Is Canada Suffering from the ‘Dutch Disease’?

CanadaBy all measures, the trade and investment ties that bind the U.S. and Canada are the world’s largest between any two sovereign states. In 2010, the two countries exchanged $481.5 billion worth of commodities, with an average of $1.3 billion in goods crossing the border each day. The same year, Canada was also the largest single destination for U.S. foreign direct investment (FDI) in manufacturing, holding an estimated $296 billion in cumulative FDI from the U.S.

Given its longstanding peaceful relationship with the U.S., Canada rarely attracts attention south of its border — and when it does, the attention is often positive. In recent years, the country’s image has been bolstered by its superior performance during the global economic meltdown, largely because of the more prudent strategies pursued by Canadian banks. Despite the relatively modest size of its GDP ($1.4 trillion, compared with $15.29 trillion in the U.S.), several Canadian financial institutions qualified for Bloomberg Markets’ most recent list of the world’s “strongest” banks. Canada’s leading banks “are well-regulated and have a long history of avoiding financial crises,” says Wharton finance professor Franklin Allen. “They provide [the country] with financial stability.”

The world’s tenth-largest economy, Canada’s unemployment rate of 7.1% in September 2012 was its lowest since December 2008. Moreover, the country’s system of universal healthcare is envied by many Americans as a model of sensible, moderate reform.

Nevertheless, analysts say, Canada has fundamental shortcomings that it must address in order to continue attracting foreign direct investment and compete effectively in an innovative global market. According to a recent report by the Canadian Chamber of Commerce, the country’s weaknesses include declining labor productivity growth; insufficient investment in infrastructure; a lack of innovative, global brands; and a shortage of highly skilled labor that, in some sectors, is “becoming desperate, threatening our ability to keep up in a global, knowledge-based economy,” the report notes.

‘Hewer of Wood, Drawer of Water’

Some economists worry that Canada will ultimately suffer from a full-blown case of so-called “Dutch Disease” — that is, when a country’s overdependence on exports of primary products pushes up the value of its currency, leading to a downward spiral in its manufacturing productivity and competitiveness. As recently as 2002, the Canadian dollar was traded at its all-time low of 61.7 U.S. cents, but it has since risen to near parity with the U.S. dollar as a result of soaring global prices for the commodities that Canada exports, especially oil.

Not coincidentally, over the past decade, manufacturing output and employment in Canada have both declined sharply. Some 600,000 Canadian manufacturing jobs have been lost since 2000, notes Jim Stanford, chief economist for the Canadian Auto Workers Union. In 2010, natural resources (energy, forest products and mining) generated a combined 11.5%, or $142.5 billion, of Canada’s GDP, and directly employed close to 763,000 people, according to Natural Resources Canada, a government agency. That same year, the natural resources sectors contributed $86.1 billion to the Canadian trade balance, while Canada’s major manufacturing sectors suffered a combined negative trade deficit of $64.4 billion.

For decades, Canada strived to escape its traditional status as a supplier of natural resources and commodities — or “a hewer of wood [and] a drawer of water,” notes George S. Day, a Wharton marketing professor who was born and raised in Canada. Yet by July 2011, unprocessed and semi-processed resource exports accounted for two-thirds of Canada’s total exports, the highest figure in decades, according to Stanford. The growth in natural resource exports has not been sufficient to offset the decline in other exports, such as manufacturing and services, Stanford adds. “This surge in resource exports, even with high global commodity prices, still isn’t enough to pay our bills in world trade. Trying to pay for sophisticated high-tech imports by digging more resources out of the ground ever faster is a losing battle.”

Rather than compete against global manufacturers, a great deal of business activity in Canada these days has been moving into “non-tradable sectors” of the economy — locally focused businesses and services, such as construction. Despite the fact that the country has signed numerous free-trade agreements in recent years (NAFTA with the U.S. and Mexico, and bilateral pacts with Chile, Colombia, Costa Rica, Israel and Peru), exports as a percentage of Canada’s GDP have declined from about 45% in 2000 to only about 30% today. This trend means that “Canada’s economy is actually de-globalizing,” according to Stanford.

Meanwhile, Canada’s labor productivity growth rate has continued to be poor. From 1962 to 1984, the country’s labor productivity grew by an annual average of 2.8% before slowing to an annual average growth rate of 1.2% between 1984 and 2010. Low productivity growth represents “an enormous challenge” for Canada’s future prosperity and competitiveness, says the Conference Board of Canada, an independent research firm, in a recent report. According to Andrew Sharpe, executive director of the non-profit Center for the Study of Living Standards in Ottawa, over the past decade, “the manufacturing sector has suffered the worst decline” — with growth rates dropping from 4% to 0.1%.

Despite those statistics, Wharton’s Day rejects the comparison between Canada’s challenges and the Dutch Disease. “I don’t see this [situation] as acute enough to qualify as Dutch Disease,” he says. He points out that in the classic case of the economic malady, the Dutch government spent its revenues from a natural gas discovery on lavish projects. On the contrary, rather than throw caution to the wind, Canadian officials “have been pretty prudent about spending.” For example, the government of Alberta still has billions of dollars in its reserve fund.

Day agrees that the high value of the Canadian dollar represents “a huge challenge” for Canada because “it puts any [Canadian] manufacturing item at a disadvantage. I worry a lot about the auto sector. Are we going to be able to keep the auto sector in Canada?” For his part, Stanford notes that Canadian exporters have already suffered “a huge loss of competitiveness compared to the U.S. and countries like China, which more or less peg their currencies to the U.S. dollar.” However, Wharton’s Allen points out that the strength of Canada’s currency “cuts both ways. Although manufacturing has problems, it also means you can buy [imported] things cheaply.”

Originally published October 10, 2012 in Knowledge@Wharton.

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