Canadians won't escape the effects of global currency chaos

For Canadians, usually the most pressing reason for thinking about global currencies is to know what you can buy with your loonie when you visit Mexico, Europe or the United States.

By that token, Canadians currently travelling in Britain will likely be very pleased when they examine their credit card statements back home. Earlier this year, you had to pay $1.70 for one pound sterling; this week the British currency plunged to less than $1.50.

It means after accounting for that country's roaring inflation, a pint of beer in some London establishments will cost you (a mere) 12 bucks. On a brighter note, a pint in a Lancashire pub without London overhead goes for less than three loonies.

But while getting travel bargains may be gratifying, the eventual reckoning for Canadians and their economy may yet be costly. Some analysts warn that a growing wave of global instability in exchange rates could actually lead to a new financial crisis quite different from the one that hit the banking sector in 2008.

If so, Canadians will not escape its effects.

And while the U.S. is riding high at the top of the currency pyramid just now, if history is a guide, the soaring greenback could lead to problems for the U.S. economy down the road that financial markets have not yet taken into account.

Pound plummets 

In a world beset by inflation, rate hikes and volatility, this week the British pound became the poster child for currency instability, a role it has played in the past, including during the "sterling crisis" of the 1990s. 

This time around, following unanticipated moves — including a big tax cut for the rich — by the latest in the U.K.'s revolving door of prime ministers, Liz Truss, and her financial minister Kwasi Kwarteng, even the International Monetary Fund felt it had to speak up.

"Given elevated inflation pressures in many countries, including the UK, we do not recommend large and untargeted fiscal packages at this juncture, as it is important that fiscal policy does not work at cross purposes to monetary policy," said an IMF spokesperson in the kind of statement usually reserved, as one commentator told me, for developing countries.

As the currency continued to slide on Wednesday, the Bank of England was struggling to calm markets, and it would "start buying government bonds at an 'urgent pace' to help restore 'orderly market conditions,'" the BBC reported. A report in the London Financial Times quoted one senior banker as saying the British bond market came near to a "Lehman moment," a reference to the chaotic moment when Lehman Brothers bank collapsed in the 2008 financial crisis.

Sharks circling

Part of the problem is that while extreme currency moves are caused by genuine worries, said Jacqueline Best, a professor at the University of Ottawa who studies the politics of finance, they also act like blood in the water to attract the sharks of the foreign exchange world: currency speculators.

"Obviously we have massively increased volatility right now in currency markets, which is worrying," said Best.

She said normally the system of floating exchange rates between national currencies works well and allows gradual changes in currency values as the relative strengths of economies vary.

"But their downside is they can become very volatile and that volatility can be self-reinforcing as speculators and traders start trying to make bets on where currencies are going," said Best.

While it is the countries with weaker currencies that are suffering, at the heart of the problem is the soaring U.S. dollar, said Eric Helleiner, a political economist at the University of Waterloo who specializes in international money and finance. He points to parallels with the 1980s, the last time the U.S. central bank pushed interest rates up sharply to defeat inflation.

"When U.S. rates are rising and the U.S. dollar is rising, it puts huge pressure on countries that have debts denominated in dollars," said Helleiner.  

Similar to what happened in the Latin American debt crisis beginning in the 1980s, known as "The Lost Decade," he said the countries and businesses that have borrowed in U.S. dollars and yet hold their collateral and get their revenue in a much-depreciated local currency can end up facing default.

A price to pay 

As money flows into the security of the U.S. dollar, that country too, may have a price to pay in future. 

"What we haven't seen but could emerge over the more medium term is that early eighties experience, when the U.S. dollar rose very rapidly," said Helleiner. "It eventually generated considerable protectionist sentiment."

Effectively, foreign goods priced in cheaper foreign currencies swept into the U.S. in turn pushing U.S. manufacturers out of business.

Karl Schamotta, chief market strategist with Corpay, who helps Canadian companies deal with currency risk, said that while that kind of U.S. protectionism may arise again, there is often a lag of years between shifts in the value of currencies and the price of imports.

More important just now is something sometimes called the "dollar funding squeeze," where countries and companies find themselves short of U.S. dollars as money pours into U.S. bonds and other secure U.S. dollar-denominated assets.

"The U.S. is like a vacuum and it's vacuuming up money from the rest of the global economy and depositing it in the U.S. and so that means less money for the rest of us," said Schamotta.

U.S. dollar versus the world

He said that for relatively small open economies like the Britain and Canada, where money is able to flow out when its owners want it to, the process makes money more expensive. In other words, it pushes the loonie down and the cost of borrowing even higher than it would otherwise be.

Low interest rates around the world led countries and businesses to stock up on debt. Now they have to repay that debt in more expensive money. That will inevitably lead to instability in global markets including here in Canada.

In some ways Canada has an advantage. Partly because of the country's commodity exports, from oil to minerals, fertilizer and food, the loonie has not fallen as far against the U.S. dollar as other global currencies. But on the other hand, said Schamotta, Canadian households and business carry some of the biggest debt loads in the world.

Schamotta said growing fears of a new global financial crisis are by no means completely out to lunch. While regulators have repaired the flaws in the banking system that led to the 2008 crisis, as global interest rates rise and world economies weaken, there are new forces at work.

"It is very, very clear that financial assets have outperformed the real economy and could fall dramatically to come back into alignment with where GDP and income are," said Shamotta.