Proceedings of the Standing Senate Committee on
Foreign Affairs
Issue 18 - Evidence, October 7, 2003
OTTAWA, Tuesday, October 7, 2003
The Standing Senate Committee on Foreign Affairs met this day at 6:07 p.m. to discuss trade relations between Canada and the United States of America and between Canada and Mexico.
Senator Peter A. Stollery (Chairman) in the Chair.
[Translation]
The Chairman: Today, the Standing Committee on Foreign Affairs begins examination of a decisive factor in bilateral trade between Canada and the United States: the exchange rate.
[English]
This new study follows a broad study of the trade relationship between Canada and the U.S. and between Canada and Mexico, which began in February. In June, the committee filed a report entitled ``Uncertain Access: The Consequences of U.S. Security and Trade Actions for Canadian Trade Policy.''
For the record, here is the order of reference the Senate gave us in November, 2002:
That the Standing Senate Committee on Foreign Affairs be authorized to examine and report on the Canada- United States of America trade relationship and on the Canada-Mexico trade relationship, with special attention to: (a) the Free Trade Agreement of 1988; (b) the North American Free Trade Agreement of 1992; (c) secure access for Canadian goods and services to the United States and to Mexico; and (d) the development of effective dispute settlement mechanisms, all in the context of Canada's economic links with the countries of the Americas and the Doha Round of World Trade Organization trade negotiations;
[Translation]
The committee intends to examine a specific item that directly affects the Free Trade Agreement and NAFTA, that is, the effects of fluctuating exchange rates between the Canadian and American dollars on trade between the two countries.
[English]
We welcome today our first expert witnesses on the subject: from the Bank of Canada, Mr. John Murray, head of the International Department; from the Department of Finance Canada, Mr. Steven James, Director, Economic Analysis and Forecasting Division; and from Industry Canada, Mr. Someshwar Rao, Director, Strategic Investment Analysis.
I apologized prior to the meeting that we are late starting because of the fact that the Senate was sitting. Senator Austin has brought it to my attention that perhaps the best way to proceed is for each of you could give us your information, and if we have time for a few questions, that would be great. However, if we do not, we will do it at another time. At least we will have your evidence on the record.
Mr. Murray, please lead off. The committee would be delighted to have your evidence.
Mr. John Murray, Head of International Department, Bank of Canada: I would like to thank the committee for inviting me and say at the start how much I enjoyed reading your last report and look forward to your work in this area.
I have provided the honourable senators with two handouts. This is a lot of material and I do not propose going through all of it. Indeed, I know that my colleagues here will cover some of the topics and I want to leave enough time for them.
I have four main messages. If you turn to page two in the bullets, entitled ``Introduction,'' I outline those main messages. First, the recent exchange rate moves that we have seen have not been all that unusual. I will explain. There is one sense in which they have but there are many senses in which it has not been. Second, it is my belief that fundamental and probably unavoidable forces are at work directing our currency in the main. Third, there is actually an upside to a stronger exchange rate. It is not all negative. Fourth — and here, I realize I may be preaching to the converted — a floating exchange rate is still the best option for Canada in terms of exchange rate regimes.
On page three of my handout, I try to put the recent depreciation in perspective by way of providing some comfort vis-à-vis recent developments. I should like to draw your attention to the graphs that I have provided.
The first graph, which plots the Canadian dollar vis-à-vis the U.S. dollar over the last few months, is fairly scary. It is going way up. It starts at about 64 cents, although it was even lower than this earlier on. The graph shows it ending at about 74 cents but today, as some of you may know, we reached 75 cents. You might consider that is rather impressive and significant. To some extent it is, however it is important to realize that this movement in our currency is not specific to Canada but is part of a more general appreciation of world currencies against the U.S. dollar.
