist government) add to the total debt. Canadas total federal and provincial debt is Cdn. $780 billion, or Cdn.$27,000 per capita. Also, over 40 percent of this national debt is held by foreign investors, worse even than Italy whose debt is mostly held by domestic investors. Canadas inflation rates are low, but her interest rates are being pushed up by rising US interest rates.
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In terms of political risk, in Mexico the January 1994 rebellion of the Zapatista National Liberation Army in the Chiapas region was allegedly tied to anti-NAFTA sentiment. A year later, after the assassinations of two major political leaders and the kidnapping of business executives, this underlying political risk fuelled negative investor perceptions of the peso in the Christmas 1994 currency crisis.
The PQ has said that it will use the Canadian dollar as its unit of account after separation, but that Qubec will not take responsibility for its quarter of Canadas national debt, and will only remit its share of interest payments on the debt if its separatist agenda is agreed to by the federal government. Obviously this means trouble. While there is unlikely to be armed conflict if Qubec leaves Canada, there will be an extremely difficult and tense transition period during which the Canadian dollar is at risk. The current premier of Qubec, Jacques Parizeau, has attempted to smooth the painful transition process by statements minimizing the economic costs of Qubec separation. He asserts that Qubec will remain a member of NAFTA, the GATT/WTO and NATO. Yet all of these linkages, in contrast to his assumptions, will have to be renegotiated. The entire process of separation will create a period of acrimony and political uncertainty, giving currency risk to the Canadian dollar.
In Canada, the new governing party in the province of Qubec, the Parti Qubecois, will likely hold a referendum in summer 1995 to vote on the creation of a sovereign state in Qubec, and its separation from Canada. The anticipated vote, the timing of the vote, debates about how separation could occur, and if it is legal and/or feasible, are all politically unstable events which could trigger a currency crisis in Canada.
Indeed, in the face of a determined attempt by the government of the province of Qubec to make a de facto unilateral declaration of independence, and reject ownership of its share of Canadas huge national debt, there is every reason to believe that the international money markets will engage in a massive sell-off of Canadian dollar denominated assets. This would lead to a major currency crisis with substantial devaluations of the Canadian dollar. It could become a northern peso. It is difficult to predict how far the Canadian dollar would fall. With a complete loss of investor confidence due to Canadas failure to reduce its deficits, Qubec separation, and Qubec reneging on its share of the national debt, there is no realistic equilibrium value of the currency. (In purchasing power parity terms currently it should be closer to eighty than seventy cents against the US dollar). The foreign exchange reserves of the Bank of Canada and existing credit lines would be lost in a few days in a major currency crisis. As
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International Monetary Fund (IMF) credits are too small and slow to mobilize, only quick intervention by the US government and US Federal Reserve would work.
Since Canada is the largest trading partner of the United States, and presumably even more important than Mexico in NAFTA, the US loan guarantees and other financial support from the IMF would help to stabilize the Canadian dollar. However, Canadians are, in general, reluctant to lose sovereignty and a bail out by the United States would undoubtedly be accompanied by US pressure to reduce the deficit, for example, by cutting Canadas social programs and related government expenditures. The external US pressures to influence Canadas internal policies would worsen the political situation in Canada, where strong anti-American sentiment would be coupled with Qubec separatism to increase political instability in Canada. Hopefully, Qubec will not vote to separate. Hopefully, Canadas huge fiscal deficit will be reduced. However, if these two events do not come to pass, then a northern peso may.
The bright spot is that it is also possible that NAFTA could act as a stabilizing, rather than destabilizing, force. If both the peso and Canadian dollar are substantially devalued then both Mexican and Canadian exports to the United States should increase, and imports decrease. As Mexican manufacturing recovers and the strong resource-based fundamentals and high productivity of Canada reduce the short-run political risk, then both the peso and Canadian dollar should strengthen against the US dollar.
Under NAFTA, there should be renewed foreign direct investment into both Mexico and Canada and more political stability in their regimes. Cross-listed Mexican and Canadian stocks (on the US stock markets) would again become attractive with a high volume of trades. So, if Canada can only resolve the Qubec issue (and stabilize its deficit) then a northern peso may be avoided.
Alan M. Rugman is Thames Water Professor of International Business at Oxford University.
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TWO CRISES: THE PESO AND THE NORTHERN PESO

Interview with: Directed by: Alan M. Rugman Jerry J. Khouri and William B.Z. Vukson
Canada Joins Soft Currency Club
The analysis in the Wall Street Journal is correct. The value of the Canadian dollar is low for two main reasons. The first reason - Canada has a huge fiscal deficit and no government at the federal level has really been able to address the debt problem. Canada has more debt per head than any other country except Italy. The problem is that Canadian debt is foreign-owned, so there is a tremendous amount of instability, reliance on external financing, and really no control over the value of the Canadian currency that is held by the international financial community. The second problem for Canada is an internal political issue. There is a real probability that Qubec may vote in 1995 to leave Canada. If that were to happen, there would be a dramatic devaluation in the Canadian dollar. In terms of the budget deficit, I dont think the Canadian dollar would depreciate much below the 70 cents US to one Canadian dollar. However, in the second scenario where Qubec separates, I really see no floor to the Canadian dollar. It wouldnt surprise me at all if Qubec voted to separate, and financial markets are already discounting this political risk in Canada. If the Canadian dollar would just keep falling, it could end up at seven cents US. In that case, I would call it a Canadian peso. Now that we have a currency range, can you also say something about a particular danger point for the Canadian debt and deficit ratios? If we analyze the debt problem in more detail, I believe that international financial markets will be happy with the current budget tabled in Canada, and the series of follow-up measures which are expected to reduce the annual shortfall, currently forecast to be $35 to $40 billion dollars. Anything below that would send a strong signal to the international financial community, that the Canadian federal government is not serious about reducing expenditures. I also agree with the Wall Street Journal editorial. The analysis about the good progress Do you have a particular value in mind?
The Wall Street Journal labeled Canada as an honourary member of the Third World. Can you comment?
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made by some of the provinces should be of note. The province of Alberta in particular, not only reduced the growth in its debt, but by reducing the current increase in the deficit, is now trying to reduce the stock of debt. At this point in time, the easy way out for Canada and other soft currency countries would be to organise into a soft-currency club, so that a solution to the debt crisis within countries like Canada, Italy and Sweden can be implemented without recourse to severe austerity measures imposed by institutions such as the IMF. How do you view such a scenario?
It has several points of merit. I agree with you that Canada has joined a group of soft currencies and Canada has the additional problem that the dollar can also be hit because it is a member of the North American Free Trade Agreement (Nafta). We now see in December 1994 and January 1995 a new phenomenon, the devaluation of the Mexican peso and the costly price of the peso which ended up in spilling over to the Canadian dollar. The Canadian dollar started falling immediately after the peso was devalued, so we have a situation of uncertainty against the peso and the Canadian dollar within the North American context. This effectively links Canada to latin American currencies. The Canadian dollar is in a very vulnerable position now, with Europes weak currencies like Sweden and Italy, but it is also together with very weak Latin American currencies. What this means is that the attention of foreign exchange traders is now being focused on Canada. The Canadian dollar has always been a boring, and uninteresting currency which nobody paid much attention to, and now this scrutiny has cast that up to the searchlights. What if the soft-currency bloc does not pay attention to the actions of foreign investors and currency traders and continues to accumulate deficits, while avoiding any serious measures towards austerity?
We need to be concerned about the Canadian dollar for the first time in our history. There is a currency crisis. We could be subjected to a currency crisis from the analysis of the debt, but I am certain that we will get a currency crisis if Qubec separates. I do not believe that Canada has enough foreign exchange reserves at this very moment. In addition, I dont think Canada can arrange credits with other major countries in order to save the Canadian dollar.
Therefore, in a classic currency crisis, the Canadian dollar would just keep falling and the IMF would be called in. That would then signal that the Canadian government would be forced to implement austerity measures whether they like it or not, measures which they have been delaying for some 15 to 20 years now since the first Trudeau government. After the IMF is called on, what would be its first practical order of business in Canada?
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I think it would follow the traditional route. What the IMF does is a basic macro analysis, so it requires that domestic expenditures be reduced and government expenditures on social services in Canada be cut. A package of internal measures would then be accompanied by some external co-operation which the IMF could bring, in terms of more credits and outside support for the Canadian dollar. I think that the mere request for IMF intervention and its eventual arrival would be enough to bring a halt to a currency crisis. The measures which then follow, are more long term in nature, and have been successful in many countries such as Great Britain in the 1970s and more recently New Zealand. The Canadian situation would be just a continuation of that pattern. However, in the Canadian case, you would need to have IMF intervention both at federal and provincial levels of government, since the provincial budgets are some of the ones that are far more unbalanced ?
First of all, I would not call it intervention. What I mean is that the IMF is basically there as an ally, as a friend, or as a linkage to the international financial community. Most countries are members of the IMF, so it in a way mobilizes resources and outside help, but it is also a broker for the international financial community. In the case of Canada, the federal government would initially act to request help, and a federal/provincial conference on the economy would need to follow shortly afterwards. Indeed, I agree with you, provincial expenditures would also have to be reviewed. That would be quite tricky. Ten provinces with different governments; socialist, liberal and conservative, would have to be disciplined. I agree this is a major problem. The provincial debt in many cases is outpacing the growth of the federal debt. At the moment, its almost an insoluble problem. Canadian politicians may favour such a scenario, since it is much easier and simpler to place blame on unpopular measures of austerity with the ensuing social program cutbacks on an abstract and ambiguous external organisation such as the IMF?
I agree. Theres good news and bad news when the IMF comes. The arrival of the IMF is the bad news; it means youve failed. It means youre giving up control over economic policies and it means that you should be. Basically, your currency is becoming worthless, interest rates are high, inflation is accelerating, and so on. The good news is that the IMF can assist in getting a more sensible economic policy. So, an austerity program can be pushed through easier by the Canadian governments if the IMF insists on it. I recall that in the case of the British devaluations, the British used to blame the gnomes of Zurich. Now Canadians would be able to blame the New York financial market. But its the same. I mean you blame somebody else for something you should have been doing all along. To go back to the hypothetical intervention or possible incursion into Canada.
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I think it is the basic economic problem of efficiency versus equity. We have financial markets judging Canada on its performance, on its productivity, on its competitiveness, on its efficiency, and that performance is not good. The exchange rate is depreciating, which represents the correct measure of Canadas lack of competitiveness. Why is Canada not competitive? Why is there a budget deficit? The answer is that Canadas political system is geared up to serve special interests, racial interests, almost tribal interests in the sense of accommodating Qubec and bribing Qubec to stay within Canada over the last 40 years. So Canada is driven politically by equity considerations and we all know from basic economics that equity distribution considerations are incompatible with ones of efficiency. Until Canada can solve its political problems, where its probably one of the most confused countries in the world in terms of its constitutional arrangements, giving immense powers to the provinces, the future for the Canadian dollar doesnt look very good.
Dont you think that both sides of the divide on the debt; the social policy leaders and economists have legitimate concerns. While the debts and deficits are important to reduce, there are also the social and political problems that will persist in Canada. Why are they working at cross purposes?
Mexican Peso Crisis
I think the Mexican peso crisis of December, 1994 and January, 1995 was unfortunate. There should have been a devaluation of the Mexican peso probably in 1993 rather than 1994, and perhaps just after Nafta was ratified would have been an opportune time. The Salinas government was committed to not devaluing its currency. One economic strategy was geared up towards providing confidence in the value of the peso and encouraging foreign investment. It was largely successful, but the trouble was that the new Mexican administration inherited a suppressed economic problem, which required a devaluation in December.
What are the short and long term lessons from the Mexican crisis, especially in context with the North-South relationship?
Having said that, the peso crisis was partly the fault of the new government, because they bungled the devaluation terribly. They did it just before Christmas, and then they all went on vacation, while the money markets had about a week to ten days without any solid policy pronouncements with regards to the ensuing developments. It was appalling that the week between Christmas and January 1, 1995, when the trades on international money markets are very thin, there was no information coming from any Mexican authorities. What had existed was the total absence of policy and nobody to reassure the international financial community. I think the Mexicans made it worse for themselves, and so the 40 percent depreciation in the peso turned out to be double what should have
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been the case, and it turned into a classic currency crisis.
The lessons from the crisis in Mexico are threefold. Firstly, if you are going to have a devaluation, plan it properly. Secondly, have your people on side to talk to the New York bankers about the shift in domestic economic policy framework, and lastly, dont go on vacation the week after you devalue.
You blame the Mexican government, but should blame not also be apportioned to Washington and Ottawa for over-promoting Mexico as a location for investment?
A somewhat provocative question! I have a definite answer. The Mexican peso devaluation has nothing whatsoever to do with policy in Washington or Ottawa. There is absolutely nothing that the United States or Canada could have done or could do in this case. The problem is with the Mexican government, which has a current account deficit that has been steadily deteriorating. The Mexican government could have solved it by a timely devaluation. Salinas should have done that. There is a history of Mexican presidents doing the dirty work in their last few months in office, and handing over a devalued currency to their successor. Salinas is partly to blame, but certainly no one in the United States or Canada. Would the peso crisis have been a lesser crisis had Nafta not been in place?
Nafta sends mixed signals around the investment and economic communities internationally. Nafta also gives Mexico access to the worlds richest market, the United States, but its not perfect access, its a negotiated access and what Nafta did for Mexico is to give it an opportunity to become more efficient, especially in its manufacturing sector. Of the three countries in Nafta, Mexico is the one with the biggest adjustment problem, so a year into Nafta, one would expect Mexico to be having difficulty. Its manufacturing sector is tremendously inefficient, it has low productivity, and has to be completely restructured. Presently, it is in the process of restructuring, in the process of privatization, consequently, it needed a small currency devaluation to help it along. Now that Mexico is part of the Nafta treaty its adjustment process will be even more intense, since the US will not tolerate a weaker peso. Meaning that domestic Mexican industry will need to become even more productive in order to successfully compete in the US market, since there is only a limited amount of time under which a devaluation will be tolerated in the US Congress. Do you have any views on the politics of Nafta?
I agree with you. I think that Mexico has a higher profile for international analysts being a part of Nafta, and especially to analysts resident in the United States. Americans are notoriously xenophobic. Only 15 percent of
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American citizens carry a passport. Which means 85 percent dont care much about anything outside of the US. There is not a leading community in the US which understands international finance and economics.
The debate on Mexico getting into Nafta, was big news in the United States. It was one of Bill Clintons few successful policies. Since Congress approved Mexicos entry into Nafta, interest in the entire matter accelerated to the point where there is a lot of interest in Nafta now. It has been manifested in US investment in Mexico increasing, but also by a lot of speculation in the stock market to the extent that in 1994, of the ten most traded stocks on the New York stock exchange, two of them were Mexican stocks in the telecommunications and petro-chemicals sectors. With the volume of trades increasing in Mexican stocks, American investors have become more aware of what is going on in Mexico, since Mexico is more exposed. And if it doesnt have a good story to tell, the risks will reflect in currency depreciations. How will the succession of countries such as Chile into Nafta potentially affect North Americas relations with the European Union? Personally I dont see a great rush to let Chile into Nafta. Having been a participant in the Canada/US free trade agreement (FTA) negotiations and in Nafta, I can tell you that there will be discussions initially in harmonizing tariffs with the three countries in Nafta. There will be a move towards having Chile adopt a national treatment for foreign investment, and that Chile would then be subject to all of the dispute mechanisms and institutional framework in Nafta. But I dont think this will be accomplished very quickly. Moreover, I believe that this entire process with Chile is a special case, so I dont think other Latin American countries are going to get into Nafta within the next five years. I dont see any constituency presently in the key country- the United States, even to rush to approve negotiations with Chile. In fact, negotiations with Chile are not proceeding on the fast track, so its most likely the US Congress would not approve it. How about countries such as Chile moving to become members of the Asia Pacific Economic Co-operation (Apec), or even the European Union? Chile does not have many alternatives. Apec, for example, is not a formal trade agreement. Apec is just a talking club and they have agreed to talk to the year 2020, so a quarter of a century from now, Apec may start to do what Nafta does, lower tariffs and adopt national treatment. However, at this moment, the interests are so strong that there are neutralizing forces preventing Apec from moving much faster.
The key players in Apec are Japan, China and the United States. Apec will not turn into a regional trade agreement, but I could be wrong, and it may be that this could be the first trade agreement designed to handle investment relationships. In that sense, the countries would be forced to move faster. Presently, I dont see
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Chile having any second choice in an organisation such as Apec. However, Chile is interesting in the sense that its trade is diversified between Asia and Europe, so it may very well turn out that a better alternative for Chile would be to seek a closer association with the European union, since as much of its trade is going there as it is with the United States. To remain with the peso crisis, can you tell us anything about the timing of the crisis? The currency crisis developed due to a herd instinct in the foreign exchange markets that reflected the underlying fundamentals. The underlying fundamentals in terms of the purchasing power parity conditions for the peso against the US dollar as long ago as 1993, supported a small devaluation by September 1994, when Salinas was on the way out. It was clear that there should be a devaluation, and that it should be around 15 to 20 percent.
Around December 20, 1994 the Mexican government devalued the peso by an amount which the market perceived as insufficient, after which a fullblown currency crisis started. The Mexican government basically did not have an economic package ready to satisfy the international financial community. In the interim, the finance minister failed to reassure the investment community and subsequently had to resign. The end result is that the devaluation is greater than it should have been. Do you think that the peso crisis will produce some kind of protectionist backlash which might see some kind of move to reverse Nafta? I dont see any impact on Nafta. What I see is more suspicion of Mexico by American investors. I believe that American investors have wised up, and they are more risk averse about Mexico, but I dont think it is in any way related to Nafta. In the long run, Nafta will encourage a higher rate of American investment in Mexico and the stock of foreign direct investment will increase. From a political perspective, Congress would probably evaluate any kind of peso devaluation as something that would be very detrimental to American industry. They are already afraid of having cheap American imports sucked into the United States. Do you share their views?
I dont share this view, because I think the US Congress is focused on one trade enemy at this point in time, and that enemy is Japan; not Mexico. I expect that there will be more protectionism, coming in a disguised form. The target is clearly Japan, not Mexico. If anything, Nafta serves to isolate Mexico and Canada from the worst excesses of US protectionism in Congress. Why are Japanese trade deficits barely an issue in the European Union? Is it the case, as with the European steel industry, where European and Japanese manufacturers have come to a tacit understanding to stay away from each others respective markets?
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There is a very simple reason why there is less tension between Europe and Japan, and that is because there is less of a trade deficit between them. Furthermore, there is much less trade and investment between Japan and Europe, as there is between Japan and the United States, so less tension exists. Trade between Japan and the European Union is trivial in comparison to the intra EU block trade. I think both. I think there is an underlying economic reason for USJapanese tension. There is this huge and persistent US trade deficit for the last ten years at some $40 billion dollars a year; there is a deficit in foreign direct investment stock between the US and Japan and there is a cultural problem. The US and Japan were at war, America helped Japanese restructuring and the Japanese are now beating the Americans in the economics and finance game. I just dont see that tension existing between Europe and Japan. Europeans are much more culturally secure. They are used to dealing with other countries within the EU, and to do that they are used to having a more international mind set than the Americans. Americans are extremely inward looking. If I were to ask the basic international business question to both a European and an American: What is the language of business? I am sure that the American would respond by saying English, but the European would give the correct answer: the language of your customer. How do you account for the strong value in the yen these days. Why do we see the yen appreciating vis vis the German mark and the US dollar continuously? Is it solely based on the trade deficit issue, or is it a cultural misunderstanding between Japan and the US as opposed to Europe and Japan?
Having said that, it is also the most liquid economy in the world, and in the recession in Japan, some interesting things have developed. Basically, the Japanese have maintained their ability to make foreign direct investment, they have turned their attention toward south east Asia and China, so Japan continues to be the worlds economic engine. Asia is the fastest growing area, with huge rates of growth when compared to North America and Europe. This is where the action is. To be a player internationally, you have to be in Asia. One amazing fact is how few American firms or European firms are competing with the Japanese. In short, Japan is leading world trade and investment which is why the yen is so strong.
You have to do an analysis of Japan. Despite the bursting of the speculative bubble in Japan and the world-wide recession leading to the fall in the Japanese stock market. It is quite clear in retrospect, that within the triad of the worlds wealthiest countries, the worlds fastest growing and overall leader in trade and investment is Japan, so the Japanese yen reflects this hegemony.
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TRAPPED IN ASIA!
William BZ Vukson
Canadian Dollar & Canadian Companies

Canadian politicians are quick to point out that all of Canadas economic fundamentals are in good shape. For the first time since the 1960s, the federal budget is in balance and inflation has virtually disappeared from the economic landscape. Despite all of the good news, the surprising collapse in the currency leaves a puzzling thought to many. How could it be that the Canadian dollar is not keeping pace with the rest of the economy?
While the dollar has slowly sunk into its new trading range between US$0.65 to US$0.70 cents, it continued to disappoint by reaching an all-time low of US$0.634, as the Bank of Canada under the direction of Governor Gordon Thiessen; reacted in a fit of desperation by raising the short term bank rate by one percent in order to protect against any further declines that may come. This futile action was a clear signal to most business people that the Bank of Canada is hopelessly out of step when considering the prevailing orthodoxy of central banking among most industrialised countries. The desperate attempt to raise rates only did more harm to the dollar over the medium and longer term. The surprising aspect of the decline is that Canada became more linked to events in Asia, while severing its historic financial link to its main trading partner- the US. As the yen fell on world markets, it seemed as though it carried the Canadian dollar with it. Unfortunately, the fortunes of Canadian economic development were set back decades, since the dollar tracked the general fall-out in global commodity prices, whose declines were accelerated by the deflationary effects that were beginning to build within the east Asian trading zone.
Despite the grand efforts of the Liberal Chrtien government to change the nature of the economy, into one that encouraged the development of a high tech and telecommunications sector, the cold reality is that 40 percent of all exports are still very much resource-based. Although Canada has several globally competent firms (Northern Telecom, Bombardier, Magna International, etc.) in the area of high tech development, they are still too few in number to have any lasting effect in changing the overall nature and perceptions of investors of it being a predominantly resource-based player in world markets. What may be even more disturbing is the push that reluctant Canadian companies have been given by an aggressive federal government in opening up trade in countries like Indonesia, Malaysia and Thailand. The team Canada trade missions were regular trips to high growth areas such as east Asia, which were designed to initiate Canadian firms to the benefits of foreign markets in the
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hopes that it would expand overall sales and in the process improve balance sheets, diversifying away from the limited domestic marketplace. With east Asia in crisis, the question now is whether these innovative participants will ever be paid for the work that was performed or for the goods and services that were sent to this region?
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First Quarter: March 21, 1992

Economic and Financial Review
With over one-third of Canada's income generated by trading with the U.S. The tight U.S. economic conditions have adversely affected Canada. This, coupled with a high dollar supported by the zero inflation goal of the increasingly independent Central Bank, has worked against any hopes of a robust recovery in the near term. The Canadian dollar, however, has come under heavy pressure that resulted in intervention by the Central Bank This comes in light of the fact that short-term rates in the U.S. were lowered to historically-low levels, with the spread remaining well above the 250-300 basis point range. Furthermore, recent massive borrowings in the Eurobond markets for the Province of Ontario and Ontario Hydro, all in Canadian funds, has put upward pressure on the Canadian dollar. In spite of these three positive factors above, the dollar has continued to fall from a level of 0.88 cents to one U.S. dollar to approximately the 0.83 cents level as of March 19, 1992. What is the reason for such a large fail, when the fundamentals indicate the reverse ? This has much to do with the present constitutional crisis with the Province of Quebec Moreover, four of Canada's vital industries at the present moment are in a contractionary phase: automobiles, real estate in southern Ontario, Oil and Gas, and natural resources. Damaging foreign investors' confidence in the domestic economy. The automobile industry has been in a world-wide free-fall over the past year and a half, with recent record loss figures being recorded by the big three North American firms: General Motors, Ford and Chrysler, and record layoffs being implemented in a vast restructuring program for General Motors. The repercussions in the industrial parts of Canada have affected all other sectors that normally rely on spinoffs from the car-making process. Real estate is one industry that especially supports most of the whitecollar employment in Canada. It has not been Impervious to the world-wide general slump. And the restructuring of the industrial-base in southern Ontario will affect this market for quite a while yet.
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The world-wide suppression of Aluminum and Pulp and Paper prices is just another example of how conditions in world markets are affecting the resource-based provinces. The addition of possible large Russian dumping on world markets, as was the case in the Aluminum sector during the early part of 1992, will further add to the grief experienced up to now. World market conditions in the Oil and Gas industry have also severely dealt a blow to major exploration activity in the Canadian north and western provinces. The most serious was the pull-out of Gulf Canada in the large Hibernia project off the coast of Newfoundland, a project that has provided an important economic contribution to that entire region. Currency Outlook The real question is when will the Bank of Canada break, in its unrelenting support of the currency, in light of the serious factors that are at work at the moment ? The difficult world price for oil, pulp, paper and aluminum could greatly benefit by a devaluation of the currency Into the high seventy cent range relative to the U.S. dollar. This would enable Canadian producers to obtain a slight important edge over competitors, hence providing for a more stable environment domestically. Unlike the economic, the political situation with Quebec can be temporarily dealt with through a high degree of intervention on world currency markets by the Bank of Canada, in combination with a moderate increase in the discount rate, although that would add to the domestic pressure on the real estate sector and on automobile purchases. The medium-term outlook for the dollar is a continuation at the present level, unless a setback occurs in the U.S. recovery, which the Canadian authorities are hoping would revive an export-led recovery. If not, and if the U.S. recovery falters in any way, then severe pressure may prompt the Bank of Canada to work in the low end of the eighties relative to the U.S. dollar, and may even come as dose as the .80 to.81 cent levels. The smart bet, however, would be in favour of continued Bank of Canada support through a combination of massive intervention on the foreign exchange markets and increases in the central bank rate.
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Second Quarter: May 21, 1992

