GLOBAL ECONOMICS
CHAPTER 9
THE LOONIE ON THE BLOCK
One thing that riles Canadians is Jacques Parizeau's baldfaced claim that a sovereign Quebec will continue to use the Canadian dollar whether we like it or not. The source of Parizeau's exasperating proclamation is the Bélanger-Campeau commission, which stated that it saw nothing to prevent businesses and individuals in a sovereign Quebec from carrying out their transactions in Canadian dollars if they so wished. In the commission's view, legislation could simply be adopted making the Canadian dollar legal tender in Quebec and sufficient Canadian currency would be available from existing holdings and from Canadian financial institutions to keep the system going. It was a short step from Bélanger-Campeau to Parizeau's challenge.
PQ strategists were ecstatic at having the Bélanger-Campeau commission seemingly remove one of the biggest stumbling blocks on the road to sovereignty. As with Canadian citizenship and the Canadian economic union, the separatists want to reassure nervous Quebec voters that they can keep the parts of Canada they like while shedding only the parts they don't want, like the Queen and the constitution. And they have tried to make as much of it as possible by reassuring voters that their savings are safe in Canadian dollars. By saying that there was nothing the rest of the country could do to stop use of the Canadian dollar, the separatists were elated at the thought that one of Canada's most important bargaining chips was already in their pocket.
Quebec should think again. If it wants to use our money after separating, it is going to have to get our approval first. And Quebec will first have to give us a few things we want, like assuming a fair share of our collective debt albatross. While it's also in our interest that Quebec continue to use the Canadian dollar, we stand to gain far less than Quebec would lose if we said no. In any game of chicken on the dollar, Quebec will end up going over the cliff. Once this reality sinks in, we should hear no more irritating claims and the negotiations should go much more smoothly.
While most Quebeckers have become increasingly estranged from Canadian symbols, they still have a deep attachment and high level of confidence in the Canadian dollar. They are paid in Canadian dollars. Their savings are in Canadian dollars. They plan their retirement in Canadian dollars. Their assets are valued in Canadian dollars. Their debts are payable in Canadian dollars. The last thing Quebeckers want is to wake up one morning and discover that everything is denominated in new Quebec dollars of uncertain value and that all their careful financial planning is out the window.
Separatists, not being stupid, do their utmost to calm worries that sovereignty might mean the establishment of a new, and likely shaky, Quebec currency. Jacques Parizeau has acknowledged that to create a Quebec currency would be to take a big risk and put in peril the "economic levers" of a sovereign Quebec. He told a group of institutional investors in Montréal in early 1992 that "Quebec as a sovereign nation would choose the Canadian dollar. That's absolutely certain."
This assurance has been formalized in the PQ government's draft bill on sovereignty which specifically states that "the legal currency of Quebec shall continue to be the Canadian dollar."
Separatists have not always voiced such strong support for the Canadian dollar. In a pamphlet released in 1990, the PQ advocates a monetary union with Canada, but says that if Canada refuses, Quebec would adopt its own currency as has been done by almost all independent states. And Parizeau himself long supported a separate Quebec currency because he viewed monetary policy as an important instrument of government intervention for a sovereign Quebec. It was only in 1978, when the PQ drew up its new policy platform endorsing a common currency that Parizeau changed positions and became a public defender of the continued use of the Canadian dollar.
The most recent PQ program is relatively quiet on the PQ's plans for Quebec's monetary future. All it says is that the "status quo will be maintained, for the moment, with respect to the Bank of Canada, the currency, and all other organizations having an important role in the monetary stability..." and that Quebec could accept under certain conditions to use the same money as Canada." Evidently, everyone in the PQ does not share Parizeau's total and unqualified enthusiasm for the Canadian dollar.