The second graph shows some selected currencies compared with the U.S. dollar. The Euro has actually appreciated over the last eighteen months — even more than we have. The appreciation of the Canadian dollar has been roughly comparable to that of Japan. Other currencies such as the Australian dollar, the New Zealand dollar and other floating exchanges rates, have experienced a sharper appreciation than we have, just to put things in context again.
It is also important to realize that over the last 25 to 30 years we have moved a great deal, both up and down — admittedly mostly down. On the third graph, you can see how the recent move shifts in terms of the historical pattern. While it has been faster than many previous appreciations, from this perspective you get a sense that it is not quite as unusual or potentially uncomfortable as you might otherwise have thought.
The fourth graph shows selected currencies versus the U.S. dollar from 1975 until now. Over the longer time perspective you get a sense of how relatively minor movements in the Canadian dollar have been compared with those of other major currencies. That is not to say that they are insignificant, however. The Canadian economy is more open than many other economies and the U.S. dollar is more important to us than to most other economies. Even minor movements can have a significant impact on the exchange rate. I am not trying to minimize the effect that the recent appreciation of our exchange rate might have on prices and output but, rather, again, trying to put things in context.
On the fourth page of my brief, under the heading ``Possible Causes of the Appreciation,'' I have explained that, for the last 25 to 30 years, most of the broad movements in our exchange rate can be explained and credited to movements in three or four underlying fundamental variables. Indeed, the Bank of Canada has an exchange rate equation that you cannot use to predict; however, you can use it to explain. According to this equation, there are four variables that explain most of the movements in our currency vis-à-vis the U.S. dollar. First, inflation differentials between the two countries — that is to say, Canada's inflation rate compared with that of the U.S.; second, interest rate differentials between the two countries — that is, Canada's interest rate compared to interest rate levels in the U.S.; and, then, two commodity price terms the world price of energy such as oil and the world price of non-energy commodities such as raw materials like lumber, minerals, wheat and foodstuffs.
The sixth graph indicates how well this equation performs with these four variables. The solid line represents the movements in the actual exchange rate; the dashed line is what the bank's exchange equation predicts or explains in terms of these four variables. The equation line does not pick up every wiggle in the actual exchange rate but it is a pretty good fit. It has been remarkably stable through time. This gives us some comfort that it is not erratic, speculative behaviour that has been driving our currency but, rather, fundamental forces. The exchange rate has moved with cause, usually in a way that has helped re-equilibrate the Canadian economy. Notice at the end, however, that there is a jump up. That is that recent appreciation that the exchange rate cannot explain.
It is important to note that sometimes the equation responds with a bit of a lag. We do know that world commodity prices rose in the last year by about 15 to 20 per cent. In time, we can expect this exchange rate equation to start moving up and explain at least some of the recent appreciation.
The Chairman: I do not want to take any time from the committee at all, but would you like to explain that? You are saying that that dotted line on graph 6 reflects the possible causes of appreciation as described by the Bank of Canada on page four of the graph. I want to be clear in my mind about what that dotted line represents.
Mr. Murray: On page four of my brief, I suggest that one cause of appreciation is the Bank of Canada's ``exchange rate equation and four critical variables — interest rates, inflation and two commodity prices.'' When we plug those two variables into our equation and run it through time — actually, from 1973 to the present — that is the sort of simulated value that you got. I am trying to show that, historically at least, our equation seems to have moved in response to these fundamental variables in a predictable and a sensible way. I am also suggesting that at the end there is an error. It does not capture that latest appreciation when you put in all the variables. However, that may be in train. It is not to say that the equation is off yet.
The second interpretation, though, is that something a little different and a little more fundamental might be at work. I am referring to the unsustainable trade deficits in the U.S. and the need to rebalance the global economy.
We may be looking at a story that is deeper than just commodity prices, interest rate differentials and inflation rate differentials. As we look at the U.S. economy instead of our own — I refer you to graphs 7 through 9 — you can get a sense of what is happening to the U.S.
