The Canadians are coming… The Canadians are coming

As the Yankee dollar continues to slide and the loonie breaks through the 90 US cent barrier For the first time since 1977, everything American – from McDonald’s hamburgers to real estate – looks damn cheap to Canadian eyes.

The $US/$CAD midday rate hit 0.9032 on May 5, 2006 as reported by the Bank of Canada and the loonie is expected to equal the greenback later in the year. There are four main reasons for the Canadian dollar’s recent appreciation against its American counterpart:

[ ] A significant increase in demand for Canadian commodities, particularly oil and precious metals, from the United States. [ ] An increasing involvement of American interests in the exploration and development of Canada’s natural reserves and a resulting increased demand for shares in Canadian companies. [ ] A steady rise in Canadian interest rates, moving faster than corresponding Fed hikes, which in turn attracts foreign investors. [ ] Financial leverage that is higher in Canada than in the US

This last point deserves a closer look as it is directly related to real estate, my specialty and field of activity. Financial leverage consists of borrowing money and reinvesting it in the hope of earning a return greater than the cost of interest. Leverage allows the investor a higher potential return than would otherwise have been available. As real capital appreciation has been observed more frequently in Canada than in the United States in recent years, it turns out that leverage is stronger in Canada than in the US, which means that the spread between real capital appreciation and the cost of borrowing in Canada is higher . This is despite the fact that mortgage rates in Canada tend to be nominally higher than in the States, and in fact wages in Canada tend to be nominally lower.

The last time the Canadian dollar was equal to the US dollar was in 1976, just before the election of the separatist government of Rene Levesque (1922-1987) in Quebec. After that election, the loonie began a long decline, fueled by flagging commodity prices and rising government deficits and domestic debt. The price slide culminated in January 2002 with a record low of 62 US cents for one Canadian dollar.

So the current exchange rate means a huge increase with drastic consequences on both sides of the border. For example, a house priced at $350,000 would convert $564,500 approximately using the 2002 exchange rate of $1.00 = 0.62 CAD. The same $350,000 for residential real estate costs just one cent $387,500 with today’s US$1.00=CAD$0.9032. That’s a difference of CAD$177,000 in just over four years, or put another way, a price decline of about 31.35 percent in four years, or 7.838 percent annually

It certainly beats government bond yields in both Canada and the United States!

It’s even easier to see how attractive American real estate has become to Canadian investors if we look at, for example, the average rental properties that would be sold across the border from my location. In 2002, rental properties in Washington state were selling for an average of $80,000, or CAD$129,000, using the then exchange rate of 0.62 cents. Now, the same rental homes are selling for an average of $115,000, or approximately $127,300 CAD using the 0.9032 exchange rate. Although they have appreciated in value and are therefore more expensive for Americans, they have actually become cheaper for Canadians.

Interestingly, the loonie has not risen rapidly against other key currencies like the euro and yen. A fact that underscores that Canada and the United States have become important trading partners for each other, putting aside disputes and disagreements over the past few years over salmon fishing and timber subsidies. In fact, the Canadian Board of Trade reports that over 70 percent of manufactured goods produced in Canada are destined for American markets, up from just 25 percent in 1980. And Uncle Sam increased his stake in Canadian holdings by 55 percent over the same period , the most recent acquisition being the December 2005 purchase of 100% of Terasen Gas, the exclusive natural gas distributor in British Columbia and Alberta, by Austin, Texas-based Kinder-Morgan LP.

Of course, there are some economic disadvantages associated with having the same exchange rate, mainly because the two economies are significantly different. Not only is America’s GDP ($13.049 trillion) about 15 times greater than Canada’s ($880 billion) – the economic philosophies of the two countries are diametrically opposed. America’s capitalism is based on consumption and prioritizes consumption, i.e. spending over saving. Canada, on the other hand, sets a precedent for saving, so Canadians are cashier and equity richer even when they actually make less money. Which, at the end of the day, makes Canada a much more stable environment.

This goes a long way to explaining why the US economy is much more vulnerable to interest rate fluctuations: with nearly double the domestic debt burden, economic ripples caused by shifts in the cost of borrowing are twice as widespread in the US as in Canada. A fact that is also reflected in the greenback’s weakness against the loonie.

Canadian companies are therefore losing their trade competitiveness from an equal or near-equal exchange rate situation, as manufacturers north of the 49th parallel must reduce their production costs while leveraging economies of scale to increase productivity to remain competitive in American markets. But on the other hand, increased international demand for the greenback, caused by an increase in demand for American real estate products by Canadian investors, may cause a corresponding increase in domestic interest rates, which could lead to further financial imbalances in the US. ‘Debt service ratio’ – the ratio of mortgage payments to disposable income – is already a whopping 47 percent in the United States.

Luigi Frascati