Currencies

How Canada’s loonie became a desired international currency

Canadians may not be aware of it, but the loonie has become an international currency.

The world, for good economic and financial reasons, seems enthralled with the Canadian dollar. In 2000, hardly any central bank held Canadian dollars as reserves. Today, the rest of the world holds about $300 billion in Canadian dollars as reserves, admittedly a small fraction of the total world reserves, but a significant increase in the normally tectonic changes of international reserve holdings.

An international currency acts as an international store of value, unit of measurement, and means of payment. Such a currency reflects global confidence in a country’s management of its banking, financial, and economic system, as well as its political and military influence. We know Canada is not a military power, but that is precisely one of the attractions of the loonie.

The U.S. dollar has been the dominant currency in the international financial system, but its dominance has been declining over the last few decades. In 1999, when the Euro was established, the dollar’s share of international reserves was 71 per cent, but today its share is about 58 per cent because of the decrease in America’s share of global economy, trade, and investment — and the U.S. government’s use of the greenback for political purposes.

The weaponization of the dollar for political purposes by U.S. administrations has contributed to the erosion of the greenback. The U.S. has increasingly imposed economic sanctions on a number of countries, more often unilaterally, occasionally with its allies. As of March 2022, 25 countries, mostly developing nations, are under American economic sanctions.

As a result of the decline in American global economic influence and its use of the dollar as a foreign policy instrument, the world has gradually adopted other currencies as international currencies. The Euro, Sterling, Yen, and Yuan have been used as alternatives to the U.S. dollar but they will not replace it because the greenback has certain advantages. It benefits from what economists call the “network effect,” because of its wide use by many investors, businesses, and governments.

Most of the bonds issued by governments and companies are in U.S. dollars, making international trade in these bonds convenient and efficient with the market for U.S. government bonds being described as “deep and large,” unlike the market for the European government bonds that is fractured, a Japanese market that is small, and a Chinese market that faces capital flow restrictions.

As a result of these advantages, the U.S. dollar will remain an international reserve currency, but it is unlikely that it will remain dominant. A recent study conducted for the IMF shows that over the years, a basket of currencies, which includes the Australian dollar, the Canadian dollar, the Chinese Yuan, and others, has been used as an alternative to the greenback. Within this basket of currencies, the Canadian dollar is the second most important currency, accounting for 23 per cent of the basket, slightly lower than the 25 per cent share of the Yuan.

The Canadian dollar will play an important global role in the basket of currencies, but why is the world gravitating towards the Canadian dollar? Canada is a multicultural country where different linguistic and religious groups live together peacefully. We are seen as a stable, liberal democracy — a soft power that has not overthrown a foreign government, nor invaded a country.

Canada is economically and financially attractive to the rest of the world. Canada, despite its low GDP, has a sound financial and banking system. The IMF study shows that the Canadian dollar has a low bid-ask gap, with a high rate of return to risk, making it highly liquid and extremely attractive to investors. Investors and central banks feel confident about their investment in the liquid, profitable, and secure loonie.

Canada, unlike the U.S., has not imposed its own unilateral economic sanctions or frozen the assets of central banks, with the exception of Russia. Canada has not confiscated the reserves of central banks.

Should Canadians rejoice at the world’s adoption of their currency as a reserve currency? Indeed, they should.

Canada would share what the former prime minister of France, Valerie Gisrcard d’Estaing, called the “exorbitant privilege” of the U.S. dollar. Canadians would pay in loonies when they pay for the import of goods and services instead of paying in U.S. dollars or in Euros; they save service charges on the exchange of the loonie for another currency. They do not have to worry about the volatility of exchange rates. Canadians will pay lower rates on their foreign debt denominated in Canadian dollars, instead of greenbacks.

It will be cheaper to finance trade and budget deficits. Lastly, when the loonies start circulating outside Canada, the circulation is tantamount to a free loan to Canadians, and if they are not used to buy Canadian goods and services, they represent a transfer of real resources to Canada.

The adoption of the loonie as an international currency enhances Canada’s global influence as well discipline Canadian policy-makers.

Move over greenback, here comes the loonie, eh!

Worku Aberra teaches economics at Dawson College in Montreal.

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