The more hard core separatists have always been concerned that their commitment to use the Canadian dollar could be turned against them to undermine their bargaining position with the rest of Canada. Parizeau's unseemly haste to adopt the Bélanger-Campeau Commission's position must be seen for what it is--a bargaining ploy intended to strengthen Quebec's hand in negotiations. It completely ignores the overriding importance of confidence in supporting something as fragile as a paper currency and the payments system. Parizeau, the professional economist, knows full well the critical role of confidence in the monetary system; Parizeau, the politician, conveniently chooses to overlook it.
The Canadian dollar is one of our most important bargaining chips. We should not be bluffed into giving it away. Quebec's perilous monetary position must be seen for what it is.
Separatists often hold up the Bahamas and Panama, where U.S. dollars circulate freely, as examples of countries unilaterally using the currency of another. If the Bahamas and Panama can do it, why not Quebec? sovereigntists ask. The Bahamas and Panama do use the U.S. dollar without a formal agreement, but both these countries are very small relative to the United States and have its acquiescence. They also have access to enough U.S. currency brought in by the tourist trade and Canal Zone to satisfy their needs for a medium of exchange. Quebec would need more than Canada's acquiescence to use the Canadian dollar.
Only the Canadian government can run a Canadian dollar monetary system. Without an explicit agreement with the Canadian Government, the confidence so critical to the functioning of a financial system would be lacking. The Canadian Government through the Bank of Canada alone can print the currency that people want to hold and make the rules under which the payments system operates.
While almost a quarter of the Canadian money supply is now in Quebec hands, it is important to remember that these bills wear out and must be replaced on a regular basis. The average life of $2, $5 and $10 bills is currently about a year and the average life of a $20 bill around two years. Only the Bank of Canada can supply replacement currency. In Quebec, this is done through a state-of-the-art currency handling facility in Montreal which sorts bills returned from the chartered banks and replaces worn ones with crisp new currency. If the bank were to suspend operation of this centre, Quebec financial institutions would have to scramble to keep an adequate supply of bills.
The Quebec government couldn't expect much help from normal balance of payments transactions, which are usually settled by bank drafts. While membership for Quebec financial institutions in the Canadian Payments Association would not be absolutely essential to clear cheques and other transactions on Canadian dollar accounts, it would facilitate the clearings and would be critical in establishing the confidence so necessary for the functioning of the financial system.
There are also more technical constraints imposed by international organizations on countries seeking to use the currency of another. What happened in Botswana after its independence from South Africa in 1968 illustrates the need for an agreement between Canada and Quebec. Botswana adopted the South African rand as its currency. When it applied for membership in the International Monetary Fund, the IMF sought assurances from South Africa that Botswana would have the right, without restrictions or limitations, to use its holdings of rands to fulfil its obligations to the IMF, and that the IMF would not be subject to any constraints on its use of the rands received from Botswana. Canada would have to provide a similar undertaking to the IMF on Quebec's behalf if it continues to use the Canadian dollar.
Even an agreement would not be very strong glue for a monetary union. If Quebec were to get Canada's support for such a union, there are grounds for pessimism about how long Quebec's use of the Canadian dollar would last that would undermine confidence. In the past, monetary unions between two countries without political unions have almost always collapsed. The longest lasting was the use of the pound sterling by Ireland from its independence in 1921 until 1928. More recently, it took less than six weeks for the common-currency agreement between the Czechs and Slovaks to collapse under speculative pressure. Following the break-up of the Soviet Union, a severe liquidity crisis also forced the Ukrainians off the ruble.
EXTREME MEASURES TO BLOCK QUEBEC
If Quebec were to separate on acrimonious terms and not to take its fair share of the public debt, the reaction of the rest of Canada would be understandably hostile. There are some, admittedly extreme, steps that the Canadian government could take to prevent Quebec from using the Canadian dollar. Restrictions could be put on the export of Canadian currency. Some countries already exercise border controls on the transportation of currency. Existing Canadian currency could be recalled and new notes issued. Regulations could be established to deny Quebec financial institutions direct access to the Canadian Payments Association. The mere threat of these measures would probably be enough to spark a crisis of confidence that would knock Quebec right off the Canadian dollar. Confidence is very fragile, and is easy to lose.
