(December 31, 2004) The rapid appreciation of the Canadian dollar was one of the biggest economic headlines of 2004 and it looks like the pricey loonie will continue to dominate in 2005, according to various economic reports.

The International Monetary Fund applauded Canada for its economic performance for 2004 and estimates a growth rate of 3% in 2005. The IMF cites “strong profits, high world commodity prices, and a pickup of business investment” as the drivers which will support continued expansion, but also warns the currency issue could haunt the country.

“While the Canadian dollar’s recent appreciation appears broadly consistent with medium-term fundamentals — including world commodity prices and a large current account surplus — its strength and the expected slowing of U.S. growth are likely to exert a dampening effect on real net exports,” the IMF said in a report.

The Canadian dollar was forced higher throughout 2004 by the rapidly falling U.S. dollar as well as rising commodity prices. Demand for minerals and energy helped keep the economy chugging along.

Economists from Canada’s big banks tend to agree that weakness in the U.S. dollar is likely to persist throughout 2005, posing one of the biggest threats to Canadian growth.

“From a Canadian perspective, the appreciation of our currency has major implications for growth, inflation and policy settings,” says Warren Jestin, chief economist at Scotiabank. “The move into the 80-85 cent (US) range has dampened exports, production and job creation in the manufacturing sector.”

Jestin says the dollar will likely “test” the 90 cent mark in 2005, thanks to continued Asian demand for Canadian energy reserves. Predictions from TD Economics also see the loonie moving higher, spending 2005 between 82 and 86 cents, while RBC expects the dollar to end 2005 around 80 cents.

“Canada’s economy weathered the rapid appreciation of the Canadian dollar in 2004 and the recent slowing in world economic growth with surprising resilience,” said Craig Wright, vice-president and chief economist, RBC. “Several key factors point to healthy economic growth for Canada in 2005, despite the continued challenges of a strong currency.”

RBC is predicting growth of 2.7%, roughly in line with Scotia’s estimate of 2.5%. Wright says growth will be driven by strong consumer spending and business investment, as steady labour markets and rising incomes boost consumer confidence. But our reliance on the U.S. market will cost exporters, as the weak U.S. dollar makes Canadian goods less competitive.

Ottawa appears to be addressing this matter, working on bilateral trade deals with other countries to broaden the export market where the loonie has not gained as much against the local currencies.

In the U.S., economic growth is seen slowing again, as the government attempts to rein in its massive current account and fiscal deficits.

“Financing the current account deficit requires that the U.S. attract US$2.6 billion in foreign capital inflows every business day — a big chunk of change that overseas investors are becoming increasingly leery about providing, given their already sizeable holdings of U.S. assets,” said Gillian Manning, economist at TD Bank Financial Group.

Further pressuring the U.S. dollar, Manning predicts China will finally adjust its currency value, which has been pegged at an artificially low rate to the U.S. dollar. An upward revision of about 10% is likely in the cards, she says, and such a move could have far-reaching consequences as other Asian economies adjust.

“This should be a catalyst for similar moves in the rest of the Asian currency bloc, where central bank intervention to date has been aimed in part at keeping exchange rates competitive versus the renminbi,” said Manning. “This has implications for fixed income markets, as well as foreign exchange markets.”

Asia’s central banks have been the main supporters of the U.S. dollar, buying up U.S. Treasuries. As the renminbi is adjusted, the appetite for U.S. fixed income could be reduced, driving yields higher and the dollar lower.

“One thing a revaluation in China doesn’t mean, however, is an end to upward pressure on other currencies like the euro,” says Manning. “The floating currencies will have to move higher, and the luckless euro — a victim of its perceived candidacy as an alternative reserve currency to the U.S. dollar — will not be spared.”

TD predicts the rising euro will also drag other European currencies higher, with the British pound “flirting” with the US$2 mark midway through 2006. The Swedish krona and Swiss franc are also expected to hit “multi-year highs.”

Scotia’s Jestin says the declining U.S. dollar will help reduce the American trade deficit, with exports rising by up to 8%. This new-found strength should allow the U.S. economy to post a respectable 2.9% advance next year.

The RBC prediction is even rosier, with GDP growth hitting 3.7%, declining from 2004’s 4.4% as the U.S. consumer finally shows signs of fatigue. RBC also says the risk of inflation should not be ignored.

“One of the most important risks to the outlook is a sharper rise in U.S. core consumer price index figures and sharply higher interest rates,” RBC says in its forecast. “This would come as a result of a more excessive response to rising commodity prices, a falling U.S. dollar, and a decade-high rise in pricing power by corporations.”

RBC predicts the Federal Reserve will raise its rate to 3.25% in 2005, with the Bank of Canada rate rising to 3%, reversing the current interest rate gap.

Filed by Steven Lamb, Advisor.ca, steven.lamb@advisor.rogers.com