Economic & Financial Review Nothing seems to be going right for Canada, as problems persist on the real side of the economy coupled with Constitutional turmoil and a very weak recovery south of the border. In particular, the weakness in the domestic industrial and property sectors continue to exacerbate the grim employment picture. And, in addition to the disappointing prospects of an export-led recovery from the U.S, the Bank of Canada may find that the outright abandonment of its pursuit of a hard dollar policy may be inevitable. As mentioned above, there can no longer be any reliance on a U.S. led recovery, and with the fiscal budgets strained both Federally and Provincially, Monetary Policy is the only policy lever that has any room to manoeuvre at this juncture. To the Deutsche Mark. From this moment, the persistently high rates on Mark denominated securities coupled with the decreasing rate on dollar instruments will add further downward pressure on the dollar over the remainder of the second quarter. As it seems that recovery will not be certain until at least that time or into the third quarter of the year. For that matter, we re-iterate our views from the February/March issue that called for the trading range to settle eventually between 1.5 and 1.6 vis-Avis the Deutsche Mark. However, once participants are convinced that recovery Is firmly in place with upward pressure on prices, then this scenario will reverse. Furthermore, the trading range with respect to the Japanese Yen will be influenced by the external trade Imbalance. As the market operations by the Fed as well as the Bank of Japan will not allow a further depredation of the Yen, regardless of the deterioration in the domestic Japanese economy. The increasing surpluses registered recently,,Aill be fought through an appreciation of the Yen to the 1Z5 to 130 range with respect to the U.S. dollar. To re-iterate, the parities between the U.S. and japanese currencies are overwhelmingly determined by external conditions. The economy showed signs of severe pressure, as the recession deepened over the past two months with an increase in 57,000 jobs lost in April/92, representing the sixth straight monthly decline. As a survey conducted by the Canadian Association for Business Economists attributes half of the current weakness to
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severe structural change In the economy. Among the sectors that according to the survey are experiencing this are: airlines, forest products, automotive, food processing and distribution, wholesale and retail trade, high technology (telecommunications, computers, aerospace, pharmaceuticals), and machine tools. Among the impediments to change that were cited in the survey were front and foremost management inertia, poor labour relations, tax burdens, interprovincial trade, insufficient investment and barriers to competition. They emphasize that a proper response to deal with these structural changes in the economy was not forthcoming by a large proportion of Canadian managers. in addition to the problems on the real side of the economy, the Constitutional problems with Quebec's threat of secession affect the inflow of foreign investment to Canada, adding downward pressure to the dollar on foreign exchange markets. Recently, the Business Council on National Issues estimated that the Canadian economy would immediately contract by 2 percent if Quebec were to separate, or an average of $ 1100 in losses in annual income for each Canadian citizen. Recently, the Bank of Canada has reacted to the depressed real economy by reducing the prime lending rate to 7.5 percent, a 19 year low. It was reported on May 11/92 that the dollar dropped one third of a percentage point to a 2 year low of U.S. 83.13 cents. It is hoped that the Monetary policy option will attenuate the severe impact of the restructuring on the real end. Currency Outlook The continued low growth In the economy, together with the restructuring that is presently taking form and the political influence on the markets should leave the Canadian dollar in the low end of the eighties with respect to the U.S. The likelihood of it falling into the high seventy cent range is low at this point in time.
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Third Quarter: July 24, 1992

Economic & Financial Overview The Canadian dollar moved in a narrow range between 0.82 to 0.84 cents to the U.S. r1rrdzIar over the past two month period. The currency held Its ground as it followed the Federal Reserve of the U.S. In slashing the Bank of Canada rate down to a record low level at S.66 percent as at July 15, 1992. Since the weak U.S. recovery was unreliable in pulling Canada convincingly out of this recession, it was still the export performance that was at the centre of any domestic revival. As the merchandise trade surplus rose 0.8 percent to Cdn. $12.9 billion In May/92 from the previous month, a fall of 3.4 percent In automotive product imports caused overall Imports to fall 3.4 percent to Cdn. $11.7 billion. Clearly, the weakness of the Import component confirmed that the economy was sluggish, as new orders in manufacturing recorded an additional 2.4 percent decrease. Still a positive aspect to the economic profile had inflation recorded through the Consumer Price Index (CPI) down to a 30 year low, as the June/92 rate attained 1. 1 percent. This was a further indication of economic weakness that the Bank of Canada was able to exploit by reducing rates in stride with the reductions coming from the U.S. Federal Reserve. In addition, the preoccupation with the constitutional crisis and Quebec's insistence that the present negotiated agreement by the Provincial Premiers go further than what was agreed to in terms of acknowledging that It was a distinct sodety~ will also exert downward pressure over the Canadian Dollar In the long-term. Moreover, the dissension within the ruling Conservative party itself was not a very encouraging sign. Of the comments that were made, none were so poignant in the economic sense as were those of Trade Minister Michael Wilson who commented on the failure to address the weakness of the economic union of the country: "It doesn't lead to a stronger Canadian economy". In addition to the political problems are continuing signs of weakness In the resource base of the country. As world market prices In areas of pulp and paper, aluminum, oil and gas, and agricultural products remain on the low side. In addition, the tragic announcement of the closure of the Newfoundland fishing industry for a two-year period due to stock depletion, further exacerbated the regional economic disparity in the country.
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Currency Outlook
In light of the continued sectoral weakness of the Canadian economy, and serious political problems which in the upcoming months may only accelerate. The Dollar remains remarkably stable as the enduring effects of the credibility attained by the Bank of Canada as an advocate of price stability still exert the predominant sentiments in the markets. If constitutional problems accelerate to unbearable levels, however, it is doubtful If the Bank of Canada could maintain the Canadian Dollar at its present level vis-A-vis the U.S. without foreign assistance. This is one factor, the severity of which, is difficult to speculate on. However, barring any severity of such a sort over the next quarter, the Dollar should in all likelihood retain its present level of support, in the low end of the eighty cent range relative to the U.S. currency.
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Fourth Quarter: September 11, 1992

Economic & Financial Overview While politicians focused their attention on the Constitutional negotiations, the Bank of Canada was left to mind the faltering Canadian economy. Due to aggressive monetary easing& the Bank rate fell on September 3, 1992 to its lowest level since 1973. The 14 basis point fall to 4.93 percent prompted the large chartered banks to lower their prime lending rates to 6.25 percent from 6.5 percent in anticipation of the outcome of Thursday's T-bill auction. In fact, the anticipated export boom from the U.S. economy did not materialize, as a triple-dip scenario became the primary focus. And, even more so In this environment, the U.S. administration was more interested in aggressively encouragIng their own exports to revive G.N.P. Any additional push into the U.S. markets, under the present environment, would elicit an equivalent ,response from American exporters. With the U.S economy on the verge of another marked decline, traditional Canadian exporters into the U.S. market are thinking twice about diversification. Irregardless of whether or not closer trading links with the U.S. or Mexico have recently been negotiated, it remains that Canadian exporters cannot any longer patiently await for a resurgence in the confidence of the American consumer. With G.N.P. off by 0.4 percent in the second quarter and a complete absence in inflationary pressures, the prospect for further monetary easing becomes ever more real. As the real economy continues to register disappointing results, fiscal policy is unable to provide any useful stimulus due to the deficit hangover. With automobile sales from the big three North American manufacturers falling by 7.6 percent in August/92 over a one year period, total manufacturing employment was down through the elimination of 27,000 jobs in August/92. Consequently, the unemployment rate came in unchanged at 11.6 percent for the month of August/92. Furthermore, the restructuring of the Canadian economy was very much a topic of conversation, as the overvalued Dollar, coupled by an anaemic recovery prompted several companies to respond through the process of labour-shedding. This was captured by the decline in total paid hours by 0.6 percent in the second quarter, which represented the third consecutive decrease. On the flip-side corporate profits rose by 5.1 percent in the second quarter and continued to show a promising positive trend. The question remains as to whether this development should cause a
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fall in the Dollar relative to the U.S. Dollar, as the Bank of Canada further eases rates? Or will the Bank rate eventually come closer to the short-term Federal Reserve discount rate? The question of spreads between the U.S. and Canadian rates has always been on the minds of international investors, as Canadian Provincial debt has always been In favour. Eurobond Investors have bought C $24 billion this year alone, as the spread offered over comparably risky Treasury bills in the U.S. has always been favoured for the higher yields offered on the Canadian issues. This factor is an additional element that has supported the Canadian Dollar at the present 0.83 cent to the U.S. range on average over the past year. The Bank of Canada with its precommitment to a zero rate of inflation, along with enjoying a relatively independent direction in monetary policy from the political authorities in Ottawa, Is an additional attraction to foreign investors. The wild-card in the currency markets will be the reaction of participants to the nation-wide referendum on the Constitution to be held on October 26, 1992. The agreement has gone a long way in satisfying each regional element in Canada; the Westerners with equal representation in the Senate, and the Natives and Quebecers being recognized as having distinct societies. Sadly, though, the agreement does not go very far with regards to the concept of free-trade between the Provinces. Currency Outlook Over the past several months, the Dollar vis-A-vis the U.S. has more or less fluctuated around 0.83 cents. As outlined In the economic and political commentary above, the factors that will have some effect on currency markets are the constitutional vote, the continued long-term restructuring of Canadian industry and the long-term effects of high unemployment, and the spread over the U.S. Federal Reserve short-term rates. Of which the Constitutional vote will overshadow the other factors considered over the immediate term. Assuming that the referendum registers an affirmative vote, then the positive sentiment flowing to the Dollar markets will ensure that the higher dollar will continue to affect long-term labour shedding. If the vote does not go as planned, a serious fall in the Dollar to the. 70-.80 cent range will ensue. And the Bank of Canada may not respond in kind with an adjustment in short-term rates for the fear of creating a greater economic crisis. Being optimists, we assume that the referendum produces one united Canada. Under this scenario we can foresee positive side-effects strengthening the Dollar and allowing the Bank of Canada to ease further, as a stronger Dollar will be detrimental to a badly needed push on the export side. Overall, a positive
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vote, as expected, should be beneficial In stimulating the domestic economy, as lower rates from the fall-out and the positive climate for investors should be a welcome element. that has for a very long time been sorely missed. Under this scenario, we expect that the Dollar will settle at an average range of 0.84-0.86 to the U.S. currency.
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First Quarter: December 15, 1992

Referendum rejects new Constitutional accord dollar falls below 79.60 u.s. in anticipation of political uncertain on September 30,1992 Bank of Canada raises prime lending rate from 6.2s to 8.25% on October 1, 1992 in support of the dollar World commodity prices continue to be depressed dollar falls below 79 u.s. for first time in 5 years fiscal position dramatically deteriorates faith is placed on recovery in u.s. to end recession
A combination of political uncertainty and deterioration in economic fundamentals have caused the Dollar to fall below .80 U.S. In addition, lingering over-supply in world commodity products has depressed prices and directly affected the profItability of Canadian exporters. With the only remedy being the continued fall In the value of the Dollar. The Bank of Canada has had to use a wildly fluctuating prime rate in order to target the desired external value of the Dollar in the run up to the referendum on a Federal political agreement, as well as once the after-shock had occurred. In very untypical fashion the Canadian public had rejected the compromise agreement known as the "Charlottetown Accord". The prevailing consensus is that the vote was a reflection of the frustration felt toward the ruling Conservative government, which had presided over three years of sub-par economic performance. The reaction of the Bank of Canada was swift, and orchestrated to preserve the credibility that it had achieved over the past five years, as the focus turned to protect the external value of the Canadian Dollar in its goal to preserve the 1% rate of inflation that It had achieved. The rate of Interest was raised Initially to 8.2S% on October 1, 1992 and then lowered to 7.75% on October 28, 1992 after the negative outcome of the referendum, very briefly caused the Dollar to rise by 0.5 of a cent against the U.S. Dollar. With the present prime lending rate as of December 3, 1992 at 9.0%, and the Dollar averaging .78 U.S., there remains an 8% real rate that will positively affect the inflow of international portfolio investment, but which will contract
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productive Investment spending. As a capital project is discounted at higher interest rate levels, it becomes less profitable until It Is delayed altogether. This is one of the present difficulties that the Canadian economy is experiencing from the policy to preserve the external value of the Dollar. In addition, the depressed state of world commodity markets require a similar cheap Dollar polIcy in order to pull the country out of recession. Compounded by the fact that both this years' and next years' deficits will severely overshoot initial forecasts. The unexpected drop in tax revenues of $18 billion have prompted Finance Minister Don Mazankowski on December 2, 1992 to propose spending reductions of $8 billion over the next two years without raising taxes. As a result of this action, the Dollar immediately rose in European trading from 77.73 U.S. to 78.08 U.S. It seems that this positive sentiment will be maintained until a general election is called during the course of 1993. With the domestic economy depressed through high rates, depressed world commodity markets and continuing political turmoil, the high Interest rate policy of the Bank of Canada is hoping to counter-balance these negative effects on the currency. In addition, the ruling party has placed faith in a quick U.S. recovery in order to gain the positive export stimulus dividend. As the Finance Minister openly stated: "We believe with the U.S. pickup and some pickup in the world economy that we've got some brighter days ahead" Currency Outlook The negative factors as mentioned above include lingering doubts about the political Identity of Canada, depressed commodity prices and the effect of high interest rates on the domestic economy. On the other hand, action to address the deteriorating fiscal position and the impending U.S. recovery coupled with the commitment of the Bank of Canada In preserving the value of the currency In order to keep Inflation low will all be posItively reflected on the value of the Dollar. With a seriously high unemployment rate and high excess Industrial capacity, the positive factors from any demand-pull out of the U.S. will be a long-term effect. On the other hand, the medium term fiscal program to limit the deficit will be a good complement to the efforts of the Bank of Canada to maintain a strong value of the Dollar. Consequently, over the medium-term, the value of the Dollar should fall within the 75-80 cent range to the U.S. Dollar.
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Second Quarter: March 19, 1993

Kim Campbell chosen as new Prime-Minister general election expected to be called in the fall of 1993 structural recession causes large Provincial deficits excessive Provincial debt causes downgrades from rating agencies foreign investment reaches record levels in recent months central bank rate lowest in history g.dp. increase of 3.8 percent recorded in flrst quarter of 1993 g.d.p. highest in 2 years driven by exports retail sales recover in april 1993 Bank of Canada targets growth and external value of dollar
Economic and Financial Overview Kim Campbell has not only become Canada's first woman PrimeMinister, but Is also the choice of the Progressive Conservative party to lead it Into the upcoming election that is expected to be called in the fall of 1993. Although not much is known at this time concerning the political skills of the new leader and how they may ultimately set the policy agenda in the upcoming election, early indications point to across-the-board restraint. While the Bank of Canada works to defend the external value of the dollar, politicians both on the Federal and Provincial stage are showing early signs of responding to the debt dilemma. While most of the economically significant Provinces have been reluctant recipients of recent debt downgrades, Provincial politicians have had to Invest extra time In order to make politically unpopular decisions on cutting back expenditures. This Is not surprising as the structural recession has seen approximately 200,000 manufacturing jobs disappear in Ontario alone. The revenue shortfall becomes even more striking as Canada faces up to a situation which is unprecedented in the sense that a large portion of the debt Is in foreign control:
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CANADIAN LIABILITIES TO NON-RESIDENTS 1981 13,313 1987 17,253 1982 16,552 1988 20,890 1983 9,643 1989 22,450 1984 9,232 1990 24,284 1985 14,912 1991 45,399 1986 25,094 1992 42,601 Source: Bank of Canada Review As the table Indicates, there has been a virtual doubling of Canadian debt that Is now held by foreigners. The volatility that this brings to the external value of the Canadian dollar forces the Bank of Canada to pay much more attention to interest rate adjustments as opposed to previous years. Moreover, this Is a major reason that explains the program of cutbacks that the country's largest Province- Ontario is now uncharacterIstically forced to make In light of the fact that It Is governed by the socially-oriented New Democratic Party. One may interpret this unprecedented recession and the actions that go with it as a symptom of the Increasingly global market for finance. With the proliferation of new Impressive advances in Information technology and the ending of the cold war, Canada, not unlike many other advanced western countries such as In Scandinavia Is finding It very difficult to adjust to the new realities. The Inertia that is shaping economic and political, relations in the world today will tend to be most unkind to the smaller players In the world economy such as Canada. Although being a very large country with abundance In natural resources, the fact remains that Canada's domestic market Is very small due to its low population. For that matter, it must increasingly rely on exports in new markets in order to replace lost jobs to the continuing outflow of old manufacturIng industries towards underdeveloped countries, as falling tariffs and technological advances encourage shifting of production facilities out of the advanced industrial countries. In addition, as the world becomes more price competitive, costs and wages will even more so become governed by the country that is the most productive and cost efficient. This, as we have already witnessed, will continue to erode employee social benefits and will Increasingly cause friction as jobs that are non-essential to the bottom-line will continue to be reduced. In such circumstances, political parties which desire progress and attempt to re-sell the stability creating policies that were so successful In the past run the risk of outright rejection of the electorate. As the challenge that faces all
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of the candidates come this fall is how to effectively govern in a period that Is actively ungovernable. Any attempts otherwise will cause wild fluctuations in the dollar, and also any attempt by any of the political parties to propose policies that were successful in the past during the run-up to the elections could over the following months yield continuous excitement in the dollar markets. Currency Outlook The Bank of Canada's stabilizing effect on the dollar may only play a supporting role over the next several months during the run-up to the election campaign. Foreign exchange markets will keep an eye on politicians proposing a return to the prosperous policies of the past. In addition, the austerIty measures adopted In the major Provinces concerning debt management will also affect confidence in the dollar. These factors, being political, are so difficult to judge. However, given the uncertainty that Is ingrained at this moment, it would be safe to conclude that the Canadian dollar vis-a-vis the U.S. would not exceed the .80 cent level. For that matter, we can anticipate a trading range of .74 to .79 to the U.S. dollar during the run-up to election day.
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New elections called on October 25, 1993 Election uncertainty and weak dollar weakens bond market Dollar slips below real competitive rate relative to U.S. Technological change causes low levels in capacity
utilization Construction permits issued continue to fall Unemployment rate continues at high levels Official discount as well as prime interest rates fall Improvement in the balance of trade reflects weak domestic demand Bank of Canada faces policy dilemma as recovery stagnates Early signs that Provincial expenditures must be cut further
Economic and Financial Overview Canada's real manufacturing side of the economy has hardly begun to show any convincing signs of growth despite the fact that the weak dollar vis-a-vis the U.S. has fallen below its competitive value of around 0. 78 cents. With unemployment frozen at historically high levels and with an election only days away, the interest on the domestic state of manufacturing and industry has been elevated as one of the prime concerns. The concerns that surround the unprecedented changes that have impacted this sector recently are not just relevant to Canada, but are an affliction in most industrialized countries today. The rapid technological changes occurring in the way industry co-ordinates production along with the intensification of global competition both contribute to the present jobless environment. Although the upcoming election campaign will focus on the issue of joblessness, the rhetoric, unfortunately, will focus on the wrong causes such as the recently negotiated free trade agreements. Should a setback occur in the ratification of the North American Free Trade Agreement (Nafta), or should the politicians mobilize to re-open the existing Free
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Trade Agreement (FTA) which was concluded in 1988, the fall-out on the Canadian Dollar would be enormous. Such an action could be one of the most irrational acts this century, as the trade agreements represent late reactions to what is already a reality. Specifically, new technological techniques and improving "information superhighways" have already allowed companies to become geographically fragmented. Any rejection of this obvious fact by politicians will only serve to increase uncertainty and domestic regulatory burdens, while making matters worse. What is of great interest at this moment is the reaction of the Bank of Canada as it simultaneously tries to balance the interests of a number of groups. The pressure on politicians to act on the unemployment problem has resulted in great pressures for lower rates, even though the new manufacturing age is not easily subjected to the familiar business-cycle cures of the past. At the same time, the Dollar must retain some stability, especially now that an increasing proportion of foreigners hold Canadian Federal and Provincial debt. In essence, this problem has become politicized, since low rates are not making any impact on job creation while manufacturing continues to produce at a steady rate as is evidenced through the table below. It is a fact that technological changes have resulted in redundancies, while the volume of production has been steady at low rates of utilization over the past three years. A very unfamiliar situation just half a decade ago. PRODUCTION: Indices of Real Domestic Product 1985=100 YEAR Industry Manufacturing Construction 1991 1 101.1 95.3 93.5 11 101.8 103.4 111.6 111 97.3 97.9 132.7 IV 101.1 97.5 121.1 1992 1 101.7 95.8 90.5 11 102.0 102.8 106.8 111 97.5 97.1 127.1 104.9 100.5 103.7 IV 1993 101.6 82.2 107.2 1 Source: OECD
Note: Industry includes: mining, quarrying, oil, manufacturing & utilities
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In addition, the possibility of a fragmented coalition government is very real. With the number of official parties increasing to six from the traditional three, this will bring about a situation similar in many ways to the gridlock that has been experienced in several European countries. The present day political map can be envisioned between the traditional parties and three new regional ones: Traditional/National: Conservative, Liberal, New Democratic Party Regional: Bloc Quebecois, National, Reform The uncertainty will be a drain on the Dollar, but the actual outcome, whatever it may be, will not have any substantial effect on the real economy or on further progress in the trade negotiations. Currency Outlook The Bank of Canada will continue to balance the interests at this point in time, being very careful to avoid any major foreign sell-off in the Canadian bond markets. This will be a great challenge over the short-term as the political campaign and outcome will become the focus of attention. In addition, foreign investors will monitor the reactions of Provincial governments, especially in Ontario should there occur further budget shortfalls. Over the next quarter, the Canadian dollar is very unlikely to exceed its equilibrium competitive rate of 0. 78 cents U.S. The pressure bias will, however, be on the down side considering the negative short-term effects outlined above. Consequently, a range of 0.72 to 0. 7 7 would be fitting given the circumstances.
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Fourth Quarter: October 12, 1993

Jean Chretien becomes new Canadian Prime Mu-minister the Liberal party is elected. by majority support Ontario debt downgrade for third time in as many years majority government helps to stabilize Dollar Bank, of Canada Governor John Crow's 7 year term ends in
January 1994 federal budget.overshoots original forecast by $15 billion inter-provincial trade wars erupt between Ontario and Quebec budget problems due to sluggish revenue rather than overspending commodity prices such as wood and newsprint remain weak big test for Dollar to come as Quebec holds elections in 1994
Economic and Financial Overview The discontent displayed by the Canadian elec-torate as demonstrated in the Federal election results on October, 25, 1993 is no different from most other industrialized countries at this very moment. With the ruling Progressive Conservative party almost entirely wiped off the Canadian political-ical map, stagnant economic performance over the past three years coupled with an unprecedented campaign of corporate re-structuring and down-sizing, prompted the electorate to release their anger on the political party of the most unpopular contemporary Canadian Prime-MinisterBrian Mulroney. The new political alignment includes two new powerful regional parties (Bloc Quebecois, Reform Party of Canada) at the expense of the tra-ditional left-wing socialiststhe New Democratic Party and the Progressive Conservatives men-tioned above. The result is not too surprising when the indus-trialized countries of the G-7 are placed into a global context. This is an absolute necessity under present geopolitical and economic events in the world, if individual results such as the recent Canadian election are to be fully understood.
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What is of some interest, is the fact that Canada was one of the first industrialized countries to experience unprecedented re-structuring. In fact, it may be wise for countries of the European Union to take note, since recent Canadian economic and political experiences may shortly be shared by a number of countries there. The electorate of whom shares a similar disillusionment, as in the contem-porary Canadian experience, with the general process of de-industrialization. To a large extent, unprecedented technological changes have temporarily displaced a large portion of the labour force in the G-7 countries. However, this natural process of evolution has combined with the recent opening up of areas in the world which were previously off limits to free markets. With the recent net addition of the natural resources of Russia, the enormous human capital of China and eastern Europe to the existing pool of world resources, has opened up great opportuni-ties, while at the same time causing great disloca-tion. Specifically, when the Russian and Chinese markets were off limits only four years ago, the G-7 was able to enjoy an artificially high standard of living, since the resources of the other half of the world were not available participants in the markets. Simply put, Canadian natural resources for export must compete with an even larger volume of Russian wood, aluminium and coal today. The same goes with the new 1.2 billion strong Chinese market, which has almost become a magnetic attraction to North American industry. Such scenarios have already impacted the real industrial sector of Canada's economy, and will continue to do so. The challenge is for Canada to take advantage of the new environment by adopt-ing an aggressive export stance. This would not only include traditional markets such as the U.S., but also thelarge number of recent entrants into the world market. Number of Parliamentary Seats Held By Canadian Political Parties Political Party New Alignment Old Alignment Progressive Conservative 2 157 80 Liberal 178 44 8 New Democratic Party Others & Vacancies 0 14 0 54 Bloc Quebecois 0 52 Reform Party of Canada 0 1 Independent 295 295 Totals
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This process of on-going re-structuring has enormously impacted Federal and Provincial gov-ernment revenues. The shortfall can be attributed to some of the following reasons: a. re-location of labour intensive industries to lower wage areas of the world b. high wage corporate redundancies who have decided to accept lower paying employment in the service sector, or have set up a selfemployment practice c. chronically high tax rates at all levels which have encouraged less work effort and a high degree of tax evasion together with a rampant black market economy d. natural attrition of jobs through technological changes e. regional sectoral recession in areas such as real-estate and property development and natural resource exports
What is interesting to note is the fact that a growing segmented workforce which is self-employed is becoming a more common occurrence in industrialized countries such as Canada. This has very serious revenue collection repercussions, as taxes are no longer conveniently deducted at source, but are collected under trust that a self-employed individual fully declares their income. The rampant black market economy ensures that the government will not be able to tax an ever larg-er proportion of economic activity. Hence leading to ever more revenue shortfalls. The solution to the entire problem of tax evasion is a lower income tax rate along with cutbacks in social services and a programme of continued privatization. In short, if the fiscal finances continue to deteri-orate on a relative basis vis-a-vis the record of other G-7 members, then the Dollar will shift downwards to a new lower trading range vis-a-vis the U.S. Dollar. Furthermore, the monetary side under the lead-ership of Bank of Canada Governor John Crow has come under serious attack recently for its pursuit of a zero inflation goal. Although low inflation is now the norm, the criticisms in this respect cannot be further from the truth, since once again the actions of John Crow and the Bank of Canada must be placed in a relative international perspec-tive. Recently, the Bank of France, the Bank of Italy and the Bank of Japan have joined the German Bundesbank and the U.S. Federal Reserve as independent central banks.
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What this means is that monetary policy is determined without the influence of politicians. Since politicians always look for short-term solu-tions to problems, any control over a policy lever such as money would tempt them to ease up on credit liquidity, in order to achieve greater levels of employment. With the advantage of having the recent experience of the U.S. Federal Reserve, this does not always work. But, over the long-term it has the potential to generate inflation which will not solve the long-term structural unemployment problems of industrialized countries like Canada. Recent rhetoric opposing the re-appointment of John Crow fails to place the workings of the Bank of Canada within an international context. In other words, yes, John Crow can be replaced by a politi-cal appointee and preferably a politician from the Ontario New Democratic Party. But, if a majority of the other members of the G-7 decide that a cred-ible and independent central bank would best serve them over the long term, then Canadian financial markets suffer and the Dollar plunges. If a far-reaching change such as this must be made, then let us all make sure that a majority of the industrialized countries also do it. Canada is much too small a global player to take an initiative such as this all unto itself, without experiencing a serious fall-out over the longer term. In that respect, Jean Chretien has no choice- just as he didn't have any real choice under Nafta- but to re-appoint John Crow for another seven years. Currency Outlook What is important to watch over the next quarter is how the Chretien government attempts to bring the Federal deficit under control. In other words, how he is able to maintain a borrowing require-ment that is comparable to other industrialized countries. The ease to which this goal is attainable is dependent to a large extent on how robust the recovery is in the U.S. economy, hence spilling over into Canada. If the U.S. begins to stagnate in any way, then the chances of reducing the deficits in line with the other G-7 members will be much more difficult. This factor will preoccupy the markets over the next quarter and should see the trading range of the Canadian dollar vis-a-vis the U.S. at 0.72 -0.76 cents. If John Crow is not appointed, then it is highly probable that the Dollar settles in the lower end of this range.
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First Quarter: 1994; December 18, 1993

