Proceedings of the Standing Senate Committee on
Foreign Affairs
Issue 19 - Evidence, October 22, 2003
OTTAWA, Wednesday, October 22, 2003
The Standing Senate Committee on Foreign Affairs met this day at 4:05 p.m. to examine and report on the Canada- United States of America trade relationship and on the Canada-Mexico trade relationship.
Senator Peter A. Stollery (Chairman) in the Chair.
[English]
The Chairman: For the benefit of our witnesses, we always have this grey area between 3:30 p.m. and 4 p.m. when our committees sit on Wednesday. There is an unusual procedure going on in the house at the moment and it is still sitting. However, I would like to start the meeting because our researchers will be busy taking notes.
We have reviewed the Free Trade Agreement and we tabled Volume 1 of our report in June. We are now exploring the impact of the exchange rate. During our determinations in the spring, it was brought strongly to our attention that the exchange rate was an important element with respect to our exports to the United States.
We are delighted that you could provide us with the benefit of your wisdom today. We have with us this afternoon Mr. Drummond and Mr. Vasic. This is our fourth meeting on the subject, so we are a bit knowledgeable about it. We have your briefs, so please give us a summary and leave time for questions.
Mr. Drummond, please proceed.
Mr. Don Drummond, Senior Vice-President and Chief Economist, TD Economics: I have submitted a short deck entitled, ``Canadian Trade Issues.'' I have also provided a brief with some commentary and some charts. However, given your guidelines, with your indulgence, I will not go through all of that in detail. Rather, I will present an abbreviated version of that.
It is timely to talk about the exchange rate. I make a lot of presentations before business audiences and I find there are only two things they want to talk about these days: The Canadian dollar and China.
In respect of looking at trade agreements, there is the notion that some of the impacts that people have assigned to our freer trade may, in fact, be a result of the dollar. I do not think that that goes very far. My view is that there is real impact from the free trade agreements and I will present some evidence in support of that.
The first chart before you indicates that exports have taken off as a share of the economy and that they started to take off at the beginning of the 1990s. The Canadian dollar had been falling more or less steadily since the early 1970s and the trade flows had not increased relative to the economy over that period of time. The most notable thing is not that the trade took off with the entire rest of the world but that it disproportionately took off with that of the United States, coinciding shortly after the Free Trade Agreement was signed.
At the top of page 2 is a notion that I fussed around with a great deal. I was at the Department of Finance when the Free Trade Agreement was signed and I could not think of it being quite as big a deal on trade as were making out in drafting the documents because it was a continuum in reducing trade barriers. It is not as though the world all of a sudden changed with the Free Trade Agreement. We started off with tariff barriers 40 years ago that were about 10 per cent of the imports and by the time of the Free Trade Agreement that was down to 3 per cent. We have continued to bring them down to 1 per cent. If we are looking at a fundamental shift in the Canadian economy and in our trade relationships, you might not be surprised to find tariff barriers the day after we signed the Free Trade Agreement because this liberalization of trade has been going on in Canada and other countries for a long time.
The chart on the following page shows the same pattern in imports after the Free Trade Agreement and the relative importance on the Canadian economy as well. If the agreement had been the dominating factor in trade flows, you would have expected the opposite: As the Canadian dollar weakened, imports would have declined.
The chart on page 4 shows the perspective of the overall Canadian economy. It was only about 20 years ago that for every dollar we exported to the United States we exported a dollar within Canada. In a short period of time, we trade $2 with the United States for every dollar we trade inside Canada. The distances are shorter and the population and the economic markets are larger. In Ontario, which is particularly export concentrated, we now export $3 to the United States for every dollar Ontario exports to the other provinces.
I was pleased to see a report in June on the importance of establishing trade agreements. The main argument for signing the Free Trade Agreement and NAFTA and to pursue further broad liberalization of trade is that Canada can put to corporations around the world that if they want access to the U.S. market, they should feel indifferent to locating in Canada as opposed to the United States. Canada can say ``Come here and we can ensure you unfettered access to the United States economy.'' If we do not have free trade with them — not only in the legal sense, but also in the sense that the border arrangements work satisfactorily — there will not be any concerns relating to difficult administrative or legal matters, they simply will not come here.
In the last couple of years, there have creeping concerns about that. As you can see from the chart at the bottom of page 3, Canada's share in total foreign direct investment in North America has been coming down sharply. In fact, disturbingly the declining share coincides with the period after the Free Trade Agreement. A good part of that is Mexico picking shares up but we have also been losing out relative to the United States on foreign direct investment. Many issues must be addressed to get that share back up but the assurance on free trade is certainly an important element of that.
At the top of page 4, I marked down the longer-term perspective of the Canadian dollar because we tend to have short memories. There is nothing particularly important, unusual, and certainly nothing unprecedented about the Canadian dollar being at 76 cents. What is unprecedented is the rapidity of the rise. As we can see over the past 20 years — and we could go back much further — 76 cents is not a particularly high level for the Canadian dollar. The difficulties are not being caused by the 76 cents; they are a result of the fact that it has risen 20 per cent so far this year. There definitely are adjustment difficulties.