Most of you know the story, so I will run through it quickly. You can see the dark line here, which is the sharp decline in the U.S. current account balance. It is now 5 per cent of their GDP and growing. That is enormous. We are talking about a U.S. $600 million to U.S. $700 billion dollar deficit, and growing. You can see the weaker line there — the solid but lighter line — representing their net international investment position. The U.S. has gone from the world's largest creditor as of the early 1980s to the world's largest debtor.
One interpretation is that the exchange rate movements we are seeing represent part of a correction of these imbalances that may prove to be unsustainable. Graph 8 reflects how the U.S. current account has moved in response to its real effective exchange rate. You can see a pattern there. Obviously, the U.S. dollar and its value has had an influence on their trade current account.
Graphs 9 and 10 provide a sense of who has been running a surplus against the U.S. The simple answer is just about everyone. Canada is the most important trading partner for the U.S., so if we are talking about a correction of the U.S. current account and balance, it could well be the case that Canada would be part of the solution. The comfort graphs 9 and 10 provide, is that to the extent that we are part of the solution, it is, optimistically, a smaller part than some of these other countries. Although we are the most important trading partner for the U.S., compared with the European Union, Latin America, China, emerging Asia, or Japan, we have the smallest surplus with the U.S. There is something global that could be going on here that is explaining some of the exchange rate movements.
In respect of Canada's trade with the U.S., clearly our two economies have become increasingly integrated — especially following the FTA and NAFTA. There are, however, important structural differences that still distinguish our two economies, most notably commodities. We are still an important net exporter of commodities; the U.S. is an important net importer. That is a happy coincidence of wants. We provide exactly what they need.
Our trade balance and our current account balance have improved through time. Graph 14 shows that not only have our current accounts balance has improved, but as a consequence, our net foreign asset position — unlike that of the U.S. — has improved dramatically through time. One of the reasons for this is no doubt the low value of the Canadian dollar through the mid-1990s into the present. That is one of the important reasons for our strong and improving external position. It is not the only reason, however. Other important reasons are the free trade agreement and the remarkable growth of the U.S. economy. Furthermore, the U.S. economy was hitting its capacity limits, whereas we were not so we were a natural source of products and services to meet that rising demand.
We also had a happy coincidence with regard to the composition of U.S. demand. Not only were they growing quickly, they also happened to want a lot of what we had — I am thinking of cars and houses. A number of forces apart from the exchange rate came into play through the latter part of the 1990s, contributing to our favourable external position.
The recent weakness is in part a reflection of the appreciation, but that is still very early days. Most of what we have seen is because of weaker U.S. growth and a decline, until recently, in commodity prices worldwide. Those two things are starting to reverse. The prospects for the U.S. economy are now much better. Indeed, some people are forecasting growth as high as 5 per cent or more for the U.S. economy through the latter part of this year and 4 per cent or more through 2004 and into 2005. We could see an improvement in our external position, strong export growth, notwithstanding the exchange rate.
This is not to say that the real effective exchange rate and the recent appreciation are unimportant. Graph 15, is very impressionistic, but you can see — and it is no coincidence — that when the exchange rate is high, our net exports are low and vice versa. The exchange rate is important. It is also important to put the movements in context. Often, when we have strengthened, we have strengthened for a reason. Those reasons are good for Canada, which means that we can not only support a stronger exchange rate but we actually need a stronger exchange rate to help contain domestic demand or demand in Canada for Canadian products, both domestic and external.
In summary, the exchange rate typically moves in response to fundamental forces. It is not capricious; it moves with cause in a way that helps maintain macro-balance in Canada. That is a good thing.
I look forward to your questions.
Senator Graham: I find this fascinating. I am particularly interested in graph 6. You said that there is an upside to a stronger dollar and that a floating exchange rate is still the best option for Canada. I am reminded of a time — probably around 1977 — when I was at a conference at the university college of Cape Breton. Tom Kent, who you may know, was there. At that time, the dollar was roughly around 93 cents. Tom Kent then was advocating that the dollar be pegged at 75 cents, even though it was then at 93 cents.