Bank of Canada Governor John Crow replaced by Gordon Thiessen Finance Minister Paul Martin Jr. tables new budget Liberals announce measures to reduce dfense expenditures, public debate held on tax and social security reforms current unofficial rate of unemployment stands at 26% Canadian general government debt at 86.2% at end of 1"3 dollar under pressure as short- term rates approach U.S. rates January/94 official unemployment rate rises from 11.2% to 11.4% 48,000 additional manufacturing jobs eliminated uncertainty mounts as Quebec election expected in fall of 1994
Economic and Financial Overview The resignation of former Bank of Canada Governor John Crow is one among a number of factors that may lead to a dollar crisis. While this did not cause an immediate panic, it doubtlessly will reemerge as an unstable element if the upcoming budget does not address the $45 billion fiscal deficit. Moreover, the fact that the U.S. Federal Reserve has just moved to raise its short-term Federal Funds rate (valid on interbank loans) to counter an over- heated economy, will undermine the historic premium in which Canadian short- term securities were able to offer investors. This will divert capital flows away from Canada and into U.S. investments. The combined effect of all these factors will be difficult to overcome, since the trade- off at this point in time presents very difficult choices. Short of any dramatic restructuring in the Canadian government bureaucracy, the pressure will culminate in an eruption which will send the dollar spiralling down-
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wards. For that matter, it is essential that Finance Minister Paul Martin Jr. acts decisively to cut the top- heavy Canadian military. Immediately to be followed by a program which retires most government employees above the age of 52, and offers a scheme whereby these talents can be diverted into the private business sector. This re-deployment of the civil service into areas of productive use must be co- ordinated with the Provinces, and be followed by lower taxes and easier access to business and venture capital, in order to move the country out of its present state of stagnation. With the U.S. experiencing a recovery for over a year now, Canada has yet to participate from the traditional spill- over effect, in the way that past U.S. recoveries have enabled exports to accelerate Canada out of recession. The inability to generate growth and reduce its traditional partner hasthe United States. employment after pursuing a very easy monetary pol-icy, leads to the suggestion that the present state of the Canadian bureaucratic superstructure must come to an end. Such a structural change, although diffi-cult, is what is needed on a relative basis vis- a- vis similar actions on behalf of other industrialized coun-tries within the G- 7. Canada has waited long enough for the U.S. economy to pull it out of recession. This has not happened, and now it must be prepared to enact some very difficult measures in order to main-tain the strength of the dollar. On a relative scale, it is very interesting to note that Canada's debt to G.D.P. is the worst, save Italy. And only the growth of debt accumulation in Italy and the U.K. can be matched to the Canadian scenario over the past three years. As the following table indicates: To reiterate, it is important at this juncture that Canada is also seen as a country which is enacting measures in order to improve its fiscal finances. Once again, we cannot stress more the importance in which such decisions are interpreted within a relative context among all advanced industrialized countries. Therefore, Finance Minister Martin has an unenvi-able task on his hands. This has turned into a far more serious proposition, since Canada has not near-ly experienced the recovery to the same extent that its traditional partner has- the United States.
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Currency Outlook
In order to save the dollar, the Liberal government must reduce its deficit through a radical re- organisa-tion of the Canadian bureaucracy, which is inevitably accompanied by real spending cuts. Any moves to avoid these hard choices by further plugging tax loopholes, or raising taxes will continue to stagnate the domestic economy. In that sense, only spending cuts will offset the natural tendency of the dollar to fall now that the U.S. is raising its short- term rates in order to counter its robust recovery, while Canada is still reducing its rates to counter stagnation. The danger is that if for-eign investors do not perceive the budget as seriously addressing domestic stagnation, the dollar could drop to the 0.67 to 0.72 range vis- a- vis the U.S. dollar. Otherwise, it will trade in the 0.74 to 0.78 range, pending a successful budget. General Government Debt (% Debt to GDP) Canada(b) France Germany Italy Japan (b) U.K. U.S. 1991 77.6 48.5 45.0 101.3 68.2 41.1 59.8 1992(g) 83.0 50.1 45.9 106.8 66.2 45.9 63.2 1993(a) 86.2 52.4 48.5 112.2 66.0 52.6 65.1
(a) 1992 and 1993 data are Commission forecasts
(b) Source: OECD Economic Outlook 53, June, 1993
Source: European Economy, Annual Economic Report 1993
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First Quarter: February 14, 1994

February 1994 budget reveals plan for gradual deficit reduction defense spending reduced by $7 billion over 5 years dollar falls to historic lows Moodys Investor Services places foreign cumrrency debt in review unemployment falls from 11.4% in January 1994 to 10.6% in March 1994 bonds experience worst decline in over 12 years net government debt rises 11.2% in fiscal year March 1994 net government debt presently at 93% to GDP- up from 30.6% in 1982 provincial foreign debt doubles to $120 billion over last 5 years Japanese investors become net sellers of Canadian debt 30% of net Canadian debt ($266 billion) held by foreigners
Economic and Financial Overview Recent evidence confirms the view that in a period of deflation, the proportion of debts to assets accelerates upwards. This problem becomes ever more acute, when governments are either unwilling, or unable, to curtail the degree to which they participate in an economy. As technological change and the integration of new countries into the multilateral trading system proceeds, the revenue base of a national budget is more and more determined globally, while the expenditure side must still contend with the national demands of a constitutional democracy. In the Canadian situation, net government debt has virtually tripled from a level of 30.6% of GDP in 1982 to 93% at this very moment. In this case, it is not wholly a question of apportioning blame to one particular government or
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another that has governed the country in the recent past. A major constraint on the policies of any political party in a constitutional democracy, are the periodic recurring elections that exist usually every 4 to 5 years. In that sense, the most difficult actions inevitably have to do with austerity on the expenditure side. Admittedly, revenues have become more difficult to collect now that trade and investment flows have become liberalized. In addition, technology and the persistent re-structuring, combined with recession over the past three years, has led to a completely different environment on the revenue collection side of the budget. As Canadian citizens continue to demand what they believe to be their basic rights in society in a continuously changing global environment, debt will continue to grow. For countries like Canada, Sweden, Finland and certain members of the European Union, recent changes have delivered a severe shock to their political systems. Unquestionably, the basic rights and demands of citizens from their governments, has not kept pace with the new global industrial reality affecting national revenues. Once again, any progress to reduce the imbalance between revenues and expenditures must be co-ordinated between all countries, if currency and financial market turbulence is to be avoided. Over the short term, Finance Minister Paul Martin Jr. had tabled a budget last February, 1994, which was designed to implement austerity very gradually. Shortly afterwards, the Canadian dollar came under heavy attack, which forced the Bank of Canada to intervene in the currency market on several occasions, and eventually raise the short term bank rate back to its historic spread with the United States. The entire crisis would have been entirely averted, if only Canada was not geographically adjacent to a super power to her immediate south, which continues to show good economic fundamentals. Specifically, the budget high points include: no new taxes; defense expenditure reductions by $7 billion over 5 years; capital gains exemption reductions and a public service salary freeze. The budget forecasts are presented on p. 17. The danger at this point in time is that these forecasts were made shortly before the Canadian dollar came under speculative attack. Consequently, the "Interest on Debt" has already been estimated to have added an additional $1.5 to $2.0 billion to the above forecasts. If the current pressures persist, then it will not be too surprising if the Finance Minister is forced to introduce a mini-budget to address the disparities, shortly after the Quebec Provincial elections.
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Currency Outlook Federal Revenues and Ex penditures (February 1994 forecasts) (Cdn.$ billions) Revenues Expenditures Operating Surplus/Deficit Interest on Debt Budget Deficit 93/94 114.7 -121.8 -7.1 -38.5 -45.7 94/95 123.9 -122.6 1.3 -41.0 -39.7 95M 132.0 -122.7 9.3 -42.0 -32.7
The budget has not convinced foreign investors to remain exposed to Canadian dollars. The recent re-patria-tion of Cdn.$3.4 billion by Japanese investors is a disturbing signal, since this is the first reversal in foreign investment flows from Japan since 1976. Moreover, it comes at the worst time, just when flows ought to be accelerating into Canada to service the growing debt. Hopefully, this reversal will not be the prelude to a general movement away from Canadian dollar denominated debt instruments over the next several quar-ters. This very moment represents a bad period for Canada, when placed in a his-torical context, coming just months before another Quebec Provincial election, again based on the theme of separa-tion from Canada. However, it is expected that Quebec will remain a part of Canada, given the enormous economic risks that an out-right move toward separation will exert upon itself. However, the uncertainty surrounding the entire issue, is worth a political risk premium that is estimated anywhere from 0.2 to 0.5 cents to the U.S. dollar. The long-term fundamentals point towards a very gradual reduction in debt levels, and any moves to acceler-ate the outflow of foreign investment will lead to much higher interest rates and a weaker dollar. However, there is also an important political limit to a fall in the Canadian dollar. Given that the North American Free Trade Agreement (Nafta) is now being implemented, and Canadian access to U.S. markets is more certain than ever before. Any use of a weaker dollar to cheapen exports to the U.S., will come under growing protests from producer interests in Congress. This is a situation which may escalate trade tensions with the U.S., even under Nafta (see article by Rugm,an and Warner in Vol.11, No.V). Evidence points to the fact that domestic U.S. pro-ducer interests will not tolerate any unreasonably low levels in the value of the Canadian dollar. The current specu-
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lation is that levels in the mid-$0.60 cent range relative to the U.S. dollar, may result in political moves in Congress which favour an I.M.F. solution to the growing Canadian deficit. Consequently, in respect to the above considerations, it would be conceivable to see the Canadian dollar trade in a range of 0.68 to 0.73 cents to the U.S. dollar over the next quarter.
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Second Quarter: April 22, 1994

United Nations rates Canada as having highest standard of living attention turns towards the Quebec Provincial elections public debt charges rise by 0.6% in April 1994 from 1993 business credit continues to decline consumer and mortgage credit on the rise current account deficit widens debt rises higher than in any other industrial country debt and political risks force real long-run rates to exceed 9 percent surge in demand for automobiles raises capacity utilisation rate net international reserves at all-time low
Economic and Financial Overview All eyes have turned towards the upcoming Quebec provincial elections. The ruling Federalist Liberals under Premier Daniel Johnson must confront a popular Parti Quebecois under Jacques Parizeau. Should the latter win, pron-dses of an early referendum on Quebec's eventual separation from Canada will instill an atmosphere of fear and panic in financial markets indefinitely, and perhaps for the remainder of this decade. Never have the stakes in previous rounds of Quebec separatist fever been as high as they are this time around. In addition to this political crisis, Canada is faced with very serious questions concerning the overall climate of economic under performance. With the US recovery now going into a phase of consolidation, Canada seems to have missed the entire upturn. A divergence from the historical norm. What makes separation far more desirable for Quebecers in the upcoming elections, is that they will be able to cast their votes on political and economic considerations. Unlike past referendums on separation which have been conducted in good economic times, any referendum now will come at a time of record unemploy-
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ment and de-industrialisation. An economic climate which often leads to dangerous political outcomes. Assuming that the governing liberals under Daniel Johnson win. Quebec will not face a referendum, but Canada will still need to face one on its economic performance. The problem over the past three years, was that economic restructuring and overall industrial decline have been far more vigorous in Canada than in most other countries organised under an Anglo-Saxon system. Unfortunately, neither the countries' elected representatives nor the electorate who put them in office, have grasped the overall geopolitical changes in the world which have forced such an environment. For this, it would be very difficult to directly accuse anyone of mismanagement. What is known, however, is that the present low inflationary climate in the industrialised countries, together with freer trading and investment arrangements, have adversely impacted all resource-based, protectionist j urisdictions such as Australia and the Scandinavian group of countries, in addition to Canada. What is becoming very clear is the extent of the protectionism that has been offered to low-skilled, undesirable industries. Industries which as soon as the barriers came down, picked-up and settled in some of the most low-cost and unregulated regions in the world. A situation that is not as visible in pro-ductive, high value-added industries, that are more usually than not, located within countries such as the US, France, Germany and the Netherlands. At a micro-level, the problem of channeling credit to finance produc-tive ventures has been virtually absent. There exists a severe problem in the process of intermediation within most Canadian financial institutions. The familiar theme of virtually nonexistent venture capital in the country becomes even more frustrating, when under a global environment of freer trade and easier access to larger markets in the world, the major portion of the coun-try's credit is reserved for sectors that only marginally figure into the coun-try's overall productive export strength (while developing a massive branch banking super-structure to assist indi-viduals with their purchases of real-estate, productive export industries usually do not figure into the overall equation). Under the present geopoliti-cal structure in which the whole world is heading, this should not be allowed to exist. As the table (above) illustrates. While the economy is being constrained by such institutional factors at work, the level of political debate by the elected representatives leaves a lot to be desired. Not only are most of the locally-minded politicians completely mystified by the ongoing economic under performance, but the general populace at large can be worryingly described as being uninterested at best in the broader international factors
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influencing present economic restruc-turing. Canadians must prepare them-selves for possible IMF intervention. Currency Outlook Under the most likely scenario of a Parti Quebecois victory, the immediate financial and currency market euphoria would send one Canadian dollar below 0.70 cents U.S. However, this will recover after several weeks to the present 0.70 to 0.73 cents range. However, once a definite referendum date has been fixed, the market jitters would again send the dollar below the 0.70 cent level. Such an oscillation will continue until the eventual outcome is known in the Quebec referendum. If separation would be the eventual outcome, the first signs of difficulty would appear in the refusal of foreign investors to add any further Canadian dollar denomi-nated assets to their portfolios. This would immediately lead to an IMF brokered solution to the problem. However, if the Liberals under Daniel Johnson win, the political turmoil would temporarily become a sec-ondary consideration to the pressing economic questions. With recovery only based in the present pent-up demand being felt in the automotive sector, further hard choices would be required. The immediate euphoria over the victory of the Liberals in Quebec would temporarily raise the dollar trad-ing range to 0.73 to 0.76 cents to one U.S. dollar. In order to sustain this level, foreign investors would need to have some signal of change primarily in the spending levels in government, and secondarily in the process of bank credit intermediation and overall industrial policy, otherwise, expect a continuation within 0.68 to 0.73 to one dollar US. Year Total Business Credit 10.0 11.2 9.3 3.6 2.5 1.5 Residential Mortgages 15.8 15.8 14.1 8.2 9.4 7.4
1988 1989 1990 1991 1992 1993
All figures are Rates of Change Based on Seasonally Adjusted Data Source: Bank of Canada Review
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Third Quarter: September 25, 1994

Parti Quebecois wins election by narrow margin popular vote shows strong support for federalists referendum may be postponed until support rises dollar rises as political risk diminishes Eurobond maturities prompt heavy reinvestment Confederation Life insurance company collapses raw materials exports surge aided by low dollar Canadian bond yields perform best in August/94 credit agencies downgrade provincial debt current account deficit widens over debt charges small growth in wages reported automotive sector to save Canada from recession
With the strong showing of Daniel Johnsons Liberals in the September 12, 1994 Quebec election campaign, the planned referendum on independence to be held within the ensuing ten month period, is fast becoming a farce. Although the separatists under Jacques Parizeau won a majority of 77 parliamentary seats of the 125 total, the markets turned to the popular vote, as the true indicator of the eventual success of a referendum on Quebecs independence from Canada. Consequently, the dollar managed to free itself from most of the political risk associated with the possible break-up of Canada. Despite the fact that both monetary and fiscal policies are continuing to move towards austerity. The prognosis of improving demand for Canadian natural resources, as well as the enormous pent-up demand that will be experienced in the automotive sector, is expected to pull Canada out of its lingering recession. The overall effect, however, will be somewhat restrained over the continuing reluctance of the banking system to lend to small businesses and the property development sector. However, the mere fact that the average age of both passenger vehicles and commercial trucks is far above their historical replacement life, will go a long way in generating optimism over the prospects of recovery in the latter half of the decade.
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Just as in the case of Germany, the production of all vehicles in Canada is expected to rise to a sustained level of 2.4 million units until 1999. This, compared with an average production rate of 2.0 million units throughout the period 1990 to 1993. The increase in production represents about 25 percent more units produced on average, in the latter half of the decade. Likewise, average Canadian sales in the latter half are expected to rise by 18 percent. From an average sales rate of 1,254,502 in the period 1990 to 1993, to an average sales rate of 1,479,565 in the period 1995 to 1999. (See table I) The question surrounding the nature of the Canadian recovery, centres on to what extent the robust recovery in the automotive sector will affect the spin-off parts industry, and in turn how far this will all go in generating more growth in the service sectors? And ultimately, will the increased activity enable tax receipts to grow, in order to cover the burgeoning deficits of all three levels of government? Early evidence from wage growth rates, do not yet lead one to believe that this may happen. The process of de-industrialisation in the provinces of Ontario and Quebec, has been so severe in the past four years, that it may take a further year or two for the positive effects to emerge in higher levels of personal and family income. As table II shows, manufacturing unit labour costs have experienced the greatest relative reduction in Canada, of all industrialised countries. If there is ever a case to be made in favour of re-inflating, the Canadian lengthy recession is a textbook example. The fact of the matter is that monetary policy has been so stringently orthodox over the last five to six year period, that the only engine remaining to lift the country out of recession, was the natural wear and tear (depreciation) in the stock of machines and automobiles (pent-up demand). In essence, it will be very much a natural recovery, without any help from either fiscal or monetary policy. Unless monetary policy is pursued more aggressively, the duration of the trough in the business cycle will get longer and be very damaging to the social fabric of the country. Such policy considerations must be addressed before the current rise in pent-up demand is expected to run out, at the end of the decade. Currency Outlook From the viewpoint of financial markets, Daniel Johnson and the federalists won the Quebec election. Given that the Parti Quebecois received only 13,500 more votes in total than the ruling Liberals, the prospect of conducting a successful referendum campaign is quickly receding. In fact, Mr. Parizeau may
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find it wise to take the advice of the leader of the Federal Bloc Quebecois, Lucien Bouchard, and postpone the vote altogether, until public opinion is willing to risk independence. However, if a referendum is called over the next ten month period, as promised, it will inevitably affect the risk premium attached to the Canadian dollar. And every successive public opinion poll, until the final day of the vote will cause movements in the currency markets, in accordance to the attitude of the Quebecois. The expectation is that the natural economic recovery will go a long way in capturing the headlines. This is vital, in the sense that a robust recovery in first the automotive sector and raw materials, will tend to even further relegate separatism to being a secondary issue. In addition, the present phase of recovery will be under scrutiny, if it will generate enough activity to raise tax receipts, and cover the enormous debt burdens created by all three levels of government. Early signals to this being successfully fulfilled, will be in the growth of personal incomes and employment levels. Therefore, with the political risk premium no longer a pressing concern, the natural recovery on the real side of the economy will favour a rise to the 0.74 to 0.78 range with respect to the US dollar. However, with an inactive fiscal and monetary policy, the best it will be able to do is 0.72 to 0.75 to the dollar.
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Canadian Vehicle Production and Sales
(Table I)
Year Units Produced Units Sold 1990 actual 1,947,106 1,314,118 1991 actual 1,887,572 1,287,056 1992 actual 1,950,646 1,227,841 1993 actual 2,237,733 1,188,992 1994 forecast 2,200,200 1,284,167 1994 scheduled 2,301,365 1,296,001 (tracking) 1995 2,500,000 1,401,783 1996 2,500,000 1,501,351 1997 2,500,000 1,528,495 1998 2,450,000 1,517,195 1999 2,400,000 1,449,000 All vehicles include both automobiles and trucks Source: DesRosiers Automotive Consultants Using Industry Data
Percent Changes in Manufacturing Unit Labour Costs (Table II)

Country Canada France Germany Italy Japan US 1991 -2.6 2.1 4.3 13.4 4.4 1.3 1992 -2.2 0.5 4.8 5.5 8.7 1.0 1993 -2.9 1.5 1.4 4.2 4.5 -1.9
Source: Bank of England Quarterly Bulletin. August, 1994
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First Quarter: January 5, 1995

$ financial markets anticipate February 1995 budget $ rising real interest rates threaten large debt levels $ US rate increases pose challenge to Canadian recovery $ historical spread on US and Canadian rates narrows $ foreign debt at 44% of GDP used to finance consumption $ current account deficit to attain 2.5% of GDP $ reduction in 1995 immigration quota by 12% $ consumer prices register a 0.2% rate of deflation $ industrial restructuring causes labour input to fall by 20% $ automotive industry expected to generate record profits
fter scoring a post-election dividend in the aftermath of the Quebec elections in September 1994, the dollar found itself on the downside once again, challenging 0.70 US in the fourth quarter of 1994. The popular opinion in Quebec continues to show overall support for the Canadian federation, however, the immediate euphoria in financial markets has been replaced by resurgent reservations about the abilities of the present Liberal government to carry out the promised reduction in the deficit for 1995-1996. Finance Minister Paul Martin Jr. has announced that the February, 1995 budget will contain draconian fiscal measures, designed to reduce the present deficit of some $40 billion to $25 billion, or 3.5% of GDP. If accepted at face value, there still remains the possibility of provincial gridlock, as both Quebec and Ontario (two of the wealthiest provinces) resist the trend to lower debt levels, despite the fact that credit agencies continuously deliver downgrade after downgrade. At this very moment, the government is showing tremendous faith in the natural recovery, as recent life exhibited in the economy from pent-up demand in the automotive industry has generated some $5.0 billion extra in revenues over the second half of 1994. Success in such a strategy of patiently waiting out the current budgetary impasse, may prove to come out short. As the present cycle of recovery will
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prove to be far more shallower than in the past. A recent report commissioned by the Paris-based OECD has concluded that the period 1989 to 1993 witnessed the most severe restructuring in the industrial base since the Second World War. Evidence presented indicates that costly Canadian labour supply has been replaced by technology and machinery in the production process. In fact, it was reported that the manufacturing industry uses 20 percent less labour now, than it had prior to 1989. Moreover, it continued by asserting the view that the jobless recovery is expected to continue, as some 80 percent of the income generated in the present upturn is derived from a more efficient deployment of the existing pool of workers. Only 20 percent of the growth in income can be attributed to new workers absorbed in the production process. Monetary policy continues to be inactive, as the Bank of Canada is forced to side with foreign investors by maintaining artificially high real interest rates. As the US Federal Reserve has raised its short term administered rate by 0.75 percent, the Bank of Canada has found itself in a position where it must raise real rates under a condition of domestic deflation. Since foreign investors expect the historical yield spreads between US and Canadian financial instruments with similar risk profiles to be maintained, any narrowing of this gap is not expected to be tolerated for too long, before Canadian securities are dumped on international capital markets. A situation which has not been too far off the mark most recently. By having to defend the value of the Canadian dollar constantly, the domestic economy is being deprived of a more beneficially active monetary policy. This argument may very well be refuted by current commentators on the Canadian economy, who cite the fact that growth has been on a recovery trend and that Canada is expected to be one of the fastest growing among industrialised countries in 1995. However, with consumer price deflation being the present condition, and with continuing long term rates at about 8 to 9 percent, the breadth of the present recovery is being supported solely by pent-up demand. Any termination in this cycle of pent-up demand could produce disastrous results, plunging the Canadian economy back into a state of heightened recession. The lingering problems that are re-surfacing on Canadas international accounts present an alarming signal for all investors exposed to Canadian dollar denominated certificates of investment. A backdrop to the entire problem is the fact that much of Canadas foreign indebtedness, amounting to some 44% of GDP, has been directed to financing an artificially inflated standard of living. The prime example of which is the battered real estate sector, which continues to lose real value, and which by some conservative estimates is still some 50 percent overvalued.
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Despite operating under a merchandise trade surplus, the overall international exposure is faced with continuing deficits, as interest payments on the stock of foreign debts are causing the need for continuing capital inflow from foreign investors. With the US economy nearing its peak in performance, the imbalance on the Canadian international accounts is bound to get even more serious. Since most of the merchandise trade surplus is with the US and Mexico in the automotive trade, an end to pent-up demand could cause even more pressure on the already high real rates to increase even further. Since yields that transcend the historical Canada-US spreads become indispensable in attracting much-needed foreign capital. The alternative of having a further devaluation in the Canadian currency can only go so far, before investors rush to dump their Canadian securities. The current danger is that if the upcoming February 1995 budget does not curtail the bloated deficit, causing capital to accelerate its outflow, a surplus on the international trading account would be the only alternative. Causing unprecedented pressures on the social welfare system. The most likely developments will ensure that the Bank of Canada maintains high real interest rates, and that the Federal government delivers a combination of higher taxes and lower regional and industrial subsidies. Major reductions in social spending should not be anticipated at this point in time. Overall, investment spending on new plant and equipment will suffer only to the extent that existing pent-up demands may lead to higher levels of production. Higher taxes will work to reduce disposable incomes further, curtailing spending on consumer goods and imports. Presently, as was reported above on several occasions, pent up demand arising out of the automotive sector has been the pillar of the improvement in economic fundamentals. The duration of the expansion is expected to continue until 1998, the basis of which has been aging vehicles and the North American Free Trade Agreement, which has resulted in two vehicles being produced for every one sold in Canada. Although the likelihood of Quebec separating is very small, the rhetoric leading up to the referendum will have an effect on the dollar. However, the most pressing concern on the minds of Canadian citizens and investors alike, is the substance in the all important federal budget promised in February 1995. Up to now, the ruling Liberals have only hinted at a combination of tax increases and minor social program re-allocations, along with some symbolic cutbacks to the
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military. The tactic seems to be entirely based on faith in the growth of the economy, through the performance in the auto sector, hence increasing the tax receipts collected. Moreover, the tight money policy together with the prevailing high real rates of interest has been tacitly accepted by politicians without resorting to criticism, through necessity. The government is fully aware that the massive foreign debt exposure of some 44 percent of GDP poses a major constraint on domestic policies. Although adversely affecting most citizens, an inactive monetary policy, implemented by an independent Bank of Canada has become somewhat of a blessing to the government, when the precarious state of the international accounts are considered. Yet still, it will be difficult to convince many investors that Canada has reached the end of its historically stable place in the world. However, most will still look to achieve some spread over comparable US denominated securities, as is expected. The danger being that Canada has missed out on the two solid years of economic growth in the US. And should the Federal Reserve continue its program of higher short-term rates to quell the record strains experienced on US productive capacities, the Bank of Canada will have no choice but to follow suit. The flipside of which would cause a severe devaluation in the dollar, and even lead to greater problems as investors bail out of their cheapened investments. Whether the budget will deliver the much anticipated result is anybodys guess. However, with current account deficits being mainly a structural problem, and with taxes on Canadians already at their limits, cutbacks in the upcoming budget are not expected to be deep enough in order to give a further boost to the merchandise trade surplus. In that respect, the dollar is expected to trade within the 0.69 to 0.73 cents range to one US.
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Canadian Automotive Trade (Millions)