The other point is that this is not a Canadian phenomenon per se. This year, this is largely a result of the weakening of the U.S. dollar. At the bottom of page 4, you can see that most of the other currencies have had strengthenings similar to ours.
The top of page 5 looks like a whole mess of squiggles and that was actually the purpose of the graphic. This chart shows that when our currency changes as rapidly as it has this year — and as it has in the past — we tend to think we have an extraordinarily volatile, unsteady and unpredictable exchange rate. You can see that most of the currencies around the world are much more volatile than ours.
The bottom of page 5 shows the Canadian dollar against the inverse of our net export position. In theory, you would expect that as the Canadian dollar strengthens, our trade balance would deteriorate. Indeed, that is what we do see.
Let us turn to the top of page 6. As economists, we are slaves of the past. We use models and methodologies that take data from historical relationships and try to extrapolate them into the future. An institution such as the Department of Finance of the Bank of Canada, would have models that are based upon exchange-rate relationships and what they have done to economic output from the past.
Those are very large estimates, as I indicated in this chart. You would expect to have a 1.8 per cent reduction in the level of output in Canada from the Bank of Canada's model occurring over about one year. If you take the Department of Finance's model for trade, you would expect that GDP growth would be lowered one percentage point in each of 2003 and 2004. Then you are stuck in the game of asking whether past relationships are reliable guides.
A number of things have changed. I do not know if this committee will have a way of quantifying that. I would like to be able to quantify it, but I am finding it is very difficult. For example, in the late 1980s, few corporations hedged their foreign exchange operations; many of them hedge now. That does not totally change the relationship but it may well delay the impact of exchange rate appreciation.
Because of the direct foreign investment out of Canada into the United States, many more Canadian companies actually have U.S. operations now. That is a natural hedge; they have a source of U.S. earnings. In the last few years, we have seen a large number of Canadian companies that borrow in U.S. dollars. That is another natural hedge. It is difficult to quantify the importance of those changes.
We just saw the release of the Monetary Policy Report of the Bank of Canada today. They are forecasting, for 2004, growth of 3.3 per cent. I do not think they are using the historical relationships in their model to generate that forecast. If they were, growth would be much less than that. For some reasons, maybe judgmentally — and we are probably both doing the same thing — they are assuming that the impacts will be smaller going forward. We are, perhaps, in part drawing a lesson from when the dollar was weakening; we certainly did not see a boost to Canadian inflation. The impact seemed to be changing over time.
Turning to the bottom of page 6, you will see the results of an exercise that has been done many times in Canada. You will frequently see people going through the export concentration of various different sectors. One sector will be described as very sensitive to the exchange rate because it does a lot of exporting, whereas another sector does not do much exporting.
We looked not only at the export concentration by sector, but also at the import concentration. The notion was that, for big importers, costs should go down as the dollar strengthens and that should help. Then we took the net of the two. We looked, sector by sector, at the net position.
We then put the sectors in order by which is most sensitive in Canada to exchange rate changes. Forestry-related sectors are the most sensitive. They export almost everything they produce. They tend to import very little. On the other hand, clothing, beverage and tobacco do not export nearly as much and they import a lot. Interestingly, the auto sector is usually the first line mentioned in any discussion of the exchange rate. That sector has a heavy export content but they also import a lot, so it is not as sensitive as some of the sectors, like forestry.
We delved further and looked at the sectoral composition by province. From the sectoral analysis, we can take a stab at which provinces have their economies most exposed to changes in the exchange rate. Quebec and Ontario come out at the high end of that; then comes British Columbia because of its forestry.
In conclusion, I do not think the fluctuation or the rise in the dollar is the main issue. The main issue for the Canadian economy is still our substandard productivity performance vis-à-vis the United States. If we can find the key to resolving that, our dollar would probably continue to rise under those circumstances but we probably would not care much about it. We would be in a competitive position and our standard of living would rise.
As your committee noted in June, it would be helpful if we could diversify our trade beyond the United States. I realize it is a natural market and a big market. The transportation costs are low; the consumer tastes are fairly similar. It is a heroic objective to diversify. However, as we have seen, we have appreciated 20 per cent against the U.S. dollar, we have not changed much vis-à-vis the rest of the world. If we did have a broader basket of trade, we would not have seen quite so large impacts.
I maintain that, although the dollar has been important in driving those trade flows over the last 15-odd years of the Free Trade Agreement, it was not the dominant impact. There have been huge payoffs from the free trade agreements.
From speaking to business people and as a representative of the Chamber of Commerce, I am aware that there is angst on the trade front. One senses growing protectionist sentiments in the United States. There is the potential for difficulties at the border. We should not be complacent about that, but the payoffs are there. Regardless of the exchange rate, Canada will benefit from the existing free trade agreement. With the work of your committee and others, we hope to extend that further.