How would a crisis of confidence lead to the forced establishment of a separate Quebec currency? If the holders of deposits denominated in Canadian dollars in Quebec financial institutions were to become worried that the Quebec Government might pass a law changing the currency of the deposits into Quebec dollars of likely lesser value, they would withdraw their money from the institutions for redeposit in Canadian or most likely American institutions where it would be safe from devaluation.
The PQ would be quick to characterize any such run on Quebec banks and other financial institutions as a plot by large corporations and the English Canadian financial elite to destabilize the new state. "Another Brink's affair," they would say, referring to the well-publicized movement of securities out of Quebec on Brink's armoured cars on the eve of the 1970 provincial election. But the truth of the matter is that francophone Quebeckers would probably be the first to line up at banks in Hawkesbury, Ontario and Plattsburgh, N.Y., to stash their money away. Nationalist feelings can be easily suppressed when your life savings are at stake.
If the withdrawal of funds were sufficiently large, Quebec financial institutions would quickly exhaust their liquidity reserves and would have to call their loans to honour these obligations. The resulting credit crunch would have a devastating impact on the non-financial sector of the Quebec economy, precipitating a collapse in asset values and investment. The solvency of Quebec financial institutions could even be jeopardized. The only way the Quebec Government could relieve the building recessionary pressures and preserve the financial system would be to announce a separate Quebec currency and to devalue it enough to establish confidence that no further devaluations were likely.
Extreme measures by the Canadian Government to block the use of the Canadian dollar by a sovereign Quebec would not be desirable and should only be taken if relations between Quebec and the rest of Canada break down completely. Even the announcement of such action would be symbolic, signalling to the international financial community and the world generally Canada's refusal. There would probably never be a need to actually take any action as markets would exert tremendous pressure. But Quebeckers must be made to know that they would not hold all the trump cards in negotiations with Canada if bargaining were to get really tough.
A study by economists David Laidler and William Robson has been cited by separatists as evidence that the Canadian government could do nothing to prevent Quebec from using the Canadian dollar. A closer reading of this study reveals what it actually says is: "The actions that the government of ROC (Rest of Canada) would need to take to prevent SQ (Sovereign Quebec) from doing so--namely, the introduction of comprehensive foreign exchange controls--seem beyond the bounds of political possibility."
Laidler and Robson never question that the government of Canada could in fact stop Quebec from using the Canadian dollar if it were willing to take the necessary action, only that it may not have the political will to do so. This should not provide much comfort to Quebeckers desirous of retaining the Canadian dollar, but unwilling to give up anything. If the backlash in English Canada unleashed by the breakup were strong enough, the political will would be there to do everything necessary short of using military force to ensure that Canada was not shortchanged. Laidler and Robson are profoundly pessimistic about the long-term prospects for the continuing use of the Canadian dollar in Quebec for many of the same reasons discussed here.
ADVANTAGES OF A COMMON CURRENCY
The advantages of using the Canadian dollar from coast to coast are great. Transaction costs are lower and the free flow of goods, services and capital are facilitated, enhancing economic efficiency. The larger the size of the area covered by a currency the more stable its value and the better it can serve as a store of value. A larger monetary zone and a more stable currency also lead to smaller risk premiums and lower interest rates, promoting investment, longer-term growth and higher standards of living.
On the other hand, sharing a common currency with a country with a high degree of political and economic uncertainty such as an independent Quebec could lead to a higher risk premium. Before agreeing to let Quebec use the Canadian dollar, we should seek assurances that appropriate fiscal policies would be pursued. Quebec can't expect to share a currency with Canada if it is going to have unsustainably large fiscal deficits and high inflation.