Exports
Assembled Vehicles Vehicle Parts Total Exports
Total 1992
28,352 10,227 38,579 15,378 18,398 33,776 12,974 -8,171 4,803
Total 1993 %Change

36,006 12,454 48,460 16,483 23,375 39,858 19,523 -10,921 8,601 27.0 21.8 25.6 7.2 27.1 18.0 50.5 33.7 79.1
Imports
Assembled Vehicles Vehicle Parts Total Imports
Balance
Assembled Vehicles Vehicle Parts All Auto Products
Source: DesRosiers Automotive Yearbook
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First Quarter: February 10, 1995

$ attention focused on all important budget due in February 1995 $ budget impact expected to last until the second quarter of 1995 as investors continue to evaluate impact $ indications that Finance Minister Paul Martin Jr. expected to aggressively bring down deficit $ current deficit of $40 billion expected to fall to $26 billion from $7 billion in tax increases & $7 billion in cuts $ current growth in automotive assembly & parts sector begins to spread to related industries $ real GDP grows by 5.0 percent in 1994 representing the highest in six years $ pent up demand beginning to show positive effects in employment growth $ 2.7 percent decline in real disposable incomes & growth in consumer spending financed by savings shortfall $ personal savings fall by 6.7 percent to their lowest level in 23 years
The Canadian dollar has hit new lows vis-a-vis the US dollar, and for a very brief moment crossing to the psychologically important 0.69 cent level. The severity of the Mexican Peso crisis prompted vigorous attacks on the dollar by currency traders, using any excuse, even if completely irrational, to drive down its value. The crisis has caused many investors and commentators to re-evaluate Canadas economic performance, by placing recent developments under far greater scrutiny than usual. In his budget, Canadian Finance Minister Paul Martin Jr. must convince not only the international financial markets, but an increasingly restless citizenry that his government has full control of the situation. The timing for a large scale reduction in the deficit could not be more opportune than in the prevailing
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climate. The Finance Ministers window of opportunity will be closed if he is unable to deliver major reductions in spending. For this task the current climate is favourable, and he is aided by a number of unrelated factors: the Mexican Peso crisis could not have been better timed for the task that awaits the Finance Minister. The crisis and fall-out from this has brought to the attention of the Canadian public, just how fragile international markets have become, and just how vulnerable the domestic economy is to events that happen in an increasingly inter-related global marketplace. current record Canadian growth rates driven by pent-up demand in the manufacturing sector and falling unemployment, are providing a climate that is favourable to budget austerity measures. recent successes in reducing spending by Premier Ralph Klein in the Province of Alberta has established a precedent and provided early evidence that austerity can be a possible option. the current rhetoric out of Washington D.C., with the newly-elected Republican majority in both houses of Congress has promised smaller government, which may have some spill-over effect in Canada. According to leading Canadian economist Jayson Myers, the government is determined to deliver a balanced budget towards the end of the decade, with a possibility of exceeding the self-imposed 3 percent to GDP deficit guideline. Any back tracking at this point would definitely send a signal that the government is not in control, causing further uneasiness in financial markets. Myers asserts that the key issue that faces the entire nation, as well as most other industrialised countries, is how can a government practice austerity and grow at the same time? Up to this time, most industrialised countries have been attempting to do so by either encouraging exports to non-industrialised countries throughout the world, or have resorted to, either by design or default, to devaluing their currency. The current export promotion trip by Prime Minister Jean Chretien to Latin and South America and to China is a perfect case in point. The fact of the matter is that an inactive monetary policy over the years, will shortly be joined by an inactive fiscal policy. Solely relying on pent-up demand considerations to drive domestic economic activity. This seems to be the chosen path of most industrialised countries, leaving the all important question: how can we cut and grow at the same time?, at the centre of political debate over the coming year.
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After all is said, the consensus scenario for the upcoming budget, according to Myers, will most probably lead to some balance between raising taxes and reducing spending. A reduction of $14 billion, from the current $40 billion deficit, to $26 billion over a time period of two years, will see a saving of $7 billion per year. This represents about a 1 percent reduction, out of a total Canadian Gross Domestic Product (GDP) of $750 billion in each year. In other words, a forecast of 3 percent growth over the next two years, will result in an overall net growth of 2 percent after the implementation of the cutbacks. At this moment, every move that Finance Minister Paul Martin Jr. makes will be under the scrutiny of financial markets. If the expected cutbacks are not delivered, or if they are by a far larger increase in taxes, the dollar will come under speculative attack. Any tax increase, must be balanced by a corresponding cutback in expenditures. The prevailing sentiment is that a dollar increase in taxes, must be accompanied by a corresponding two dollar reduction in spending, for the budget to be deemed as being credible to the markets. In spite of the upcoming presentation of the budget, the real economy is showing continuing improvement, primarily driven by the pent-up demand being experienced in the automotive sector. The fact that the North American Free Trade Agreement has helped in producing two cars in Canada, for every one sold domestically, has figured prominently in the recovery. However, the current Mexican Peso crisis will undoubtedly have a major impact. This may cause the forecast growth in economic activity to drop, as foreign imported automotive products into the domestic Mexican market become prohibitively expensive. The negative real disposable income posted in the third quarter of 1994, is an indication that some of the current recovery in consumer spending has been exclusively financed by a fall in personal savings. Except for the automotive sector, many others in the services and government are in a mode of retrenchment. With wage and salary roll-backs being the present norm, the consumption component that drives economic activity can not be relied on to assist in recovery. Personal spending is expected to suffer further from the impact of the Martin budget. A positive development that places upward pressure on the dollar is the improving current account (international account) balance. Record levels of merchandise trade exported out of Canada has resulted in a reduction some $10 billion from the second to third quarters of 1994. It remains to be seen what impact the recent trade promotion trips by the prime minister will have on exports, and conversely, what negative impact the Peso crisis will have on automotive parts exports to Mexico.
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The Peso crisis has affected the dollar to the extent that investors now perceive both to be part of a soft currency club. The budget is expected to sever this relationship, and once again inject credibility to the currency. Consequently, the dollar will recover to trade within the 0.72 to 0.75 cent range, shortly after the presentation of the budget. A sustained rally will be dependent upon how quickly the domestic economy can restructure, to provide for sustained growth under austerity.
Economic Indicators
Indicator
Current Acct. Balance Percentage of GDP Real Disposable Income Profits Before Taxes Unit Labour Costs Unemployment Rate Prime Interest Rate
1992
26.5 -3.8 1.0 -1.9 1.8 11.3 7.48
1993 1994:Q1 1994:Q2 1994:Q3

-30.7 -4.3 0.8 20.3 0.3 11.2 5.94 -29.8 -4.1 8.0 73.6 -1.2 11.0 5.75 -30.2 -4.1 2.1 43.4 -0.6 10.7 7.17 -20.5 -2.7 -2.3 58.4 -1.3 10.2 7.25
Source: Department of Finance
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Second Quarter: March 30, 1995

$ budget presented by Finance Minister Paul Martin Jr. received well by markets $ 13.6 bn. reduction in spending over next two years is the largest in Canadian history $ long bond yield spread differences with US securities stabilise at 1.4% $ Moodys credit rating agency places Canada on its surveillance list despite budget $ support slides for Quebec independence $ residential property prices continue downward decline $ Canadian military confronts Spanish trawlers accused of over-fishing $ rail strike incurs shortages in the automotive sector $ automotive sector expected to slow down in 1995 with business conditions rising in 1996 & 1997 $ successes in computer & industrial export markets for Canadian companies
Finance Minister Paul Martin Jr. has presented a historic budget document. It calls for historic expenditure roll-backs on programs ranging from defense to business subsidies. The notable exemption has been any increase in personal income taxes, although excise taxes on petroleum products have increased. In short, Martin has delivered to investors a budget that they have been waiting for. However, judging by the response in the Canadian dollar, it has not been as positive on the up side as what many have expected. Why? For one, problems affecting the dollar extend to factors beyond the simple reduction of the Federal deficit. Not only must the fiscal position of the federal government be taken into consideration, but more importantly that of the provinces.
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Although progress on the deficit and debt has been forthcoming by the governments of Alberta and New Brunswick, the two major economies of Ontario and Quebec have not indicated that debt and deficit reductions are explicit goals in their agenda as yet. Further, the problem on the international accounts has not been on the trade side. In fact, a balance of trade surplus has been the norm for quite some time, a typical example of which has been the 2:1 production to sales ratio (1:1 is the minimum required by Nafta) in the Canadian automotive sector. A good portion of the excess vehicles produced are being exported to the US and Mexican markets. However, the problem exists more on the capital side of the international account. Here, payments to foreigners account for most of the overall deficit, when factored in. In fact, with over 40 percent of Canadian debt held externally, any payments in Canadian dollars must be dumped on the foreign exchange markets and converted to the bondholders domestic currency of choice. This does not exist in the cases of Belgium and Italy, two other industrialised countries with above average debt positions, whose foreign holdings of debt merely amount to 10 percent of the entire outstanding. From the point of view of economic fundamentals, the current decreases in the Canadian deficit by $13.6 billion over the next two year period, as announced by the finance minister only reduce the growth in the stock of debt outstanding. The current budget, although a step in the right direction concerning the fundamentals, does not retire any of the debt stock outstanding and held by foreign investors. All that it does is reduce the amount of bonds that will be offered on international debt markets over the coming two years. In that respect, the amount of dividends paid out periodically, will only have their rate of increase fall, but will continue to rise, although at a slower pace. On the real side of the economy, the automotive parts and assembly side has provided most of the business activity, however, there are initial signs that small to medium sized specialty computer manufacturers are poised to play a big role in the export markets. Services have also been in a state of recovery, with the photographic and film industries now beginning to attract attention in the capital markets. Overall, a very different profile from the business conditions existing only four years ago. No longer are real estate and construction-related projects the preferred destinations for finance capital. Although the shift towards creative services has accelerated, it remains to be seen if they can endure cyclical slowdowns as well as traditional manufacturing. The industrial growth pattern in Canada over the recent past, very much resembles that of the UK. Services are gaining in prominence, while Nafta con-
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tinues to ensure that for every one automobile sold in the Canadian marketplace, one is produced in Canada. Although the UK does not have a formal trade agreement with the automotive sector, it has become the third most important country of manufacture within the European Union. Aside from the good performance in the automotive assembly and parts sectors, there exists optimism that the sector will continue its current level of business activity, based only on the expected scrappage of automobiles over the next two years. The fact of the matter is that the current atmosphere of restraint will not overcome the need for new automobiles, as the current stock of automobiles aged 10 years near the end of their useful life. These automobiles compose the majority under ownership at this point in time. Politically, Quebec separatism seems to be a dying cause at this point in time, although sentiments may very well pick up, if Parti Quebecois leader Jacques Parizeau manages to turn the recent budget against the Federal government. Other than the Quebec referendum, the domestic political environment remains subdued, except for the current fishing impasse on the Grand Banks of Newfoundland, as a fleet of Spanish fishing trawlers using illegal nets continue to plunder the already diminished stocks of fish. The depressed regions of the Atlantic fisheries have already rallied behind the actions of the Federal government. The fishing issue may very well become an issue that will unify a fragmented country. The popularity of PrimeMinister Jean Chretien is at an all-time high. As the Spanish fleet gets larger, and the confrontation escalates, the European Union is urged on to do what it doesnt wish- impose trade sanctions against Canada. Already, the EU Spanish Ministers action to impose Europe-wide sanctions has been dismissed by a majority of European ministers. President Jacques Santer has opted to publicly pursue a negotiated settlement over the issue, much to the dismay of Spains representatives in Brussels. However, if the confrontation continues to build, and if Canadian maritime patrol boats attack the illegal fleet, it could be the badly needed issue for Canada to unite over. The risk of having the dollar fall below 0.70 cents US has greatly diminished. The combined effect of a budget friendly to foreign capital and a far lesser chance of Quebec separating from the rest of Canada, have once again instilled a degree of confidence in the foreign exchange and bond markets.
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However, the possibility of systemic market risk hangs over the dollar, as now it has attained the status of an international soft currency, grouped together with the likes of the Italian lira, Belgian franc and ironically, the Spanish peseta. The problem that this association exerts can be seen by the recent series of crises that has plagued the Mexican peso, and continues to do so to this day. Not only has the peso problem encouraged sales of the Canadian dollar, but has also brought down with it the once invincible US currency. With perfectly mobile international capital, what happens in Mexico City or Milan, will affect the financial markets in Toronto or Montreal. With an increasing tendency towards volatility for the remainder of the decade, especially in the European sphere, towards the Maastricht intergovernmental conference, speculation against some of currencies of the latin core group in the EU, should the concept of a single currency fail to progress, will exert some sort of a fall-out on global markets. The only way in which the Canadian dollar can uncouple itself from the upcoming events in the EU, would be for further reductions in the budget deficits. Not only reductions for their own sake, but reductions that go together with a powerful re-development in the private sector. One cannot occur without the other. For the time being, the Canadian dollar is comfortable in its current trading band of 0.70 to 0.74 cents to one US dollar.
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Budget Summary
deficit set at $37.9 bn. in 1994-95 & $32.7 bn. in 1995-96 & $24.3 bn. in 1996-97 personal income taxes will not increase excise taxes on petroleum products to rise by 1.5 cents/litre privatisations to continue with Petro-Canada & Canadian National Railways & the air navigation system $560 mn. annual subsidy under Western Grain Transportation Act (Crow rate) eliminated federal civil service to reduce 45,000 positions or 14% of workforce provincial transfer payments reduced by $2.5 bn. in 1996-97 & by $4.5 bn. in 1997-98 Corporate taxes rise by $1.0 billion over 2 years special tax on banks set at $100 million general business subsidies to be reduced by 60% over 3 years foreign aid spending to be reduced by 21% over 3 years defense budget cut by 14.2% by 1997 deferment against capital gains tax eliminated after January 1, 1999 & treated as realised & subject to tax
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Second Quarter: June 6, 1995

$ business activity declines by 0.1% in February 1995 $ export growth shows early signs of weakness $ Province of Ontario regional elections called for June 8, 1995 $ equity markets over-inflated due to surplus pool of capital $ Province of Ontario becomes largest non-sovereign borrower in international capital markets $ real estate sales collapse by 45% in most major urban markets from 1994 values $ stock markets continue to be severely over-valued $ upcoming recession in US to transmit to Canadian markets $ dollar recovery as uncertainty over Quebec separatism begins to fade $ manufacturing sector in continuous depression as output falls by 0.3% in February 1995
Canada is awash with investment capital that cannot seem to find a proper home. As large players increasingly pull out of the stock market, small mutual fund investors continually pick up the shares at grossly over-inflated prices. In addition, numerous investment funds are scouring the Canadian landscape to finance viable investment projects, but little up to now has surfaced, causing large scale channeling of capital into paper assets in the stock and bond markets. The evidence is everywhere, as Provincial government bond premiums have narrowed considerably. A symptom of capital that is restricted to the geographical confines of what investors term as Canadian investment. In short, indebted Provinces benefit from this captive capital.
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The fact that such a surplus of cash hangs over paper assets usually traded in very thin markets, is an unfortunate consequence of a chronic long-term disease affecting Canada. As innovation and a manufacturing base was allowed to slip deliberately over the past decade, and as property development has come to a resounding halt, perhaps never to recover again, a very serious situation confronts the policy makers of the day. How can policy effectively re-channel resources into viable projects that are not in the traditional property development, resource extraction and automotive parts manufacturing industries? Up to this moment, the good performance of the automotive parts and assembly industries has saved Canada. Admittedly, it has been generated solely on pent-up demand conditions, the most basic way that an economy can progress, but nonetheless, is the only thing that is happening at this point in time business-wise. The unfortunate situation that presently exists, where too much money is continuously chasing too few ideas, is a deep-rooted problem of the Canadian business and cultural establishments, which are most important issues that require a great deal of thought, and which are central to the current imbalance experienced in Canadian financial markets. Most major business activity remains depressed. As manufacturing continues to slide and as early signs of an impending downturn become visible in the automotive sector, real estate equity values edge on the negative. The slide in residential property values over the last four years, and with the current drop of some 50 percent over the spring-time sales in 1994, have instilled a feeling of general panic. As personal equity positions of individuals continue to erode with every fall in housing values, retail activity is directly affected, further depressing business conditions. As recession once again grips Canadas major market; the US, it will not be long until reduced business activity from the US will be directly transmitted to Canada. This, when the pent-up activity up to now has fallen far short of most peoples expectations of what a normal level of recovery ought to be. Certainly, by having experienced inactive policy over the past four year period, unemployment and business conditions have both suffered. Unfortunately, the upcoming recession will tend to harm the presently devalued asset positions of Canadians even more. When the recession arrives, the lower level of business activity will reveal severely devalued real-estate assets, and what is more dangerous, pressure on the security held by the banking system. The immediate danger of banks lending money on only property, and not on good ideas that may generate cash-flow is fully indicative of the conservative financial institutions that currently operate in Canada. Not only have the
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underwriting policies of these banks held back creativity and innovation, but lending practices that take assets as security such as property, are in the current deflationary climate left exposed. For instance, a default on a loan that is backed by greatly devalued property, will cause the financial institution to withhold the asset from the depressed marketplace, as is currently happening. In turn, there develops a severe mismatch between what depositors are owed, and what liquidity the financial institution may salvage from the depressed property asset held as security. The ultimate result is an erosion of the capital base, leading to further practices of conservative lending to compensate for the initial default. A situation all too familiar, but one that stifles the development of badly-needed innovation in Canada. The Provincial election in Ontario (largest Province) is expected to reign in a new political party, one that will be alot friendlier to business than the current New Democratic Party has proved to be over the past four years. This should put an end to the re-patriation of foreign investment capital, and add value to the dollar immediately. Over the past four years, Provincial borrowing patterns have contributed to Canadas position as a debtor country. It has become a very well known fact that the Province of Ontario has become a valued customer in the Euromarkets. This transformation has been a common experience, with countries such as the US and UK, and is the underlying long-term cause of dollar weakness. The question at this point in time, is whether or not this can be reversed? In an era where the importance of raw materials and the extraction industries has been steadily eroded in significance, it will be most difficult for a country to sustain good business based only on the automotive sector. Something must be developed in order to supplement the importance of the automotive parts and assembly factories. Although there has been initial signs of a push towards the new economy industries, such as various forms of computer electronics, assembly and communications industries, the jury is still out on whether these can be categorised as good business. Or if the other members of the G-7 industrialised economies, also consider the new electronics industries as something that is desired? Three months after the presentation of Paul Martin Jr.s austere budget, the prospect of recession transmitted from the US, may cause the level of austerity in the Canadian economy to be unbearable throughout the downturn. Whether it causes any back-tracking remains to be seen. The positive political fall-out that the election in Ontario is expected to bring, will however, be offset to a great degree by the impending downturn. This
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will have even greater negative effects, should it be pre-dated by some form of financial crisis and fall-out in the equity and bond markets. The signals are in place for the stock markets to experience a correction. The current conventional wisdom, used to justify the stability of most stock market indices is one that argues in favour of the soft-landing hypothesis. Under this scenario, also believed to be presently applicable to the US economy, equity markets justifiably increase, or hold on to existing value. The argument that a soft-landing will encourage independent central banks not to raise interest rates, will in turn maintain stocks and bond values within the current trading range, and not produce a flight of capital to moneymarket instruments. It may be true that interest rates will not cause a flight out of stocks and bonds, but what may do more damage is the further erosion of profitability in the industrial sector. Pent-up demand can only go so far in adding value to stocks. Since longer term capital flows have had direct effects on currency values most recently among the industrialised countries, the upcoming dollar value will be primarily determined from two offsetting effects. The defeat of the Socialists in one of the most economically important Provinces in CanadaOntario, should reverse the flows of foreign profits. This will be countered by the recessionary fall-out, which will inevitably lead to a much-reduced official bank rate over the short-term. Which effect will dominate? Under present circumstances, an exchange rate that exceeds 0.78 cents US to one Canadian dollar, deems Canadian industry uncompetitive in US export markets. Likewise, the longer-term trend of Canada becoming a debtor nation mitigates any permanent rise in the dollar over the medium-term. As the results of the Ontario election are reported, investors can come to expect the Canadian dollar strengthening vis--vis the US dollar only marginally. With the current trading range of 0.72 to 0.74 cents US for one Canadian dollar, the positive political fall-out may push the currency up to a range of 0.74 to 0.76. Should the recession be of a greater intensity, and of a greater duration than what is experienced in the US, the Canadian dollar will dip back to a trading range of 0.69 to 0.72 cents US. After all is said, a level near 0.78 cents US will be difficult to sustain.
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Provincial Debt Positions

