Why a Dying Manufacturing Industry Leaves Canada More Vulnerable to Dutch Disease

I am really enjoying the Economy Lab feature at the Globe and Mail.  Two stories in particular caught my eye: Why Canada's manufacturing sector is dwindling and Get ready for a $1.15 loonie.  Keeping in mind Dan Gardner's warnings on expert predictions, both pieces hit the mark.  In particular, Prof. Gordon is correct that the Canadian dollar is only a minor factor in the decline of Canadian manufacturing.

However, other than some obscure Ivey lecturer who won't shut up about it, not enough is being made to connect the two issues.  When we put the two arguments together, it almost certainly leads to the conclusion that Dutch Disease is going to become an increasing problem in Canada in general, but southwestern Ontario in particular.  Here's why:

As I discussed in Productivity, the Canadian Dollar and Small Business - A Case Study, Canadian exporters can insulate themselves against currency fluctuations by having their revenues and expenses aligned in the same currency.  For most southwestern Ontario businesses, this means having both revenues and expenses largely in U.S. dollars.  If you're a chemical manufacturer, this is often possible.  A typical Canadian manufacturing exporter will have around a 80/20 U.S. dollar/Canadian dollar revenue split.  The largest expense for a manufacturer is raw materials.  In the case of a chemical company, these are either already priced in U.S. dollars on world markets (oil, copper, etc.), can be purchased from U.S. companies, or purchased from Canadian companies in U.S. dollars.  Machinery can be purchased or leased from U.S. companies in U.S. dollars.  The company will still have some expenses that will have to be demoninated in Canadian dollars (labour, land, utilities), but they may be to obtain a 70/30 U.S. dollar/Canadian dollar expense split.  The company will have some net exchange rate exposure, but it is relatively small.

But manufacturing is dying.  What is to take it's place?  The obvious solution is 'services' - computer programming, logistics, research and development, graphics design, management consulting, etc.  However, service companies typically only have two major types of expenses: labour and utilities (including rent).  Both of which are demoninated in Canadian dollars.  Instead of having a 70/30 U.S. dollar/Canadian dollar expense split, the ratio is closer to 10/90.  If the company has the same exporting profile as our manufacturing company, they face a giant exchange rate exposure, with no obvious way to hedge against it.

If the Canadian dollar continues to rise, then we should not expect service exports to 'pick up the slack' - there is simply no comparative advantage there.  Either our service companies will  have to focus more on servicing the domestic market (or foreign markets other than the U.S.), or we will need to look to other industries for economic growth in southwestern Ontario.

 

 

Comments

[Mike Moffatt]

Of course, there's an obvious solution to this: have your employment, mortgage and rent contracts denominated in U.S. dollars. I know of a handful of companies that have done this with their landlords. At Nexreg, we don't pay for anything in Canadian dollars if we can at all avoid it - in fact, during the recession we renegotiated contracts with Canadian suppliers to be in U.S. dollars. But are firms going to be willing/able to push their forex risk onto their employees? We've actually considered doing this for new hires, but we couldn't bring ourselves to do it. But at what point do companies start going this route? And if it catches on and everything except consumer prices start to be denominated in U.S. dollars, at what point does consumer prices then follow?

[Just visiting from Macleans]

Why a Dying Manufacturing Industry Leaves Canada More Vulnerable to Dutch Disease

Isn't that like saying if you have the flu, you're more susceptible to having the flu? I thought Dutch Disease was booming resource sector (ie oil - in Holland's case gas) => appreciating currency => uncompetitive manufacturing sector.

What proportion of jobs lost in SW Ont, in the period SG covers in his opinion piece, were auto industry related? Because when I think of that industry, I think of overcapacity, inflexible unions with high legacy expenses, and gov'ts in bidding wars to locate plants in their jurisdictions (equivalent to a subsidy - no different than a targeted CIT cut).

[Stephen Gordon]

I thought Dutch Disease was booming resource sector (ie oil - in Holland's case gas) => appreciating currency => uncompetitive manufacturing sector.

Not quite. It's only a disease if the jobs lost in manufacturing can't be compensated by gains in other sectors.

