Why Is the Canadian Dollar Down?

Okay, perhaps this topic isn’t timed terribly well, on a day when the loonie jumped nearly 4 cents versus the U.S. dollar, but the overall trend for the Canadian dollar since the start of the recent financial crisis has been down, and in a big way. I’ve had many questions on the topic, which all pretty much boil down to this: if the American economy is doing so poorly, the Federal Reserve is lowering rates down to near-zero, and the government is borrowing money like it grows on trees, how come the greenback is still doing so well against most world currencies? It’s a 3-reason answer.

  1. The Canadian dollar is now a petro-currency. Canada’s exports consist mainly of resources, and more specifically, oil. With the slowing global economy, oil prices have fallen dramatically, dragging down the Canadian dollar along with it. Canada’s ‘fortunes’ are linked to the prices of the various resources we export. Although our financial system has weathered the brunt of the storm, other countries will experience slower growth, which means less oil consumed and slower consumption of base metals, hampering our economy nonetheless.
  2. Supply. Although the U.S. Federal Reserve has been pumping money into the banking system to lubricate the gears, many banks are hoarding money, not willing to lend. Of course this defeats the point of the money inflows to the market, but despite the talk of hundreds upon hundreds of billions of dollars, not much of it is seeing light outside the banks.
  3. Demand. Despite everything that’s happened in the United States, the greenback is still the choice currency during flights to safety. It is one of the global currencies that almost any business can be done with. In times of uncertainty, the U.S. dollar is the fallback for many people.

So despite a weakening U.S. economy, low interest rates, and a large money supply, its dollar still remains the de facto standard for world trade. Whether this financial crisis ends up being a turning point for that fact remains to be seen.

Another Black Monday

Although I’d rather see the market go the other way, the crash of the North American stock markets today was a sight to behold. Following (eerily) in the footsteps of several previous Black Mondays (1929, 1987), perhaps Monday, September 29, 2008 will go down in history as the beginning of a serious global financial crisis, after the United States House voted down the proposed $700 billion bail out package. With the 777.68 point fall, the Dow Jones had broke its single day point loss record. Here are a few other market finishes at a glance.

  • Dow Jones -777.68 to 10365.45
  • NASDAQ -199.61 to 1983.73
  • S&P 500 -106.62 to 1106.39
  • TSX -840.93 to 11285.07
  • FTSE 100 -269.70 to 4818.77
  • CAC-40 -209.90 to 3953.48
  • DAX -256.42 to 5807.08

Today’s Activity – Bank Run

If there was any point drilled home by Larry Smith in my ECON102 class, it would be that the entire basis of the  financial system is, in effect, imaginary; for example, the worth of money or the perception that we can always get our deposits from a bank. In fact money only has worth in that everyone accepts it as a certain value (usually enforced by the federal reserve banks. That’s where the statement on your $20 bill that goes something along the lines of ‘this note is legal tender’ comes from. We’re ‘forced‘ to accept cash as a form of payment! Furthermore, banks certainly do not hold in their vaults enough money for everyone to withdraw their deposits at once. But that’s not the point. If everyone regularly withdrew all their money at the same time, there’d be little need for banks. You could simply stash your cash under your mattress.

See it all boils down to the reserve ratio (ratio of legal notes held at a bank versus transaction deposits). No bank has a 1.0 reserve ratio. That means it’s impossible for everyone to withdraw their deposits at the same time. In reality, reserve ratios for banks in many developed countries is very low, typically in the low to mid single digit percentages. And so enter the danger of a ‘run’ on a bank.

When the masses sense impending danger at a bank, they typically rush to their nearest branch and attempt to withdraw a lot of money. This has been especially prevalent in recent months, as even large financial institutions have shown they’re not immune to the effects of the credit crisis. Washington Mutual, the latest banking failure in the United States, had around $16 billion of deposits withdrawn, or nearly 10% of all deposits! Capital is the lifeblood of the banks and when liquidity is squeezed by mass withdrawals, it’s pretty much the end of the story.

But you might also be able to see the paradox in the system. It’s a huge feedback system. A bank gets into a tight spot due to a financial crisis, but perhaps one it could work its way through. All of a sudden, customers hear of the problem and make a run on the bank, withdrawing deposits. Then, what was possibly a manageable problem turns into a nightmare as all capital dries up at the bank, making it unable to do business. It’s what happened at Northern Rock, Washington Mutual, and as word comes out of Europe, what will possibly happen at Fortis, a major bank in the Benelux countries and one of the largest financial institutions in the world. Because the financial system is based on trust and a belief, fear can in effect destroy it.

That’s why some form of a rescue package for these banks is so important. The trust of the Americans in their financial system is teetering. A further deterioration in the financial system there will have catastrophic effects on the entire world.

Lehman – Bankruptcy, Merrill – Acquired

The U.S. financial crisis is no longer a crumbling cookie. It’s been smooshed by a sledgehammer. Shortly after all parties walked away from a takeover bid for Lehman Brothers, apparently forcing it into bankruptcy, Merrill Lynch, the world’s largest brokerage, was pressured into a takeover by Bank of America, who has already consumed a victim of the recent financial meltdown, Countrywide Financial.

Although I’ve been following the news on a daily basis, I don’t think I’m alone when I say I really didn’t see the situation getting this dire this quickly for the investment houses. And for all we know, this could be just the tip of the iceberg. Washington Mutual and American International have both been hard hit and are under pressure by investors. (AIG will reportedly announce asset sales tomorrow to bolster liquidity.) Of the 5 major U.S. investment houses, it’s starting to look like only Goldman Sachs and Morgan Stanley will be able to ride this crisis out.

My sympathies to the massive job losses that are sure to come at both Lehman and Merrill.