Fraser Forum

Exchange rates can overreact to news reports including NAFTA buzz

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This week a report stating that the Canadian government is increasingly convinced that President Trump will pull the United States out of NAFTA was credited with causing the Canadian dollar to drop from a closing value on Jan. 9 of US$.8030 to US$.7953 by midday Jan. 10.

This despite the same sources indicating that Canada plans to stay at the negotiating table, even if Trump pulls out of NAFTA.

Substantial changes in exchange rates shouldn’t be ignored, as they reflect the economic judgments of numerous relatively informed participants in the international economy. Indeed, it’s tempting to rely on changes in exchange rates as relatively reliable signals of future changes in the international economic landscape. However, exchange rates respond to many factors and often “overreact” to specific events and news reports. In this regard, the reaction of foreign exchange markets to the latest Canadian government assessment of NAFTA seems inconsistent with exchange rate changes that have occurred over the past year.

Specifically, U.S. authorities have threatened to pull out of NAFTA at various times in 2017. For example, at the end of the fourth negotiating round in October, U.S. Trade Representative Robert Lighthizer expressed his surprise and disappointment at the resistance to change by Canada and Mexico.

Indeed, the fourth round was sufficiently contentious that the fifth round in Mexico City was conducted in the absence of trade ministers from all three countries in hopes of softening tensions between the parties.

Unfortunately, tensions did not seem to soften. Lighthizer again expressed his concern about a lack of headway, while Canada’s Minister of Foreign Affairs Chrystia Freeland highlighted proposals put forward by the U.S. that Canada cannot agree to. And prior to the fourth and fifth negotiating rounds, President Trump in August expressed his doubts that the U.S. could reach a deal to renegotiate NAFTA.

In short, the outlook for a successful renegotiation of NAFTA was fraught throughout 2017, particularly in the second half of last year. Yet, the Canadian dollar closed stronger at the end of 2017 than it opened that year. On Jan. 10, 2017, the exchange rate was C$1 = US$.7557, whereas, as noted above, on Jan. 9 of this year, the exchange rate was C$1 = US$.8030.

To be sure, the Canadian dollar has benefited from an increase in the price of crude oil, which was US$53.26 per barrel on Jan. 4, 2017 and US$62.05 per barrel on Jan. 8, 2018. As a large energy exporter, Canada’s terms-of-trade improve with higher energy prices, which should boost the value of the Canadian dollar. Yet Mexico is a net energy importer, and its currency also appreciated over 2017. For example, on Jan. 19, 2017, the exchange rate was US$1 = 21.9780 Mexican pesos, while on Jan. 8 of this year, US$1 USD was worth only 19.2285 pesos.

The main point here is that foreign exchange markets will respond to news and rumours, but they shouldn’t be seen as reliable guides to the future.

The NAFTA trade ministers are meant to return for round six of the NAFTA talks in Montreal later this month. More will be known about the outlook for NAFTA after that round. However, the odds are that substantial changes to the bilateral trade environment will be a drawn-out affair.

Nevertheless, Canadian government officials should be evermore focused on liberalizing trade relationships with other countries—regardless of ongoing developments in the NAFTA negotiations. In this regard, Prime Minister Trudeau should reengage relatively quickly with other countries involved in the renewed Trans-Pacific Partnership negotiations. Although complaints by Australian and New Zealand trade officials, about Canada sabotaging TPP talks last November, should worry Canadians concerned about the uncertain status of NAFTA.