[Just visiting from Macleans]

So, is an increasing unemployment rate a necessary condition for Dutch Disease? The wiki entry doesn't specifically say so.

http://en.wikipedia.org/wiki/Dutch_disease

[Mike Moffatt]

"Isn't that like saying if you have the flu, you're more susceptible to having the flu? I thought Dutch Disease was booming resource sector (ie oil - in Holland's case gas) => appreciating currency => uncompetitive manufacturing sector."

Partly - but keep in mind manufacturing in SW Ontario is often insulated from currency effects, because it's often straightforward to line up revenues and expenses in the same currency. An appreciating CAD reduces the value of USD revenues, but also the value of USD expenses, so it can close to net out.

"and gov'ts in bidding wars to locate plants in their jurisdictions (equivalent to a subsidy - no different than a targeted CIT cut)."

They're completely different. For one thing a CIT cut is only useful to companies that turn a profit. Subsidies are often given to companies who *aren't* turning a profit.

[Mike Moffatt]

That should say "is only DIRECTLY useful to companies that turn a profit." It can (and likely would) have indirect effects on non-profitable companies.

[Just visiting from Macleans]

They're completely different. For one thing a CIT cut is only useful to companies that turn a profit. Subsidies are often given to companies who *aren't* turning a profit.

I meant in the sense of a race to the bottom line in an effort to entice investment, a point K was raising in your earlier blog.

What about the wiki entry on Dutch Disease? I read it a bit differently than what SG clarified. In the sections on "Core Model" and "Effects" I read it to mean that a booming resource sector (and its attendant effects) CAN leave you susceptible if the booming sector turns for the worse (commodity prices decline) or when the capital building boom ends once all the primary facilities/infrastructure have been built. All the eggs in one basket argument.

[Mike Moffatt]

"What about the wiki entry on Dutch Disease? I read it a bit differently than what SG clarified. In the sections on "Core Model" and "Effects" I read it to mean that a booming resource sector (and its attendant effects) CAN leave you susceptible if the booming sector turns for the worse (commodity prices decline) or when the capital building boom ends once all the primary facilities/infrastructure have been built. All the eggs in one basket argument."

That wiki article is pretty messy - I should see if I can find a better source for an explanation of Dutch disease.

There are actually (at least) two effects from Dutch disease - the pushing up price of labor effect and the exchange rate effect. I meant to only refer to the latter effect - I should have made that explicit.

[Jon]

But at what point do companies start going this route? And if it catches on and everything except consumer prices start to be denominated in U.S. dollars, at what point does consumer prices then follow?

After the government adopts it as a matter of policy in the way of Panama, but maybe you should get some citizens on the US Federal Reserve Board first. To do that, you first need a treaty establishing a common bank supervision board.

I, for one, would much rather see the Canadians overseeing the US banks...

[Mike Moffatt]

Jon - I hope it doesn't come to that! I put the part about companies paying their workers in USD in a comment instead of the blog text, because I don't think it's remotely likely to happen on a significant scale. But it would solve the problem.

[happyjuggler0]

Abolishing the corporate income tax on non-resource industries would help, at least until the US follows suit. I suspect the US wouldn't follow suit however, our politicians aren't smart enough to do that.

[Mandos]

But manufacturing is dying. What is to take it's place? The obvious solution is 'services' - computer programming, logistics, research and development, graphics design, management consulting, etc. However, service companies typically only have two major types of expenses: labour and utilities (including rent). Both of which are demoninated in Canadian dollars. Instead of having a 70/30 U.S. dollar/Canadian dollar expense split, the ratio is closer to 10/90. If the company has the same exporting profile as our manufacturing company, they face a giant exchange rate exposure, with no obvious way to hedge against it.

This is utterly deadly. There isn't much of this that can't be eventually crowdsourced or sent to India.

[Guillaume]

Here's Jeff Rubin on a related topic, the new divide between the resource provinces and the manufacturing provinces: goo.gl/0kyR

Could it be that a boom in resources coupled with a global glut of manufacturing capacity is exposing the Canadian monetary union as profoundly suboptimal?

[Stephen Gordon]

I dunno about 'profoundly'. Interprovincial migration does happen.

eta: And so do interprovincial transfers of income.

[Tim]

I'll just point in regards to Mike's comment that several major companies such as Research in Motion already issue their financial statements in US dollars. I am actually surprised this doesn't occur more often in the oil patch as oil is priced in US dollars