British Columbia Saskatchewan Manitoba Newfoundland Prince Edward Island New Brunswick Provinces With Large Imbalances Ontario Qubec Capital Flows
Provinces Tabling Balanced Budgets For 1996
Suppliers
Japan Switzerland Taiwan Netherlands Germany Hong Kong Belgium China Other
(%)
53 8 6 6 5 5 4 2 11
Users
US UK Canada Mexico Saudi Arabia Spain Italy Australia Other
(%)
27 9 8 6 6 5 5 5 30
Source: IMF, FT
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$ Ontario Conservative leader Michael Harris tables far-reaching spending cutbacks $ austerity measures introduced across most Canadian provinces save Qubec $ spending reductions in Ontario to be matched by a 30 percent reduction in provincial income tax rates $ stronger dollar presents opportunity to Bank of Canada to lower short term rates $ automotive retail sales slide into recession while production maintains pace $ Bank of Canada draws down gold reserves in favour of the US dollar $ reductions in government transfers in Ontario shifts burden on business to create employment $ housing sales continue to stagnate at levels not seen for over a decade $ GDP falls by 2% in second quarter of 1995 $ sentiment over dollar reverts back to the spread offered over comparable risk-weighted US securities
Under a climate of over-valued stock markets, excess supplies of credit and negative economic growth, newly-elected Ontario Premier Michael Harris tabled a back to basics economic statement after only four weeks in office. The shift towards a more investor-friendly climate in Canadas largest province should set a trendline for the entire country over the remainder of the decade. Specifically, the Ontario Conservatives have reduced program spending by some $1.9 billion initially, with some $6.0 billion still expected to be cut from business activity in a planned mini-budget that will be detailed in October of 1995. With some 500,000 inhabitants relying on some form of welfare transfer payment from the
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provincial government, out of a total population of some 7.5 million in Ontario, the announced reduction of 21.6 percent will spin-off and reduce the general level of business activity in the provincial economy. However, as equally as troubling as the reductions in social expenditures, is the effect on small and medium sized businesses that reductions in various capital spending programs on rapid transit, road and infrastructure spending, will all have on the overall economy, despite the promise of a 30 percent reduction in personal income tax rates later in the year. In addition, some $71 million in business grants and guarantees will hit the very vulnerable sectors of the economy that have been historically marginally profitable. Altogether a very dangerous set of aggregate circumstances for Ontario-based businesses. The question at this point in time, is whether the loss of purchasing power generated by the budget and on-going recession, will be offset to any great extent by the presumably favourable investment climate created by the Harris budget? It has been argued that the costly social infrastructure in Ontario, has caused many businesses that traditionally re-invested their profits to re-patriate the surplus earned, back to their parent companies that were resident in another country. This was a common pattern during the tenure of the previous socialist government of Bob Rae. However, a precondition for a return to business investment in Ontario, must be the existence of a robust domestic economy that shows high potential for expansion and sustained levels of good business activity. Certainly, any move to withdraw purchasing power through restricting spending, will bring into doubt the possibility for profitable investment opportunity. Not only has the current philosophy over the role of government began to grip most Canadian levels of government, it has most vigorously been advocated by the right-wing revolution in the United States led by Congressional Representative Newt Gingrich. Although it is far too early to judge what effects on purchasing power and business conditions budgetary cutbacks can be directly accountable for, the contrast between the US and Canada may end out to be the most worrying aspect. In the case of the US, government has never fully taken on a role as the main generator of business activity. However, the Ontario economy has historically had far greater inclination to rely on centralised purchasing power. Although from an accounting perspective, deficits may be bad and immoral, they nonetheless, provide a good deal of spin-off income that helps sustain the small and medium sized business sector. Consequently, a move to import the current revolution in government from the US, may see a large divergence in the growth of business activity between the two countries. All depends on how quick Ontario-based business sectors respond to the incentive-based programs that the Harris government is offering.
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The real-estate market still has not bottomed out, while the automotive sector at the retail level is beginning to show visible signs of weakness. With two of the most vital sectors to the Ontario economy showing signs of stagnation, the oversupply of credit is continuously being channeled into the stock markets. With a good deal of pension and institutional money withdrawing from equities, the support levels have recently been sustained on the backs of small retail investors, entering at the tail end of the bull market. The timing of further increases in stock prices will all depend on the speed at which the promised reductions in income taxes will become legislation. Consumer spending will benefit business conditions, should the promised 30 percent reduction in income taxes become law. At the front end of the beneficiaries of the tax cuts, will be luxury imports ranging from automobiles to jewellery and vacations. It is hoped that such a tax cut will revive the terminally depressed high-end retail sector, since many well-named boutiques still breach the thin line of bankruptcy by the hour. Should a general reduction in tax rates only affect one small segment of the population, it will not add much to overall consumer confidence, thereby resulting in a harmful reduction in the trade surplus adding downward pressure on the dollar. Regardless of the offsetting effects in the upcoming policy debates, one thing that will clearly be evident, is the harmful effects that the new policies in Ontario will have on low income earners. It is vital that the newly-elected government not alienate the lower income segment of the population. Only well-rounded tax-incentive based measures will ensure a level playing field, and only until this is achieved can the Harris government claim any degree of success. However, as of this moment, knowing only the negative impact of spending cuts, consumer spending is bound to get worse. Already burdened by the great loss of wealth caused by the bursting of the 1980s property bubble, a situation not unique only to Canada; any correction in the grossly over-valued stock markets will ensure that a continuous relapse at the retail level will persist over the next quarter. Although business investment flows into the province are front and centre to the current cutbacks, they will also depend on the improving state of domestic business conditions. Deregulation without adequate demand for the goods and services produced, will not provide for the full effects that the policy originally intended. In that case, a repeal of restrictive social legislation can only result in positive investment effects over a longer period of time. For the next quarter, both consumer and business spending will continue to be depressed, while the export markets will continue to act as safety-valves in generating the badly needed purchasing power in the Canadian economy. In many respects, the coming year should provide yet another opportunity to test how well a derivative of the Reagan inspired supply-side economics can
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work. On a comparative basis, the original Reaganomics of the 1980s consisted of two elements: a reduction in taxes and the unprecedented spending on militaryindustrial projects. The latter of which is excluded from the Harris budget and more or less a function of a completely different geo-political era. It does, nonetheless, present an ideal comparative framework. Should the tax cuts in the Harris budget, not result in a rejuvenation of purchasing power in Ontario and only benefit a selective few luxury importers, then spending increases as in the case of Reagans military build-up, will be considered as the more vital policy element by default. The way in which a depressed consumer sector responds to the Harris budget in Ontario, and the way in which business investment behaves both domestically and from foreign investors will be closely watched over the next several quarters. If it is the case that the business community does not take up the challenge presented, or if the tax cuts favour only a select few luxury importers, then a consensus will quickly build towards the importance of spending, that may once again create the all-important purchasing power needed to power business opportunities. A general respite from the turmoil in international currency markets benefitted the Canadian dollar. From a frenzy of pressures in the early part of 1995, the dollar firmed to a point where it was trading at 0.74 US cents. Despite the fact that the fundamentals were further weakening, the firmer dollar allowed the Bank of Canada to lower its short-term administered rates, feeding into the entire banking system. The wild-card on the horizon is still the referendum planned on Quebecs separation from Canada in September. Although highly unlikely at this point in time, it still may give investors an excuse to dump Canadian paper in the upcoming quarter. Although the presentation of the cost cutting measures in Ontario had no immediately noticeable effects in Canadian financial markets, any signs of further deterioration in purchasing power and domestic growth rates will put investors on alert. In general, since the business community generally applauded the initiative, the emergence of positive signs in private investment initiatives by industry, should place Canadian investment paper in a desirable position with foreign investors. Likewise, any recovery in consumer spending from the current depressed state that its in, will also support the Canadian currency at higher levels. Although no visible effects from the budget will result over the immediate quarter, it would not take much positive news to raise investor euphoria. For one, the continual easing in US short term rates, will ensure that the dollar will trade within the 0.73 to 0.76 US cents range.
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G7 Books 1995-96 Spending Reductions in Ontario

$millions Program Spending Cuts Operating: Capital: Ministry Spending Reductions Operating: Capital: Public Debt Interest Savings Total Spending Reductions 850 307 500 187 40 1,884
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$ Province of Qubec calls for referendum to be held on separation on October 30, 1995 $ budget austerity adopted by provinces leads to a recovery in foreign investor confidence $ Canadian chartered banks report record profits for the third quarter of 1995 $ consolidation continues to affect insurance sector as Manulife Financial & North American Life merge $ slight recovery detected in new homes market for second quarter $ paper industry plans $4 billion investment in new plant & equipment $ capacity utilisation falls in most sectors with the exception of paper manufacturers $ stock markets continue to rise on expectations of low inflation $ dollar recovers relative to most G-7 currencies $ US investors perceive Canada as not meeting her economic potential
All eyes have focused on the Qubec referendum campaign, its aftermath, and the likelihood that Qubeckers will be able to set a firm foundation for their destiny by voting yes or no to the following question: Do you agree that Quebec should become sovereign, after having made a formal offer to Canada for a new economic and political partnership, within the scope of the bill respecting the future of Qubec and of the agreement signed on June 12, 1995?. What bill respecting the future of Qubec? What agreement signed on June 12, 1995? From an international investors perspective, such a question could only be understood by the staunchest of Qubec separatists. Unfortunately,
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Canadian internal political affairs do not normally attract too much attention among international investors. Perhaps this time around they should. If the current referendum campaign is placed in a historical perspective, one may be able to argue that the separatist tendency of Qubec follows a cyclical pattern. When Rn Lvesque led the campaign in 1980, the argument in support of separation was based on the traditional historical resentment that Qubeckers had over English Canadas domination over cultural issues. Qubec did not separate in 1980, but the economic costs were very high, as most corporations shifted their headquarters to Toronto, in response to the political uncertainties created. The prosperity of the booming 1980s discouraged any moves to even consider separating from Canada. Swept up in a lengthy period of economic expansion, the concept of separation continued to be an abstract ideal that was best left to some future decade. The return of Jacques Parizeau and the Parti Qubecois, once again asserted a timetable for the ultimate vote. Although there has always been historical constitutional tension between the Federal government of Canada and Qubec, there may also exist an economic argument for provinces to become separate. For this, parallels between Canada and the program for a single currency that is currently on the receiving end of large doses of political capital among the European community, provide for informative case studies. Viewed in relative terms, the European Union is an economic area that attempts to tie numerous culturally diverse countries economically. The Treaty of Rome in 1957 established a framework that would create similar conditions for the conduct of business over a grouping of culturally diverse countries. At that point in time, political leaders and the electorate of France, Germany, Italy, Belgium, Luxembourg and the Netherlands viewed some form of co-ordination in economic and commercial policies essential for stability and prosperity. The future addition of the UK, Spain, Portugal, Ireland, Denmark and most recently, Austria, Sweden and Finland, also represented culturally-diverse states that deemed it beneficial for one reason or another to join the EU. The benefits of sharing a common external tariff, standardisation in cross-border commerce, a common agricultural policy and a central mechanism to monitor monopolistic takeovers and mergers, were all functions that could best benefit a close economic area through some type of central control mechanism. The degree to which member states consider being part of the EU essential, will vary according to the policy in question. In the opinion of many diverse
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European politicians, the current program that will take the economic area under a single currency will not be effective over the longer term. Aside from the usual cries over the loss of sovereignty in countries such as the UK and Denmark, the economic reasons are even more compelling. A currency can at times be viewed as a substitute to fiscal policy. Deliberate devaluations act to stimulate the export sector and to import goods at higher prices, adding to domestic inflation. Moreover, such a policy can only be effective under certain conditions, one being that a countrys economy is sufficiently large and that any attempts at devaluation be co-ordinated among major trading partners. In addition, it is also true that surprise devaluations work the best in stimulating the domestic sector. Devaluations also tend to work well under deflationary situations where business conditions tend to be depressed for a very lengthy period of time. Both Italy and the UK have benefitted their respective industrial sectors by being dumped out of the fixed exchange rate mechanism in 1992. Likewise, Canada is a very large economic space composed of twelve diverse provinces. As with the European Union, all provinces have benefitted from co-ordinating various expenditures in a central government. They have also all been a part of an enduring currency union tied under a single money called the dollar. Under such a regime, vast differences in regional economic and industrial development existed among the provinces. This has been exacerbated in the slow growth and unstable 1990s. By tying 15 European countries under one currency, the same problem will surface in Europe, as it has in Canada. States like Spain, Portugal, southern Italy and the UK are recipients of regional development transfers, which will only escalate under a single currency. The European Union in its experiment of a single currency need look no further than at the Canadian situation for guidance. Under a period of slow growth, regional development transfers have dried up, causing vast standard of living differences among provinces. Although very difficult, Qubecs introduction of its own currency would create stimulus within the province, provided no hostility and bad feelings would arise from the rest of the country. Ironically, Jacques Parizeau and the Parti Qubecois have rejected the benefits accruing from their own currency, but have reiterated their preference for the continued use of the Canadian dollar. A stance that may lead the marginal separatist, or the separatist that looks forward to an independent Qubec for economic reasons to reject separation. Clearly, time has come to re-examine the argument that favours an independent province of Qubec. On economic grounds, at least, the Parizeau plan comes up far short of what is required to stim-
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ulate the prolonged recession. Fortunately for Canada, it may be too late for the Parizeau government to realise that the majority of Qubeckers intend to vote on a sound economic agenda. Central to which is the introduction of their own currency. Political jitters before and after the vote in Qubec will cap the progress of the dollar. US investors have voiced their impatience over yet another political upheaval in Canada. Although only the impulsive will shift short term funds out of Canadian dollar denominated financial products, the attempted separation in Qubec is not expected to be successful. Already, investors are taking the referendum vote as a foregone conclusion, judging by the risk premia on offer in the bond markets. The dollar will continue to hold its ground within the 0.72 to 0.77 US cents range over the next quarter. Despite the vote in Qubec, the dollar is continuing to attract positive sentiments in the markets, with recent austerity programs adopted by various provincial governments that will reduce large debt levels. However, despite such efforts, the dollar is a recipient of positive natural sentiments emanating from investors that view it as the best alternative, next to growing instability in Japan and various parts of Europe.
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Fourth Quarter: November 25, 1995

$ Qubec referendum results show narrow Federalist victory $ leader of separatist Parti Qubecois Jacques Parizeau tenders resignation $ leader of separatist campaign Lucien Bouchard favoured to assume role of Qubec premier $ dollar trades within narrow range as Qubec government intervenes to support a floor $ Prime-Minister Jean Chrtien attacked for pursuing an indifferent campaign in favour of unity $ investors fear shift in political agenda away from real economic & competitiveness issues $ decision in favour of unity prompts surge in dollar & fall in official discount rate shortly after referendum $ Progressive Conservative leader Jean Charest emerges as spokesman for the Federalists $ economic conditions deteriorate as raw material prices weaken on world markets $ early evidence of slowdown in retail sales as consumer debt reaches record levels
Despite the victory for the Federal side in the Qubec referendum on sovereignty, entrepreneurs have been leading an exodus out of the country. Their choice to leave behind an increasingly fragmented and regionalised country, is made more on the basis of what the government is choosing to retreat from on the spending side, rather than on any resurgence of political uncertainty. True, the Canadian political architecture is more deeply in doubt now than in any time since confederation. However, what is preoccupying the minds of most members in the business community is the negative impact that cutbacks in spending have produced in Ontario. Premier Mike Harris strict insistence on balancing the
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budget and retreating from the economy on many fronts, was in the classical sense, supposed to have incited a stampede of new investment dollars, paired off with as many projects to finance. It has instead produced the opposite, with business people supported for the most part by government money (for which there are numerous such persons in Canada) turned away in droves from the harsh realities of free markets. The double effect of first the political doubts surfacing from the Qubec referendum, coupled by the revelation of the true colours of those in the business community now fleeing, have combined to depress overall economic conditions for the immediate fiscal quarter, if not well into the early quarters of 1996. Evidence of the great investment retreat comes from sectors that have been the traditional beneficiaries of government contracts. The construction sector in particular, and any other industrial or service sector that has grown through the traditional procurement process, is preparing to mothball existing operations and shift its remaining cash-flow out of the country. Unfortunately, the depressing impact on regional Ontario and Qubec business conditions will further deepen the economic distress caused by technological re-structuring. The fact of the matter is that the glorious decades of economic growth in Canada, and Canadian economic development in general, has always had a large level of participation from all levels of government. To succeed under a regime of freer markets, is asking too much from those traditionally dependent on the procurement process, hence the short term exodus. The new climate of minimalist government involvement in business and economic affairs is consistent with the broader trend in most industrialised countries. Whether or not a country such as Canada can go it alone, and sever its links to the global trend of seeking out ever more greater efficiencies, and relying ever more on a self-regulating market, is one where national government control is directly proportional to the increasing technological changes that have occurred since the beginning of the decade. The irony of the modern age from a Canadian perspective, has been that a political balkanization is now taking shape. Instead of reaching out, and becoming more outward-looking, Canadian society remains very insular. Instead of following the global trend towards free-trade, and replacing an outdated group of business, government and social leaders, old ideas fight to survive. Evidence from the immediate aftermath of the Qubec referendum shows that separation will continue to resurface at a far quicker and regular pace, than what is assumed by the existing political leadership. Just as the old procurement-dependent practitioners in the business community have decided to withdraw, those wielding stale political solutions in the post-1995 referendum era are down to their last chips.
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The performance of Jean Chrtien, as the leader of the Federalists in the 1995 referendum, has come under severe attack. After sustaining a comfortable margin of 59 to 41 percent in favour of the Federalists throughout the early months of summer past, when the referendum was still deemed to be a non-issue, it quickly became a crisis after the entry of Bloc Qubecois leader Lucien Bouchard. What seemed as an insurmountable lead for the Federalists, ended up as a 50.6 to 49.4 percent margin. After the quick resignation of Parti Qubecois leader Jacques Parizeau, there is a very good chance that Lucien Bouchard will resign as leader of the Federalist Bloc Qubecois separatists, to take over the leadership of the provincial Parti Qubecois. Such a development would only lead to further instability, as the prospect for another referendum on separation could become linked to a renewed mandate for the Parti Qubecois under the leadership of Bouchard. In all, a very unattractive prospect to committed free-market business people, and to the longer term committed investment capital in the Canadian economy. As matters presently stand, a scenario that would likely occur, should Bouchard assume the leadership of the Parti Qubecois, would result in a referendum linked to a provincial election victory. The mere prospect of such a coupling would solicit howls of protest from the Federal establishment, and would certainly cause long term committed investors to question their roles in the Canadian economy in a serious manner. The remainder of the decade is likely to rattle the remnants of the traditional Canadian political architecture, which will ensure that a climate of uncertainty prevails well into the early years of the twenty-first century. In the immediate cyclical economy, business conditions point to an ending in the growth experienced from the revival of pent-up demand in 1994. The fall in commodity prices that has engulfed the manufacturing sectors in the second quarter, is now very visible. Steel, and most importantly, paper prices have reached their elixir, only to initiate a lengthy period of price reductions that will likely begin to affect margins very early in the cycle. It is safe to say, that for the most part, the manufacturing boom of 1994 is now coming to an end. With the likely negative impact on investment plans affecting the rate of unemployment. This, despite the fact that Canadian financial institutions are currently awash with investment capital, left to be recycled once again in the steeply over-valued Canadian stock markets. Personal finances are deteriorating even further, as negative equity has become a familiar phenomenon, just as it is in France and the UK. Housing prices have reached depression status, with no real prospects of a turnaround in sight. In addition, debt repayments are showing signs of liquidity strain, as the familiar net 30 day term, is now more commonly associated with a term of 60 to 90 days for repayment, if at all.
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The problems that are being witnessed on the personal financial side, can only call into question the quality of the assets of most Canadian banks and financial institutions. Given that the five chartered banks have virtually retreated into being primarily domestic savings and mortgage banks, the underlying quality of secured residential properties for which most mortgages are based on, must come into question. It is no secret that the global ranking of Canadian banks in terms of asset volume has dropped by 50 percent. For a variety of reasons, Canadian financial institutions have chosen to slowly retreat from the active lending market, save residential mortgages. A category for which they are bound to pay very dearly in the coming years. Before any form of banking panic ensues, we must remember that fee-driven activity is coming to play a very important role in Canadian banking. Despite the fact that lending has become an activity in decline, fee-driven services will serve to offset any problems that may arise from the continuing property shake-out. However, coupled with the overhang of political uncertainty, investors would be advised to pay more attention than usual to developments in banking. With the US government on the verge of defaulting on its interest payments, and with a general climate of a slow-down in growth, the traditional Canadian export markets south of the border will contract well into 1996. Add the presidential election campaign, and a rise in trade friction is bound to surface. This may become a very hot issue, even among traditional business partners, should the Mexican peso come under continuous pressure. Afall-out over the rhetoric connected to the North American Free Trade Agreement (Nafta) in the context of a growing trade deficit with Mexico, as cheap imports pour into the US, will generate some fall-out with their trade relationship with Canada. In all, conditions in the traditional US export market will act to further depress domestic business conditions. At the height of referendum jitters, the Canadian dollar maintained its value within a narrow range of 0.725 to 0.74 US cents, despite massive intervention by Qubecs powerful pension fund, to offset some of the short-term outflows. Evidence of a 0.65 cent dollar surfaced in US border towns, as panic-stricken Canadian citizens moved to convert their savings into US funds. The narrow victory, however, eliminated the risk premium and the immediate panic from the referendum. On fundamental grounds, the dollar should not move too far above the 0.75 cent level. However, should problems surface in Europe over the single currency project (always a risk), or should more political fall-out afflict the US budget, then a level above 0.75 cents is likely.
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First Quarter: January, 1996

$ OECD warns over heavy debt burden and suggests that large public sector debts prevented gains from low inflation $ economic activity heavily dependent on investment in export-intensive sectors $ substantial gap still exists between actual and potential production output $ federal Finance Minister Paul Martin Jr. proposes further budget cuts prior to 1996 budget address $ Lucien Bouchard becomes premier of Quebec while investors expect early provincial elections $ Ontario Premier Michael Harris plan to reduce spending raises prospects of widespread user fee charges $ Federal government system of transfer payments in doubt as reallocation of Ontario budget likely $ retailers face prospect of 1995 being the worst Christmas season in a non-recession year $ large domestic Canadian banks report record profit performances based on retail service charges $ venture capital industry under attack for investing mostly in safe and secure treasury bills
Business Outlook The year 1995 ended in an anticlimax, as one of the most important periods for retail sales fell flat. Leading up to what has become termed as "the worst Christmas in a non-recession year" were record high personal debts, the Qu6bec referendum on sovereignty and evidence throughout 1995 that went against the official views that "recovery had taken hold."
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If one was forced to proclaim that something positive occurred in the Canadian economy in 1995, it must have been the record breaking run that the Toronto Stock Exchange registered. On the real side of the productive economy, it was the continuing search by talented new technological small and medium sized companies worldwide, for interested buyers that would match their enthusiasm for their products. Consequently, most business investment was made in those sectors that were mainly oriented towards the export markets. On the surface, the events above may be deemed as being positive newsworthy items, however, in actuality, they are mirror reflections of the depressed state of domestic business activity. In the case of record breaking stock exchange indices worldwide. Financial research has commonly established the view that what happens on the Dow in New York, will also happen in Luxembourg, Brussels, Paris, Prague, Zagreb and Toronto. An initial impetus that the New York Stock Exchange is able to deliver to world markets, indicates the high level of correlation that exists in global financial markets. As such, stock markets even more remotely mirror any real economic fundamentals within individual countries themselves, than they have on any occasions in the recent past. Just because the Toronto Stock Exchange is continually pointing to record high activity, does not at all mean that things are going well within industry, and especially in the small and medium sized business sectors. What is more, the record breaking market in Toronto has captured the peculiar behaviour of the Canadian banking system, which has just been able to register record levels of earnings, by behaving most unlike the way in which bankers ought to behave. In Canada, lending activity is virtually absent in the sectors that generate most of the dynamic growth- the small and medium sized companies and recent start-ups that have been around for a period of less than two years. Instead, credit decisions are usually made on the basis of the size of the recipient. Most Canadian bankers are domestic in orientation, with a large propensity to take as little risk as possible. Very often, large amounts of money are allocated to companies that really do not need the financing, and have committed themselves to raising funds through such things as commercial paper and stock issues. The dynamic of the Canadian banking system is a very interesting one, if followed in its entirety to its final conclusion. Credit decisions that are made on the basis of size, compete with a flood of capital that is readily available, but only to a select grouping of multinational organisations and governments. Herein lies what is termed as the "Canadian Growth Trap", as the process of credit intermediation bypasses the small and medium sized sector, or those companies that have the highest propensity to create growth and deliver employment opportunities.
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The intermediation process that has become most identifiable with the large domestic banks in Canada, runs along the following lines. A government raises money by issuing savings bonds or treasury bills. Spending occurs to finance the public service and outlays are advanced to various public institutions such as universities, hospitals and entitlement programs such as pensions and welfare. By their very nature, public sector workers are risk-averse, and the money transfers that are not spent on the necessities of every day life, are commonly placed in savings deposits with the banking system. In turn, the Canadian banking system re-shuffles deposits to those very same institutional organisations that have raised money at the outset: hydro utilities, public corporations and the various levels of govemment themself. This circular process continues to spiral around, while some money is channeled to small and medium sized companies that service only those necessities of everyday life, invariably such things as grocery shops, laundromats and garages. Recently, it was revealed that the last hope for the financing of innovative small and medium sized export companies, was also caught up in this "Canadian Growth Trap." Instead of having the massive capital of the labour-sponsored funds go into dynamic job producing companies, it was revealed that they were all caught up in the game for searching for the "big deal." In essence, the labour- sponsored venture capital funds were trying to play the role that the domestic Canadian bankers currently perform. More specifically, it is becoming a well-known fact that 75 percent of these labour- sponsored venture capital funds, that were supposed to have been reserved for growing the dynamic small company sector, have instead been invested in such things as treasury bills and even risk-free stocks. In essence, the intermediation spiral has enticed the very organisations that were supposed to have been created to assist the small and medium sector, not able to be active participants in the spiral of capital themselves. Although very profitable at this moment, the entire banking system in Canada has become a burden in achieving the required level of business activity and income growth. In a period of government spending cutbacks, this must change. It is now more vital than ever, that capital be channeled to dynamic growth industries. Companies that have endured over a period of fifteen to eighteen months of operation, but have primarily cash-flow and receivables to offer as assets, must become "financeable" entities by the Canadian banking sector, if there is any hope at all for better business and employment conditions in Canada. With the retreat of the public sector, the private sector must have the means by which it can assume the role of the previous public entities.
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In 1996, the cutbacks announced by the Ontario provincial government of Michael Harris are expected to filter through the economy. What is more, the spending cuts announced in the economic statement of November 1995, are expected to be followed up by even more cuts in the upcoming budget. In all, a general retreat in the public sectors of Canada will that were supposed to have been reserved ensure a completely different composition for growing the dynamic small company of the economy. The withdrawal of spending such a great extent may further erode the ability of the Federal government to manage regional disparity througout the country. As an overall reduction of transfer payments from the most prosperous province of Ontario, will agitate further divisions in national unity. Not only will Qu6bec deliver yet another round of voting for separation, but remote provinces such as Newfoundland and Saskatchewan, will become increasingly regionalised and unable to relate to the central powers which bind the entire country together. Evidence is everywhere, that the effectiveness of the Federal government is continuously being eroded. Severe structural changes in the Canadian economy, will serve to depress any hopes that consumer spending will lead a durable recovery. The danger is that the recent display of restraint during the Christmas shopping period, may continue well into 1996. Continuous cutbacks in the public service, will ensure that some 3.0 million residents of Ontario will continually lack confidence to commit to the purchase of big ticket items. Moreover, a retail sector shake-out, the second time in five years, is expected to impact retail distribution throughout Canada. Small retailers will find it increasingly difficult to continue to trade, while large discount stores from the United States will continue to expand their presence within the Canadian market. Currency Forecast The seriousness under which all levels of government have displayed will to balance budgets, will have a positive effect on the dollar. Investors will take note that Canada is a willing participant within the G-7 group of industrialised countries, that has made a commitment to leading the general trend towards less public involvement in its economy. An orderly reduction in the public sector in Canada, countered by turmoil in France and Germany, will further benefit the dollar.
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Second Quarter: April, 1996

