The Early Years (pre-1841)
The
story of the Canadian dollar begins in the currency chaos
of the early French and British colonial period in North
America. 1 Through the seventeenth
century and until well into the nineteenth, various coins
from many countries circulated freely in the colonies.
These included not only English and French coins, but
also coins from Portugal, Spain, and the Spanish colonies
in Latin America--notably Mexico, Peru, and Colombia. The
hazards of sea travel and persistent trade imbalances
with the home country left the colonies chronically short
of coins.
In
an effort to attract fresh supplies, French and British
colonial authorities typically gave higher values to
coins circulating in their jurisdiction than to the same
coins circulating in England and France. For example, in
New France, coins under the monnoye du pays system
during the late seventeenth century were given a value
one-third higher than monnoye de france.
Similarly, British colonies in North America valued the
silver Spanish dollar at rates of up to 8 shillings,
despite the passage of legislation by the British
government (Act for Ascertaining the Rates of Foreign
Coins in Her Majesty's Plantations in America) in 1707
that valued the coin at 4 shillings and 6 pence. 2
The
chronic coin shortage also encouraged the introduction of
paper money. The most famous issue is undoubtedly the
card money of New France. Introduced in 1685, card money
initially consisted of playing cards cut to different
sizes according to denomination and signed by colonial
officials. Despite the protests of authorities in Paris,
who objected to the loss of budgetary control, there were
several issues of card money before it was withdrawn from
circulation in 1719. Card money reappeared in 1729,
however, and remained readily accepted until rising
inflation, associated with the financing of the Seven
Years' War during the 1750s, undermined confidence in its
value.
To
add to the confusion, different colonies rated coins
differently. Sometimes, certain coins were deliberately
overrated (i.e., overvalued) or underrated (undervalued)
relative to others, given their weight in gold or silver,
in order to encourage or discourage their use. In such
circumstances, overrated coins drove underrated coins
from circulation--an application of Gresham's Law,
"bad money drives out good." Underrated coins
were typically hoarded or shipped to colonies that valued
them more highly. To counteract this, colonial
legislatures periodically revised their ratings. Ratings
were also revised in response to other factors, including
the decline in the value of silver relative to gold
throughout the eighteenth and nineteenth centuries and
the gradual wearing of old coins (which lowered their
weight and reduced their intrinsic value).
The Halifax and York ratings
One
rating that became particularly important in British
North America was the Halifax rating. Named after the
city of Halifax, where it was first used, this rating was
given legal standing by an act of the first Nova Scotia
House of Assembly in 1758 (McQuade 1976). This rating
used pounds, shillings, and pence (£, s. and d.) as the
unit of account and valued one Spanish (or colonial
Spanish) silver dollar weighing 420 grains (385 grains of
pure silver 3 ) at 5
shillings, local currency. This valuation of the Spanish
dollar, the most common coin in circulation at that time,
was to be used in settling debts. In effect, the Spanish
dollar became legal tender in Nova Scotia.
Although
the British imperial authorities overturned the
legislation in 1762, since it did not conform to the 1707
Imperial Act, the rating remained in common use and was
later adopted in Quebec by the British authorities after
the Seven Years' War, as well as in New Brunswick and
Prince Edward Island. The Halifax rating, with some
modifications, persisted well into the mid-1800s.
In
contrast, following the U.S. War of Independence, Upper
Canada used the York rating, as did merchants in
Montreal, for a time. 4 This
rating had originally been established in New York and
was brought to Upper Canada by Loyalist immigrants (Turk
1962). In York currency, one Spanish dollar was valued at
8 shillings. Although an 1821 act re-established the use
of the Halifax rating in Upper Canada and, hence, valued
one Spanish dollar at 5 shillings, the York rating
remained in use in rural areas until the unification of
Upper and Lower Canada in 1841.
Dollars and cents or pounds,
shillings, and pence?
During
the eighteenth century and the first half of the
nineteenth, the pound sterling (pounds, shillings, and
pence) was the unit of account in British North America.
Given the scarcity of British coins, however, and the
prevalence and wide acceptance of Spanish silver dollars,
it became increasingly difficult to maintain a currency
system based on sterling. The introduction of the U.S.
dollar (modelled on the Spanish dollar) in the United
States in 1792, together with growing trade links between
Upper and Lower Canada and the United States, also
favoured the use of dollars.
The
widespread use and popularity of the dollar stymied
periodic efforts by the imperial authorities in British
North America to establish a common monetary system
throughout the British Empire based on pounds, shillings,
and pence. It is therefore not surprising that when Sir
Isaac Brock issued up to £250,000 worth of Army Bills in
Lower Canada in 1812, to help finance the War of 1812,
the bills were denominated in Spanish dollars. Army Bills
became legal tender in both Upper and Lower Canada until
their redemption shortly after the war ended.
The
first bank notes in Canada, issued by the Montreal Bank
following its establishment in 1817, were also
denominated in dollars. 5 These
notes could be redeemed in coin, upon demand. As new
banks were incorporated in Upper and Lower Canada during
the 1830s and 1840s, their bank notes were typically
denominated in both dollars and pounds. These notes
circulated freely through both Canadas and in the United
States. Dollar-denominated bank notes issued by U.S.
banks also circulated widely in Upper Canada during the
early 1800s. This two-way movement of notes across the
Canada-U.S. border strongly favoured the continued use of
dollars and cents in Canada over pounds, shillings, and
pence.
In
contrast, bank notes circulating in New Brunswick, Nova
Scotia, Prince Edward Island, and Newfoundland, before
Confederation, were typically denominated in pounds,
shillings, and pence. This reflected both the stronger
ties these provinces had with Great Britain and their
weaker commercial links with the United States.
Political
union of Upper and Lower Canada on 10 February 1841
led to a new standardized rating for coins in the two
Canadas that took effect in April 1842. 6 The
British gold sovereign was valued at one pound, four
shillings, and fourpence in local currency, while the
US$10 gold eagle was valued at two pounds, ten shillings.
7 Both
coins were considered legal tender. Spanish (including
Spanish colonial) and U.S. silver dollars with a minimum
weight of 412 grains were also made legal tender 8 with a
value of five shillings and one pence--a valuation very
similar to the old Halifax rating.
At
this time, efforts also began to move to a decimal-based
currency system and to introduce a government issue of
paper currency. In 1841, Lord Sydenham, Governor General
of the new united Province of Canada, proposed that the
provincial legislature establish a provincial bank that
would issue up to £1 million in provincial paper
currency denominated in dollars, 25 per cent of which
would be backed by gold, the remainder by government
securities. He also recommended that notes issued by
chartered banks be prohibited. In effect, Lord Sydenham's
proposal amounted to the establishment of a Canadian
central bank.
While
Lord Sydenham sought a paper currency with guaranteed
convertibility, he was also strongly motivated by a
desire to acquire funds to finance provincial public
works and to obtain the seigniorage profits from the note
issue. Seigniorage was estimated to be at least £30,000
per annum and had the potential to rise considerably as
the currency issue increased (Breckenridge 1910). 9
The
proposal was studied by a parliamentary select committee
on banking and currency, headed by Francis Hincks, who
strongly favoured the Governor General's plan. The
provincial assembly turned it down, however, because of
widespread opposition, particularly from a strong bank
lobby. Banks were concerned about the impact on their
profits if they lost the right to issue paper currency.
Interestingly, borrowers were also worried that
government control of the bank note issue would lead to
tighter credit conditions. In addition, there was concern
that the government would gain too much power. Because of
the assembly's rejection of the Governor General's
proposal, a provincial issue of paper currency had to
wait another 25 years. The establishment of a central
bank was delayed by close to 100 years.
Despite
this failure, reform efforts gained momentum through the
1850s, especially during the government of Francis
Hincks, who became prime minister of the Province of
Canada in 1851. In June of that year, representatives
from the Province of Canada, New Brunswick, and Nova
Scotia met in Toronto to work towards the establishment
of a decimal currency. A few months later, the Canadian
legislature passed an act requiring that provincial
accounts be kept in dollars and cents. However, the
British government, still seeking to establish a currency
system based on pounds, shillings, and pence throughout
the Empire, delayed confirmation of the act. A compromise
Currency Act was finally passed in 1853 and proclaimed on
1 August 1854. Under this act, pounds, shillings, and
pence as well as dollars and cents could be used in
provincial accounts.
The
Currency Act also confirmed the ratings of various
British and American coins that had been in place since
the establishment of the Province of Canada in 1841.
Pounds, shillings, and pence as well as dollars and cents
were recognized as units of Canadian currency. The
British gold sovereign was rated at £1. 4s. 4d. currency
or Can$4.8666, while the US$10 gold eagle (those minted
after 1834 with a gold content of 232.2 grains) was
valued at Can$10.
Since
the colonial authorities in New Brunswick had passed
similar currency legislation in October 1852, the
proclamation of the Currency Act in the Province of
Canada meant that the two provinces had compatible
currencies, fixed at par with their U.S. counterpart,
with $1 equivalent to 23.22 grains of gold.