In the whole scheme of things, and in your examination of the economy and the ups and downs, is there an optimal value for the Canadian dollar with which you would be comfortable?
Mr. Murray: The short answer is no, in the sense that the optimal value, if it does exist, changes through time. Therefore, I feel very uncomfortable fixing a value and then having to live with it. The consequences would be bad and would manifest themselves in more unpleasant ways than movements in the exchange rate.
That reminds me of something I raced over in my presentation, which is at the heart of what I hoped to say. That is the fact that appreciations have an upside in terms of lower cost of imports and, more specifically, cheaper capital goods, making investment in Canada easier and cheaper and, potentially — but at the margin — promoting productivity growth in this country.
There is also the sense that any exchange rate appreciation has an uneven effect on the economy. Not all industries are affected equally; indeed, many actually benefit net from the appreciation. Clearly, this is not the majority, but depending on their export orientation, the extent to which they rely on imported inputs, and the import competition they might face domestically, there are different consequences in different industries across this country.
That is a long answer to your question. There are different optimum currencies for different industries and at different times. It is best to let the market decide.
The Chairman: One of the purposes of our hearings is to find out the effect on our exports. To ensure that I understand, on graph 15, as you have confirmed, when the Canadian dollar is low in terms of the U.S. dollar, our exports go up; and when the Canadian dollar is high in terms of the U.S. dollar, our exports go down. Is that an oversimplification?
Mr. Murray: No, that is exactly right.
The Chairman: I call on Mr. James next.
Mr. Steven James, Director, Economic Analysis and Forecasting Division, Department of Finance Canada: I believe that everyone has copies of the charts to which I will refer during my presentation.
I would like to start by putting recent events in context. In the past few years, economists had been expecting that the Canadian dollar would appreciate — that is, it would rise in value against the U.S. dollar. They had been expecting it repeatedly quarter after quarter. Of course, they were always proven wrong; it actually depreciated. To some degree, the appreciation that had been expected finally occurred this year, but it has occurred probably more than had been expected and certainly a lot faster than had been expected. The rapidity of the appreciation is one issue here.
As Mr. Murray has already indicated, to a considerable degree what we have seen occurring is generalized U.S. dollar weakness against a broad basket of currencies. Since the end of 2002, when the Canadian dollar was particularly low, it is true that the U.S. dollar has depreciated more against the Canadian dollar than a number of other currencies. However, if we go back further, say since the end of 2001, the picture is different. The U.S. dollar is down about 23 per cent against the Euro and 15 per cent against the Canadian dollar. Generally speaking, regardless of what time frame you pick, there is no question that there is a generalized U.S. dollar story here as well that we have to keep in mind.
It is important to recognize that the dollar is not just something that is it out there that happens and affects the economy as a force from outside. Events in the domestic economy affect the dollar as well. There are external shocks that affect both the dollar and the Canadian economy simultaneously. In important ways, when that happens, the dollar can actually act as a buffer against those shocks.
A key example is the case of commodity prices, to which Mr. Murray referred. Canada is a net exporter of commodities, which account for about 30 per cent of our exporters. That is down from what it was 20 years ago, but it is still an important number.
Chart 1 shows the real exchange rate. This is simply the value of the Canadian dollar adjusted for relative prices between Canada and the United States. It tracks it against the Bank of Canada's real non-energy commodity price index, which is one of the variables to which Mr. Murray has already referred. There certainly is some clear relationship here. It is not as tight as the relationship he shows in his equation, where the equation considers this sort of variable along with a number of other variables as well. The last data point, if it were to be included in the weekly data, would show even a bit more of an uptick in the series this year.
At the same time, there are periods where you get divergences as well, where commodity prices are going one way and the exchange rate is going the other.