Quebec sovereigntists are currently living in Fantasyland with their belief that the deficit could be cut painlessly by eliminating overlap and duplication. Quebec economists Marcel Côté and John McCallum estimate that a sovereign Quebec would have a deficit of $20 billion or 10 per cent of GDP and would have to make $10 billion a year in expenditure cuts. By any reckoning, the Quebec deficit will be too high for it to continue to use the Canadian dollar. It would far surpass the 3-per-cent of GDP target established by the European Community to ensure the stability of the European Monetary Union, the same mark set by Finance Minister Paul Martin for the federal deficit.
We would have to extract commitments to sustainable deficit targets through clearly-stated agreements with the federal government and the Bank of Canada. Otherwise, it would be impossible to gain the confidence of markets in the permanence of the arrangement. Deficit and debt commitments were an essential part of the European Community's plan to move to a monetary union. Curiously, Quebec may find its fiscal margin of manoeuvre more constrained once it becomes sovereign than it is right now, when Ottawa can exercise only moral suasion over its budget decisions.
If no agreement were reached on the use of the Canadian dollar, the lack of a common currency between Canada and Quebec would be more troublesome for Quebec than for Canada. Because Quebec has a smaller and less diversified economy with a more variable level of economic activity, it would reap fewer benefits from a separate currency. It also faces higher risks due to increased transaction costs and volatility. Economist Bernard Fortin, who wrote the study for Bélanger-Campeau on using the Canadian dollar, estimated that a separate Quebec currency could cost Quebec $1 billion per year or 0.6 per cent of Quebec GDP, because of the cost of exchanging one currency for another and the volume of transactions. The costs to Canada would be comparable in absolute dollars because it would be the other party to the currency exchanges, but taking into account Canada's higher GDP, only 0.2 per cent of GDP. This is a cost Canada could afford if Quebeckers prove intransigent, but one that would be best avoided.
Two separate currencies would lead to disputes over the appropriate exchange rate. Quebec's weak current account position would probably cause the new Quebec dollar to trade at a significant discount to the Canadian dollar (economists Marcel Côté and John McCallum speculate that a devaluation of a Quebec dollar of the order of 15 per cent would be inevitable). But if the Quebec dollar sank too deep or the Quebec government was perceived to be trying to use an undervalued dollar to engineer a competitive advantage, serious conflicts could threaten trade relations. Neither Quebec nor Canada should expect to determine unilaterally the appropriate exchange rate between the Quebec and the Canadian dollar if it were fixed or expect to conduct a market intervention strategy without consulting the other if it were allowed to float. Better to avoid these problems by both using the Canadian dollar.
An additional advantage of keeping the Canadian dollar is that it would make it easier for Quebec to assume its fair share of the government debt. Since this debt is denominated in Canadian dollars, Quebec could be expected to bargain harder for a lower share if it were to have its own currency. Obviously, Quebec would experience more difficulties in carrying its share of the debt load if it were denominated in a foreign currency.
Canadian political leaders are unlikely to have a problem with Quebec using the dollar if the breakup goes smoothly. Preston Manning acknowledged that there was a public reaction to the PQ's assertion that Quebec could unilaterally use the Canadian dollar, but said that it would be to our advantage if Quebec were to use the Canadian dollar. In his view, this would expand our economic area just like it does when some countries use the U.S. dollar. But he wouldn't give Quebec any say in monetary policy.
Another option for Quebec would be to use the U.S. dollar, provided that the United States was willing to cooperate. This would involve the same potential for an initial loss of purchasing power in Quebec. In fixing the conversion rate, there would be much pressure on the Quebec government coming from financial markets to devalue. Canadians would have a stake in this because too low a conversion rate would undercut our ability to compete with Quebec industry. An advantage of the U.S. dollar from a Canadian point of view would be that a new currency market for Quebec dollars would not have to be created and the transaction costs of currency exchanges would be lower with only two main currencies to deal with rather than three. Disadvantages for Quebec would be that it would not have a say in U.S. monetary policy and would lose the seignorage on its money. (Seignorage originally was the Crown's right to a percentage of the bullion brought to the mint for coinage. It now represents the government's ability to gain command over resources interest free by issuing paper currency.)