Decimalization
received a further boost a few years later. Following a
recommendation from the public accounts committee, the
Province of Canada revised the Currency Act in 1857 so
that, as of 1 January 1858, all provincial accounts would
be kept in dollars. Silver and bronze coins, denominated
in cents and bearing the word "Canada," were
also issued for the first time later that same year. 10 This
marked the birth of a distinctive Canadian currency.
In
Nova Scotia, decimalization occurred on 1 January
1860. Nevertheless, because that province rated the
sovereign at $5 instead of $4.8666, its currency remained
incompatible with that of Canada and New Brunswick. New
Brunswick officially decimalized on 1 November 1860, and
Newfoundland followed in 1863. Like Nova Scotia,
Newfoundland's currency was not compatible with that of
Canada or New Brunswick. The colony of Vancouver Island
also decimalized in 1863, followed by British Columbia in
1865. 11
Manitoba decimalized in 1870, upon its entry into
Confederation, and Prince Edward Island followed in 1871.
In
the late 1850s and the early 1860s, efforts were renewed
in the Province of Canada to introduce a government issue
of paper money. This time, the financial and political
environment was more receptive than had been the case in
1841.
The
collapse of a number of banks during this period brought
bank notes issued by chartered banks into disrepute. In
1859, two Toronto-based banks, the Colonial Bank and the
International Bank, failed. This was shortly followed by
the collapse of the Bank of Clifton and the Bank of
Western Canada. The failures of these last two banks were
particularly scandalous, with the former pretending to
redeem its notes in Chicago and the latter, owned by a
tavern-keeper, attempting to circulate worthless bank
notes in the U.S. Midwest. In his authoritative review of
early banking in Canada, Roeliff Breckenridge wrote,
- No great loss was caused
to the Canadian public by their collapse, but the
scandal and the ease of acquiring dangerous
privileges which had led to the scandal, called
forth bitter and general complaint (Breckenridge
1910, 71).
Nevertheless,
a loss of confidence in chartered bank notes, the
principal means of payment, posed a threat to economic
prosperity. To restore confidence in the currency and to
raise funds for the government in 1860, A.T. Galt,
Finance Minister of the Province of Canada, proposed
replacing chartered bank notes with an issue of
government notes. 12 Once
again, the chartered banks objected strongly to the
potential loss of their privileges, and the proposal was
quickly withdrawn. In 1866, however, with the Canadian
government seriously short of resources, the need for a
new source of funding became acute. Domestic and British
banks were unwilling to advance new funds or roll over
existing loans. Moreover, the provincial government was
unable to sell bonds in London even at very high rates of
interest. With all funding avenues apparently closed, the
provincial authorities passed controversial legislation
to issue up to $8 million in legal tender, provincial
notes. These notes were payable on demand for gold in
either Toronto or Montreal and were partly backed by
gold--20 per cent for the first $5 million and 25 per
cent for amounts in circulation in excess of $5 million.
The Provincial Notes Act received royal assent on 15
August 1866.
Unlike
Galt's earlier proposal, chartered banks were not obliged
to give up their right to issue bank notes although they
were encouraged to do so. 13
Compensation was offered, including the payment of 5 per
cent of their average notes in circulation and a further
1 per cent per year for issuing and redeeming provincial
notes. Nevertheless, only the Bank of Montreal, the
government's fiscal agent, took up the offer. It too
resumed its bank note issue following the passage of the
1871 Bank Act.
Other
provinces had broadly similar experiences with paper
money. When the War of 1812 caused a coin shortage in
Nova Scotia, the provincial authorities issued treasury
notes. But unlike Sir Isaac Brock's issue of Army Bills
in Lower Canada, these notes were not legal tender,
although they were widely accepted. Denominated in
sterling, treasury notes became very popular, leading the
government to issue new notes throughout the first half
of the nineteenth century. Following the incorporation of
the Halifax Banking Company in 1825 and the Bank of Nova
Scotia in 1832, bank notes (denominated in pounds) were
also issued and circulated widely in the province and
throughout the Maritimes.
In
New Brunswick, the authorities also issued provincial
treasury notes on several occasions, first denominated in
dollars in 1805 and 1807, and then in pounds following
the War of 1812. While the government discontinued such
issues in 1820, bank notes denominated in pounds filled
the gap following the granting of a charter to the Bank
of New Brunswick in 1820.
Prince
Edward Island experimented with paper money as early as
1790, when the province issued £500 of treasury notes to
make up for a shortage of coin. These notes were legal
tender and were issued in amounts up to £2. Further
issues followed through the first half of the nineteenth
century. Government issues of paper money were
supplemented by the widespread use of notes issued by
chartered banks in Nova Scotia and New Brunswick and by
notes from the Bank of Prince Edward Island, the island's
first bank, chartered in 1855.
Confederation
Confederation
on 1 July 1867 brought sweeping changes to banking and
currency legislation in the provinces of Canada, Nova
Scotia, and New Brunswick. Under the British North
America Act, the government of the new Dominion was given
jurisdiction over currency and banking. The Dominion
Notes Act came into effect the following year. Under this
legislation, the Dominion took over the various
provincial note issues. Provincial notes issued in the
Province of Canada were renamed "dominion
notes" and were made redeemable in Halifax and Saint
John in addition to Montreal and Toronto. The Dominion
Notes Act was subsequently extended to cover Prince
Edward Island, Manitoba, and British Columbia in 1876 and
the Northwest Territories in 1886.
Like
earlier provincial notes, dominion notes were partly
backed by gold. The first $5 million issued were 20 per
cent backed and the next $3 million, 25 per cent backed.
Over time, the size of the authorized note issue was
increased. There were also some changes to the percentage
of notes backed by gold. By 1913, the first $30 million
had a 25 per cent gold backing. 14 Issues
in excess of $30 million had to be fully backed with
gold.
Interestingly,
although dominion notes became redeemable in Halifax in
1868, Nova Scotia retained its own currency until April
1871, when the dominion government passed the Uniform
Currency Act. 15 At that
time, Nova Scotian currency was converted into Canadian
currency at a rate of 75 Nova Scotian cents to 73
Canadian cents. 16
The
Uniform Currency Act also established that denominations
of Canadian currency would be "dollars, cents and
mills" (a mill equalled one-tenth of a cent).
Moreover, the Canadian dollar's value was fixed in terms
of the British sovereign at a rate of $4.8666 and the
U.S. gold eagle at a rate of $10--the same rates
established in the 1853 Currency Act.
The
dominion government also passed the Bank Act in 1871,
which repealed all provincial acts that were in conflict
with federal jurisdiction over currency and banking.
Consequently, chartered banks in the four provinces
eventually came under common regulation. 17
Chartered banks were allowed to issue notes with a
minimum denomination of $4 (raised to $5 in 1880).
Although banks, as a matter of course, held substantial
reserves of dominion notes and gold, they were not
required to secure their note issues either by gold or by
specific collateral. Note issues could not, however,
exceed a bank's paid-in capital. 18 The
notes that a bank had in circulation represented a first
lien on that bank's assets in the event of failure. 19 The
government preserved the issuance of smaller notes for
itself. It also issued notes in larger denominations to
be used mainly for transactions between banks.
From
1 August 1854 when the Currency Act was proclaimed, until
the outbreak of World War I in 1914, the Province of
Canada, and subsequently the Dominion of Canada, was
continuously on a gold standard. Under this standard, the
value of the Canadian dollar was fixed in terms of gold.
It was also valued at par with the U.S. dollar, with a
British sovereign valued at Can$4.8666. As noted earlier,
both U.S. and British gold coins were legal tender in
Canada.
With
the gold standard in place, monetary policy was largely
"on automatic pilot." Paper money was freely
convertible into gold without restriction, and there were
no controls on the export or import of gold. This implied
that there was virtually no scope for the authorities to
manage the exchange rate or conduct an independent
monetary policy. 20
Fluctuations
in market exchange rates between the Canadian dollar and
the U.S. dollar and the pound sterling, respectively,
around their official values were generally limited by
the gold "export" and "import"
points. These points marked the exchange rates at which
it was profitable for individuals to take advantage of
price differences between the market and official
exchange rates through the export and import of gold from
the United States or the United Kingdom. The difference
between the export and import points and the official
rates reflected the cost of insuring and shipping gold to
and from New York or London and Montreal, Canada's
financial centre at that time. Given the proximity of New
York, the margins against the U.S. dollar were very
narrow around parity with a gold export point of
Can$1.0008 and a gold import point of Can$0.9992. The
margins around the $4.8666 par value of the pound
sterling were somewhat wider, 1 per cent, given the
greater distance to be travelled (Rich 1988). On rare
occasions, the Canadian dollar traded outside the gold
points for periods of several weeks, much longer than one
would have expected if arbitrageurs were efficient. This
suggests that obstacles, probably imposed by governments,
might have impeded their activities (Turk 1962). While
not a particularly significant phenomenon prior to 1914,
government-erected impediments to the cross-border flow
of gold became common during World War I and even more so
through the late 1920s and early 1930s.