Chart 2 shows energy prices. Actually, in this case, it is the real U.S. dollar crude oil price index. We often tend to break energy and non-energy apart because, in the case of energy — particularly in the case of oil — we were not always a net exporter. In the past, we were a net importer. You would have expected that the impact on the dollar would have been different. That is something that we find in the data. In the more recent period, where we have been a net exporter, there is a positive correlation between energy prices and the exchange rate, although it is not as pronounced as you see in the case of non-energy prices.
When you have a decline in world commodity prices — for example, at the time of the Asian crisis — the profits of commodity exporters tend to decline in Canada and there tends to be some withdrawal of marginally profitable production. At the same time, foreigners need fewer Canadian dollars to purchase a given amount of commodity. Additionally, there will tend to be a reduction in the demand for, say, the equities associated with firms in that sector. This would cause a weakening of the Canadian dollar. That is the ``buffering effect'' I mentioned whereby as commodity prices fall — a negative for the Canadian economy — you have some partial offset coming from a weaker value of the Canadian dollar. This ability to buffer these ``shocks'' to world prices and demand is a key advantage of flexible exchange rates. Mr. Murray has already spoken a great deal about that.
In respect of the recent appreciation, a fair amount of this will sound like what you have just heard. As Mr. Murray has said, we have had some increase in non-energy commodity prices since the end of 2002. You see that in chart 1. Interest rate differentials would certainly be another factor that, over time, tends to influence the value of the dollar. That is shown in chart 3, where the solid line represents the nominal Canada-U.S. exchange rate and the three-month T-bill spread.
Again, it is important to note that although this is the sort of variable that will work in an equation with a lot of other variables, at any one point in time you do not necessarily have a precise match. You can have periods where the differential will go negative and the dollar will hold up and vice versa. That is because other factors are also driving the dollar. It is not just the short spread. Again, we do have a positive correlation here.
A fourth factor would certainly be investor sentiment, or you could call it ``animal spirits,'' related to international, economic and political developments. These are the sorts of things that are hard to measure and you cannot put them in equations. It is the sort of thing that you can, after the fact, allude to as an explanation. Certainly, a lot of analysts, for example, pointed to the Iraq war's uncertainty as being in some sense the catalyst on the start of the depreciation of the U.S. dollar. Again, it is a plausible story, but it is not the sort of thing that you can prove one way or the other.
The fifth factor would certainly be the current account situation. Mr. Murray has also talked about that and the issue of global imbalances.
Chart 4 gives you some information that Mr. Murray has shown you already, although it is packaged a bit differently. You can see on the left-hand side the bars represent Canada's current account balance as a percentage of GDP. You can see how we went from many years of current account deficits — historically, we were a current account deficit country — into solid surpluses. You can see the United States, on the other hand, going into quite significant current account deficit. It is a real parting of the ways between Canada and the United States on this front. If you sum up those current account balances, you will get our net foreign debt. Historically, we were quite indebted in terms of net foreign debt. That is also turning around with a sharp decline in Canada's net foreign debt and a steady increase in U.S. net foreign indebtedness, and it is actually now higher than is Canada's.
It is that issue of rising United States foreign indebtedness that is ultimately posing this issue of imbalances and how they might be corrected, because you cannot have a permanent unending increase in United States net foreign indebtedness up to astronomical levels. Ultimately that needs to be corrected in some way.
What will be the impact of the recent appreciation? Again, we must keep in mind that it is not so much the appreciation itself; it is where we are relative to expectations. If everyone had been expecting the dollar to appreciate on a certain path, and that is how firms had been planning and it did exactly that, then in some sense there is no surprise, but there certainly has been some surprise, at least in terms of the rapidity of the appreciation.
In theory, we know that if Canadian exporters are price takers on the world market — if they simply have to accept world prices — then a higher dollar means lower Canadian dollar prices. That, in turn, would affect their profits and, particularly in the resource sector, you might see some withdrawal of marginal production, just as you would see in the case of a decline in commodity prices. Of course, that is to some degree offset by the fact that we have some strength in commodity prices at present.