Ontario plans to cut back civil service erupts in labour action record number of bankruptcies recorded in January 1996 residential property prices continue to slide as bankoffered mortgages fall to historic lows 1996 federal budget delivers spending cuts and no additional tax increases defense sector scaled down even further as budget cut back by $600 million incentives for labour-sponsored venture capital corporations reduced federal budget to be balanced by 2000 at the current pace of program cutbacks mergers & acquisitions activity in 1996 is expected to surpass the levels of 1995 a dormant mortgage market and a surplus of capital prompts Canadian banks to reconsider leveraged buyouts slowdown in US market encourages Canadian companies to search for alternative markets
Business Outlook Business sentiment has experienced a reversal of fortune as a record number of bankruptcies were registered in January of the new year. The deflationary environment in most regions, encouraged through spending cutbacks in Ontario and most western provinces, together with the federal government's goal of balancing the budget by the year 2000, all create a dangerously unstable environment.
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Behind the broader trend towards depression, are subtle signs of unrest and uncertainty. The environment on most Canadian university campuses is one of high anxiety. With very few employment opportunities in the private sector, public cutbacks have caused a virtual collapse in the traditional professions. Teaching positions in both universities and secondary schools, along with candidates trained for medical practice and legal work are all finding the current period extremely difficult. Moreover, the technological revolution continues to place the Canadian work environment on the vanguard of change among most of the G-7 countries. A hallmark of the changing environment is the effect that the computer has had on the Toronto Stock Exchange. Recently, stock equity traders have been made redundant on the floor, while those trading futures and options await similar destinies over the next year or two. The pace of technological change has been so revolutionary, that only service-sector employment opportunities are what remain. Such uncertainties have created a great deal of anxiety and displacement, and have resulted in chronically depressed levels of consumer confidence. This has in turn depressed the housing market so much, that one can conceivably purchase a home through a common credit card. A tight fiscal stance by both the federal and provincial governments, has to some extent been countered by historically low interest rates on mortgages and loans charged to the best corporate customers. Recently, federal Finance Minister Paul Martin Jr. presented a document that will lead to a balanced budget by the year 2000. Specifically, he committed his Liberal government to reducing the fiscal deficit to $24.3 billion or 3 percent of GDP by 1996-97, from its current $32.7 billion. Moreover, he went on to present a plan to continue with the progress and hold the deficit to $17 billion or 2 percent of GDP by 1997-98. It is interesting to note that while the Democrats and Republicans in the US have been arguing over balancing the budget within either 7 or 10 years, Canada may achieve the goal in a matter of 4 or 5 years. Despite the presentation of such a scenario, the dollar did not show any reaction as of yet. While the business environment continues to undergo very revolutionary changes, the T o r o n t o S t o c k Exchange (TSE), has continued to set new records in step with the Dow Jones Industrial Average.
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A brief summary of the status of the Canadian financial system continues to reveal a large surplus of investment funds. On top of this large surplus of funds, is a drying up of mortgage demand for house ownership in the consumer sector, along with subdued interest in borrowing for consumption purposes. The purchase of a new automobile, or some household item also rank very low down the list. The break-out of a computer price-war in the personal computer market among most of the major brand names, is signalling a temporary saturation point for the sales of computer and high tech products in the consumer marketplace. All of these trends underscore the low demand for capital financing in a low growth environment. Financing of the small business sector with turnover of $500,000 is almost non-existent in Canada. The traditional banking system is not showing any interest in this sector since the time and money that it takes to consummate a deal with a small player, a far higher rate of return can be achieved by doing a very large deal. The problem is that there just are not that many large deals in the Canadian market. Consequently, a situation exists where far too many financial institutions -domestic and foreign are going after the same deals, and crowding into an already overcrowded market. The combination of low rates of return for savers and a lack of willingness to intermediate in the small companies sector, has led to the record run-up in the Toronto Stock Exchange index. As with the Dow Jones, The Toronto Stock Exchange has been the recipient of capital flows driven by the concerns that it is the "only game in town" at the moment. Meaning that only the stock market can deliver the returns far and above what are being offered from the intermediation process in the real economy, via the mortgage or small business loans markets. Privatisations Several foreign merchant banking presences have been established recently to advise all levels of government on selling off public assets. The Ontario government of Michael Harris is expected to decide on the privatisations of the state-controlled liquor control board (LCBO), Ontario Hydro and several other smaller functions that could be assumed by the private sector. Likewise, Qu6bec Premier Lucien Bouchard will most likely move to reduce the provincial deficit by privatising several state-controlled assets, should the domestic political climate be right.
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Mergers & Acquisitions Acquisitions activity in 1996 is expected to break the levels seen in 1995, and move closer to those in 1994, according to managing editor of Mergers & Acquisitions in Canada, Mr. Paul O'Brien. Accompanying this accelerated activity, will be Canadian banks' willingness to once again engage themselves actively in the leveraged buyouts market (LBO). As an additional outlet for the surplus capital that is available, the LBO has been available to several ver large deals in the Canadian mark e t p I a c e . Specifically, this form of financing was offered by the large Teachers' Pension Fund in two transactions recently. One of which was the emergence of a $2.7 billion bid by Belgian based Interbrew SA for Canadian brewing and entertainment group John Labatt Ltd. In contrast to the LBO situation in the US, LBOs are somewhat more limited in Canada. In Canada, financing must be in place before a bid is tendered, whereas the US only requires a communication through a press release. According to Mr. O'Brien, the LBO in the US is enjoying a resurgence, as LBO funds have been able to raise over $10 billion in 1994, with new funds recently launched by specialists Kohlberg Kravis Roberts & Co. and Goldman Sachs. What is less common in Canada, as opposed to the recent market for acquisitions in the US, has been the use of an all share transaction. The preference for a combination of share and cash offerings is consistent with the small Canadian marketplace, since a targets acceptance of the shares of the bidder are dependent upon the upside potential of the stock after the acquisition has taken place. This is only common when two companies decide to merge in a specialised industry sector, such that economies of scale are immediate. The growing use of cash in Canada may indicate that such tie-ups have been exhausted for the time being. The Canadian dollar has been steady after the passage of the 1996 budget and the Qu6bec referendum in 1995. Overall, the dollar is one of the better currencies among the members of the G-7 grouping of countries on fundamental grounds. The prospect of a balanced budget, should add even more value to the currency. Currency Forecast
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Second Quarter: April 28, 1996

$ consumer bankruptcies continue to increase as overall economy continues to depend on exports $ auto sales show slight recovery in first quarter of 1996 as production share continues to grow from transplants $ employment shows marginal increase in service industries & contraction in manufacturing & financial services $ Canadas net foreign debt declined as did the rate of increase in 1995 individual net worth $ corporate debt to equity ratios decline as the corporate sector becomes a net lender to the Canadian economy $ consumer debt rises even though a borrowing slump takes hold $ number of jobs in the financial sector continues to decline as technology introduces new innovation $ property prices continue downward trend despite short respite as mortgage quality issue resurfaces $ Qubec Premier Lucien Bouchard becomes determined to halt continued decline of the city of Montral $ selective group of Canadian based companies participate in acquisitions activity in both US and Europe
Now that the element of political risk has disappeared for the time being, Canada has continued to register a slow, but consistent improvement trend in business conditions in line with most members of the G-7 group of countries. The unspectacular, but steady level of growth in business conditions, is in fact, directly in contrast to the worsening conditions in France and Germany. In fact, it may also be accurate to admit to the fact that the Canadian recovery may be just as good as the prevailing business climate in the US, if not better.
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Although the automotive sector has been coasting on an unspectacular rate of growth for a consecutive eighth month, February has shown some early signs of the continuation of an upward trend. In fact, new vehicle sales have increased by 3.4 percent in February, offsetting somewhat the 4.5 percent decline registered in January. An interesting development in the automotive sector has been the increasing share of production attributed to Japanese transplants. The market share for vehicles manufactured at these plants has tripled since February of 1993. The slow growth climate in the domestic Canadian economy, no different from most other re-structuring industrialised countries, has shown an increasing merchandise trade surplus. Since the middle of 1993, the divergence solidly in favour of a surplus in merchandise trade has been clearly evident. In that respect, the Canadian situation is remarkably similar to the prevailing conditions among businesses and consumers in France. What is very clear, however, is the receptive response in which the Canadian export industry has taken up the challenge. Many instances are beginning to emerge of outward looking industries in Canada. Many of the export-oriented brand-name companies such as Magna International and transportation equipment manufacturer Bombardier, have been joined by lesser known medium sized industries with a keen interest in establishing operations in other markets. While on the subject of corporate export success stories, it is interesting to note the progress that the corporate sector as a whole has made in managing its debt structure. Overall, credit market debt which includes short term paper, loans and bonds issued, grew at a rate of 4.0 percent in 1995, compared with a 6.0 percent rate in 1994. Indicating an overall trend towards stronger balance sheets. In 1995, corporate internal sources of funds, mainly generated by corporate downsizing exceeded capital expenditures, implying that they became net lenders to the overall Canadian economy in 1995. In short, the corporate sector, with unprecedented amounts of credit available, is currently confronted by a climate of increasing liquidity. Consequently, the cash-rich corporate sector has increasingly little need to access bank-generated lines of credit, leading to the intermediation problem of the 1990s. Not only has the rigid Canadian banking system come to rely on acting as an investment manager under current conditions, but has left itself vulnerable to the criticisms of small and medium sized businesses, that highly desire more credit at more favourable lending rates.
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The unwillingness of Canadian chartered banks to lend to these producers of future wealth, has placed them in a very uncomfortable situation when it comes to investing their enormous deposit base. Recent indications point to the fact that they have a clear preference in acting as stock brokers and investment advisers, over being traditional bankers which provides for the foundation of future wealth. The problem in the intermediation process may become resolved to a certain extent. Recently, the push by some global banks in Canada such as Hong Kong Bank, NatWest Markets and Citibank, prompted the government to consider changing the bank act. Currently, the subsidiary status of these global banks operating in the Canadian environment, imposed restrictions on their activities to the amount of their Canadian capital base, as presented in their balance sheets in Canada. Any ruling that would allow these banking operations to allow the full backing of their parents capital base, would bring immediate pressures on the margins that have been traditionally generated by the Canadian chartered banks. Not only would the fierce competitive climate add pressures to the overall pricing scheme, but, it is hoped, that a far better process of intermediation would be available to the credit needs of Canadian businesses. Specifically, the credit needs of the neglected small and medium-sized enterprises, by which the future wealth of the country is generated. If not, then the financial assets available over the stock markets and bond markets, would become even more valuable by virtue of the fact that there will now be even more financial institutions chasing the too few investment outlets that have been on offer for so long. Somehow, financial innovation must come about.
Mergers & Acquisitions

Some of the more prominent international activity, occurred in the precious metals, consumer products and automotive parts sectors. In the gold mining sector, Placer Dome Inc. has entered into negotiations with US based Newmont Mining Corp. to explore the possibility of acquiring an interest in a development. At issue is the Indonesian based Batu Hijau gold property that is 80 percent controlled by Newmont. Recent activity in the world gold markets and steady consumer demand in some far eastern emerging markets, continues to generate interest in precious metals. Automotive parts producer Devtek Corp. has acquired UK based Automotive Components Dunstable Ltd. The $22.4 million purchase price will be financed through a combination of cash and a 1.3 million Devtek common stock
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exchange. The deal is an example of exceptional European opportunities for wellmanaged automotive parts producers in Canada. In a transaction that is still subject to regulatory approval, US based agricultural products producer Archer-Daniels Midland, through its Canadian subsidiary, plans to acquire Maple Leaf Mills Inc. from owners Maple Leaf Food Inc. and ConAgra Inc. Overall, it is expected that merger and acquisition trends will continue over the next quarter. This co-incides with an abundant supply of acquisition finance for larger deals, and attempts to take advantage of economies of scale in specific sectors. More and more, the well-managed firms with a good deal of financial backing will prefer to look for acquisitions outside of Canada, and may even conduct a strategy of export replacement. The push towards new markets will offset the exceedingly depressed conditions domestically.
Concentration
In an interesting study conducted by Statistics Canada, corporate ownership remains very concentrated, despite the passage of the North American Free Trade Agreement and a greater openness to capital flows and direct investment in the world. Canadian corporate concentration is still led by the Edper Group owned by Edward and Peter Bronfman. The top 24 enterprises in Canada encompass some 2,574 corporations. Of the corporations that are resident in Canada, some 80.8 percent are Canadian controlled, while 9.9 percent are US controlled and the UK and Japan control 2.0 and 1.0 percent, respectively. In a surprising revelation, the study noted that the government of France controls 59 corporations in Canada in the banking and aluminum sectors, ranking behind the governments of Canada and Qubec when government ownership is at issue.
Currency Forecast
The Canadian dollar has averaged 0.734 US cents over the last quarter. With a good deal of the political uncertainty in Qubec gone, the upward movement of the dollar has been limited by very weak fundamentals in the domestic economy. The only reason that the dollar has not challenged even lower levels is that most other industrialised countries in the group of seven, are showing even weaker fundamentals. Export growth will add upward pressure.
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Third Quarter: June 18, 1996

$ unemployment rises in manufacturing and construction industries $ passenger car sales reach lowest level in more than 25 years as consumers prefer minivans & sport vehicles $ big 3 auto sales climb as imported vehicle sales suffer $ house prices decline for the 22nd consecutive month as builders cite competitive market conditions $ raw materials price index falls by 1.5% in May 1996 as mineral fuels drop by 8.6 % $ export based industries suffer sluggishness in their markets $ manufacturing capacities fall to 82.7 % from a peak of 86.0 % reached in the first quarter of 1995 $ reduction in capacity utilisation in wood industry signals large correction in paper prices $ further austerity measures enacted by the Ontario provincial government begin to hear protests from businesses $ banks continue to report record profits from stock broking and trading activities
Canadian business conditions have deteriorated since the first quarter of 1996, and continue to steadily worsen from one year ago. Depressed demand conditions domestically, have been joined by worsening prospects in export markets. The underlying trend for the remainder of the second quarter, and leading into the third quarter is the possibility of more sluggishness and recession. The evidence in Canadas most important export market, the United States, is further contraction leading to an easing of the pent-up demand conditions that have fueled the US recovery in 1994 and most of 1995. Consequently, the most significant
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declines have been registered in the production levels of export-based firms in Canada. The reductions came in the form of the strike in US automotive brake parts, which ultimately affected the assembly of models based in Canadian plants that were destined for the US market. Further, recent decreases in the demand for newsprint and paper products have caused a great deal of panic in the pulp and paper sector, as over investment over the past six quarters has created excess capacity in production. Producers are expected to reduce supplies and prices in order to clear out their large inventory positions. Overall, Canadian industries have reduced their use of production capacity for the fourth straight quarter, or 82.8 percent in the first quarter of 1996, compared with 82.9 percent in the fourth quarter of 1995. The surge in production throughout 1994 was mainly driven by pent-up demand conditions and successful exporting activity joined by record increases in business investment. Currently, business has recorded a 11.2 percent decline in profits of non-financial corporations in the first quarter.
Brake on New Cars
It can be argued that the automotive parts and assembly sector is Canada. Without the Auto Pact and the two consecutive free trade agreements, Canada would have a difficult time convincing anyone that there was anything resembling a manufacturing industry at all. Likewise, the fortunes of manufacturing and most industrial activity are mainly determined by the success of this industry, especially in Ontario and Qubec. For the first time in over three years, evidence of a downturn in the auto sector has surfaced. The overall level of vehicle sales has fallen by 89,833 from March 1996, or by 6.5 percent. Sales in April were well below the monthly average of 97,000 vehicles recorded throughout 1995. Despite signs of a setback in domestic vehicle sales and falling exports, the overall sector is expected to rebound, as most aging fleets of vehicles in the Canadian market will be replaced over the next several years. Despite this upbeat scenario in the industry, there are some existing disturbing signs for the overall passenger car market. Sales in April 1996 have recorded their lowest level of sales in more than a quarter of a century, as the growing popularity of minivans and sport utility vehicles have captured the imagination of consumers. The shift in tastes could have a profound impact on tooling and investment in existing passenger car plants, in favour of mini van and sport utility vehicles.
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Real Estate
Poor consumer confidence and continuing job uncertainty, coupled with the downsizing of good paying public sector jobs has joined demographic trends in depressing most of the Canadian real estate sector. After the robust growth of single family buyers in the 1970s and 1980s, poor economic conditions have combined with falling numbers of first-time buyers to collapse the real estate market. Recently, the new housing price index has decreased by 2.7 percent over a one year period, representing the twenty-second consecutive month of decline. Such a situation in this sector has not been experienced before in recent history, and what is more, the rate of decline in house prices has been gathering pace since 1994. On this note, it can be argued that both demographics and the changing geo-political climate in the world are both working against any upward correction in real-estate prices. Moreover, the decline in this most important sector in the Canadian economy has created very disturbing trends in several areas. For instance, the domestic nature of the Canadian banking system is oriented towards servicing the mortgage market second only to its growing reliance on incomes from stock broking and trading activities. Any downturn in the value of the assets that these mortgage loans are based on, will affect the quality of the banking systems assets, regardless of the usual Government of Canada guarantee on such loans. In addition, falling real-estate values, coupled with the collapse in commercial real-estate will affect other domestic lending activity in the small business sector. This is already in evidence, as is the preference for the Canadian banking system to lend to large internationally syndicated projects, not to mention increased securities operations.
The prolonged climate of low growth, and evidence of a downturn in profits should continue to drive merger and acquisition activity. Early evidence from the first quarter of 1996 shows that the dollar volume of transactions was the strongest on record. The deal base shifted from the large to medium-sized sector, after posting several landmark deals that included publishing groups Thomson acquiring US based legal on-line publisher West Publishing for $4.7 billion, followed by mining company Incos $4.5 billion offer for Diamond Fields Resources Inc., after a brief bidding war with rival Falconbridge saw the quick retirement of its management strategy.
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. In a bid to gain control over the massive Voisey Bay nickel project in Labrador, Inco Ltd. has moved its stake in the mine from 25 to 75 percent, which will boost its market share in nickel to just over 40 percent. This, the sixth largest acquisition transaction in Canadian history, will see Inco issue 51 million common shares as part of the overall purchase agreement, with a provision for a buyback of one-third of the new stock with a four year period. In addition, original equipment automotive parts manufacturer Magna International Inc. has paid $100 million in acquiring UK joint-venture partner Marley Plc. Magna will acquire six plants, along with new assembly business from the likes of German-owned Rover Group Plc. and Nissan Motor Co. Ltd. Further activity will be expected in the Canadian banking sector, as Canadas largest bank, The Royal Bank of Canada, has responded to a recent government white paper that recommends further deregulation and a more open domestic regulatory regime to foreign competitors. Specifically, the foreign banks have requested that their operations in Canada be treated as subsidiary operations, able to draw on the capital base of their parent banks. In turn, some Canadian banks have agreed to this, only if the government would allow them to merge with other fellow Canadian banks, forming large international banks that could compete more easily in the changing climate.
Currency Forecast
Clearly, the industrialised countries in the world continue to stagnate. A pervasive climate of uncertainty has been created from dramatic technological changes, coupled with the fall of communism and the dramatic collapse in the property price bubble. The industry-specific situation is not any better, as companies profits are on a downswing, combined with the general de-stocking of inventories and weak export markets. The upside for the Canadian dollar under such circumstances is limited, and may even begin to challenge its lows with respect to the US dollar.
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New Automotive Sales (%change)

New Motor Vehicles Passenger Cars North American Imported Big 3 manufacturers Other manufacturers Trucks,Vans,Buses
(1) April 1995 to April 1996 (2) March to April 1996
Source: Statistics Canada
(1) 1.2 -5.9 -0.3 -30.2 -5.7 -6.2 11.2
(2) -6.5 -5.2 -4.8 -7.3 -6.5 -2.9 -7.9
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Third Quarter: August 7, 1996

$ Canadian banking consolidation begins as CIBC and the Bank of Nova Scotia combine on back room operations $ mid-market manufacturing companies continue to hollow-out as large corporations cut back on contracts $ foreign investors begin to shift portfolio investments in Canadian securities to stocks & out of money markets $ US investors increase investments in Canadian stocks to record levels $ corrections on the Toronto & Montral stock exchanges closely follow the sell-offs on Wall Street $ companies plan to increase business investment by 2.2% in 1996 over last year $ new orders for durable consumer goods & retail trades decline $ all levels of government begin to seriously consider privatising various divisions $ Conrad Blacks Hollinger Inc. gains control of the old & directionless publisher Southam Inc. $ small business liquidity continues to deteriorate as used car purchases begin to exceed new car purchases
Just as when demographic shifts in the Canadian population base brought the countrys building and housing sector to a virtual halt, a recent survey by our contributing editor and automotive expert Dennis DesRosiers reveals an equally disturbing trend in the new and re-sale automotive markets. Stagnating incomes and consumer uncertainty have shaken the normal buying patterns in the new car market, not only in Canada but also in the UK and France. DesRosiers shows that of all vehicles acquired in the past year, 64 per-
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cent were used and just 36 percent were new. In addition, the number of vehicles that are aged between six and ten years have risen to 41 percent of all vehicles in operation today. More and more, changing habits and tastes are combining with falling standards of living to raise a number of concerns in the most vital industrial sector in Canada today. The automotive industry has experienced steadily rising growth from 1992 to 1995, while 1996 has revealed signs of deceleration from the levels recorded in previous years. It is expected that sales will continue to be driven by replacement demand, as vehicles already aged from six to ten years begin to reach the end of their productive cycles. Automotive sector performance is vital to the economic prosperity of Canada, and upon closer reading of the North American Free Trade Agreement (Nafta), the auto sector was central to the framework of negotiations. Clearly, the growing preference of consumers to purchase used vehicles in todays marketplace, can also be interpreted as a sign that most of todays vehicles are manufactured with a high level of precision and quality in mind. Consequently, it no longer makes any sense to habitually change a vehicle after every two to three years, since the depreciation schedule has been informally extended over five to even seven years. The implications of this gain in technical efficiency are very unclear at this moment. It has been argued that the lengthening replacement schedule derived from better-made vehicles will result in noticeably lower uses of productive capacity in the auto sector, to very optimistic forecasts that base their logic on the steady replacement of a very large stock of used cars stretched over a number of years, that are aged between six and ten years. Radical changes in the automotive sector have combined with demographic and technological changes to erode overall living standards in Canada. After the spectacular collapse in commercial property values in the early 1990s, marked by the fall of Olympia & York property developments, and now with technology making large-scale banking redundancies inevitable in the latter half of the 1990s, the Canadian economy has undergone very abrupt structural changes. Not only has the level of business activity changed, but the way of doing business is very different from just one decade ago.
Foreign Investment
Recent international securities transactions have been directed towards the record purchase of stocks. In following the general global trend, most of the
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influx of cash has originated from US based institutional and mutual fund investors. What is striking is the fact that the record investment in Canadian equities has not added any new net capital inflows. Instead, the foreign purchase of stocks has come at the expense of money market financial instruments. Overall, the first half of 1996 has registered a net inflow of foreign money into the stock markets. So far, over $5 billion worth of equity investment has been accumulated by US investors. Moreover, sales and purchases of Canadian stocks initiated by foreigners has exceeded $10 billion per month in 1996. Despite recent evidence of the short-term money-market differential favouring US financial products over similar Canadian based investments, the buoyant stock market activity has prevented a complete repatriation of cash, but has instead shifted the funds into Canadian stock markets. The attractiveness of US capital shifts into the Canadian market has been supported by gains in Canada exceeding those available in the US on similar riskweighted products. In specific terms, Canadian stock prices, as measured by the Toronto Stock Exchange 300 Composite Index gained 11.3 percent in the first five months of 1996, as opposed to the 8.6 percent return on comparable US stocks as measured by the Standard & Poors Composite 500 index. This difference in rates of return favouring Canadian equity investments, have far exceeded the shortfall in the traditional spread that favoured Canadian money-market instruments. Although equity investments in Canada by foreign investors are generally blue-chip in orientation, they can lead to more volatility than the traditional short-term money-markets and bond investments driven by the 1.5 percent spread available over US instruments. Evidence of this volatility has come to light recently, as financial outflows have driven down the value of the Canadian dollar to the high 0.72 US cents range. The general stock market correction that has come in July 1996, has also spurred some US based fund investors to dump Canadian equities, putting further pressure on the Canadian dollar.
In a move to diversify its regional Qubec based banking operations, the National Bank of Canada has tentatively acquired the domestic Ontario-based branch network of Municipal Financial Corp. The deal has been negotiated at $35.5 million which is below the Municipal book value. The deal, once approved by financial services regulators, will raise the number of Nationals Ontariobased banking branches to 123 from 94. Overall, the move can be justified more on the grounds of diversifying political risks, than it can on sound profit strate-
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gy, given the uncertainty surrounding the existence of physical branch banking in a period of revolutionary technological change. More in tune with the new technological environment that currently grips global banking, is the move by Canadas second largest bank CIBC, to concentrate on consumer banking opportunities that transcend the traditional physical presence of branch banking. More use of electronic processing units in heavy-traffic retail operations will be central to CIBCs overall strategy. In addition, further defensive moves in securing profitability have been evident in the Canadian banking sector, as CIBC has combined its back office operations with those of the fourth largest and most international of all Canadian retail banks; the Bank of Nova Scotia.
Currency Forecast
With falling interest rates and a narrowing of the traditional spread over comparable US bond investments, the situation has become much more volatile in context to foreign financial flows. Should more volatility emerge in global stock markets, enormous pressures on the Canadian dollar could materialise as US funds withdraw.
International Finance in Canada ($millions)

-168 -62 166 2,610 -2,838 -2,469 -2,258 -211 2,362 1,470 892 10,467 11,084 2,158 14,517 -5,591 1,324 944 380 -1,941 -2,375 434
May/96 Jan-May/95 Jan-May/96

