Sink, swim or fly? Coping with a loonie at par

The following is the 20 September 2007 article in “globeandmail.com” by Glen Hodgson, the senior vice-president and chief economist at the Conference Board of Canada.

As the Canadian and U.S. dollars reach parity for the first time in more than 30 years, there are many complaints about the spectacular run-up's negative effects on exporters, specifically on manufacturers in Ontario and Quebec. The dollar's rise is being blamed for everything from sagging economic performance to lost jobs, while Finance Minister Jim Flaherty has exhorted Canadian firms to invest in new machinery and equipment to boost their productivity and international competitiveness.

Yet exports to the United States have held up remarkably well - nominal merchandise exports, excluding energy, are near the same level they were five years ago, although the loonie is 50 per cent higher against the U.S. dollar. Some export sectors are in shock (tourism revenues from American visitors have fallen sharply, as have forestry exports), but other sectors are coping. How can this be?

We believe the conventional analysis of the effects of a rising Canadian dollar is incomplete for some key sectors. Under the Canada-U.S. free-trade agreement (FTA) and the North American free-trade agreement (NAFTA), this continent's economy has become more deeply integrated. Regional supply chains have been formed as firms reposition their production for maximum regional and international competitiveness. This new international business paradigm - we call it "integrative trade" - has led many Canadian companies and sectors to shift to foreign (often U.S.) sources of inputs, with a resulting rise in the foreign content and foreign costs of their production. Interestingly, the greatest integration has taken place in manufacturing, where foreign content for the average exporter is about 40 per cent of the value of their production. In some sectors, such as auto assembly and niches of high tech, foreign content is 60 per cent or higher.

As a result, the soaring loonie may mean less Canadian dollar revenue from exports, but it also means lower costs for imported inputs used by manufacturers and exporters - creating a kind of natural hedge to exchange-rate movements for companies with significant foreign inputs.

But even Canadian firms that are deeply integrated into the North American market need to worry about international competitiveness. Globalization has introduced a whole new level of competition into the North American marketplace, with the arrival of lower-cost competitors from China, India, Brazil and other emerging markets.

Moreover, Conference Board research indicates that deeper integration between Canada and the United States essentially came to an end after 2000. The existing FTA has reached its limits. And not all sectors or firms are benefiting from falling import costs due to the higher dollar. Adding to these challenges is slower labour-force growth due to our aging population, which in turn, puts upward pressure on real wages. For many, adaptation to a new reality is critical.

To enhance Canadian international competitiveness and kick-start productivity growth, the Conference Board recommends action on multiple fronts:

Fixing the border infrastructure is the obvious place to start.
We need FTA II, which could do for services exports what the original FTA did for manufacturing. Reducing non-tariff barriers is a top priority.

Companies should take up Mr. Flaherty's challenge and boost investment in new machinery and equipment, ideally supported by pro-investment tax reform in the next budget.

Canadian governments must seriously tackle the vast web of regulatory barriers that balkanize the country's economy, and reduce barriers to competition in specific sectors. A single national securities re