On the import side, to the degree that there is a partial pass-through of the higher dollar into lower import prices, you could expect to see some substitution of domestic demand away from domestic production and toward imports. There is some evidence, though, that this degree of pass-through may be less than it was in the past. In the late 1990s, when the dollar was depreciating, we did not tend to see the upside pass-through into prices that we would have expected to see based on earlier experiences.
At the same time, there are those who are importers in Canada who do make profits in Canada. These are Canadian firms, for example, on the wholesale or retail side, for which lower import prices are a boost to profits, a boost to margins and possibly as well to sales.
There is another positive impact of a higher dollar and that is in a lower cost of imported materials, parts, machinery and equipment. About 80 per cent of Canadian machinery and equipment tends to be imported, so to the extent that lower prices would boost investment you could see higher productivity growth in Canada going forward and higher potential output growth as well.
Again, many of these factors are difficult to quantify precisely. As I mentioned earlier, this degree of pass-through appears to be changing over time. The impact would also depend on what people were expecting in any case and what expectations are in terms of the persistence of the shock to the dollar.
From a broader perspective again, trade flows depend not only on the exchange rate but also on many other factors. Obviously we have seen the great increase in trade flows since the early 1990s, and a good deal of that would be a result of the free trade agreements and just a generally more outward orientation of Canadian businesses competing in global markets. Imports as well are driven by domestic demand and exports by foreign demand as well as by commodity prices. Exports to the U.S. in particular — as Mr. Murray has already mentioned — are critically dependent on the strength of the U.S. economic expansion, which seems at present to be gaining steam.
Chart 5 shows that the correlation is quite pronounced. This shows real Canadian export growth in the solid line and real United States GDP growth in the thin line. It is on the right scale and export growth is on the left scale. There is quite a high correlation here. As Mr. Murray mentioned, forecasters are expecting that the U.S. economy will be growing quite strongly. There are a number of private sector forecasters who are predicting the U.S. economy growing at close to 6 per cent in the third quarter and over 4 per cent in 2004. Looking forward, this is certainly a factor that, regardless of what is happening to the dollar, is certainly a significant positive for our export industries.
The Chairman: What happened in 1995? Canadian exports went way up but the U.S. real GDP growth was quite modest.
Mr. James: I confess that I would not be able to say exactly what happened in that episode, although we could look at the data.
The Chairman: No, that is all right.
Mr. James: In terms of the volatility of export data for Canada, the auto industry is often quite important. We have big auto movements in one quarter or another. That, for example, explains a lot of the weakness in exports in 2001, for example. Even though the U.S. economy was weak, you will see here that our exports were even weaker. Autos and high-tech also play a role there. That is something that we could check to see in terms of the detail.
The Chairman: Thank you very much. That was a very interesting presentation. Both witnesses have been very interesting.
Mr. Rao, if you would like to give us the benefit of your wisdom, we would be very interested and receptive.
Mr. Someshwar Rao, Director, Strategic Investment Analysis, Industry Canada: Thank you for inviting me to appear before the committee. My presentation today is based on a study that I co-authored with my two colleagues, Ram Acharya and Prakash Sharma from Industry Canada. As you will see, my presentation will complement that of my two colleagues from the Bank of Canada and the Department of Finance.
My presentation is entitled, ``Canada-U.S. Trade and Investment Linkages.'' I will talk about the experience between 1990 and 2002 and what we found some of the important factors to be.
I have provided everyone with copies of my handout. On page two, you see that the Canadian economy has become much more outward oriented — particularly since 1990, which is when the Canada-U.S. Free Trade Agreement came into effect. As you can see, there is a dramatic increase in outward trade orientation — both export as a percentage of GDP and import as a percentage of GDP increased. Today, it is about 78 per cent of the exports plus imports as a percentage of GDP as compared to 52 per cent in 1990. At its peak in 2000, it was about 86 per cent, so there has been a drop, which I will discuss later.
