January 16, 2013 - MLI's Philip Cross writes about his latest study, Dutch Disease, Canadian Cure: How Manufacturers Adapted to the High Dollar, in the Financial Post.


Dutch Disease in Canada a myth

By Philip Cross, Financial Post, January 16, 2013

Manufacturers have adapted to the higher loonie

One of the hoariest concepts to muddy the public debate in recent years was that Canada suffered from Dutch Disease — the idea that surging revenue from resource exports lifted the loonie to levels that stifled manufacturing.

In a new study released Wednesday by the Macdonald-Laurier Institute, I argue that Canada does not suffer from Dutch Disease. Whatever hurdles the higher Canadian dollar presented, manufacturers have overcome them.

The debate revolves around three questions. Did commodity prices drive the exchange rate? Were manufacturing losses due to the high dollar? And did manufacturers adapt to the higher exchange rate?

There is an emerging consensus that commodity prices explain less than half of the loonie's ascent since late 2002. Among others, the Bank of Canada attributes the largest part of its increase to the generalized depreciation of the U.S. dollar. Since the financial crisis began in 2007, foreign investors have moved $274-billion into our bond markets, seeking a safe haven. So it is more appropriate now to characterize the loonie as the 'Bay Street buck' rather than as a petro-currency.

Did the exchange rate cause manufacturing losses over the past decade? It is misleading to look at manufacturing as one entity. Over the past decade, manufacturing has been divided into two sectors: one half whose sales increased between 2002 and 2011 and the other half whose sales declined over this period.

The half that expanded was driven by resource-based industries such as petroleum and metals, or capital goods industries supplying the material needed by the investment boom in the energy and mining sectors. So, clearly, some manufacturers benefited from the resource boom, although there is a strong regional pattern to these gains.

Meanwhile, the declining sector of manufacturing was dominated by three industries. The largest losses were in autos and forestry-related, which suffered from the unfolding disaster in the U.S. auto and housing markets, while clothing was devastated by cheap imports from Asia. Clearly, these industries would have suffered irrespective of changes in the exchange rate. This can be seen by the comparable loss of sales for these same manufacturing industries located in the United States.

So overall, the largest manufacturing losses were due to declining markets in the U.S., not the higher exchange rate. Worrying about Dutch Disease in these industries is like your doctor fretting over your cold, while cancer was ravaging your body.

Manufacturers took aggressive action to adapt to the now-decade old reality of a higher dollar. They did this by reducing their dependence on exports, down to 45% of output, and raising their use of imported inputs (such as parts) to 27% of output.

By so doing, manufacturers have reduced their net exposure to exchange rate fluctuations. Ironically, it is the mining industry that is most exposed to changes in the exchange rate, since it exports two-thirds of its output with almost no offsetting use of imported inputs.

The success of these strategies to adapt to a higher loonie is reflected in manufacturing's place in the vanguard of industry growth in the recovery, the third fastest among the 18 major industry groups and ahead of even mining and oil and gas. The recovery of manufacturing has shown impressive depth, with only two industries straggling. One of the largest gains has been in the beleaguered auto industry, now brimming with optimism at this week's auto show in Detroit.

Surveys of manufacturers find a near-universal buoyancy about its prospects for 2013, even as some continue to wring their hands about the exchange rate. Of course, manufacturers, like any exporter, would prefer a slightly lower dollar, since this would boost Canadian dollar revenues.

Interestingly, about the same percentage of U.S. as Canadian manufacturers cite the exchange rate as an impediment, suggesting it is the Chinese yuan they find most vexing.

It is really no surprise that Canada does not suffer from Dutch Disease — turns out, neither did the Dutch. The whole idea of Dutch Disease went off the rails right from the beginning. The concept began as a theoretical exercise among academics about a resource boom raising a country's exchange rate enough to hamstring manufacturing, after natural gas was discovered offshore from the Netherlands in 1959. But its annual manufacturing output never fell in the early 1960s, and six years after the discovery of its offshore gas fields, its factory output was up one-third.

Researchers looking at the record of other countries with sudden resource booms, notably Britain and Norway with their North Sea oil riches, find little empirical evidence that manufacturing was significantly hampered.

Like most maladies, the best cure for this disease has been the passage of time. It has been a decade since the dollar began its historic appreciation, and six years since it first reached parity with the U.S. dollar. Manufacturers have adjusted and adapted their strategies to this new reality, and are moving forward. It is time the public debate on Dutch Disease caught up to them.

Philip Cross is Research Co-ordinator at the Macdonald-Laurier Institute and former Chief Economic Analyst at Statistics Canada.


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