A Lower Dollar Won't Reverse Manufacturing's Decline

The decline in the value of the Canadian dollar relative to the US dollar is expected to provide a boost to the manufacturing sector.  There is certainly no shortage of commentary on whether the fall in the dollar is the result of economic fundamentals or an engineered conspiracy designed to boost Conservative re-election prospects in the short-term.  Check out some of the commentary by Coyne, Corcoran or Babad.  Yet what I find more interesting is the belief that somehow a lower dollar will resurrect Canadian manufacturing and provide the antidote to a decade of “Dutch Disease”.  If that is indeed the hope, good luck with that.

Three quick exhibits for your contemplation.  Figure 1 plots the monthly value of the Canadian dollar (CAD per USD) and the manufacturing share (%) of total employment from 1987 to the present.  The data is from Statistics Canada (v2085317; v2085353; v37426).  This suggests that there is a relationship over time between an appreciating Canadian dollar and a decline in manufacturing.  Over a 25 year periof, the share of manufacturing employment dropped from about 17 percent to 10 percent while the Canadian dollar goes from about 1.40 CAD per USD to parity.  Yet, on closer inspection, you will note that there are short periods where the dollar depreciates and the manufacturing share of employment continues to decline. 
Figure 2 plots the manufacturing share of employment against the value of the exchange rate and the relationship here gets quite a bit muddier.  There seem to be a relationship between the two variables comprised of several arms and a torso.  For lack of a better term, lets call it a Y-curve.  Why the Y-curve exists is a good question.  This suggests to me that there are forces other than just the exchange rate at work.  There are different effects of the currency in the short term on the manufacturing share of employment as a result of other economic factors that may be at work.

 

 

So, to deal with the distinct possibility that short and long term factors are at work here as well as the possibility of spurious correlations, Figure 3 plots the first difference of the two variables against each other.  Needless to say, the result is a pretty wide scatter plot.  There is not a strong relationship between a depreciating Canadian dollar and the manufacturing share of total employment that I can pull out of that scatterplot.  If there is indeed any effect of a deprecating currency on Canadian manufacturing, it is entirely a short-term effect.   In the long run, structural factors such as technological change and basic productivity are the main drivers of what has happened to manufacturing.  Any conspiracy to drive down the dollar to boost exports in manufacturing and revive our manufacturing sector should have done a bit more homework. It is not going to work. But what do I know?  I'm just a country economist who harvests data and reaps simple results.

 January 24th Update

Figure 3 was first differences based on immediate month to month changes. I've also done the figure with the first difference based on 12 months (eg. Jan1989 minus Jan1988, etc...). Here is the result. Again, not a very strong relationship but the r-squared on a linear fit this time was 0.044.

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Why Is Manufacturing Special?

"Does Canada have Dutch disease?" is a question without a meaningful answer

The Decline of Manufacturing in Canada - 1926-2011: Dutch Disease?

Comments

[Nick Rowe]

Dunno Livio. Your Figure 1 looks to me like there might be some sort of relationship. Sure, there's a long-term downward trend in manufacturing employment, in Canada like in most other advanced countries. But I was a bit surprised that Figure 1 showed some sort of relationship in the fluctuations.

[Livio Di Matteo]

Nick:
Re Figure 1: Even when there is large depreciation from 1992 to 2003, there is a bit of recovery in the manufacturing share of employment but it does not return to its prior level. At best, what depreciation of the dollar appears to have done is slow down the decline in manufacturing's employment share. Then once the dollar appreciates, it enhances the decline. Re Figure 2: This two arms picture is curious. Again, overall there seems to be a relationship but as the dollar depreciates - along the upper arm, the manufacturing employment share is quite sensitive to depreciation, along the lower arm, not as much. I have not drilled deep enough into the data but this may represent different time periods in the relationship. This suggested to me that there might be other factors affecting this relationship and I thought there might be elements of a spurious correlation between the two variables (my time series econometrics is not that strong). So I first differenced and put together Figure 3. If you might a straight line to that you get a very slight positive slope - the r-squared was 0.00242.

[Nick Rowe]

Livio: my tentative hypothesis would be: manufacturing share = A -B.Time -C.exchange rate.

There's a declining trend, but the exchange rate also matters.

What I can't figure out is why your Figure 3 doesn't work. Maybe annual first differences(?) is just too quick to expect any reaction. We don't expect to see manufacturing employment jump up and down that quickly in response to the exchange rate?

[Nick Rowe]

Strictly, it should probably be a trade-weighted real exchange rate, not just nominal USD. But I don't think that would matter much at all, over this time period.

[Livio Di Matteo]

Nick:
The first differences in Figure 3 were actually month to month. If I annualize the monthly differences (eg. Jan89-Jan88,etc), the relationship is a bit stronger but the r squared was still only 0.0440. I'm going to add this second graph to the post.

[Nick Rowe]

Aha! Looking a bit better. But 12 months is still a short time to get a factory to increase production.

[Majromax]

Is the coincident difference also the best measure? Manufacturing employment may respond to the prior trend of exchange rates, especially if over the short to medium term firms that deal in cross-border trade use hedging instruments to lock in exchange rates.

Thinking out loud, there may also be a relationship to the purchasing power parity level of exchange. If the true exchange rate is weaker than PPP, then it would be to the benefit of a fully flexible firm to move investment to Canada from the US, as paying identical real standards of living would be cheaper. Likewise, if the true exchange rate is stronger than PPP then the converse holds. The problem is, of course, the PPP level is itself a moving target.

[genauer]

sorry, test

[genauer]

Hmm,

trying to explain the exchange rate by a commodity index like the CRB, should take care of the 2008 spike, and I believe actually also of a lot of the 1992 - 2001 trend (I need to get some old CRB data).

Adding the variable of secular decline of the manufacturing share (happening in Europe as well) ? Maybe by putting this into the analysis via the US manufacturing share?

In the German small town I was born, manufacturing was close to 50% as late as 1989, and is now down to < 20%. Pretty brutal structural change, but China and Eastern Europe also have to earn their money, somehow.

Reducing the noise in Figure 3, by taking only quarterly values, more typically for orders filled ? And still preserving spike like 2008.

And, like Majromax said, some lag variable of the order of one year for adjusting production

[D.O.]

There seems to be a 1 to 2 year lag between changes in the exchange rate and the manufacturing. I would vote for taking a difference an examining the correlation function.

[Osman]

Hi there:
Would the results be still the same if you compare the manufacturing share of GDP or export or any other metric with the exchange rate (not employment but the value/volume of manufacturing itself)?
Just wondering!
Thanks!
Osman

[Glen]

Figure 1 might have added context if you plotted China's WTO entry in 2001.