With
monetary policy essentially on autopilot and little in
the way of active fiscal policy, there was nothing to
buffer economic swings and the impact of large
international capital movements. Accordingly, Canada
experienced significant periods of boom and bust during
the gold-standard years. For example, during the 1870s,
Canada suffered a prolonged economic contraction and
falling prices. In contrast, between 1900 and 1914,
Canada grew rapidly, and inflationary pressures mounted
as huge amounts of foreign capital (as a percentage of
Canadian GDP) entered the country. 21
The Canadian dollar and the U.S.
greenback (1862-79)
In
1862, the American Civil War began to affect currency in
the United States. As the finances of the Union
government deteriorated, U.S. banks suspended the
convertibility of their notes into gold, and the
government suspended the right to convert U.S. Treasury
notes (government-issued paper money) into gold. Shortly
afterwards, the U.S. Congress authorized the government
to issue non-convertible legal tender currency, which
became popularly known as "greenbacks." While
little was said officially regarding the future
convertibility of greenbacks into gold, it was widely
assumed that convertibility would be restored when the
war was won (Willard et al. 1995). Trading in the
greenback vis-à-vis gold commenced in mid-January 1862
in New York and continued with only one short
interruption until the United States returned to the gold
standard on 1 January 1879.
Almost from the start of
trading, the greenback depreciated relative to gold and
against other currencies, including the Canadian dollar,
which remained on the gold standard. The weakness in the
greenback undoubtedly reflected the rapid expansion of
the U.S. note issue from $150 million in early 1862 to
$450 million by March 1863. Fluctuations in its value
also reflected the military and political fortunes of the
Union government and, hence, the expected likelihood that
the government would eventually be able to redeem the
greenbacks in gold. The greenback tended to strengthen on
news of Union victories, such as the Battle of Gettysburg
in 1863, and weakened on Union reversals. It reached its
nadir during the summer of 1864, when the Union
government, in a move against speculators, temporarily
shut down gold trading for two weeks in late June,
followed by a threatened Confederate raid on Washington
in early July. 22 Based
on available information, the U.S. greenback fell from
close to parity against the Canadian dollar in early 1862
to less than 38 Canadian cents (or Can$1 = US$2.65) in
mid-July 1864 (Turk 1962). 23 This
represents the all-time peak for the Canadian dollar in
terms of its U.S. counterpart.
The
greenback subsequently began to recover, almost doubling
in value by the end of the Civil War in April 1865. After
the war, it continued to strengthen, albeit at a slower
pace, as the government retired a significant amount of
greenbacks during the 1866-68 period. Deflation after the
Civil War enabled the United States to return to the gold
standard on 1 January 1879, with the greenback
convertible into gold at the old pre-war rate of
23.22 grains of gold (Yeager 1976). Once again, the
Canadian dollar traded at par with its U.S. counterpart.
This exchange rate held until the outbreak of World War
I.
Canada off the Gold Standard
(1914-26)
World War I
The
beginning of World War I marked the end of the classic
age of the gold standard. 24 All
major countries suspended the convertibility of domestic
bank notes into gold and the free movement of gold
between countries. This was often done unofficially. For
example, in the United Kingdom, private exports and
imports of gold remained legal in theory. However, in
addition to a number of government-imposed regulations
that discouraged the buying and selling of gold, bullion
dealers refused to permit gold exports on patriotic
grounds (Yeager 1976, 310).
In
Canada, convertibility was officially suspended. As
tensions mounted in the days immediately prior to the
declaration of war on 4 August 1914, there were heavy
withdrawals of gold from banks. In an "atmosphere of
incipient financial panic" (Macmillan Report 1933,
22), there were concerns about the possibility of bank
runs. In the absence of a lender of last resort, this was
potentially very serious since banks were legally
required to close if they were not able to meet depositor
demand for gold or dominion notes.
On
3 August 1914, an emergency meeting was held in Ottawa
between the government and the Canadian Bankers
Association to discuss the crisis. Later that day, an
Order-in-Council was issued that provided protection for
banks that were threatened by insolvency by making notes
issued by the banks legal tender. This allowed the banks
to meet their depositor demands with their own bank notes
rather than with dominion notes or gold. The government
also increased the amount of notes that banks were
legally permitted to issue. The government was also
empowered to make advances to banks by issuing dominion
notes against securities deposited with the minister of
finance. This provision enabled banks to increase the
amount of their bank notes in circulation.
A
second Order-in-Council, issued on 10 August 1914,
suspended the redemption of dominion notes into gold.
This and the previous Order-in-Council were subsequently
converted into legislation as "An Act to Conserve
the Commercial and Financial Interests of Canada"
(the Finance Act), which received royal assent on 22
August 1914.
The
Finance Act gave the government the power to act as a
lender of last resort to the banking system--one of the
powers of a modern central bank. It also provided a means
for the government (Treasury Board) to set the Advance
Rate, the rate at which it would make loans to the
chartered banks. Advances under the Finance Act were made
at the request of banks. The government could not freely
adjust bank reserves in order to expand or contract the
monetary base. Hence, the government did not actively
manage interest rates, nor was there any board overseeing
the conduct of monetary policy (Shearer and Clark 1984,
279).
Throughout
the war, the Advance Rate remained at 5 per cent,
although a special 3.5 per cent rate was established in
1917 under which the government discounted British
treasury bills held by the chartered banks. This facility
was designed to assist the British government's war
effort. It was complemented by a special $50 million
issue of dominion notes backed by British treasury bills
to help finance British purchases of war materials in
Canada (Macmillan Report 1933, 22). The government also
increased the fiduciary issue of dominion notes (i.e.,
notes not backed by gold) in 1915 under an amendment to
the Dominion Notes Act.
Despite
the suspension of gold convertibility in August 1914, the
Canadian dollar traded in a very narrow range close to
parity with its U.S. counterpart throughout the war
years. In 1918, however, the Canadian dollar began to
weaken, and its decline accelerated during the two-year
period following the end of hostilities, until it reached
a low of roughly US$0.84 in 1920. The weakness of the
currency reflected excessive monetary expansion during
the war, which continued in the immediate post-war years
partly because of the financial needs associated with
demobilization as well as the related deterioration in
Canada's balance of payments (Shearer and Clark 1984,
282; Knox 1940).
Setting the stage for a return to
the gold standard
There
was a general presumption that, after the war, the major
industrial countries would return to the gold standard.
The United States, which was a late entrant into the war
and did not experience the same sort of financial or
inflationary pressures as the United Kingdom or Canada,
returned to its old fixing in terms of gold in June 1919.
The United Kingdom controversially followed suit in 1925
at its old pre-war price in terms of gold, equivalent to
US$4.8666. 25
In
Canada, the Finance Act of 1914, which had been adopted
as a war measure, was extended in 1919 and revised in
1923. Under the revised act, provision was made for an
automatic return to the gold standard after three years
unless the government took steps to the contrary.
The
revised act also gave the dominion government greater
flexibility to adjust the rate at which banks could
obtain funding. 26
However, the Treasury Board, which was responsible for
administering the act, did not conduct an active monetary
policy. The Advance Rate remained fixed at 5 per cent,
the same level it had been throughout the war. Thus,
there appeared to be little overt official effort to
tighten monetary policy in anticipation of an eventual
return to the gold standard, which would fix the dollar
at its pre-war value in terms of gold and at par with its
U.S. counterpart.
Despite
the apparent lack of action, the money supply did
contract significantly during the first half of the
1920s, permitting a return to the gold standard. The
maintenance of the Advance Rate at 5 per cent, despite a
fall in market interest rates, had deflationary
consequences. Moreover, Britain's repayment of war loans
from Canadian banks (which were subsequently discounted
under the Finance Act at the special 3.5 per cent rate)
and the retirement of the so-called "British
Issue" of dominion notes issued in 1917 against
British treasury bills also contributed to the monetary
contraction (Shearer and Clark 1984, 291). Canada
returned to the gold standard on 1 July 1926.
Back on the Gold
Standard--Temporarily (1926-31)
With
Canada's return to the gold standard, currency supplied
by the chartered banks lost its legal tender status,
although the government could restore this status under
the Finance Act in the event of an emergency.
Consequently, legal tender in Canada once again consisted
of British gold sovereigns and other current British gold
coins, U.S. gold eagles ($10), double eagles, and half
eagles, Canadian gold coins (denominations of $5 and
$10), and dominion notes. Limited legal tender status was
also accorded silver, nickel, and bronze coins minted in
Canada. 27
Canada's
return to the gold standard proved to be short-lived. It
has been argued that monetary operations under the
Finance Act were inconsistent with maintaining a gold
standard. Dominion notes issued to banks under the
authority of the act upon the pledge of securities were
not backed by gold. 28 They
were, however, legally redeemable in gold on demand. In
1933, James Creighton, a prominent University of British
Columbia economics professor, wrote,
- Apparently the sponsors
of the 1923 Act did not realize that when Canada
went back on the gold standard, as she did 1926,
the effects of the operations of the Act would be
vitally different from what they were during the
paper money period.
