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The Canadian Dollar will need to depreciate significantly unless the trade deficit closes.
Donald Trump's trade war hit Canada hard in April as exports to the U.S. plummeted, widening a trade gap that will require the domestic currency to depreciate unless it closes.
Canada reported a negative trade balance of C$7.14BN in April, easily surpassing a 1.5BN deficit that was expected by economists.
This represents a sizeable surprise that points to struggles for the Canadian economy and will raise questions as to whether the Bank of Canada will be required to cut interest rates further in the coming months.
The deterioration was driven by a collapse in exports to the U.S. (exports were down to 60.44BN from 67.76BN in March).
"Trade fell off a cliff in April," says Randall Bartlett, Deputy Chief Economist at Desjardins Bank. "This was the largest trade deficit going back to at least 1988, and was significantly below the consensus of economists."
Deficits matter for currencies not in the short term, but in the long term. Hence, the Canadian Dollar was relatively stable following the release. However, the warning is clear: if this situation persists, the currency must adjust lower to make Canada's exports cheaper and imports more expensive.
"The shock was actually much greater than anticipated, at least with regard to trade data," says Jocelyn Paquet, an economist at National Bank of Canada.
"U.S. tariffs are starting to come into force, with customs revenue data showing rapid rises. China accounts for a large share of this, but tariffs on non-Chinese goods are also reaching the highest levels for decades," says Adam Slater, Lead Economist at Oxford Economics. "Based on daily Treasury data, we can see that customs receipts as a share of imports rose from a little more than 2% at the start of this year to an estimated level of nearly 8% in May."
U.S. Census Bureau data shows the average U.S. tariff rate on imports from Canada rose to 2.3%, with some industries seeing a far larger rate, like autos, steel & and aluminium.
Nathan Janzen, Assistant Chief Economist at Royal Bank of Canada thinks the deficit can close as Canada is in a better position than most other countries, owing to the North American free trade agreement (CUSMA) that exists between the U.S., Mexico and Canada.
"Almost 90% of Canadian exports appear to have accessed the U.S. market duty free in April," he explains.
"We continue to expect that current rules, if maintained as currently in place, would leave Canada with the lowest tariff rate of any major U.S. trade partner," he adds.
RBC thinks this puts Canadian exporters in a stronger position than other countries to compete for U.S. import market share.
"The concern remains, though, that U.S. tariff hikes have been so large — and uncertainty so high surrounding their announcements — that U.S. economic growth will slow with negative implications for close U.S. trade partners like Canada," he warns.