Total Investment Bonds (net) Outstanding New Issues Retirements Money Market (net) Government Other Stocks (net) Outstanding New Issues
Source: Statistics Canada
7,462 966 -2,473 16,484 -13,045 1,194 237 957 5,303 3,346 1,957
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$ Federal government of Canada will seek a legal ruling by the Supreme Court on Quebecs plans to separate $ Quebec Premier Lucien Bouchard causes dissension in Parti Qubcois over his opposition to unilingualism $ exports rise to the US & Japan but fall with most other important trading partners in July $ new softwood lumber agreement with the US results in a one-third rise in exports in July $ strong demand in the US causes motor vehicle exports & parts to rise by 6.0% & 4.7% respectively $ business investment & operating profits of Canadian enterprises falls by 3.4% & 1.6% respectively $ manufacturing shipments & new orders increase as foreign investors look to acquire manufacturing base $ increasing competitiveness in Canadian industry & budget controls begin to create positive sentiment for dollar $ political & economic uncertainties in other G.7 countries rank Canada in best overall position by IMF & OECD $ US steps up acquisition activity in Canada in real estate & industrial products sectors
Successes in negotiating a North American Free Trade Agreement that benefits Canadian manufacturing, together with a very competitive dollar has raised the interest of foreign companies wanting to acquire a manufacturing presence in Canada. Once again, manufacturers that are in the business of exporting more than fifty percent of their product to the United States are very profitable. Not only is this evident in the fast-growing knowledge based industries, but is apparent in the raw materials and automotive sectors. Softwood lumber products which have been
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a traditional sore point in Canada-US trade relations, despite the existence of free trade agreements, have responded to a recent clarification of the problem by raising exports by one-third. Likewise, the auto pact that was since carried over into the new Nafta agreement, has continued to perform well. Specifically, Canadas overall exports advanced by 2.1 percent in July to a record $22.5 billion. Exports saw increases mainly to the United States and to Japan, but decreased in most other important markets. However, imports began to increase faster than exports. As they reached their highest level in July since February of this year. Most of the main trading partners to Canada sold more industrial goods and machinery. The increase in imports has outstripped some of the good news in the export sectors, creating a small drop in the overall trade surplus. The manufacturing sector began to take advantage of the very competitive Canadian dollar. The push towards the US market by Canadian producers seems to be reaching a point of maturity. It can be said that Canadian companies are finally taking full advantage of the emerging climate of globalisation. The initial fall of communism coupled with the tremendous technological developments together with perfect capital mobility, has been a shock initially to the overly-domesticated managers of Canadian companies. Four years of a changing corporate managerial culture, together with an aggressive push to educate the newly-emerging leaders of business in universities, seems to finally be bearing fruit for the Canadian economy.
Falling Interest Rates
Despite the successes in trade relations with the United States recently, things are not so good with the two-thirds of economic activity in Canada that is not subjected to cross-border commerce. It is only the one-third of Canadian industry that can be deemed to be the most globally competitive. The other twothirds of goods and services that are produced locally, are subjected to continuing depressed business conditions domestically. Recently, Canadian monetary policy has been mainly shaped by the conditions that are representative of this domestic sector. Bank of Canada Governor Gordon Thiessen has made a recently unprecedented break with US monetary policy. By lowering rates for the fifth consecutive time in 1996, he has displayed a very rare degree of independence, while causing the dollar to appreciate, instead of following recent history and coming to its defense. Most US investors have adopted the sentiment that Canada is a very good investment at this moment, based on its relative merits among most other members of the G.7 group of industrialised countries. In particular, this group is
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very bullish towards the Canadian dollar, as some have even voiced their opinions that they believe that the Canadian currency is on its way to once again achieving parity with the US dollar (see Dennis Gartman interview in this issue). It may be possible to conclude that these sentiments are mainly based on observing recent Canadian trade successes south of the border, and really have very little bearing with the two-thirds of the economy that remains subject to defensive strategies of job losses and restructuring, coupled with very high rates of unemployment. In fact, evidence on the jobless rate indicates that it has exceeded the nine percent point for every month for the past six year period, which is a stretch that has only been equalled since the Great Depression of the 1930s. Monetary policy has been shaped by this two-thirds uncompetitive sector, as it moves in sharp contrast to the on-going austerity measures introduced by the federal government and the provinces. In fact, it can be said that the policies being followed by the government spending programs more closely correspond to what is necessary in the robust and competitive export sector, while monetary policy has been responding to the intensive care that is required for the battered two-thirds of the economy that is the domestic sector. Central to the problems in the domestic sector has been commercial property development and residential mortgage sales. As with most property sectors in the industrialised world, activity continues to barely respond to low interest rates, while bankers in most countries still show a very deep aversion to financing any grand projects which are not very conservatively capitalised. Recently, commercial property has shown some signs of revival in the UK market, as an almost complete cessation of building over the past four years has caused demand to exceed the space that is currently available. Likewise, it is in the residential side of the US market that recent activity has made the best showing since that in 1989. This has been one of the main reasons for the increased demand for Canadian softwood lumber exports in the summer of 1996. With US investor sentiment going one way and Canadian monetary policy the other, a window of opportunity has opened up for the continued reductions seen in short term interest rates. This will hold as long as the dollar continues to hold its ground and stock markets stay steady. The trend with short term rates is that they have dipped below comparable US rates in February of this year, and have continued to fall ever since. Currently, the historical investment spread has been attacked, as the spread on two year bonds was about one percent, while that on five year bonds has dipped below their US counterparts. Likewise, it is expected that the prime rate of interest charged by Canadian chartered banks to their best customers will continue to hold steady, or fall even further. This will
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be evident in the consumer mortgage credit market, as record low levels of financing should spur more activity in the housing market, as debt burdens will be reduced even more through a rise in re-financings.
Most foreign manufacturers and trading groups can sense how profitable the Canadian manufacturing sector has become. From the large Japanese trading companies to medium-sized US based automotive parts producers, to European engineering groups, all are in the hunt for possible acquisitions of Canadian companies that are exposed in a big way to the outside world. Manufacturer and distributor of gas wellheads in the Emco Ltd. group, Walker Steel, was acquired by Texas-based provider of oil and natural gas field services ABB Vetco Gray Inc. In the automotive parts industry, New York based Standard Motor Products Inc. has acquired Montral based manufacturer of brake pads Fibro Friction Inc. for $19 million in cash. The fast changing global financial services industry saw both of Canadas largest chartered banks, Royal Bank of Canada and Canadian Imperial Bank of Commerce acquire the worldwide electronic bank payment card system Mondex International Ltd., developed by UK based National Westminster Bank. CIBC and Royal are both acquiring a five percent stake in Mondex International, joining US based Wells Fargo Bank and AT&T and a consortium of European banks, with National Westminster retaining a ten percent stake in the project. In turn, the CIBC and Royal banks will hold the Canadian franchise rights for the Mondex smart card in Canada.
Currency Forecast
The positive sentiments created in the US by the successes of fiscal cutbacks by the Federal government and the provinces, has joined the transformation of Canadian manufacturing industry as the main reasons for the early interest in the Canadian dollar. Problems in Europe with recessions in France and Germany, along with the colossal Japanese banking problems, have created relative sentiments in favour of Canadian investment paper. In contrast, the politicisation of the operations of the Bank of Canada under the relatively new leadership of Governor Gordon Thiessen, has generated some early debate within the Canadian business community. The question at this very moment, is how much more independent can Canadian interest rate policy be from that of the Federal Reserve? The recent
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strength may come to a quick end, once the US central bank decides to raise its short-term rates, perhaps after the US presidential elections in November. For the time being, the dollar should enjoy some welcomed strength and challenge the 0.75 cents US level. Any further movement upwards will be countered by the Bank of Canadas policy of yet even more lower short term interest rates.
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Investors NewsFlash dollar continues to trade at low end with respect to US dollar real estate sector shows signs of revival as new condominium projects and conversions of unused commercial space reach impressive levels Bank of Canada rate remains at minimally acceptable level in support of the dollar Canadian banking sector begins to grow through acquisition of US boutiques and brokerages federal government halts new borrowing for the first time in 25 years no new bonds will be offered to finance operations as finances head towards a surplus position as provincial debt declines the only investment in the bond market will remain corporate bonds evidence of which shows an increase of $10 bn. in the past year bank rate climbs one-quarter of a point to 3.5% as prime remains at 5.0%
The Canadian recovery, although showing signs of maturity still hangs on a very thin thread. Evidence of which is the continued spread over the prime lending rate in the US of an average of 3.0 percent in favour of Canadian borrowers, and a continuing weak Canadian dollar. The actions of the Bank of Canada continue to indicate reservations about jeopardizing the recovery in any way, through a very slow and cautious policy of gradually moving the bank rate up very slowly, and only when circumstances warrant the move. Although the real-estate sector is showing early signs of recovery in Ontario, as conversions of old commercial space are brought onto the market, there still remains the fact that an unprecedented amount of space has been taken
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off of the commercial real-estate market since the recession of the early 1990s. What has not been demolished, has been successfully sold in the Condominium market, although at the low margin end more so than at the luxury level. The Canadian economy has become so tied to the export markets of the US and to a lesser extent Latin America and Mexico, that the movement of the dollar upwards beyond $0.76 cents to one US dollar, will impact many companies profit margins. This is a situation that never existed to such a great extent in history as it does now. It is as if the Canadian dollar must continue to be pegged at its historical lows with respect to the US dollar, in order to ensure a healthy performance on the real side of the economy. The issue more and more centres on US industrys annoyance at the success that Canadian exporters are having in their own domestic marketplace. The danger being that the Canadian-US trade relationship could become similar in nature to the one that currently exists between the US and Japan. With a Japanese trade surplus that cannot seem to fall, the US has used the dollar-yen relationship as an outlet for policy. Since the election of the Clinton administration, any rumblings on the trade deficit over an extended period of time always brought a correction in the yen upwards, making Japanese exports more expensive to US consumers, hence shutting off any increase in demand for cars and electronic products. There currently exist fears in Canada over a similar brand of politics, as there already is evidence that Congress is considering a re-negotiation of some aspects of the North American Free Trade Agreement (Nafta), to address some of the competitive disadvantages that US industry is currently having against Canadian imports. Should there continue to be an escalation of the Canadian trade surplus to even greater levels, then the US may decide to seek a political solution to the problem. It would not be surprising that the low Canadian dollar over the past three years would become the negotiating tool for US trade policy, just as it has become so for trade relations with the Japanese. Although recovery is at hand in the industrial provinces of Ontario and to a lesser extent, Quebec, it remains fragile and requires the existing low rates of interest along with a very competitive exchange rate in the US.
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Investors NewsFlash dollar continues to trade at low end with respect to US dollar real estate sector shows signs of revival as new condominium projects and conversions of unused commercial space reach impressive levels Bank of Canada rate remains at minimally acceptable level in support of the dollar Canadian banking sector begins to grow through acquisition of US boutiques and brokerages federal government halts new borrowing for the first time in 25 years no new bonds will be offered to finance operations as finances head towards a surplus position as provincial debt declines the only investment in the bond market will remain corporate bonds evidence of which shows an increase of $10 bn. in the past year bank rate climbs one-quarter of a point to 3.5% as prime remains at 5.0%
The Canadian recovery, although showing signs of maturity still hangs on a very thin thread. Evidence of which is the continued spread over the prime lending rate in the US of an average of 3.0 percent in favour of Canadian borrowers, and a continuing weak Canadian dollar. The actions of the Bank of Canada continue to indicate reservations about jeopardizing the recovery in any way, through a very slow and cautious policy of gradually moving the bank rate up very slowly, and only when circumstances warrant the move. Although the real-estate sector is showing early signs of recovery in Ontario, as conversions of old commercial space are brought onto the market,
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there still remains the fact that an unprecedented amount of space has been taken off of the commercial real-estate market since the recession of the early 1990s. What has not been demolished, has been successfully sold in the Condominium market, although at the low margin end more so than at the luxury level. The Canadian economy has become so tied to the export markets of the US and to a lesser extent Latin America and Mexico, that the movement of the dollar upwards beyond $0.76 cents to one US dollar, will impact many companies profit margins. This is a situation that never existed to such a great extent in history as it does now. It is as if the Canadian dollar must continue to be pegged at its historical lows with respect to the US dollar, in order to ensure a healthy performance on the real side of the economy. The issue more and more centres on US industrys annoyance at the success that Canadian exporters are having in their own domestic marketplace. The danger being that the Canadian-US trade relationship could become similar in nature to the one that currently exists between the US and Japan. With a Japanese trade surplus that cannot seem to fall, the US has used the dollar-yen relationship as an outlet for policy. Since the election of the Clinton administration, any rumblings on the trade deficit over an extended period of time always brought a correction in the yen upwards, making Japanese exports more expensive to US consumers, hence shutting off any increase in demand for cars and electronic products. There currently exist fears in Canada over a similar brand of politics, as there already is evidence that Congress is considering a re-negotiation of some aspects of the North American Free Trade Agreement (Nafta), to address some of the competitive disadvantages that US industry is currently having against Canadian imports. Should there continue to be an escalation of the Canadian trade surplus to even greater levels, then the US may decide to seek a political solution to the problem. It would not be surprising that the low Canadian dollar over the past three years would become the negotiating tool for US trade policy, just as it has become so for trade relations with the Japanese. Although recovery is at hand in the industrial provinces of Ontario and to a lesser extent, Quebec, it remains fragile and requires the existing low rates of interest along with a very competitive exchange rate in the US.
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Investors NewsFlash federal government delivers balanced budget and forecasts a $5.0 billion surplus in 1998-99 and $10 billion the year after Bank of Canada extends inflation target of 1 to 3% until the end of 2001 federal debt to GDP is forecast to fall to 63% by 2000-01 political stability as Jean Charest becomes opposition leader in Quebec trade surplus falls to $1.7 billion in January reflecting reduced exports of machinery and forest products Japanese investors continue to repatriate their Canadian based investments Trade strategy for far east falls into disarray Canada begins negotiations to become member of European Free Trade Association more bank mergers as CIBC and TD announce intentions exports to Japan fall by 33% all economic indicators peak as commodity pressures sink dollar
Throw away the Finance Ministry and the Bank of Canada because Canadas economic policy is now determined by what happens in Asia and Japan! Evidence of the ineffectiveness of domestic economic policy making is now coming into real focus. Ever since Team Canada trade missions began circling the globe in pursuit of contracts for Bombardier and Northern Telecom, and by equal measure escaping the small and inactive domestic marketplace in the new era of globalisation, something even more disturbing was happening in the far east and in Russia. The collapse of the Thai Baht, Indonesian Rupiah and now the yen has left the Canadian export sector badly exposed and in need of cus-
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tomers. Not only has the meltdown in Asia forced the cancellation of numerous contracts for commodities, but the growing inclusion of Russian based raw materials on world markets has also had undesirable effects on the prices of Canadian based natural resources. The lapse into recession of the Asian trading zone has revealed just how exposed the Canadian economy is to that part of the world. In a related way, it also indicates just how resource-based the country still is, despite the growth in financial services and in high technology in most of its major cities. In fact, the Asian crisis is a real slap in the face, as in this new era of globalisation and information technology, Canadian resource exports are still the supreme fundamentals that drive the value of the currency. Consequently, the recent business slowdown in the Asian region has caused a structural decline in the price of commodities, taking the dollar downwards. Not only have production-based commodities fallen, but the crisis has also caused another relapse in the price of gold, sending stocks to challenge their lows and confirming the new lower trading range of the dollar at the bottom of $0.65 to $0.75 US. The current climate of resource deflation has effectively sidelined any existence of a monetary policy, as the Bank of Canadas refusal even to consider the raising of short-term rates, has unnerved dollar based investors even further. Not only has the Bank of Canada been marginalised in the collapse of resource and commodity prices, but rumours abound that the inaction of Governor Gordon Thiessen in raising rates even to support the dollar symbolically, have devalued the credibility of the Bank. Canada may be faced with even more problems as the profitability of its manufacturing and export sectors comes under further attack from the US. With more and more cheap imports attacking the US market, growth rates are bound to be affected, which will in turn reduce the demand for Canadian exports, causing even more dollar grief.
Forecast
The deluge of cheap products that will be sent from Japan to the US and with the real prospect of even more competitive devaluations in Asia, have already caused pricing pressures on domestically-produced items. The challenge that Canadian exporters will have is to further raise productivity to counter the pricepressures from the Asian market. Failing this, the dollar will fall even further.
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Investors NewsFlash federal government delivers balanced budget and forecasts a $5.0 billion surplus in 1998-99 and $10 billion the year after Bank of Canada extends inflation target of 1 to 3% until the end of 2001 federal debt to GDP is forecast to fall to 63% by 2000-01 political stability as Jean Charest becomes opposition leader in Quebec trade surplus falls to $1.7 billion in January reflecting reduced exports of machinery and forest products Japanese investors continue to repatriate their Canadian based investments trade strategy for far east falls into disarray Canada begins negotiations to become member of European Free Trade Association more bank mergers as CIBC and TD announce intentions exports to Japan fall by 33% all economic indicators peak as commodity pressures sink dollar
Throw away the Finance Ministry and the Bank of Canada because Canadas economic policy is now determined by what happens in Asia and Japan! Evidence of the ineffectiveness of domestic economic policy making is now coming into real focus. Ever since Team Canada trade missions began circling the globe in pursuit of contracts for Bombardier and Northern Telecom, and by equal measure escaping the small and inactive domestic marketplace in the new era of globalisation, something even more disturbing was happening in the far east and in Russia. The collapse of the Thai Baht, Indonesian Rupiah and now
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the yen has left the Canadian export sector badly exposed and in need of customers. Not only has the meltdown in Asia forced the cancellation of numerous contracts for commodities, but the growing inclusion of Russian based raw materials on world markets has also had undesirable effects on the prices of Canadian based natural resources. The lapse into recession of the Asian trading zone has revealed just how exposed the Canadian economy is to that part of the world. In a related way, it also indicates just how resource-based the country still is, despite the growth in financial services and in high technology in most of its major cities. In fact, the Asian crisis is a real slap in the face, as in this new era of globalisation and information technology, Canadian resource exports are still the supreme fundamentals that drive the value of the currency. Consequently, the recent business slowdown in the Asian region has caused a structural decline in the price of commodities, taking the dollar downwards. Not only have production-based commodities fallen, but the crisis has also caused another relapse in the price of gold, sending stocks to challenge their lows and confirming the new lower trading range of the dollar at the bottom of $0.65 to $0.75 US. The current climate of resource deflation has effectively sidelined any existence of a monetary policy, as the Bank of Canadas refusal even to consider the raising of short-term rates, has unnerved dollar based investors even further. Not only has the Bank of Canada been marginalised in the collapse of resource and commodity prices, but rumours abound that the inaction of Governor Gordon Thiessen in raising rates even to support the dollar symbolically, have devalued the credibility of the Bank. Canada may be faced with even more problems as the profitability of its manufacturing and export sectors comes under further attack from the US. With more and more cheap imports attacking the US market, growth rates are bound to be affected, which will in turn reduce the demand for Canadian exports, causing even more dollar grief.
Forecast
The deluge of cheap products that will be sent from Japan to the US and with the real prospect of even more competitive devaluations in Asia, have already caused pricing pressures on domestically-produced items. The challenge that Canadian exporters will have is to further raise productivity to counter the pricepressures from the Asian market. Failing this, the dollar will fall even further.
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Investors NewsFlash federal task force on financial services rules favourably to planned banking mergers department store sales fall 4.9% in June for the third consecutive month as domestic spending begins to fall GDP forecasts have been downgraded for the second half of 1998 to 2.0% from the 3.7% that was registered in the first quarter of 1998 CIBC issues profits warning over slowdown in trading revenues as banking shares take a huge hit in August Toronto Stock Exchange TSE300 index falls to 5,600 from a peak range of 7,800 worries in financial services sector over possibility of a bear market in Canadian stocks EU joins Japan in challenging Canada at the World Trade Organisation over its Auto Pact tariff on imported vehicles dollar hits all-time low of US$0.634 as Bank of Canada raises rate by 1%
The dollar has broken through our most pessimistic trading scenario of US$0.65 to US$0.70. It now hovers just above the low end of this range, climbing from its most recent low of US$0.634. Not only has this unprecedented trend been lost in the overall global crisis that is affecting many corners of the globe, it comes as a severe shock to most establishment commentators and analysts, who only a year ago were forecasting that the dollar would progress towards the US$0.75 to US$0.80 range. What is even more disturbing from the perspective of foreign investors in Canadian dollar denominated paper securities, is the double effect that they have had
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to contend with recently. Not only have they been drastically affected by the unprecedented move downwards by the Canadian currency, but they have also been caught in a substantial correction on Canadas main stock market index, the TSE300. Losing some 30 percent of its value in just one month, the fall-out has mainly been caused by the banking sector, after it issued an unexpected profits warning from a fall in trading revenues. The Bank of Canada has further lost credibility by responding in a most untimely fashion to the dollar crisis. After hitting its all-time low, the Bank argued that the extremely cheap currency was viewed as a proxy for a lower interest rate in Canada. Consequently, the bank reacted to this by raising its bank rate by one percentage point, despite the fact that the country was caught in a severe commoditiesinduced deflationary spiral, and that the G7 group of countries may very soon engage themselves in a co-ordinated general rate reduction to counter the growing global financial turmoil. Aside from the fact that the Canadian dollar has been adversely affected by the lack of credibility coming from the Bank of Canada, many are quick to point to the effect that the Asian crisis will have had on commodity prices. With some 40 percent of Canadian exports being composed of commodities, a price collapse from a contraction in global demand will create a trade balance deficit. This may or may not lead to an immediate effect on the value of the dollar. However, a more compelling reason for dollar weakness can be explained by the fundamentals. On trial by global investors has been the entire establishment and elite that run the country. From the politicians over-reaction to Quebec separation, to only a handful of Canadas business leaders that truly know how to compete in a global economy, the dollars decline has been in the works for a very long time. Throughout the 1990s, the dollar has been more driven by the status of Canadas rate of unemployment, than it has by the trade fundamentals or by foreign direct and portfolio investment. What foreign investors and business people continue to focus on is how Canada is adjusting to an increasingly global economy, where the resources of Russia and China were increasingly being tied to a market
Forecast
The dollar can only be rescued by a strong figure at the Bank of Canada that is willing to reassert its authority.
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Investors NewsFlash economic growth slows to 1.8% in the 3rd quarter as retail inventories fall by C$4.6 billion Exports to the US rose by 1.4% in the fourth quarter while a weak dollar lowered the balance of payments deficit from C$20.9 billion in the second quarter to C$17.6 billion Canadian Government rejects the banking mergers proposed by the Royal Bank and Bank of Montreal and by the CIBC and the TD Bank on the grounds that there would be very little competition in credit cards, retail brokerage and retail branch banking services Finance Minister Paul Martin jr. warns that no further merger proposals would be considered from banks until a review of financial services regulation was completed dollar rebounds from recent lows as the launch of the Euro makes it more attractive to investors
The Canadian dollar began 1999 on a positive note, as the global currency markets were undergoing a mass reconfiguration of investment strategies. The launch of the new euro currency has re-denominated most securities issued by the 11 participating members voiding their previous national denominations. Instead of investors being presented with a choice of punts, escudos, pesetas, marks, francs, guilders and markkas, they are now restricted in their choice of only five or six blue-chip industrialised country currencies. The G3 composing the US, Japan and Europe will capture most of the liquidity available on the international markets, together with the pound sterling, while the Canadian dollar, Swiss franc and the Australian and New Zealand dollars will make up the second tier.
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The Canadian dollar will benefit to a certain degree from the launch of the euro. When a broad range of European currencies were available, investors were preoccupied with betting on the exchange rate direction of various fixedincome and equity investments. For most of the decade of the 1990s, the Canadian dollar was not a favoured currency by foreign fund managers. Set back by political concerns over Quebecs possible separation, and the rough economic climate in the early to mid-1990s, Canada was always considered to be ill-prepared for the new global climate of competition that unleashed Russia's vast natural resources on global markets to compete. The 1990s were not very kind to commodity-based producers or to commodity exporting countries. Supplies flooding international markets from emerging market countries, joined technological change in oil exploration and the automotive sectors to further depress prices and profits. Although the real economic prognosis remains depressed for the foreseeable future in Canada, dollar investors can take some comfort in the launch of the euro. With the elimination of 11 blue-chip currencies, European based investors will come to re-evaluate the dollar as an alternative choice which will only gain in prominence and acceptance.
Forecast
As the US economy braces for a downturn, trade rhetoric is now almost as intense in Washington, as are the proceedings to impeach the president. Recently, the US unveiled a hit list that it hopes to use against selected European imports over the dispute concerning the EU banana regime. Likewise, the issue that surrounds US based split-run magazines in Canada remains very fragile. With Canada threatening to protect its cultural heritage, by preventing US mega-media groups access to the Canadian advertising market via split-run editions of US magazines, the Cultural Minister has threatened to impose various forms of tax or subsidy measures to protect the fledgling Canadian magazine market. The US has countered by threatening to impose broad-ranging sanctions on industrial and agricultural products. With growing reliance on the US market, Canada needs a cheap dollar to be competitive. Trade wars instigated by the US call for a stronger Canadian dollar, just as with the yen in Japan. The launch of the euro also calls for a stronger dollar over the following quarter.
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Second Quarter: May 9, 1999