Some
modern-day economists also point to excessive monetary
expansion during the late 1920s as causing the eventual
demise of the gold standard (Courchene 1969, 384). The
percentage of gold reserves to dominion notes outstanding
fell from 54 per cent on 30 June 1926 to 28 per cent
three years later (Macmillan Report 1933, 38). Other
economists have emphasized the unwillingness of the
Canadian authorities to accept the discipline of the gold
standard, especially during a period of significant
international financial stress (Shearer and Clark 1984,
300). A fall in commodity prices and a resulting
deterioration in Canada's trade balance was also a
factor. The currencies of other heavily indebted,
commodity-producing countries, such as Australia and
Argentina, also came under significant downward pressure
during the 1929-31 period (Knox 1940, 8).
The
Canadian dollar experienced three bouts of weakness
between 1928 and 1931. But instead of automatically
allowing the export of gold when the dollar weakened
beyond the gold-export point, as it would have done under
a "pure" gold standard, the government
increasingly relied on a number of "gold
devices" to stop its export (Shearer and Clark 1984,
29-30). For example, instead of making gold available in
Montreal or Toronto as required by law, it was available
only in Ottawa, thereby increasing the cost and
inconvenience of exporting gold. Similarly, instead of
supplying U.S. gold coins, the authorities provided
British sovereigns or bullion, which had to be assayed
before the U.S. authorities would accept it.
Alternatively, only coins of small denomination were
provided. Moral suasion was also used on bullion
shippers. As well, banks began to charge prohibitive fees
on gold purchases or refused to purchase gold on behalf
of foreign banks.
An
increase in the Advance Rate would have been the expected
monetary response to the outflow of gold. While the
"ordinary rate" was increased from 3.75 per
cent to 5 per cent on 9 June 1928, a special 3.75 per
cent rate remained in effect. To facilitate the sale of a
special issue of 4 per cent treasury notes, the
government had apparently made a commitment to the banks
to discount these notes at this special rate (Shearer and
Clark 1984, 295). When the pressure on the Canadian
dollar temporarily eased in the autumn of 1928 because of
seasonal factors, the ordinary Advance Rate was reduced
to 4.5 per cent. It stayed at this level until late
October 1931, despite the Canadian dollar falling below
the gold-export point during late 1929 and early 1930 and
again through the summer of 1931.
In
effect, if not in form, Canada went off the gold standard
in 1929. However, the export of gold was not officially
banned until 31 October 1931 by an Order-in-Council. The
banks and the government also used moral suasion, through
appeals to patriotism, to convince Canadians not to
convert dominion notes into gold (Bryce 1986). But with
the politically traumatic, though economically sound,
decision by the United Kingdom to abandon the gold
standard on 21 September 1931, the fiction of a gold
standard was finally abandoned.
With
the pound sterling falling precipitously from its old
fixed rate of US$4.8666 to as low as US$3.40 in the days
immediately following the British decision to float the
currency, the Canadian dollar came under sharp downward
pressure amid a general loss of confidence in the global
financial system. World money markets essentially ceased
to function. High-grade borrowers, such as Canada, were
therefore unable to borrow in the New York market.
Investor concern focused on the wavering nature of
Canada's commitment to the gold standard, its high level
of debt, and its low gold reserves (Creighton 1933, 122).
In this environment, the Canadian dollar fell to a low of
roughly US$0.80 in the autumn of 1931 before recovering.
The
coup de grâce to Canada's adherence to the gold
standard was finally delivered on 10 April 1933 when an
Order-in-Council officially suspended the redemption of
dominion notes for gold.
The Depression Years (1930-39)
Since
advances under the Finance Act were made at the
initiative of banks, and there was no money market, the
government had relatively limited scope for activist
monetary policy. But it did not even use what little
power it had. As a result, questions were widely voiced
regarding Treasury Board officials' understanding of
monetary issues as economic conditions deteriorated
following the 1929 stock market crash. 29
Despite
mounting evidence that a major economic contraction was
underway, the government kept the Advance Rate unchanged
at 4.5 per cent from September 1928 to October 1931.
Concurrently, the chartered banks repaid their borrowings
from the government under the Finance Act, leading to a
monetary contraction. This exacerbated the economic
downturn. 30 The
banks became increasingly cautious about their own
lending activities as the economic environment
deteriorated. Banks may have also repaid their borrowings
under the Finance Act in response to earlier criticism
for having borrowed so extensively prior to the stock
market crash (Fullerton 1986, 36). While the extent of
the economic downturn in Canada was undoubtedly made
worse by these monetary developments, the monetary
contraction helped to strengthen the Canadian dollar,
which reached US$0.90 by the spring of 1932.
The
government finally made a serious effort to reflate the
economy in the autumn of 1932, when it used moral suasion
to force the banks to borrow under the Finance Act (Bryce
1986, 132). This led to some temporary further weakness
in the Canadian dollar, which briefly fell as low as
US$0.80. However, the weakness was short-lived. Following
the U.S. decision to prohibit the export of gold in April
1933 and similar efforts in the United States to reflate,
the Canadian dollar began to strengthen. 31 The
Canadian government's decision in 1934 to expand the
amount of dominion notes in circulation by reducing their
gold backing to 25 per cent did not have much impact on
the Canadian dollar. In the economic circumstances of the
time, and given similar developments in the United
States, this move was viewed as appropriate and elicited
little market reaction (Bryce 1986, 142). The Canadian
dollar returned to rough parity with its U.S. counterpart
by 1934 and, at times, even traded at a small premium.
Establishment of a central bank
Concerns
about the adequacy of the Finance Act, rising political
pressure to do something about the Depression, and public
distrust of a concentrated banking system led the
government to set up a commission in July 1933. The
commission had a mandate to study the functioning of the
Finance Act and to make "a careful consideration of
the advisability of establishing in Canada a Central
Banking Institution . . . ."
(Macmillan Report 1933, 5). 32 Lord
Macmillan, a famous British jurist and known supporter of
a central bank, was chosen by Prime Minister Bennett to
chair the commission. 33 The
other members were Sir Charles Addis, a British banker
with both commercial and central banking experience; Sir
William T. White, the former wartime Canadian Finance
Minister and banker; John Brownlee, Premier of Alberta;
and Beaudry Leman, a Montreal banker.
Public
hearings began on 8 August 1933, and the final report was
presented to the government less than seven weeks later
on 28 September. While the commission voted only narrowly
in favour of the establishment of a central bank, its
conclusion was never really in doubt. The two British
members of the committee, joined by Brownlee, voted in
favour of a central bank, a position supported by both
the Conservative government and the Liberal opposition.
White
dissented from the majority on the grounds that it was
unwise to establish a central bank in the prevailing
uncertain economic environment. In his view, a newly
established and untried central bank might hinder the
government. Favouring a return to the gold standard,
White contended that Canada's main problem was excessive
debt (Macmillan Report 1933, 89). Leman shared this view
and also believed that the establishment of a central
bank raised constitutional issues that needed exploring
(Macmillan Report 1933, 95).
The
Bank of Canada Act received royal assent on 3 July 1934,
and the central bank officially started operations on 11
March 1935. On that day, the Dominion Notes Act and the
Finance Act were both repealed. Dominion notes were
quickly replaced by new Bank of Canada notes. A revised
Bank Act, governing the operations of the chartered
banks, also took effect in 1934. Revisions to this act
initiated a gradual phase-out of private bank notes in
favour of Bank of Canada notes.
Another
important piece of legislation passed at this time was
the Exchange Fund Act, which received royal assent on 5
July 1935. The primary purpose of the act was to provide
a fund that could be used to "aid in the control and
protection of the external value of the Canadian monetary
unit" ( Statutes of Canada 1935). The
resources of the Exchange Fund came from the profits
associated with the revaluation of the Bank of Canada's
gold holdings from the old statutory price of Can$20.67
per ounce to the prevailing world market price of US$35
per ounce. 34
Although the Exchange Fund Act was passed in 1935, the
section of the act dealing with the use of the fund to
protect the value of the Canadian dollar was not put into
effect until 15 September 1939, following Canada's
entry into World War II.
In
any event, an Exchange Fund Account was not required to
stabilize the Canadian dollar during the mid-1930s. With
the currency trading in a relatively narrow range around
parity with its U.S. counterpart, little intervention by
the Bank of Canada was required. The currency's
fluctuations were limited by substantial current account
surpluses on the one hand and the repayment of foreign
borrowings on the other (Watts 1993, 40).
By
late 1938, as the international political climate
deteriorated, the Canadian dollar began to slip, falling
to a small discount of roughly 1 per cent against the
U.S. dollar. The decline was modest, however, compared
with that of the pound sterling, which fell by roughly 6
per cent in the second half of 1938, reflecting a
considerable shift of funds out of the United Kingdom
(Bank of Canada 1939, 13). After several months of
relative stability, the Canadian dollar came under
renewed, and this time significant, pressure in the last
days of August 1939, as world tensions increased and
funds moved to the safety of the United States. The
Canadian dollar fell roughly 6 per cent vis-à-vis the
U.S. dollar in the two weeks prior to Canada's
declaration of war with Germany on 10 September 1939, and
by another 3 per cent by the time the government
imposed foreign exchange controls in mid-September (Bank
of Canada 1940, 12). The pound sterling fell even more
sharply, declining from US$4.86 to US$4.06, a
depreciation of roughly 14 per cent, before the
imposition of exchange controls in the United Kingdom in
early September.
