Dollarization? Not here

National Post
May 17, 2002

The sharp depreciation of the Canadian dollar and the successful launch of the euro have spawned an animated debate among academics and policymakers concerning the potential benefits of "dollarization." Some observers have suggested that any decision made at an official level will be largely irrelevant -- since dollarization is already proceeding through less formal channels. With or without the agreement of policymakers, therefore, market forces will eventually ensure that the U.S. dollar becomes our preferred unit of account, medium of exchange, and store of value.

Although the evidence that we report is admittedly fragmentary, existing data suggest that informal dollarization is proceeding at a very slow (to non-existent) pace. Indeed, by many measures, Canada is less dollarized now than it was 20 years ago, and bears little resemblance to those economies that are typically regarded as truly dollarized. Some Canadian companies maintain their financial statements in both Canadian and U.S. dollars, and roughly 9% of the deposits held at Canadian banks are now denominated in U.S. dollars. Canadians also appear to be holding an increasing proportion of their financial wealth in U.S. dollar assets. It would be a mistake to interpret this as evidence of dollarization, however, in the sense that domestic economic activity is being conducted increasingly in U.S. dollars. The assets that Canadians hold in foreign currencies are used, for the most part, to support business activities abroad and to achieve a more efficient allocation of wealth. Globalization and diversification, in other words, should not be confused with dollarization.

While globalization may eventually push us to a point where the benefits of operating under a common currency outweigh the advantages of a separate national currency, this "tipping point" does not appear to be imminent. Some observers would like to believe that the end is near, but the changes we have witnessed so far are less revolutionary than these visionaries suggest. To paraphrase from Samuel Clemens: Reports of the impending death of the Canadian dollar are greatly exaggerated.

The ratio of foreign currency deposits to broad money has traditionally been used by the International Monetary Fund and others as a proxy for assessing the extent to which a country is "dollarized." After holding relatively steady through the 1980s, U.S. deposits rose sharply in absolute terms through the 1990s to stand at roughly US$43-billion in 2001 on a booked worldwide basis. On a "booked in Canada" basis, U.S. dollar deposits of Canadian residents stood at about US$35-billion. Converted into Canadian dollars and scaled as a proportion of broad money (M3), one can see a sharp pick-up in the proportion of U.S. deposits through the 1990s, touching slightly over 9% on a booked worldwide basis in 2001, up from roughly 3% in 1992. It is worth noting, however, that these ratios have fluctuated over a wide range during the past 25 years. In neither case is the current level exceptional.

Generally speaking, foreign currency consumer lending by Canadian banks to Canadian individuals has been on a slow upward track in current dollar terms over the past 20 years. But as a share of total bank lending, foreign currency lending accounted for slightly less than 1%, unchanged from its share in 1981. Foreign currency lending to Canadian firms has also been on a slow upward track in current dollar terms over the past 20 years. However, as was the case for consumer lending, the share of foreign lending as a proportion of total business lending has remained essentially constant over the past 20 years at roughly 18%.

Relative to many other industrial economies, we are remarkably "undollarized." Despite the close proximity of the U.S. economy and the evident importance of U.S. exports and imports to the Canadian economy, very little informal dollarization has taken place. The significance of the U.S. dollar as a medium of exchange and store of value is often greater in countries like Japan and the United Kingdom, than it is in Canada.

Most goods and services in our country are priced exclusively in Canadian dollars, unless they are destined for the U.S. market or involve the sale of a primary product. The same is true for the preparation of corporate financial statements, unless the company is a large multinational and conducts most of its business outside Canada. Firms with inter-listed shares are often required to use the U.S. dollar for reporting purposes, but the relative importance of Canadian firms with stock listed on the NYSE and other U.S. exchanges has actually been declining over time -- both compared to other foreign firms and as a share of the firms listed on the TSE. In short, the U.S. dollar is seldom used as a unit of account for domestic transactions.

The one area where dollarization is more prevalent is as a store of value. Canadian households seem to be directing an ever larger share of their portfolios to U.S. dollar assets, while Canadian firms are raising an ever larger share of their long-term capital in U.S. dollar denominated bonds. Once again, however, the relative importance of foreign investment and borrowing activity in Canada are often much lower than those reported in other industrial countries. Moreover, most of the foreign investment activity that we have seen in the recent past can be credited to looser government restrictions. Standard portfolio models indicate that, by most measures, Canadians are still seriously under-diversified, and that more outward investment can be expected in the future.

There has never been a case in which unofficial dollarization was effected under a regime of sound macroeconomic management. In fact, the evidence tends to go in the other direction. Countries, it seems, must chronically mismanage their economies before households and firms show any indication of shifting to other currencies.

The counter to this argument, as well as to past experience, is that Canada is special, and that dollarization remains a strong possibility. Old rules, therefore, will not necessarily apply. Canada enjoys a unique relationship with the United States, and has an unprecedented amount of trade and investment with its southern neighbour. These factors, the proponents suggest, increase the likelihood of dollarization and override the lessons learned in other countries.

While such an outcome is always possible, nothing that we have uncovered in the data points in this direction. Many of the recent trends actually move in the opposite direction, and indicate that dollarization is less likely now than it was in the past. The best contribution that the Bank of Canada can make to the performance of the Canadian economy and to the longevity of the Canadian dollar is to maintain low and stable inflation.

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