We see a similar outward orientation with respect to foreign direct investment as a percentage of GDP. Today, we are net exporters of capital in foreign direct investment. The outward investment as a percentage of GDP is 7 percentage points higher than the inward investment as a percentage of GDP. That compares with a gap of about 30 percentage points in favour of inward direct investment in 1962. We have become much more outward oriented.
This was largely due to closer economic linkages with the U.S. in trade. As you can see, there was a dramatic increase in trade — exports as well as imports, but especially exports. Our exports to the U.S. between 1990 and 2002 increased by more than 200 per cent. Imports increased also, but not to the same extent. Exports of goods and services today represent about 82 per cent. The U.S. share in our exports of goods and services is about 82 per cent compared to about 72 per cent in 1990, so there is a big increase in the importance of the U.S. market. The imports also increased but not that much. It is 68 per cent to 70 per cent.
Direct investment between Canada and the U.S. more than tripled between 1990 and 2002, but the U.S. share of Canadian inward investment stock remained more or less constant during this period at about 64 per cent, whereas, with regard to outward investment stock, Canadians are investing more abroad. In 1990, 63 per cent of our foreign outward investment stock went to the United States. Today it is only 47 per cent. We are becoming much more outward-oriented with respect to our investment. A similar picture emerges if you look at portfolio investment.
Senator Di Nino: I want to make sure that I understand your graphs, Mr. Rao. Do the graphs on page two represent Canadian trade with the world or the U.S. and/or the FDI with the world or the U.S.?
Mr. Rao: This graph addresses the world picture. However, I am saying that the world picture is driven mostly by the U.S.
Senator Di Nino: That is fine. Your title, ``Canada and U.S. Trade Investment Linkages'' confused me. Thank you for the explanation.
Mr. Rao: Canada's trade linkages increased across all provinces between 1990 and 2002. Saskatchewan, which is the lowest percentage of direct export to the U.S., is still 62 per cent; in Ontario's case, the figure is 93 per cent. As honourable senators can see, all provinces saw an increase in export percentages.
The same story can be told about industries. All industries experienced an increase in exports to the U.S. The importance of the U.S. market increased for all industries.
Canada's trade links with Mexico are still not that strong, but they have increased considerably. Canada's trade with Mexico increased by 300 per cent between 1992 and 2002, but Canada's exports to Mexico still constitute only about half a percentage point, compared with imports from Mexico increased from about 2 to 4 per cent.
I should like to talk briefly about the benefits. As a result of increased trade with the U.S., much of the manufacturing sector benefited a great deal. More than 80 per cent of Canada's manufacturing output growth in the 1990s can be attributed to exports.
The FTA as well as NAFTA raised manufacturing productivity as expected prior to the FTA. A study done by Daniel Trefler, at the University of Toronto, suggested that the FTA has increased productivity in industries where the tariff barriers were higher prior to trade agreements and low tariff barriers had lower productivity growth. There was also turbulence. The industries with higher-than-expected numbers had a higher net exit rate of firms.
The next chart, on page 9, shows the foreign-controlled firms in general. The message —not only from our study, but also from all other studies — suggests that foreign-controlled firms in general are more productive than domestically controlled firms. By bringing foreign direct investment into Canada, the productivity on average increases. It is true that our foreign-controlled firms are not only more productive, but also, at the same time, they pay higher wages.
Canadian firms that are outward-oriented and export are more productive than the average Canadian firm. Outward orientation in general has been good for productivity and for the Canadian standard of living.
I would like to summarize some of the challenges that we have seen from our study. First, competition from Mexico and China in the U.S. will rise. It has already risen considerably between 1990 and 2002. In spite of the dramatic increase in Canada's exports to the United States, our market share has remained more or less stable. It went up and came down. However, the Mexican market share almost doubled from 6 per cent to 11.6 per cent. The Chinese market share increased from 3 per cent to about 11 per cent.