Canada under Exchange Controls
(1939-51)
Exchange
controls were introduced in Canada through an
Order-in-Council passed on 15 September 1939 and took
effect the following day, under the authority of the War
Measures Act. 35 The
Foreign Exchange Control Order established a legal
framework for the control of foreign exchange
transactions, and the Foreign Exchange Control Board
(FECB) began operations on 16 September. 36 The
Exchange Fund Account was activated at the same time to
hold Canada's gold and foreign exchange reserves. The
Board was responsible to the minister of finance, and its
chairman was the governor of the Bank of Canada.
Day-to-day operations of the FECB were carried out mainly
by Bank of Canada staff.
The
Foreign Exchange Control Order authorized the FECB to
fix, subject to ministerial approval, the exchange rate
of the Canadian dollar vis-à-vis the U.S. dollar and the
pound sterling. Accordingly, the FECB fixed the Canadian
dollar value of the U.S. dollar at Can$1.10 (US$0.9091)
buying and Can$1.11 (US$0.9009) selling. The pound
sterling was fixed at Can$4.43 buying, and Can$4.47
selling. 37 These
rates were roughly consistent with market exchange rates
immediately prior to the imposition of controls. Currency
rates on futures contracts of up to 90 days were also
fixed by the FECB. These exchange rates were maintained
for the duration of the war.
To
conserve Canada's foreign exchange and effectively
support the value of the Canadian dollar, the Board
introduced extensive controls. These controls allowed the
Board to regulate both current and capital account
transactions, although most current account transactions,
other than travel, were treated fairly leniently. 38 Permits
were required for all payments by residents to
non-residents for imports of goods and services. Permits
were also required for the purchase of foreign currencies
and foreign securities, the export of funds by
travellers, and to change one's status from resident to
non-resident. Residents were also required to sell all
foreign exchange receipts to an authorized dealer.
Interbank trading in Canadian dollars ceased.
On
30 April 1940, the Foreign Exchange Acquisition Order
stiffened the controls even further. Canadian residents,
including the Bank of Canada, were now required to sell
(with minor exceptions) all the foreign exchange they
owned to the FECB.
The
imposition of exchange controls by the Canadian
authorities reflected a number of concerns
(Handfield-Jones 1962). First, even though it was
expected that Canadian exports to the United Kingdom
would increase, there was a concern that the Canadian
military buildup would lead to a significant rise in
imports from the United States. Second, under U.S. law at
the start of the war, loans to "belligerent"
countries were forbidden. Hence, U.S. imports had to be
paid for in cash, i.e., U.S. dollars or gold. Moreover,
given British exchange controls, an increase in sterling
assets arising from net Canadian exports to the sterling
area could not be converted into U.S. dollars. Finally,
there was a concern that Canadians might seek to place
funds in a non-belligerent country and that U.S.
residents, who held considerable Canadian assets, might
seek to repatriate their holdings.
It
is interesting to note that while all foreign currency
transactions were subject to exchange controls, in
practice the controls centred on transactions involving
U.S. dollars. Although permits were required for sterling
transactions, there were no restrictions (FECB 1946, 19).
Moreover, Canadian residents were not required to sell
sterling receipts to the FECB (Wonnacott 1959, 83). This
reflected the buildup of sterling balances held by the
FECB, which could not be converted into U.S. dollars. 39
Canada's
need for controls during World War II contrasts with its
experience during World War I, when exchange controls
were not imposed. In 1914, Canada's principal foreign
creditor was the United Kingdom, with the bulk of British
claims on Canada in the form of direct investment or
denominated in sterling. British holdings of U.S. dollars
were also substantial at the outbreak of World War I.
Consequently, the British authorities were able to pay
for their own U.S. imports, maintain a stable and
convertible currency, and provide U.S. dollars to Canada
in settlement of Canada's trade surplus with the United
Kingdom.
The
situation had changed by 1939. The United States had
become Canada's most important source of foreign capital,
and there was concern that neutral U.S. residents would
not wish to hold the securities of a belligerent country.
British holdings of U.S. dollars were also much
diminished. Therefore, Canada could not expect the United
Kingdom to provide U.S. dollars in exchange for surplus
sterling balances, as it did in 1914. Indeed, the British
authorities introduced their own exchange controls at the
outbreak of World War II (FECB 1946, 9-10).
The revaluation of 1946
By
late 1944, pressure on Canada's foreign exchange reserves
had eased dramatically. The Hyde Park Agreement of April
1941, 40 the
entry of the United States into the war in December 1941,
as well as major U.S. infrastructure projects (such as
the building of military bases and the construction of
the Alaska Highway) contributed to a rebuilding of
Canada's foreign exchange reserves. There were also
significant capital inflows into Canada, partly from
Canadian residents repatriating funds invested in U.S.
securities, but also from U.S. residents buying Canadian
Victory Bonds. U.S. direct investment in Canada also
increased.
The
rebuilding of reserves allowed a slight easing of
exchange controls in 1944 to facilitate travel to the
United States and to allow Canadian firms to extend their
foreign business activities. By the end of 1945, Canada's
holdings of gold and U.S. dollars had increased to
US$1,508 million from only US$187.6 million at the end of
1941.
With
expectations of continued capital inflows, the Canadian
dollar was revalued upwards by roughly 9 per cent against
both the U.S. dollar and the pound sterling on 5 July
1946. The new rates were: buying Can$1.000, selling
Can$1.005 (US$0.9950) for the U.S. dollar, and Can$4.02
buying and Can$4.04 selling for the pound sterling.
Interestingly, the rationale for the revaluation related
more to dampening inflationary pressures emanating from
the United States than to the buildup of reserves or to
Canada's balance-of-payments situation. In a statement to
the House of Commons, the minister of finance noted that
the revaluation of the Canadian dollar was one of the
measures taken to maintain order, stability, and
independence in Canada's economic and financial affairs.
He added that
- these measures we feel
will go a long way toward insulating Canada
against unfavourable external conditions and
easing the inflationary pressures which are now
so strong (Ilsley 1946, 3181).
The devaluation of 1949
The
new exchange rate did not hold for long. Imports from the
United States rose sharply, leading to a marked decline
in Canada's holdings of gold and U.S. dollars in the
second half of 1946 and through 1947. While Canadian
exports to the United Kingdom and other countries
remained robust, they were financed largely by Canadian
loans. Hence, they did not boost usable reserves.
In
November 1947, Canadian authorities reduced travel
allowances for Canadians visiting the United States and
tightened import controls to restrict the importation of
non-essential goods. The provision of U.S. dollars for
Canadian direct investment abroad was also virtually
suspended. Even with the intensification of exchange
controls, Canada's gold and U.S. dollar holdings declined
to US$501.7 million by the end of 1947. These
developments led to considerable criticism of the
Canadian government for its 1946 decision to revalue the
Canadian dollar.
The
situation eased somewhat in 1948. Canada's trade deficit
with the United States narrowed, a sizable U.S. dollar
line of credit was established with the U.S.
Export-Import Bank, and Canada's trade balance with other
countries improved (including an increase in actual
receipts). In fact, by the end of 1948, Canada's holdings
of gold and U.S. dollars had doubled to US$997.8 million.
Nevertheless,
following a major realignment of the pound sterling and
most other major European currencies vis-à-vis the U.S.
dollar, the Canadian dollar was devalued by approximately
9.1 per cent against its U.S. counterpart on 20 September
1949. 41 The
Canadian dollar thus returned to its pre-July 1946 value
against the U.S. dollar of Can$1.10 (US$0.9091) buying
and Can$1.105 (US$0.9050) selling. New official rates for
the pound sterling were also established by the FECB of
Can$3.0725 buying, and Can$3.0875 selling.
The
main reason cited for the Canadian dollar's devaluation
was the possible effect of the substantial devaluations
of other currencies on Canada's balance-of-payments
position. There were also concerns that Canada's reserves
had not recovered sufficiently from their 1947 low (FECB
1949, 7).
The decision to float, 1950
Once
again, international economic conditions quickly changed
and obliged the Canadian authorities to alter their
approach to foreign exchange policy. The earlier
depreciation of the Canadian dollar against its U.S.
counterpart, which boosted Canadian exports, and rising
commodity prices associated with the beginning of the
Korean War in June 1950 had strengthened Canada's trade
balance with the United States. At the same time, the
economic recovery in Europe, aided by the Marshall Plan,
which provided European countries with convertible U.S.
dollars, boosted Canadian exports (Muirhead 1999, 138).
There were also strong inflows of direct investment into
Canada. Short-term capital inflows also increased
sharply, particularly through the third quarter of 1950,
as speculation regarding a Canadian dollar revaluation
intensified.