Investors NewsFlash dollar shows impressive gains in first quarter as external factors cause a flight to quality resource prices stabilise as foreign investors begin to reconsider cyclical investments dollar helped by war in Adriatic and by the adverse effects that it is having on the newly-minted euro currency launching of the new euro works in dollars favour as less choices are made available to currency investors and speculators seasonal unemployment heads higher while UK treasury announces the sell-off of 50 percent of its gold reserves hitting mining stocks Toronto Stock Exchange posts 3rd best gains in first quarter among G7 members as cyclical and traditional non-technology shares come back into favour banking sector braces for far-reaching rationalisations inflation rises to 1 percent in March
The recent move towards US$0.70 is an unwanted event that Canadian manufacturing interests can barely afford at this stage of the business cycle. Once again, the upward spike in the Canadian dollar is solely driven by external events, and in no way is it the result of good domestic fundamentals or management. For most of the mid to latter half of the 1990s, it has been the manufacturing sector of Canada, that has slowly pulled the economy out of the malaise that culminated in the close-call referendum vote in Quebec in 1995. With a US population that is all too willing to consume imports, it has been the stimulus that this has provided exporters of manufactured products. Most of the job creation
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that has occurred in Canada in the past two years is a direct result of the sales that Canadian firms have been making to a red-hot US market. Times could not have been better for Canadian based exporters, as dollar weakness combined with the US boom to lift Canada out of its lingering recession in 1996. As was reported in previous issues, the launch of the new single European currency would spring the Canadian dollar back into favour among foreign currency investors and speculators. This is in fact what has been happening, as the positive effects on the value of the dollar are clearly evident now in the second quarter. By launching the new single currency, there has been an overnight elimination of some ten hard investment grade currencies available to international portfolio managers and currency traders, allowing all parties to re-position their books as well as their sentiments in favour of the Canadian dollar. In addition, the weakness of the euro in the first quarter, along with the possibility of long term instability in the Adriatic over the war with Serbia, has further heightened foreign interest in the Canadian currency. With growing concern in the instability caused by this unexpected war in the Balkans, the world economic stage that has normally become accustomed to discussions over emerging market bail-outs over the past several years, is now moving in the direction of military strategies, with infant signs of old Cold War tensions resurfacing once again. Should this movement relegate the global liberal market themes of the 1990s to the geo-political strategic sphere once again, Canada will experience an economic renaissance as a resource-producing country. In short, the 1990s period of global and open markets, with resources from the old Soviet countries cheaply available have not been good for the average living standards of Canadians. In fact, Canada has a very hard time competing on the global stage, since this is something that it just is not suited for culturally. Consequently, it is not merely coincidence, that the dollar has been weak throughout the 1990s.
Forecast
The dollar has made a comeback against the interests of manufacturing exporters, which have been the foundation for recovery in the latter half of the 1990s. The dollar will continue to benefit from a prolonged war in the Adriatic region of Europe, but will not be expected to cross into the US$0.70 cents range.
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Toronto Stock Exchange warns over the use of creative accounting to inflate quarterly earnings trade surplus in July is the highest recorded since December of 1996 Gold and Oil price recovery should bring resource production back onto international commodity markets commercial real estate sell-offs by Royal Bank and CIBC depress sector Dollar hit by remarks at Federal Reserve over the prospect of higher US short term rates recovery in commodity prices fails to lift dollar beyond US$0.68
Cross Border M&A Effects on the Dollar Canadian companies acquiring foreign companies: 3 Capital Outflows From Canada From M&A: $3.0 billion Foreign companies acquiring Canadian companies: 7 Capital Inflows to Canada From M&A: $10.6 billion Net Capital Inflows to Canada From M&A: $7.6 billion Net M&A Impact on the Canadian Dollar in Global Markets is Positive (+) Business activity continues to rise but not to the extent of positively impacting employment as well as reversing the downward spiral in interest rates. The recent pronouncement by Alan Greenspan, that the Federal Reserve has adopted a bias in favour of higher interest rates, is not a stance that Canadian monetary authorities share. Still, despite encouraging signs, the recovery is still considered to be very fragile.
For the past several years, numerous resource based companies in gold production and oil exploration have seen their capacities reduced. The collapse in these resource prices has depressed the western and northern regions of the country and has contributed in some way to a depressed Canadian dollar that found itself trading in a historically lower range relative to the US dollar. Even the recent recovery in these commodity prices has not convinced investors that
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the dollar should climb back above the US $0.70 range. Many analysts have recently argued that the Canadian economy is far less resource dependent than many would tend to believe. They argue that there has been a great transformation over the past several years which has created a very strong high tech, services and mixed industrial sector in several major regions across the country.
This may be true, however, Canada still lags when its companies are compared to the activities undertaken in the global economy by comparable enterprises in other G7 industrialised countries. For instance, when considering cross border merger and acquisition activity undertaken by Canadian companies, the statistics are always at the bottom of the ranking. Only Japanese companies fail to surpass the Canadian volumes, and data from Canada is usually comparable to the data generated from Italy. What has this to do with the changing nature of the composition of Canadas leading sectors? Since most of the leading-edge M&A deals usually involve high technology companies, and fewer and fewer mature industries, Canada is really not a player in any significant way. The fact of the matter is that the export boom, mainly to the US market, has been driven by medium sized machine tool and traditional industrial product industries.
Moreover, although the banking system is much better from just four years ago, when it comes to financing high tech industries, it still comes up far short in relation to the environment in the US or in the UK. An equity gap exists in Canada just as much as it does in the UK. Most of the venture capital in Canada that is allocated to high tech industries, is only reserved for the minority that are connected in some way with the big groups like Nortel. The general consensus among high tech investment bankers in Toronto is that there really is no venture capital or proper financing still to this day for adequate high tech development.
Forecast
The dollar continues to trade at its all-time historical lows. The resource price increase has not helped, nor has the introduction of the Euro. In short, the currency is following the general long term decline in resource prices.
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January/ February, 2000

Shifting balance of power towards Capital Account will not affect dollar despite record $270 bn. trade deficit in 1999 Interest in establishing presence in EU countries declines Household and Corporate debts rise by 9.2 and 11.5% in 1999 Corporate debts at 45% of GDP highest in history Fed raises rates to highest level in 4 years Venture Capital Subsidiaries account for most of the profits of US banks Nasdaq ends 1999 85% higher with P/E twice the peak of Tokyo market in 1989 Greenspan re-appointed
CROSS BOARDER M&A EFFECTS ON DOLLAR
(Data for 4th quarter of 1999) US Companies Acquiring Foreign Companies: 25 Capital Outflows From US From M&A: $13.28 bn. Foreign Companies Acquiring US Companies: 37 Capital Inflows to US From M&A: $53.7 billion Net Capital Inflows to US From M&A: $40.46 bn. Net M&A Impact on US Dollar Value in Global Currency Markets is Positive (+) With the re-appointment of Federal Reserve Chairman Alan Greenspan to another four year term, and continuing momentum propelling the US economy to a record 108 months of business expansion, the dollar continues its surprising record run-up against the Euro. With the Euro falling from the one-to-one parity level in relation to the dollar, many have begun to take a long a critical look at what has been transpiring recently among Euro-zone members. With no slowdown in sight in the US, the Fed has been slowly raising short-term rates out of inflationary fears. This, despite definite signs of inversion in the bond yield
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curve as the Treasury announces its aggressive campaign to buy-up and retire 30 year T-bills. Recent moves to raise short-term rates by the European Central Bank (ECB), has resulted in greater scrutiny among investors in Euro assets. Such moves have been associated with a central bank that has been quickly losing sovereignty over its monetary policy. Despite stating that it does not use the exchange rate to determine monetary policy, any recent moves to raise short-term rates under a period of continuing sluggishness driven by unprecedented restructuring in the industrial landscape of Europe, has led to the only logical reason for the recent increase of rates by 0.25 percent. In short, to protect the Euro from further weakness, means that sovereignty over monetary policy has been relinquished at the expense of the credibility of the central bank. Only once this credibility has been re-gained among investors, can the Euro once again climb back above the parity level with respect to the dollar. The yen, however, has encountered some recent weakness in trades with the dollar. Continuing weakness in the domestic Japanese economy, together with record bankruptcies and re-structuring activity, has spoiled the strength that the currency has been exploiting from a tight monetary policy that has been executed by an ever more credible Bank of Japan. After living through a decade aftermath from the bubble years of the late 1980s, the Bank of Japan has kept its word to never again re-inflate the financial system so as to re-create the conditions of a bursting bubble again. FORECAST Despite a historically high trade deficit, the dollar market has become mainly dependent on cross-border acquisitions and portfolio investments. European companies are showing high levels of interest in establishing a US presence via a buy-out of a US firm, and as long as the soaring high tech stocks continue to drive up the benchmark indexes, the dollar should remain in a strong position. TOP NEWS STORIES AFFECTING THE DOLLAR Equity risk premiums impact currency values the lower the risk premium or the more international a stock is the greater will be its effect in the currency markets savings rate rises from 1 to 1.4% in January Greenspan warns of further rate rises after quarter point rise to 6% in February and warns bankers not to assume current boom represents a normal state of affairs trade deficit widens to $28 bn. from $24.6 bn. in December/99 FTC asserts presence in large cross border M&A deals venture capital quadruples in fourth quarter of 1999 LBOs at all-time low while high-yield debt losses are at highest since 1991
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March/ April 2000

CROSS BORDER M&A EFFECTS ON DOLLAR (Data for January/February of 2000) US Companies Acquiring Foreign Companies: 16 Capital Outflows From US From M&A: $24.37 bn. Foreign Companies Acquiring US Companies: 22 Capital Inflows to US From M&A: $45.23 billion Net Capital Inflows to US From M&A: $20.90 bn. Net M&A Impact on US Dollar Value in Global Currency Markets is Positive (+)
Alan Greenspan has once again pushed up short term rates by one quarter of a percent to six percent, hence re-establishing the significance of a yield spread that continues to power the dollar at record highs relative to the euro. However, this relationship completely breaks down when the yen enters into consideration, as the paradox of the Bank of Japans zero interest rate policy becomes ever more apparent against the surging short term US rates. Notable developments that have affected the progress of the dollar have been the short term rate inertia and the absence of any clear variables that are affecting the dollar/yen relationship. Furthermore, there currently exist sentiments of a soft-landing which investors are confident that the Fed will be able to engineer via its incremental interest rate policy. Developments in the short term have been in contrast to the falling longer term yields on the benchmark thirty year Treasury, and to a lesser extent on the ten year bond. Inflationary expectations seem to be at bay at the current moment, as the recent move in short term rates by the Fed have combined with an aggressive repurchase program that has been instigated by the surging surplus position of the US budget, which have pushed inflationary expectations over the longer term lower. This, in addition to the recent turmoil on the Nasdaq market set off by the FTCs ruling against Microsofts monopoly position on the internet browser issue, has caused fearful investors to seek the security of Treasury bonds. Without a doubt, inflationary expectations are on the way down as accelerated competition in product markets is a good substitute for any further action by the Fed. In fact, recent moves on short term rates are bound to be reversed as soon as convincing signs of a slow down have begun to set in. Any adverse sentiments reflected through a prolonged stock market correction will lead the Fed into an accelerated reversal in its stance on rates and beliefs that centre on an overheating economy.
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FORECAST The dollar is bound to head lower relative to the euro once signs of lower inflationary pressures begin to set in in the US economy. A lower euro has begun to positively affect the balance of trade in the EU, and has created a risk of higher prices based on the cost of imported oil. The European Central Bank (ECB) is poised to raise short term rates, despite the opposition of the German Bundesbank to such a move. A narrowing of the short term spread on dollar and euro assets will lend more support to the euro. In the case of the yen, a slowdown in capital repatriation will cause the dollar to gain ground.
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May/ June, 2000

Investor Warren Buffet warns that the internet will create no more wealth than a chain letter and that it is a net negative for capitalists S&P company profits are still up by 20% FTC investigates online anti-trust issues value of all M&A in 1999 is set at $1,100 billion private investors regain appetite for Latin American stocks LBOs surge among old economy firms taking them private once again Investors still not making commitments to emerging market economies IPO underwriting at second highest in first quarter 65% of mergers fail to benefit acquiring company dollar sentiment begins to fall
CROSS BORDER M&A EFFECTS ON DOLLAR
(Data for March/April of 2000) US Companies Acquiring Foreign Companies: 15 Capital Outflows From US From M&A: $22.87 bn. Foreign Companies Acquiring US Companies: 22 Capital Inflows to US From M&A: $73.22 billion Net Capital Inflows to US From M&A: $50.35 bn. Net M&A Impact on US Dollar Value in Global Currency Markets is Positive (+) Judging by the actions of several prominent currency hedge funds, the dollars days as the strongest currency among G7 countries is numbered. Despite the stability in yen markets over the past several quarters, most funds are making very large bets on the Euro, which has been severely oversold. This, combined with a heightened state of risk in the US economy after the Federal
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Reserve has opted to aggressively raise interest rates, could propel the US economy into a sudden recession far faster than most investors are prepared to admit. Any correction that is unexpected among the leading high tech stocks and the top Dow Jones performers, could reverse the record capital inflows into the US. This, combined with a stubborn trade deficit, will divert attention from the positive fundamentals that have been so prevalent over the past several years. Sentiments have favoured the US economic performance so much, that fundamentals such as the record trade deficit have been overlooked as well as submerged under the record investment flows that have been favouring dollar based assets.
This time around, it is the US economy that may easily fall under scrutiny, should there be an about face in investor sentiment spurned on by the unexpected aggressiveness in Fed policy. No longer are dot.com investments and high tech stories so irresistible, after the Fed has pegged risk free rates to levels that can no longer be overlooked by investors. With a Euro zone that is reaping the benefits of a record low currency and which is enjoying record low prices in the credit and money markets, a turn around in the regions economic fortunes is just around the corner. This time, it is the lofty valuations of US stocks that will determine how far the dollar will correct should there be a puncture in the stock markets by the Fed. FORECAST Go long the Euro. The European single currency has hit bottom- finally! Current parities between the old German mark and the US dollar have not been so out of line since the early to mid 1980s, under Ronald Reagans presidency. After realising the imbalance in the mid 1980s, the Plaza accords negotiated among G7 Finance Ministers, revalued both the Deutsche mark and the Japanese yen relative to the dollar. At that time, the dollar was overvalued based on the persistent and growing current account deficit in the US. This situation is once again being played out, yet this time around the current account deficit has been smothered by the inflows from portfolio as well as longer term direct investors that desire an exposure to the US economy. In short, the makings are once again in place that signal the need for a reversal in the value of the US dollar relative to the Euro.
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July/ August, 2000

FDI at record level of $282.9 billion in 1999 or 31.4% higher than 1998 FDI is three times higher now than in 1997 FDI flows were driven by the high tech sector anti-trust issues arise in UALs acquisition of USAirways as merged company will control about 27.4% of available seat miles in U.S. Internet sales jump by 1.2 % in first quarter Manufacturing slows in May Fed not expected to raise rates in election year any further Internet companies will have trouble raising funds Junk bond issues rise ten fold in May $165 billion of international contracts affected by bribes to public officials over past 6 years
(Data for May/June of 2000) US Companies Acquiring Foreign Companies: 12 Capital Outflows From US From M&A: $17.47 billion Foreign Companies Acquiring US Companies: 24 Capital Inflows to US From M&A: $65.98 billion Net Capital Inflows to US From M&A: $48.51 billion Net M&A Impact on US Dollar Value in Global Currency Markets is Positive (+)
Alan Greenspan is convinced more than ever before, that productivity gains from the new information economy are irreversible. In its official report, the Fed sees more high tech driven expansion in the west, with high tech gains continuing to drive house prices higher in California, Oregon and Washington state. In addition, the productivity gains generally from high technology are visible in reduced inventories which companies keep, as well as in information that is generated in order to better meet consumer demand and serve the marketplace.
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The Nasdaq high tech market which was close to falling into the high 2,000 range, has recovered back near the 4,000 level. It is an indication of uncertainty, as cash burn-out rates are continuing for some second-tier companies such as CDNow and Buy.com, only to be contrasted by the above expectations results that were generated from Yahoo. As the good internet companies begin to absorb the weaker groups, the Nasdaq may be expected to rise further, given that there still exists a surplus of funding capital that is looking for alternative investments. The downturn in the economy will come from the enormous competitive pricing pressures, and will ensure that disinflation will become the real problem over the second half of the year. The Fed should be thinking of a rate reduction at this point to engineer the highly desired soft landing. in the U.S. FORECAST The dollar continues to trade high relative to the Euro, despite a recent attempt to break out of its trough. It is relatively stable with respect to the yen. With rates expected to decrease, the Euro should see some life return to its trading pattern. The yen will remain strong at its current level.
Further, Greenspan admitted that rate increases may be coming to a natural end, despite the political manoeuvring in an election year, as competitive pressures in the economy are creating uncertainty in the job market. Now, more than ever before, the internet economy seems to have carved out a marginal hold over consumer buying patterns in the U.S. This, despite the fact that we are still in some sort of high tech overshoot correction in the stock market, the evidence nonetheless points to slow marginal gains when it comes to online sales. The prime internet companies such as AOL Time Warner and Yahoo, will report increased earnings, while others such as Amazon.com will attract attention from reports of continuing losses and cash flow burn-out. Some internet companies will collapse, while the merger of the weaker will ensure that the high level of venture capital investment that was committed to these companies, will be preserved in some way by continuing the business in a restructured form.
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September/ October, 2000

Bank of Canada Governor Gordon Thiessen steps down UK Competition Authorities launch investigation over Air Canadas takeover of Canadian Airlines Reports of intensifying capacity pressures DeBeers focuses on diamond exploration in Canada spending $28.5 million Nortel Networks becomes most profitable multinational company in the world Hollinger to sell most of its community newspapers across Canada Bank of Canada moves to raise central bank rate in step with Fed Speculators attack dollar over rate hike fearing that recession is inevitable
Canadian companies acquiring foreign companies: 2 Capital Outflows From Canada From M&A: $4.65 billion Foreign companies acquiring Canadian companies: 1 Capital Inflows to Canada From M&A: $900 million Net Capital outflows from Canada From M&A: $3.75 billion Net M&A Impact on the Canadian Dollar in Global Markets is Positive (-) The recent increase in US short term interest rates prompted the Bank of Canada to match the half percent increase. The red hot tech economy of the US which was behind the move to raise rates, was only lukewarm in Canada at best. Since the increase, many have stepped forward to criticise the move, based on the fact that the Canadian economy has not experienced the rapid growth that is based on productivity gains driven by technological advances. Sure, there have been a few global success stories that have come out of Canada; most notable of which have been Nortel Networks and telecoms group BCE. Although they make up nearly thirty percent of the market capitalisation of the Toronto Stock
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Exchange, they are not necessarily representative of the broader Canadian economy.
To a very large extent, the broader economy in major cities is fast becoming dependent upon a growing retail sector. A sector which is notable for experiencing severe price competition. In this area, large US retailing groups continue to expand in Canada, driving out their much smaller competitors based on price competition on purely economies-of-scale grounds. In that respect, the broader Canadian economy has experienced very uneven growth rates throughout the 1990s, including the booming latter half. There are areas that mirror the high tech boom of the US, but they are not representative of the overall composition of the economy. To an even larger extent, Canadas over-reliance on retail growth means very severe price competition and disinflation. Add in the commodity argument, and the overall picture begins to look very different from the case being made south of the border.
Based on this view, a matching of the rate increase by the Fed is not warranted, and may tip the Canadian economy into a recession in the third quarter of the year. Investors fear that should a recession be manufactured domestically, then a weaker dollar will be the only way out of the situation. Already, manufacturers are lobbying for an even weaker currency as the US market begins to slow somewhat. The recent rate increase may have gone just a little too far. FORECAST The dollar challenged the US$0.69 level for a very brief period of time. Since the rate increase, it has come back down to US$0.66 and risks falling below this resistance point. The performance of the economy will come under even greater scrutiny over the next quarter for signs that growth has come to an end. The fears that are beginning to grip many investors are that growth can only maintain its pace at the expense of the dollar.
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November/ December, 2000

Royal Bank of Canada moves to acquire US regional securities house Dain Rauscher for $1.46 billion Trade surplus registers C$4.2 billion in July falling below expectations Gold and banking stocks perform well after strong growth in the second quarter Hollinger seeks buyer for the Jerusalem Post Of the Big 5 banks only the Bank of Montreal has reported disappointing results for the quarter TSE300 index begins to retreat as high tech stocks like Northern Telecom begin to experience consolidations Cross border acquisition activity suppresses dollar as a record net capital outflow ensues
Canadian companies acquiring foreign companies: 5 Capital Outflows From Canada From M&A: $49.06 billion Foreign companies acquiring Canadian companies: 6 Capital Inflows to Canada From M&A: $3.16 billion Net Capital outflows from Canada From M&A: $45.90 billion Net M&A Impact on the Canadian Dollar in Global Markets is Negative (-) Recently, the trade surplus has been slipping, but remains positive overall. However, net capital outflows of some $46 billion have worked against the Canadian dollar in global currency markets. Several large acquisitions involving telecoms group JDS Uniphase, have exerted enormous down pressures on the Canadian currency, while capital inflows from acquisitions activity have resulted in an inflow of only three billion dollars. Just as the cross-border mergers and acquisitions account is not in favour of the dollar, the portfolio investment side remains convinced of the record performance in the Toronto Stock Exchange. Therefore, with both the
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trade account and portfolio investment favouring the dollar, investors can see just how powerful the erratic acquisitions flows can be. The recent evidence in Canada can be called a perfect case study of how a mega-deal directed towards the U.S. market, can destabilise the Canadian dollar and cause it to drift downwards.
If we factor the acquisition effect out, and try to measure the risks of reversal in the portfolio investment accounts and the trade surplus, then what could be a possible scenario for the dollar? For one, the risks of an imminent U.S. economic slowdown is foremost on the minds of trade dependent manufacturers in Canada. Likewise, any reversal in the fortunes of the TSE300 stock market index, would require a severe setback and correction in high technology stocks. Both of these events would be evident in the U.S. first.
To begin with, a downturn in the U.S. economy is inevitable, as is currently being witnessed in the all-important auto parts and components sector. This is where the Canadian trade surplus could really be hit hard, and the risks for a setback can be considered as being quite high. Any setback in the TSE300 index would require a substantial high technology meltdown, affecting the infrastructure-driven stocks such as Nortel Networks. This is not expected to occur so that foreign investors would be so turned off of the Toronto stock market. However, mega-deals of a cross-border nature are not expected to hit the levels seen over July and August in terms of capital outflows. They may have a reverse affect, with a foreign group making a large play for a Canadian based asset. FORECAST The dollar is expected to regain some of the lost ground made over the past several months, as the cross-border effect works itself out. The only danger from here is the impact of a protracted U.S. economic slowdown on the all-vital component of Canadian exports.
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November/December, 2000
Liberals propose a C$100 billion five year package of personal and corporate tax cuts TD Bank moves to raise provisions against loans to the telecom and media sectors TSE300 index challenges the 9,000 level after being as high as 11,000 Nortel Networks loses some $200 million in market value since its peak in July 2000 TSE300 index is left with a gain of just 5% for the year after peaking at 35.7% in September dollar dips to a two year low of US$0.6424 nearing its alltime low of US$0.6311 Canadian investors send $39.1 billion to foreign securities in first ten months setting a new record
Cross Border M&A Effects on Dollar
Canadian companies acquiring foreign companies: 2 Capital Outflows From Canada From M&A: $1.73 billion Foreign companies acquiring Canadian companies: 2 Capital Inflows to Canada From M&A: $1.87 billion Net Capital inflows to Canada From M&A: $0.14 billion Net M&A Impact on the Canadian Dollar in Global Markets is Positive (+) Many analysts and business persons feel more optimistic over the prospects of the Canadian economy than they do about the US. The US was greatly buoyed by the dot.com revolution, which at this moment has suffered a serious setback, as most successfully financed companies are now finding it enormously difficult to attract further funding, after going through very high burn rates in their cash reserves.
The revolution in internet financing did not play a big role in Canada. Sure there were a few leading-edge high tech groups such as Ballard Power Systems and Nortel Networks, but the venture capital scene was never in step with what was happening in the US.
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Canada sends one-third of everything that it produces to its southern markets. Another way of looking at its relationship with the US, is that any given household income would have about thirty-five percent of its source determined by what was sold in the US. Therefore, any setback as is the case currently in the prospects for economic growth in the US, has very serious repercussions for the well-being of Canada.
The Canadian dollars recent weakness partly reflects this over-reliance on the US market. It also reflected the high long term capital outflow from merger and acquisition activity, not to mention the fact that Canadian financial investors sent some US$39.1 billion out of the country and into foreign securities for the first ten months of 2000.
Is the current setback in US growth a temporary development, or will it be broad and for a longer duration. The recession in the early 1990s created real havoc in Canada, as the downturn was deeper and much longer than in the US. The structural changes that were required for a regime of free trade and one that embraced new and more efficient technologies did not result in good economics in Canada until at least 1996, leaving the country in a state of recession for at least four years after the US recovery took hold shortly after the Gulf War.
Inevitably, the US slowdown will lead to deteriorating conditions in Canada. A downturn is much more closer than what the current wisdom indicates and an ever weakening dollar is evidence of that. Dollar weakness will continue.
FORECAST The dollar was on its way towards its all-time low of US$0.6311, stopping just short at US$0.6424. Despite generally favourable economic and business conditions, the dollar continues to languish at its all-time lows. This is the opposite from the evidence in the US, where the dollar is at historic highs in global currency markets, despite the record trade deficits that countries such as Canada contribute to regularly.
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G7 Books Canadian Dollar Chaos by William B.Z. Vukson

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Canadian Dollar Chaos

G7 Books Toronto, Ontario, Canada g7research@eol..ca

Canadian Dollar Chaos

Canadian Dollar Chaos

Canadian Dollar Chaos

CANADA AND THE DOLLAR

Canadian Dollar Chaos

Canadian Dollar Chaos

THE G7 AND EXCHANGE RATES

Canadian Dollar Chaos

Canadian Dollar Chaos

MARKETS OVER POLITICS

William B.Z. Vukson

Canadian Dollar Chaos

THE NORTHERN PESO

A Vote For Separation In Quebec Will Create Another Peso Effect

Canadian Dollar Chaos

TWO CRISES: THE PESO AND THE NORTHERN PESO

Canada Joins Soft Currency Club

Canadian Dollar Chaos

Canadian Dollar Chaos

Mexican Peso Crisis

been the case, and it turned into a classic currency crisis.

Canadian Dollar Chaos

Canadian Dollar Chaos

Canadian Dollar & Canadian Companies

Canadian Dollar Chaos

First Quarter: March 21, 1992

Canadian Dollar Chaos

Second Quarter: May 21, 1992

Canadian Dollar Chaos

Third Quarter: July 24, 1992

Canadian Dollar Chaos

Fourth Quarter: September 11, 1992

Canadian Dollar Chaos

First Quarter: December 15, 1992

Second Quarter: March 19, 1993

Canadian Dollar Chaos

Third Quarter: July 16, 1993

Canadian Dollar Chaos

Note: Industry includes: mining, quarrying, oil, manufacturing & utilities

Fourth Quarter: October 12, 1993

Canadian Dollar Chaos

First Quarter: 1994; December 18, 1993

Canadian Dollar Chaos

(a) 1992 and 1993 data are Commission forecasts

(b) Source: OECD Economic Outlook 53, June, 1993

Source: European Economy, Annual Economic Report 1993

First Quarter: February 14, 1994

Canadian Dollar Chaos

Canadian Dollar Chaos

Second Quarter: April 22, 1994

Canadian Dollar Chaos

1988 1989 1990 1991 1992 1993

Third Quarter: September 25, 1994

Canadian Dollar Chaos

Percent Changes in Manufacturing Unit Labour Costs (Table II)

Source: Bank of England Quarterly Bulletin. August, 1994

First Quarter: January 5, 1995

Canadian Dollar Chaos

Canadian Automotive Trade (Millions)

Canadian Dollar Chaos

Total 1993 %Change