Canada’s Un-Development and the Loonie

The Commons Finance Committee, spurred by my old debating opponent John McCallum, is holding hearings in the next two weeks on the economic and fiscal consequences of the loonie’s unsustainable flight.

(I kind of miss crossing swords with John, actually: In the good old days he was the evil but friendly Bay Street banker, justifying federal spending cuts — and I was arguing for other ways to reduce the deficit.  Things seemed a bit simpler back then, than today — when we are all scrambling to keep up with Harper’s chess moves.  Mind you, I still get nostalgic at times for the Cold War … so what does that tell you?)

Attached below is my testimony to the Committee on Tuesday.  It repeats an argument I also presented to the Ontario Economic Summit last week oin Niagara-on-the-Lake: namely, the flight of Canada’s loonie is both a consequence and a cause of the accelerating structural “un-development” of Canada’s economy.

The causation goes like this:  High global commodity prices generate super-profits for Canadian minerals producers.  And believe me, they are “super.”  Oil and base metals profits in Canada are jaw-dropping.  EnCana’s $6 b net income last year is just the tip of the iceberg.

Those super-profits in turn generate several effects.  To some extent, they generate a real supply response: new capital goes into new resource developments, production, and exports.  Resulting capacity pressures, via the Bank of Canada, translate into higher interest rates and a stronger dollar.

But the extent of that supply response should not be over-stated.  There hasn’t been that much growth in production and employment in minerals.  Nor in our actual (real) exports of the stuff — although their value is certainly skyrocketing, with the world oil price.  Even still, in dollar terms we still export more motor vehicles than oil.  And Canada’s net oil exports (again in dollars) are barely 1 percent of our GDP.  Hardly enough to qualify us for membership in OPEC — nor our currency as a “petro-currency.”

Yet the FOREX markets clearly think we’re a petro currency: the correleation between oil prices and the loonie’s value seems irrefutable these days.  I think the chain of causation is more in the financial sphere, than the real sphere, as follows:

* mineral super-profits generate high equity valuations for mineral companies, and portfolio inflows (including from foreigners) to take advantage of those valuations

* in some cases, they buy the company altogether: the inflow of purely M&A-related transactions dwarfs any back-and-forth real FDI flows these days

The policy response (in addition to cutting interest rates, which will take some of the steam out of the loonie’s bubble — but certainly not all or even most of it) is to deliberately slow down the resource/profit boom that caused it in the first place:

* slow the pace of resource expansion (through development or environmental rules)

* reduce the profitability of resource extraction (through higher royalties and corporate taxes — something’s that worthwhile doing in the first place)

* slow the foreign takeover boom by instituting a genuine net benefit test in the review process

On the middle point, it could be concluded that Flaherty’s CIT cuts (which he claimed were aimed at helping manufacturers cope with the high dollar) could do more harm than good.  They mean very little for manufacturers (many of whom have no profits to report these days anyway), but mean a lot for minerals producers.  In fact, the federal cuts will more than offset the (sickeningly modest) increase in Alberta royalties that is coming — with the result that oil sands production is becoming MORE profitable, not less.  This, according to my model, will drive the loonie still higher, further hurting manufacturing.

I think this is a great moment, following the grand tradition of Canadian political-economy (from Innis to Watkins and beyond) to inject a solid critique of the structural un-development of our economy into debates over the dollar and the decline of manufacturing.  I am working (with Erin Weir, Andrew Jackson, Keith Newman, and Diana Gibson) on some material along these lines for the 2008 Alternative Federal Budget.  Any input or feedback on these ideas would be most appreciated.

In the meantime, here is my unexpurgated testimony to the Finance Committee:

Speaking Notes for Jim Stanford, Economist, Canadian Auto WorkersBefore the House of Commons Finance CommitteeHearing on the Economic Effects of the Rising Canadian DollarNovember 20, 2007

 

 

The CAW represents about 260,000 members in a wide range of Canadian industries, mostly in the private sector.  About one-third of our members work in the auto industry, which has been especially hard-hit by the unjustified and destructive run-up in the Canadian dollar.