In
this environment, Canadian authorities became
increasingly concerned about the inflationary impact of
the inflows if Canada tried to maintain a fixed exchange
rate. There was also concern that the inflows were
leading to a "substantial and involuntary increase
in Canada's gross foreign debt" (FECB 1950, 14).
On
30 September 1950, Douglas Abbott, the Minister of
Finance, announced that
- Today the Government, by
Order in Council under the authority of the
Foreign Exchange Control Act, cancelled the
official rates of exchange which had been in
effect since September 19th of last
year . . . . It has been
decided not to establish any new fixed parity for
the Canadian dollar at this time, nor to
prescribe any new official fixed rates of
exchange. Instead, rates of exchange will be
determined by conditions of supply and demand for
foreign currencies in Canada.
He
also announced that any remaining import prohibitions and
quota restrictions, imposed in November 1947, would be
eliminated, effective 2 January 1951. Controls on
imports of capital goods were also to be reviewed.
Interestingly,
the idea of floating the Canadian dollar was widely
discussed as early as the beginning of 1949. A
then-secret memorandum prepared in January of that year
and attributed to James Coyne, who later became Governor
of the Bank of Canada, made the case for floating the
currency while retaining exchange controls. In his paper,
Coyne noted that it would be better to "have a
natural rate which could move up or down from time to
time as economic conditions might require." He also
noted that government inertia made it very difficult for
the authorities to adjust a fixed exchange rate in a
timely manner (Coyne 1949).
Options
other than floating the exchange rate were apparently
dismissed as impractical, including revaluing the
Canadian dollar upwards, widening the currency's
permitted 1 per cent fluctuation band, or restricting
capital inflows. Given the criticism levelled against the
government after the 1946 revaluation of the Canadian
dollar, followed by the short-lived 1949 devaluation,
another revaluation was viewed as unacceptable. It was
also unclear how much of a revaluation would be required
to stem the capital inflows. Widening the bands also
posed problems since it was unclear how wide the bands
would have to be. Likewise, restrictions on capital
inflows were seen as untenable from a longer-term
perspective for a country dependent on foreign capital
(Hexner 1954, 248).
This
view is consistent with a speech on exchange controls
given by Douglas Abbott, Minister of Finance, in December
1951,
- The conclusion I have
come to is that we would be better advised not to
rely on exchange restrictions, but rather on the
general handling of our domestic economic
situation to keep us in reasonable balance with
the outside world and to maintain the Canadian
dollar over the years at an appropriate
relationship with foreign currencies.
The
system envisaged by Coyne in 1949 of a floating Canadian
dollar within a system of foreign exchange controls was
put into practice when markets opened on 2 October 1950.
With interbank trading now permitted, the Canadian dollar
quickly appreciated, rising to roughly US$0.95.
With
the floating of the Canadian dollar, the rationale for
the continuation of exchange controls came into question.
Through 1951, controls were progressively eased. Finally,
on 14 December 1951, the Foreign Exchange Control
Regulations were revoked by an Order-in-Council. New
regulations were passed that exempted all persons and all
transactions from the need for permits to buy and sell
foreign exchange. The Foreign Exchange Control Act
itself, which had been renewed for another two-year
period earlier in 1951, was repealed in October 1952.
The unofficial exchange market
Shortly
after the imposition of exchange controls in 1939 and the
official fixing of the Canadian dollar's value in terms
of the U.S. dollar by the FECB, an unofficial market for
Canadian dollars developed in New York that persisted
until the Canadian dollar was floated at the end of
September 1950. This was a legal market involving
transactions in Canadian dollars between non-residents of
Canada. Residents of Canada were prohibited from
acquiring foreign exchange through the unofficial market.
Similarly, no resident of Canada was ever authorized to
convert foreign exchange into Canadian dollars through
the unofficial market.
The
source of "inconvertible" Canadian dollars
consisted of Canadian dollar bank balances held by
non-residents when exchange controls were introduced in
1939, sales by U.S. residents of certain types of assets
(such as real estate), and the proceeds of maturing
Canadian dollar securities paid to non-residents.
Canadian
dollars purchased in the unofficial market could be used
only in a very circumscribed manner. For example, they
could not be used to purchase Canadian goods and
services. In this regard, the purpose of exchange
controls was not just to conserve available foreign
exchange but also to maximize the receipt of foreign
exchange. U.S. residents wishing to buy Canadian
securities or real estate were, however, permitted to use
Canadian dollars obtained in the unofficial market, as
could travellers to Canada.
The
unofficial market for Canadian dollars ended with the
floating of the Canadian dollar. Throughout most of its
existence, the inconvertible Canadian dollar traded at a
sizable discount compared with its official counterpart.
The spread between the two rates mirrored the pressures
on the Canadian economy, widening to more than 10 per
cent during the darkest months of 1940 and narrowing as
the war progressed and Canadian prospects improved. By
1945, the discount was temporarily eliminated. Indeed,
for a few months during 1946, prior to the upward
revaluation of the official Canadian dollar back to
parity with its U.S. counterpart, the inconvertible
Canadian dollar traded at a slight premium in the free
market.
Interestingly,
when the official rate was finally revalued on 5 July
1946, the inconvertible Canadian dollar, while also
appreciating, did not move up the whole amount. It
generally traded between US$0.95 and US$0.96 through the
remainder of that year. Clearly, the revaluation was not
viewed as completely credible by free-market
participants. Indeed, the free rate slowly weakened over
the next few years, foreshadowing the eventual
devaluation of the official rate in September 1949. 42
The
inconvertible Canadian dollar declined with the
devaluation of the official exchange rate in 1949, but to
a lesser extent, temporarily eliminating the differential
between the two rates. With the inconvertible Canadian
dollar continuing to weaken to about US$0.8840, through
the winter of 1949-50, a differential of roughly 2.5 per
cent temporarily re-emerged. Sudden improvement in
Canadian economic prospects, however, and strong capital
inflows from the United States, eliminated the
differential between the two rates once again by March
1950. Indeed, the unofficial rate actually moved to a
marginal premium to the official rate immediately prior
to the decision to float the Canadian dollar.
The relevance of the unofficial
rate
During
the 1940s, there was an active debate over whether the
unofficial rate was the "true" value of the
Canadian dollar. The Bank of Canada maintained that given
the "limited use" of inconvertible Canadian
dollars and the small size of the market, prices were not
necessarily an accurate reflection of sentiment towards
the Canadian dollar (FECB 1947, 5). 43
This
was disputed by many economists, including then-assistant
professor of economics, Milton Friedman. In a 1948
University of Chicago debate with Donald Gordon, Deputy
Governor of the Bank of Canada, and Dr. W. A. Mackintosh,
head of the economics department at Queen's University
and wartime economic adviser to the government, Friedman
argued that there was no particular reason why a small
market should necessarily lead to a distorted price. He
also argued strongly that Canada should introduce a
flexible exchange rate rather than relying on a system of
exchange controls to balance trade. Gordon, on the other
hand, contended that a 10 per cent decline in the
official Canadian dollar (to roughly the level prevailing
in the unofficial market) would have comparatively little
impact on trade flows (Friedman et al. 1948).
A Floating Canadian Dollar
(1950-62)
As
a member of the International Monetary Fund (IMF),
Canada's decision to float the Canadian dollar was at
odds with its commitment to the Fund to maintain a fixed
exchange rate within the Bretton Woods system. 44 In this
regard, in 1949 the Canadian authorities had established
with the IMF a "par value" of US$0.9091 with a
fluctuation band of 1 per cent. At least
initially, floating was viewed as a temporary state of
affairs. The minister of finance noted the government's
intention to remain in consultation with the Fund and
- ultimately to conform to
the provisions of the Fund's Articles of
Agreement which stipulate that member countries
should not allow their exchange rates to
fluctuate more than one percent on either side of
the par values from time to time established with
the Fund (Abbott 1950).
It
would be almost 12 years before Canada reintroduced a
fixed exchange rate and regained the good graces of the
IMF. Consequently, Canada came to be viewed as something
of a maverick in international financial circles. The
unwillingness to re-fix the exchange rate appears to have
reflected concern about repeating the mistake of 1946
when the dollar was revalued upwards only to come under
significant downward pressure the next year, followed by
a devaluation in 1949.
After
quickly rising to the US$0.95 level immediately after the
exchange rate was freed, the Canadian dollar slowly
appreciated, moving to a small premium of about 2 per
cent vis-à-vis the U.S. dollar by 1952. From then until
the end of 1960, it traded in a relatively narrow range
between US$1.02 and US$1.06. The peak for the Canadian
dollar during this period was US$1.0614, touched on 20
August 1957. Foreign exchange intervention by the Bank of
Canada through the Exchange Fund Account was limited to
smoothing short-run fluctuations of the Canadian dollar.
While
unpopular in business circles, the floating exchange rate
was strongly supported by academic economists as a means
of insulating the domestic economy from external shocks,
either inflationary or deflationary. It was also
recognized that the two-way risk associated with a
flexible exchange rate could itself lessen large capital
movements (Hexner 1954, 253).