FINANCIAL RISKS AND REGULATIONS
Separatists always argue that it would be in Canada's interest to have Quebec continue to use the Canadian dollar. And it is true that a wider common currency area would have certain advantages in facilitating trade and contributing to a more stable dollar. But there would also be some problems that must be overcome if Canada were to allow Quebec to use the Canadian dollar. It would be much more difficult to guarantee the solvency of the Canadian financial system if Quebec financial institutions could clear their cheques and other transactions through the Canadian Payments Association without the federal Office of the Supervisor of Financial Institutions having supervisory authority over them.
The bankruptcy of a major Quebec financial institution could occur without warning and could bring down the Canadian financial institution with which it had clearing arrangements. This risk would be greatest during the transition period to Quebec independence when the Quebec financial system would be subject to extraordinary strains. We would have to be on guard to protect our financial system as much as possible from the disruptions of the Quebec financial system likely to follow independence.
The breakup of the country could fragment the current Canadian financial system on Canada-Quebec lines if steps were not taken to maintain a high degree of integration. A single regulatory authority and legislative framework to govern the financial system would no longer exist. After Quebec independence, the federal Office of the Supervisor of Financial Institutions would continue to have responsibility for overseeing the global operations of financial institutions licensed in Canada. In Quebec, the mandate of the Inspecteur général des institutions financières would have to expand to include the regulation of the formerly federally regulated institutions operating in Quebec and federal deposit insurance would have to be replaced by Quebec.
As a result of the likely efforts of both Canada and Quebec to regulate the same financial institutions, Canadian institutions operating nationally would have to be reorganized along Canada-Quebec national lines to comply with the demands of the two sets of regulators. It would be very difficult for the Canadian and Quebec regulatory agencies to coordinate their activities in the wake of the breakup, but the necessary arrangements would have to be made. If Quebec wants to use the Canadian dollar, it will have to be willing to subject its financial institutions to some form of mutually agreed regulatory oversight and to provide our regulatory authorities with the required information.
If Quebec separates, restrictions on foreign ownership of financial institutions would have to be rethought. Under existing Canadian financial institution legislation, the so-called "10/25" rule that prevents any single non-resident from acquiring more than 10 per cent and all non-residents from acquiring more than 25 per cent of the shares of a federally-regulated Canadian controlled financial institution such as the Big 5 banks.
The United States and Mexico have been exempted from this requirement under NAFTA. Why shouldn't the same be done for Quebec as long as reciprocal treatment can be obtained? In addition, foreign bank subsidiaries from non-NAFTA countries are subject to an asset ceiling that limits them to 12 per cent of the banking sector. If the legislation were not changed, the National Bank of Canada would be subject to these same restrictions. Because non-residents (Quebeckers) hold more than 25 per cent of its shares, it would be considered a foreign-owned bank. Restrictions on foreign assets to 20 per cent of pension funds and RRSPs would also necessitate liquidations of Quebec investments if regulations were not changed. Shares in Quebec-based companies like Alcan, Domtar and Imasco would presumably have to be sold or counted as foreign stocks if the rules were not changed.
The PQ platform schizophrenically talks of welcoming foreign corporations in the financial sector, but at the same time reinforcing control over the sector. In particular, the PQ proposes to require a certain proportion of assets to be reinvested in Quebec, to favour the provision of risk capital to small and medium-sized businesses in the less developed regions of Quebec, and to encourage foreign financial institutions to establish a head office in Quebec. We need to make sure that Canadian financial institutions operating in Quebec, including such venerable features of the Quebec financial landscape as the Bank of Montreal and the Royal Bank of Canada, are not discriminated against in any new regulations established by the Quebec government. If Quebec joins NAFTA, it will have to treat financial institutions from member countries in a non-discriminatory manner.