 

The auto parts sector is feeling the pain most immediately.  Over 15,000 jobs have now been lost in auto parts facilities since 2002, when the dollar first took off.  I can tell you from personal knowledge that there are literally dozens more auto parts plants facing imminent closure, unless something dramatic changes in the sector’s business outlook.  I would expect at least another 10,000 auto parts jobs to disappear in the coming year, without dramatic change.

 

The situation in auto assembly is not as dire, but is still very negative.  Auto assembly has lost about 10,000 jobs since the late 1990s.  Thousands more jobs will be lost in coming months due to plant shutdowns and shift layoffs at Oshawa and Brampton.  It is increasingly difficult to make a business case for new investments in Canadian assembly plants, and the escalation of the currency is by far the most important reason why.

 

The decline in both the parts and assembly sectors closely mirrors the appreciation of the Canadian dollar.  It would be wrong to claim that this downturn in what is still Canada’s most important export industry is solely due to the dollar.  The North American auto industry faces important structural changes resulting from the declining market-share of continental producers, and a growing flood of automotive imports from Asia and Europe.  But the rising Canadian dollar has taken a bad situation, and made it far, far worse.

 

Canadian manufacturing as a whole has lost well over 300,000 jobs since the loonie started rising in 2002.  But the job losses we are seeing today, are the result of where the currency was at two or three years ago.  There are significant lags in adjustment resulting from company investment plans, multi-year contracts, the impact of hedging, and other transitional factors.  We have not yet begun to see the consequences of the dollar’s rise in the last twp years through 90 cents and then through parity.  If the Canadian dollar stays anywhere near parity with the U.S. dollar in the medium term, I project another 300,000 lost jobs in the next 2-4 years.

 

Canada’s relative production costs have grown by more than 60 percent in 5 years, viewed from the perspective of an international investor choosing where to locate a new investment.  This is not because Canadian wages have grown quickly – far from it.  It is solely because financial markets, intoxicated by the prospect of super-profitable oil exports from Alberta, have driven our currency to a level that is completely unjustified on the basis of real Canadian productivity and economic performance.

 

Some commentators have blamed the problem on a global rebalancing, resulting from the restructuring of the American economy and the consequent weakness of the U.S. dollar.  This is part of the story, to be sure – but a surprisingly small part.

 

Most of our problem is that the Canadian dollar has been uniquely strong, not that the U.S. dollar is weak.  Consider the evidence.  Compared to its 2005 average level, our dollar is up by about 25% against the U.S. dollar (using month-average figures for October of this year).  That is almost twice as much as the currency of any other major U.S. trading partner.  Of the ten largest exporters to the U.S. market, Canada’s currency has appreciated by far the most.  On a trade weighted basis, the U.S. dollar has fallen by 10% since the 2005 average (versus the 25% rise in the dollar).  Less than half of the problem is that the U.S. dollar is weak.  More than half of the problem is that the Canadian dollar is strong.

 

The picture is even clearer from a longer-term perspective.  Since average 2002 levels, the loonie is up over 60% against the greenback.  Again, that’s far more than any other major U.S. trading partner.  On a trade-weighted basis, the U.S. dollar has declined by only just over 20% during this time.  In this case, one-third of the problem is that the U.S. dollar is weak.  Two-thirds of the problem is that the Canadian dollar is strong.

 

Not all currencies have appreciated significantly against the U.S. dollar.  Some have even fallen.  The yen, the yuan, the peso, and the Taiwanese dollar.  These are four major U.S. trading partners whose currencies have been broadly stable against the dollar.  It is factually false to claim that Canada’s experience of rapid appreciation, has been universal.