Canada's
successful experiment with a flexible exchange rate
regime through much of the 1950s inspired considerable
early academic work on the merits of a flexible exchange
rate system. Later, it would provide a model for the rest
of the world when the Bretton Woods system of fixed
exchange rates finally collapsed during the early 1970s.
Return to a Fixed Exchange Rate
(1962-70)
During
the late 1950s, Canadian authorities became concerned
about a deterioration in Canada's international
competitiveness, aggravated by its strong dollar, which
continued to be supported by substantial capital inflows.
After the investment boom of the mid-1950s, economic
activity had slowed significantly, and the unemployment
rate more than doubled from 3.4 per cent in 1956 to 7.2
per cent in 1961. In this environment, the government
sought to ease policy in order to support demand and
reduce the economic slack in the economy.
Bank
of Canada Governor James Coyne resisted any significant
easing, however. He viewed Canada's large current account
deficit as a symptom of excessive demand pressures, even
though domestic inflationary pressure had eased
throughout this period, falling from somewhat more than 2
per cent in 1958 to 1.3 per cent by the end of 1960. He
was convinced that
- to engage in further
large over-all monetary expansion in an attempt
to drive down interest rates generally, with or
without the motive of thereby reducing the inflow
of capital from abroad, is an unsound and
dangerous approach and would prove to be an
ineffective approach, to the problems of the
exchange rate, of the recession, and of achieving
more consistent economic growth (Bank of Canada
1960, 22).
The
policy dispute between the government and the central
bank came to a head during the summer of 1961. On 30 May,
the government requested the resignation of Governor
Coyne but was refused. On 20 June, the minister of
finance introduced an expansionary budget and announced
that the government would take steps to lower the value
of the Canadian dollar, including, as necessary,
purchasing substantial amounts of U.S. dollars in the
exchange market (Fleming 1961a).The government also
introduced a bill in Parliament (An Act Respecting the
Bank of Canada) to declare the position of governor
vacant (House of Commons 1961). The bill passed the House
of Commons on 7 July, but after testimony by Governor
Coyne, the Senate Standing Committee on Banking and
Commerce concluded that there had been no misconduct on
his part. On 14 July, the full Senate defeated the bill.
Having had "his day in court," Governor Coyne
resigned. Louis Rasminsky succeeded him as Governor on 24
July 1961 (Bélanger 1970).
Not
surprisingly, the Canadian dollar began to weaken in this
environment. From a level of about US$1.01 prior to the
June budget statement, the dollar quickly fell to
US$0.97. It weakened further in October 1961 to under
US$0.96, following an announcement by the minister of
finance that the appropriate discount of the Canadian
dollar against the U.S. dollar "might well turn out
to be greater than the present 3 per cent" (Fleming
1961b).
The
introduction of a "managed" flexible exchange
rate regime, under which the government would intervene
to keep the Canadian dollar at a significant discount to
its U.S. counterpart, as opposed to just smoothing
fluctuations, was in some ways a compromise with the IMF.
The Fund was encouraging Canadian authorities to return
to a fixed exchange rate regime within the context of the
Bretton Woods system. No new par value for the Canadian
dollar was recommended, however. Additional time was seen
as necessary to prepare for the re-establishment of a
fixed rate.
After
stabilizing at about US$0.95 between November 1961 and
March 1962, the Canadian dollar began to weaken further,
despite significant intervention by the Bank of Canada to
support the currency. On 2 May 1962, the government, in
agreement with the IMF, established a new par value for
the Canadian dollar, fixing it at US$0.9250 with a
fluctuation band of 1 per cent.
Fixing
the exchange rate at a markedly lower level did not,
however, relieve the pressure on the Canadian dollar.
Doubts remained about the viability of the new rate,
particularly given the prevailing political uncertainty. 45 Heavy
official intervention was therefore required to hold the
Canadian dollar within its allowed fluctuation band.
On
24 June 1962, the government announced a major economic
and financial program aimed at restoring confidence in
the Canadian dollar and indicated its determination to
defend the currency's new par value. Measures taken
included a tightening of fiscal and monetary policy, the
imposition of temporary import surcharges, and the
marshalling of US$1,050 million in financial support from
the international community. This support consisted of a
US$300 million drawing from the IMF, 46 a
US$400 million line of credit from the U.S. Export-Import
Bank, US$250 million under a reciprocal swap facility
between the Bank of Canada and the Federal Reserve Bank
of New York, and US$100 million from the Bank of England
under a similar arrangement. 47 Other
European central banks were also willing to provide
additional assistance, if necessary (Bank of Canada 1962,
8).
This
program restored confidence in the Canadian dollar. The
resumption of private capital inflows during the second
half of 1962 enabled the Canadian authorities to
gradually ease the emergency measures imposed earlier.
Much of the international financial assistance received,
excluding that of the IMF, was repaid by the end of the
year. Funds owed to the IMF were fully repaid by 1964.
For the remainder of the decade, the Canadian dollar was
maintained, relatively easily for the most part, within
the permitted fluctuation band around its US$0.9250 par
value.
The
dollar did, however, come under significant, temporary
downward pressure during the summer of 1963, following
the U.S. announcement on 18 July that it would impose an
"Interest Equalization Tax" on foreign
borrowings in U.S. capital markets. Although Canada's
current account deficit had narrowed significantly over
the previous two years, it remained large. Consequently,
there was a general fear that unless Canadian interest
rates rose by an offsetting amount (roughly 1 percentage
point per year), capital inflows from the United States
would cease. On 31 July, the United States agreed to
exempt Canada from the tax, with the proviso that Canada
would not increase its foreign international reserves
through the proceeds of borrowing in the United States
(Bank of Canada 1963, 6). Downward pressure on the
currency ceased with this agreement, and Canadian markets
stabilized.
The
Canadian dollar experienced another bout of temporary
downward pressure in March 1968, after the U.S.
announcement of controls on capital outflows. The
pressure eased with an agreement on 7 March that exempted
Canada from all such controls. Similar to the exemption
from the Interest Equalization Tax, Canada agreed that
the U.S. balance-of-payments position would not be
impaired as a result of its actions.
Because
of concerns about the Bank of Canada's ability to conduct
monetary policy in light of these accords, there was a
follow-up agreement with the United States on 17 December
1968, which stated that no particular level of reserves
would have to be targeted (Bank of Canada 1968, 13). This
made it easier for the Bank to intervene in foreign
exchange markets during periods of upward pressure on the
currency. 48
Return to a Floating Rate (June
1970-present)
Rising
domestic inflation led to the establishment of the Prices
and Incomes Commission in 1968 and to the introduction of
a restrictive stance on monetary policy. This occurred at
a time when the United States was pursuing expansionary
policies associated with the Vietnam War and with a major
domestic program of social spending. Higher commodity
prices and strong external demand for Canadian exports of
raw materials and automobiles led to a sharp swing in
Canada's current account balance, from a sizable deficit
in 1969 as a whole to a large surplus. Combined with
sizable capital inflows associated with relatively more
attractive Canadian interest rates, this put upward
pressure on the Canadian dollar and on Canada's
international reserves. The resulting inflow of foreign
exchange led to concerns that the government's
anti-inflationary stance might be compromised unless
action was taken to adjust the value of the Canadian
dollar upwards. 49 There
was also concern that rising foreign exchange reserves
would lead to expectations of a currency revaluation,
thereby encouraging speculative short-term inflows into
Canada.
On
31 May 1970, Finance Minister Edgar Benson announced
that, for the time being, the Exchange Fund Account would
cease buying sufficient U.S. dollars to maintain the
exchange rate for the Canadian dollar within its
prescribed margins (Department of Finance 1970). Canadian
authorities informed the IMF of their decision to float
the Canadian dollar and of their intention to resume the
fulfillment of their obligations to the Fund as soon as
circumstances permitted. The Bank of Canada concurrently
lowered the Bank Rate from 7.5 per cent to 7 per cent, an
action aimed at making foreign borrowing less attractive
to Canadian residents and at moderating the inflow of
capital, which had been supporting the dollar.
The
government made the decision to float the Canadian dollar
reluctantly. But Benson believed that there was little
choice if the government was to bring inflation under
control. He hoped to restore a fixed exchange rate as
soon as possible but was concerned about a premature peg
at a rate that could not be defended.
As
in 1950, other options were considered but dismissed. A
defence of the existing par value was untenable since it
could require massive foreign exchange intervention,
which would be difficult to finance without risking a
monetary expansion that would exacerbate existing
inflationary pressures. A new higher par value was also
rejected since it might invite further upward speculative
pressure, being seen by market participants as a first
step rather than a once-and-for-all change. The
authorities also considered asking the United States to
reconsider Canada's exemption from the U.S. Interest
Equalization Tax. Application of the tax to Canadian
residents would have raised the cost of foreign borrowing
and, hence, would have dampened capital inflows. This
too, was rejected, however, because of concerns that it
would negatively affect borrowing in the United States by
provincial governments (Lawson 1970a).
