Investing Daily Article of the Week
by Ari Charney, Investing Daily
Canadian policymakers are worried about their economy’s dependence on the country’s overleveraged consumers. Consumers have been doing much of the heavy lifting the past few years, and as a result, debt as a percentage of household income remains near an all-time high, which suggests that the economy’s reliance on consumer spending is unsustainable.
As such, Bank of Canada (BoC) Governor Stephen Poloz hopes the economy will eventually shift back toward growth via exports and the resulting business investment that usually follows. However, based on Canada’s latest trade data, which we unpack in the forthcoming issue of Canadian Edge, this transition remains elusive.
Complicating the situation is that, according to Mr. Poloz, the linkage between US economic growth and Canadian export activity has been weaker than in the past. This relationship is of paramount importance because the US absorbs the vast majority of Canada’s exports of goods and services. In 2012, for instance, the US was the destination for 70.3 percent, or CAD384 billion, of Canada’s exports, according to data from Statistics Canada.
Mr. Poloz believes the “wedge” that’s undermining this historically strong relationship can partly be attributed to what was, until recently, Canada’s relatively strong currency. But the loonie dropped below parity with the US dollar last year and now trades near USD0.91, down more than 14 percent from its cycle high.
There are other explanations as well that he and his colleagues are pondering. In fact, a significant part of the problem is that the country’s export sector, particularly manufacturers, took a tremendous hit during the Great Recession, with the ensuing period more akin to a post-war recovery than a typical rebound. Indeed, many of the smaller export-oriented firms that would typically be the most responsive to subtle improvements in foreign demand were wiped out during the downturn.
The International Monetary Fund (IMF) also apportions some of the blame to Canada’s dismal productivity. According to the Organisation for Economic Co-operation and Development (OECD), from 2001 through 2009, labor productivity grew just 0.7 percent annually, which puts Canada in the bottom quartile of that entity’s member countries.
The boost to efficiency that typically comes from business investment, the other half of the BoC’s economic wish list, is the main culprit here. According to Deloitte, a major accounting firm and consultancy, Canadian companies invest less than half of what US firms spend on research and development. And on a per-worker basis, expenditures on machinery and equipment are just 65 percent of what US firms spend, while Canadian companies invest just 53 percent as much as their US peers on information and communication technology.
One area that’s received less attention is the fact that Canada’s export sector is so dependent on relatively slow-growing, developed-world economies. In addition to the US, whose economic resurgence has been anemic, at best, Canada also has strong trade ties with the European Union (EU), which has been struggling to produce growth. In 2012, the EU accounted for 10.1 percent of Canada’s exports of goods and services.
The missing component here is substantial exposure to fast-growing emerging markets, which the Conference Board of Canada examines in a new report. The report notes that while global trade in goods expanded by almost 70 percent over the 10-year period that ended in 2011, Canada’s export growth was essentially flat during that time.
The Conference Board tracked the export activity of all small and medium Canadian companies over the period from 1994 through 2008. During that period, top-performing companies nearly doubled their sales in emerging markets every year. But the study also found that numerous companies faced significant challenges in entering these markets, with many opting to discontinue exports to such countries after less than a year.
Based on the Conference Board’s list of characteristics of firms with a successful track record of exporting to emerging markets, overcoming these hurdles requires smaller companies to pursue a demanding strategy. The best firms first establish themselves in Canada before attempting to penetrate emerging markets. To gain traction overseas, they must be innovators, with new products introduced frequently. And to mitigate risk, they must diversify across a number of regions, while ensuring continued access to substantial capital.
On the manufacturing side, gaining greater access to emerging markets is a process that will likely unfold over a number of years. In the nearer term, assuming various pipeline projects and liquefied natural gas (LNG) export facilities finally get built, energy shipments to emerging Asia will drive export growth.
As for trade relations between the US and Canada, we’re betting that the decline in the exchange rate will help spur Canada’s export activity with its neighbor to the south. But it will take at least another several months to get a better sense of the extent to which a cheaper currency will change the present dynamic.