 

Our currency has risen the fastest against the U.S. dollar.  Yet we are far more dependent on sales to the U.S. market than any other trading nation (along with Mexico).  U.S.-bound exports account for 25% of our GDP, compared to 10% for China, and 5% or less for Japan, Korea, and Europe.

 

If we are uniquely dependent on continuing exports to the U.S., why are we taking a uniquely lax approach to managing our currency?  Why are Canadian policy-makers sitting on their hands, as speculative pressures in financial markets drive some of our most important industries out of business?  The combination of the rapid rise of our currency, and our dependence on U.S.-bound exports, puts Canada absolutely in a different category from other countries, in terms of the economic risks we face from currency markets.

 

How do we understand this unprecedented run-up in our currency?  This is an important question, because the answer will inform our efforts to bring the loonie back down to earth.  Monetary policy is part of the story, but again just part.  Our central bank has increased rates, while the U.S. Fed has cut rates.  The Canada-U.S. interest rate differential is a consistent determinant of the exchange rate, and so this has added to the loonie’s climb.

 

The Bank of Canada’s recent actions were a mistake.  They have been guided by an unduly narrow reading of its inflation-targeting mandate.  It should cut rates immediately and substantially.  Moreover, it should indicate more clearly that its future interest rate decisions will take into account exchange rate volatility, and the long-term economic risks resulting from that volatility, in developing its interest rate strategy.  These actions alone would release much of the steam from the loonie’s bubble.

 

But that would not be enough.  The loonie has been driven up in tandem with world oil prices and other mineral prices.  Record prices for these minerals have generated unfathomable profits for Canadian energy and mineral producers.  This in turn has led to very high equity valuations for these companies, attracting great interest from foreign investors – some of whom were looking for safe havens to protect against U.S. depreciation anyway.  In a growing number of cases, foreign investors like Canadian resource firms so much, that they’ve bought the company altogether, as witnessed by the expensive takeover of many Canadian resource firms.  The inflow of many tens of billions of dollars of foreign portfolio investment to Canada has been a crucial cause of the loonie’s ascent.

 

The government can take action on this front, too.  The pace of Canadian resource expansion must be controlled more carefully, to reduce the extent to which it directly damages other important parts of our economy through the over-valued loonie.  Development and environmental regulations could slow down oil and mineral developments.  Higher taxes and royalties would ensure Canadians capture a fairer share of the wealth that, after all, they own – while at the same time reducing the panicked gold-rush mentality that has fueled the foreign takeovers.  A meaningful system for reviewing those takeovers, blocking those that do not add real long-term value to our national economy, would also help.  Merely announcing these measures would be akin to taking down the “For Sale” sign currently hanging on Canada’s door – and would cool down the overheated speculative inflow driving up the dollar.

 

In this regard, the federal government’s recently-announced across-the-board corporate income tax cuts may actually have a perverse impact on the problems facing manufacturing and other non-resource sectors.  Even the Alberta government has taken very modest steps toward implementing a fairer royalty regime.  But Mr. Flaherty’s no-strings-attached tax cuts will overwhelm those provincial measures, making oil sands production even more profitable than it was before the Alberta royalty changes.  This is equivalent to throwing gasoline on a speculative fire.  For hard-pressed manufacturers, on the other hand, corporate income tax cuts mean nothing.  Many don’t even have taxable income to report on their returns.  What we need instead of tax cuts, are targeted measures to directly stimulate investment spending, and help firms and industries survive this storm in hopes of reaching calmer times ahead.

 

The federal government and the Bank of Canada have both declared, implicitly and explicitly, that there is nothing they can do to tame the loonie’s flight.  This amounts to a blatant shirking of economic responsibility.  Other countries, including those far less vulnerable to a downturn in U.S.-bound exports than we are, do a fine job of managing their currency risk.  Our policy-makers can and must do the same, using tools and techniques which reflect Canada’s current economic reality.

 

But to do that, the Finance Minister and the Bank of Canada must first admit that we have a problem.  And as yet, that hasn’t yet occurred.