While
recognizing the need for a significant appreciation of
the Canadian dollar, the Bank of Canada saw merit in
establishing a new par value at US$0.95 with a wider
fluctuation band of 2 per cent (Lawson 1970b). A new fix
was seen as being more internationally acceptable than a
temporary float, and since the lower intervention limit
of about US$0.9325 would have been the same as the
prevailing upper intervention limit, such a peg would
have been accepted by academics that favoured a crawling
peg. A new peg was also viewed as desirable because it
would preserve an explicit government commitment to the
exchange rate consistent with its obligations to the IMF.
There was also some concern that a floating exchange rate
might "encourage, as it had in the late 1950s, an
unsatisfactory mix of financial policies" (Lawson
1970a).
For
its part, the IMF urged Canada to establish a new par
value. Fund management was concerned about the vagueness
of Canada's commitment to return to a fixed exchange
rate, fearing that the float would become permanent as it
had during the 1950s. The IMF also feared that Canada's
action would increase uncertainty within the
international financial system and would have broader
negative repercussions for the Bretton Woods system,
which was already under considerable pressure. Canadian
authorities declined to set a new fix, emphasizing the
importance of retaining adequate control of domestic
demand for the continuing fight against inflation.
The dollar in the 1970s
Immediately
following the government's announcement that it would
allow the Canadian dollar to float, the currency
appreciated sharply, rising roughly 5 per cent to about
US$0.97. It continued to drift upwards through the autumn
of 1970 and into 1971 to trade in a relatively narrow
range between US$0.98 and US$0.99. By 1972, the Canadian
dollar had traded through parity with its U.S.
counterpart. It reached a high of US$1.0443 on
25 April 1974.
The
strength of the Canadian dollar through this period can
largely be attributed to continued strength in the prices
of raw materials. There were also large inflows of
foreign capital, partly reflecting the view that Canada's
balance of payments was expected to be less affected by
the tripling of oil prices that occurred through 1973
than that of other major industrial countries.
During
the early 1970s, the dollar's strength was also due to
the general weakness of the U.S. currency against all
major currencies as the Bretton Woods system of fixed
exchange rates collapsed. With the U.S.
balance-of-payments deficit widening to unprecedented
levels, the U.S. government suspended the U.S. dollar's
convertibility into gold on 15 August 1971 and imposed a
10 per cent surcharge on eligible imports. This action
followed a series of revaluations of major currencies. On
18 December 1971, the major industrial countries agreed
(the Smithsonian Agreement) to a new pattern of parities
for the major currencies (excluding the Canadian dollar)
with a fluctuation band of 2.25 per cent. The U.S. dollar
was also devalued by 8.57 per cent against gold, although
it remained inconvertible. This last-ditch attempt to
save the Bretton Woods system failed. By 1973, all major
currencies were floating against the U.S. dollar.
The
strength of the Canadian dollar against its U.S.
counterpart during this period concerned the authorities,
who feared the impact of a higher dollar on Canada's
export industries at a time of relatively high
unemployment. Various measures to rectify the problem
were examined but dismissed as being either unworkable or
harmful. These included the introduction of a dual
exchange rate system, the use of moral suasion on the
banks to limit the run-down of their foreign-currency
assets, and government control of the sale of new issues
of Canadian securities to non-residents. None of these
options were ever pursued (Government of Canada 1972).
However, under the Winnipeg Agreement, reached on
12 June 1972, chartered banks agreed, with the
concurrence of the minister of finance, to an interest
rate ceiling on large, short-term (less than one year)
deposits. The purpose of the agreement was to reduce
"the process of escalation of Canadian short-term
interest rates" (Bank of Canada 1972, 15). Lower
Canadian short-term interest rates and narrower rate
differentials with the United States helped to relieve
some of the upward pressure on the Canadian dollar.
Monetary policy was also more accommodative than it
should have been through this period, as the Bank of
Canada sought to moderate the upward pressure on the
currency.
After
weakening temporarily in 1975 and falling below parity
with the U.S. dollar, the Canadian dollar recovered as
monetary policy was tightened to address rising
inflationary pressures. The currency moved up to the
US$1.03 level during the summer of 1976 in volatile
trading, but the election of a Parti Québécois
government in Quebec on 15 November 1976 prompted the
markets to make a major reassessment of the Canadian
dollar's prospects. Political uncertainty, combined with
softening prices for non-energy commodities, concerns
about Canada's external competitiveness related to rising
cost and wage pressures, and a substantial current
account deficit, sparked a protracted sell-off of the
dollar, which lasted until the end of 1978. The dollar
fell to under US$0.84 by the end of this period. It
steadied in 1979, however, and recovered to roughly
US$0.87 by the end of that year.
The dollar in the 1980s
Throughout
the 1980s, the Canadian dollar traded in a wide range,
weakening sharply during the first half of the decade,
before staging a strong recovery during the second half.
The weakness of the currency in the early 1980s can be
attributed to several factors including, most
importantly, continuing weakness in commodity prices,
periodic concerns about the commitment of the Canadian
authorities to an anti-inflationary policy stance, and a
significant appreciation of the U.S. dollar against most
other major currencies. In October 1980, the federal
government introduced the National Energy Program, which
prompted a wave of takeovers of foreign-owned firms by
Canadian-owned firms, particularly in the oil sector, and
also placed downward pressure on the dollar. The failure
of two small chartered banks in 1985 also temporarily put
downward pressure on the currency.
After touching a
then-record low of US$0.6913 on 4 February 1986, the
dollar rebounded following a concerted strategy of
aggressive intervention in the foreign exchange market,
sharply higher interest rates, and the announcement of
large foreign borrowings by the federal government.
Initially stabilizing at about US$0.72, the dollar began
an upward trend against the U.S. dollar, which lasted
through the remainder of the decade. The currency was
boosted by various factors including a buoyant economy
led by a re-bound in commodity prices, expansionary
fiscal policy at both the federal and provincial levels,
and a significant tightening of monetary policy aimed at
cooling an overheating economy and reducing inflationary
pressures. The Canadian dollar closed the decade at
US$0.8632.
The dollar in the 1990s
Through
1990 and most of 1991, the Canadian dollar continued to
climb against its U.S. counterpart (and against major
overseas currencies). This was largely due to a further
tightening of monetary policy and widening interest rate
differentials that favoured Canadian instruments. It
crested at US$0.8934 on 4 November 1991. Subsequently,
however, it began to depreciate, falling sharply through
1992 to close the year at US$0.7868. The gradual, but
sustained decline in the value of the Canadian dollar,
which continued through 1993 and 1994, reflected various
factors. With inflation falling to--and for a time
below--the target range established in 1991 and with
significant unused capacity in the economy, the Bank of
Canada sought easier monetary conditions through lower
interest rates. 50
Downward pressure on the currency also reflected
increasing concern about persistent budgetary problems at
both the federal and provincial levels, softening
commodity prices, and large current account deficits. The
international environment was also unfavourable. The
Exchange Rate Mechanism in Europe came under repeated
attack through 1992 and 1993, followed by rising U.S.
interest rates through 1994. The Mexican peso crisis in
December 1994 and early 1995 also precipitated a
generalized flight into U.S. dollar assets.
A degree of stability in
the Canadian dollar was temporarily re-established
through 1995 and 1996 owing to a number of factors. These
included higher short-term interest rates (at least early
in the period), evidence that fiscal problems were being
resolved, a marked improvement in Canada's balance of
payments partly because of strengthening commodity
prices, and diminished focus on constitutional issues.
The Canadian dollar traded in a relatively narrow range
close to US$0.73 through much of this period.
Renewed weakness in the
currency began to emerge in 1997 and became increasingly
apparent in 1998 despite strong economic
fundamentals--very low inflation, moderate economic
growth, and solid government finances. Once again, much
of the slide in the currency could be attributed to lower
commodity prices, which began to soften in the summer of
1997 but subsequently weakened significantly as the
financial and economic crisis in emerging markets widened
and intensified. The large negative interest rate
differentials that had earlier opened up between Canadian
and U.S. financial instruments also weighed against the
Canadian dollar, as did the U.S. dollar's role as a
safe-haven currency during times of international crisis.
The Canadian dollar touched an all-time low of US$0.6311
on 27 August 1998 before recovering somewhat
following aggressive action by the Bank of Canada.
Interest rate reductions by the Federal Reserve Bank and
the return of a modicum of stability in financial markets
permitted the Bank of Canada to reduce Canadian interest
rates without undermining confidence in the Canadian
dollar. The currency closed the year at US$0.6522.
Concluding Remarks
This
history of the Canadian dollar has been largely
descriptive. Nonetheless, useful conclusions can be drawn
from examining the past. Although Canada has tried most
major types of exchange rate regime, it has generally
favoured a flexible exchange rate system through much of
the twentieth century. This has reflected three factors:
Canada's role as a major commodity producer and exporter;
the high degree of capital mobility, especially between
Canada and the United States; and a desire to direct
macroeconomic policy towards achieving domestic
objectives. In this regard, concern about importing
inflation from the United |