Although the commodity composition of our exports is not the same — the products we export to the U.S. are oriented more towards knowledge and high tech — Mexico and China are catching up in these respects. In the future, there will be more competition from these two countries in the U.S. market.
Our study confirms what Mr. Murray and Mr. James mentioned in regard to the big factor for the expansion of our exports in the 1990s was the United States economy. The chart on page 10 shows how closely the two are correlated. The U.S. import growth is correlated with Canada's export growth to the U.S. Our exports to the U.S. constitute about 18 per cent. However, the close correlation is phenomenal. According to our study, this was one of the dominant factors for our export expansion between 1990 and 2002.
Another important factor was the dollar depreciation. The chart on the left side of page 12 shows the depreciation of the dollar, which Mr. Murray has already spoken about. On the right-hand side of the page, you will see a diagram that shows that between 1990 and 2000, our cost competitiveness improved by 19 per cent over the whole period. That was entirely due to the depreciation of the dollar. The dollar depreciated during that period by about 30 per cent. Although our productivity increased significantly, it lagged behind that of the U.S., which had a substantially higher pace of growth in productivity.
Our hourly compensation grew at a slower pace than the U.S. but at the same time, productivity was lower. The message is that we improved our cost position. As a result, we improved our net export position to the U.S. However, this cannot be sustained in the long term because we must depend on productivity. By depreciating the dollar — as Mr. Murray and Mr. James pointed out — you will reduce our standard of living as well as increase the cost of imports and machine and equipment that may have a negative impact on productivity.
The next chart displays the Canada's productivity problem in the manufacturing area, which is the key sector for international trade. That is where 80 per cent of our exports are and that is where international competition is fierce. The manufacturing productivity, on page 13, shows that the gap has widened. Between 1995 and 2002, the gap opened up from about 17 per cent to 35 per cent in 2002. The problem seems to be that in the future, if we want to improve our trade performance, it is not so much the dollar that we should worry about — we cannot control the dollar — it is the productivity that we have to worry about. That will improve our real wages and at the same time improve our cost position and trade performance.
From our study, we concluded that to improve Canada's trade performance in the future, we cannot depend upon the dollar depreciation as we have to some extent in the past. We should concentrate on improving productivity. At the same time, we should reduce border risk and impediments to our trade with the U.S. because almost 87 per cent of our merchandise exports go to the United States. Any border risk and impediments will have a negative impact on trade performance. We must improve productivity through facilitating more efficient operation of the markets, encourage private sector entrepreneurship, attract and retain highly qualified people and investment in key sectors and improve Canada's innovation and productivity performance. They are not independent; they are all interrelated. The bottom line is that we must improve our productivity performance so that in the future we can improve our standard of living and at the same time improve our productivity performance.
The Chairman: We will adjourn now because there is another meeting that we must attend.
We have many questions and could be here for another hour and a half. Would all three of you agree with the fact that the increase in U.S. demand and the value of the Canadian dollar have had a big impact on our exports to the U.S.? You seem to all agree on that.
Mr. Murray: Yes.
Senator Di Nino: I want to extend apologies to our guests. They have given three wonderful and informative presentations and we are not able to participate.
I would like to get some commitment from you, Mr. Chairman, to invite them back so that we can explore some of the comments they made and learn a little more from them.
The Chairman: There is no question about that, Senator Di Nino. While I have members of the committee here, I wish to inform you that we are trying not to hold meetings next week. As you know, the House of Commons and the Senate are not sitting and we are trying to schedule next week's work into the following week. As we have had few replies for people to come next week, that would be the best.
To answer Senator Di Nino's observation, I apologize. The Senate sat. We will do everything we can to get you back so that we can question you on these very important briefs that you have given to us.
The committee adjourned.