MONETARY POLICY
The Bank of Canada's conduct of monetary policy would be more difficult if a large proportion of Canadian currency and Canadian dollar bank accounts were outside its control. Quebec financial institutions could not be compelled to report regularly to the Bank of Canada as are Canadian financial institutions. This would make it more difficult for the Bank of Canada to rely on current monetary indicators to determine monetary policy and decide whether interest rates should move up or down. More importantly, changes in the Canadian domestic money supply caused by inflows and outflows of Canadian dollars from Quebec resulting from factors like differing economic policies on the two sides of the border would have to be neutralized to promote Bank objectives like price stability.
Quebec would likely seek a say in running the Bank of Canada as part of an agreement on the Canadian dollar. In his study for the Bélanger-Campeau commission, economist Bernard Fortin put forward an elaborate proposal for a supranational Quebec-Canada Council to replace the Board of Directors and Executive Committee of the Bank of Canada and for monetary policy to be conducted through Canadian and Quebec central banks. Parizeau himself has favoured something along these lines in the past. From a Canadian point of view, it is the type of proposal that can be easily dismissed as a sovereigntist pipedream. Canadians are not about to reward a separate Quebec with a major say over Canadian monetary policy.
The PQ has been more modest, only calling for Quebec participation in the Bank of Canada. We can speculate that this might include Quebec representation on the Board of Directors or Executive Committee and Quebec staff, including perhaps a Deputy Governor. While this would not require large changes in the way the Bank operates, it would be difficult for other provinces to swallow given that their own efforts to get a say in Bank policy have always been rebuffed.
It would also be difficult for the Canadian government and the Bank of Canada. The PQ has voiced its profound dissatisfaction with recent monetary policy and has expressed a touchingly naive faith in the ability of easy money promote full employment. The PQ has argued that measures taken to reduce overheating of the Ontario economy have often aggravated the already too high unemployment in Quebec. The PQ claims that it would put an absolute priority on full employment and is silent on the Bank of Canada's main objective of price stability.
Given these problems likely to be caused by direct Quebec government participation in the governance of the Bank of Canada, we believe that it would be better to rely on more informal coordinating arrangements.
The sharing of Bank of Canada $1.6 billion in profits -- the seigniorage -- is an important financial issue that is integrally related to the division of the debt. Quebec's share of these profits based on GDP would be around $360 million. Quebec's share of the $23 billion in government debt held by the Bank of Canada would have to be taken into account in the negotiations over the division of the debt.
The Bank of Canada is important in any sharing of federal government assets and liabilities since it holds so much government debt and since its liabilities, which are chiefly Canadian currency, bear no interest. If Canada agrees to let Quebec use the Canadian dollar after separation, Quebec should be given credit for the share of the federal debt it holds indirectly in the form of Bank of Canada notes and deposits. But if Quebec subsequently is forced to abandon the Canadian dollar, it should be required to pick up its share of the federal government's debt held by the Bank of Canada.
To protect the integrity of the financial system, Canada would have to insist that a common regulatory framework for financial institutions be established. For additional assurance, Canada could also demand that Quebec guarantee any clearings through the Canadian Payments Association by Quebec financial institutions. This would put the Quebec government on the hook for any defaults by its financial institutions. Information on the assets and liabilities of Quebec financial institutions would have to be provided to the Bank of Canada on a regular basis to assist it in monitoring the growth of the money supply. All of these matters would have to be resolved to Canada's satisfaction before it would make sense to enter into an agreement to support Quebec's use of the Canadian dollar.
If Quebec wants a fighting chance of keeping the Canadian dollar, it is going to have to come to terms with us. That means assuming a fair share of the $550-billion national debt. No discussion over continued use of the Canadian dollar can be held in isolation from this, the biggest financial issue of all. Rough financial waters are ahead. It is in our mutual interest to cooperate to weather the storm.