Mr. George Vasic, Chief Canadian Economist, UBS Securities Canada Inc.: Honourable senators, I am delighted to be here. I should like to point out that while our firm may not be a household word, as is TD, UBS is an international financial institution with a market cap greater than that of the three largest Canadian banks combined. We also are a large pension fund manager in Canada and globally. As well, we are the largest trader of Canadian equities anywhere in the world. That comparison includes our position relative to our domestic peers. We do get a lot of exposure to foreign institutions, foreign money managers and foreign investors. I would hope that you would indulge us in case you were not familiar with our name at the beginning of the remarks.
The Chairman: UBS is the ``Union de banque Suisse,'' is it not?
Mr. Vasic: Actually, it was. The bank ownership is the merger of UBS and the former Swiss bank together with the former S.G. Warburg, Paine Webber, Dillon Read, and other companies.
You will be pleased to know that we have recently gone through a global re-branding to rename us UBS.
Senator Di Nino: The fact that Michael Wilson is associated with you is a big plus to many of us.
Mr. Vasic: That is encouraging to hear.
I will make six points. First, I am sensitive to the fact that you have been hearing many other people speak, not just today but prior to this and probably after this as well. With such a topic, you are likely to cover a lot of the same ground more than once. I hope that will not repeat too much of what you might have already heard.
In respect of the impact of the exchange rate on trade, the plain record of history shows that it is ambiguous. The circumstances in which it occurs tend to matter more. From that point of view, we need to look at the potential impacts of the currency by examining our current circumstances.
Second, the appreciation we have had of late has occurred from what was clearly an undervalued currency. Most would agree that a number in the low 70s is about right. In the current context, even with today's strengthening of the dollar, the overvaluation may well be there, but it would have to be described as moderate and, accordingly, the trade impacts as a result would be less than expected.
Third, the rise in the Canadian dollar has occurred, encouragingly, from a position of economic strength. Most particularly, profits in Canada are high. That allows for a greater scope for price adjustment. Employment and other impacts will be either mooted or delayed relative to expectation as a result. Once again, the trade impact will be lower than you would otherwise expect.
Fourth, the Canadian dollar rise has been rapid. This will spur an early adjustment by Canadian industry. This time around, the cumulative effects of a gradually rising or falling dollar will not get built into the system because everyone we speak to does not expect it to go back down and they are taking action now as they deem appropriate.
Fifth, one point that is lost in all of this and I hear mentioned nowhere else in terms of implications for Canadian trade is what the U.S. will do about its own current account? They have a large deficit. If that is to be resolved through lower imports, the impact on us might be quite severe, irrespective of the level of our exchange rate or whatever else we may do. Clearly, we have no control over that particular aspect.
In this regard, studies have shown historically that most current account adjustments occur more as a result of changes in exports and much less so due to changes in imports. Furthermore, studies of developed nations tend to show that relative demand between the two countries is more important to trade performance than the exchange rate.
I would further argue that our production processes have become much more integrated over time. It is easy and catchy for some studies to say that 40 per cent of GDP is exported and almost 90 per cent goes to the U.S. You do the math; it is significant. What gets lost is the fact that a substantial chunk of our exports are in fact imports. If our exports fall, our imports will also fall. The net effect is that it is far less as a per cent of GDP than you would expect looking at those raw numbers.
Many moons ago, I constructed an econometric model of Canada. That took nine months of my life. Having participated in many of these model studies, I would suggest to you simply that if all these impacts and coefficients were accurate, our economy would be far more volatile and our inflation rate would have bounced up and down much more than it has. We would already be in a recession given the dollar raise we have seen this year, et cetera.
Finally, we need to concern ourselves in terms of trade — not only with the goods side but also with the services side. A more appropriately valued currency makes foreign acquisitions much more attractive. Thus, if done prudently, they can set the stage for a long-term stream of income. This will help reduce the large imbalance we have between our goods surplus and our services deficit that is within the current account.
It is part of the normal maturation of a nation to move from producing goods to a stage where you want to live off the income. It is a situation to which countries and individuals aspire.
In summary, the trade impacts will be significantly less than you would expect. Second, most have ignored how the U.S. will adjust to their significant current account deficit and their transformation from what has been a creditor nation into a significant debtor nation. How that occurs will have a far greater impact on our current account and our trade performance with them than moves in the exchange rate.
Finally, we would note that the silver lining in all of this is that the rapid rise will spur productivity much more quickly than otherwise would be the case and, perhaps, kick-start a much-needed virtuous cycle of productivity rises associated with a stronger Canadian dollar and a more balanced current account overall.
In most of the commentary we hear about changes in the currency and its impact on trade refer to the short run of ``all else being equal'' type of analysis, which most people understand. However, that is only a small percentage of the end result.
A look at history will show that fluctuations in the dollar across Canada and across other international experiences have shown a much more ambiguous result in terms of their impact. It is a more complex topic and more reflective of the current environment.
It is important to note that we have come from a position of undervaluation. No one would agree that 63 cents was the right level of the Canadian dollar, even in model results. Anecdotally, if you look at the behaviour of people, 63 cents was not right. You saw many U.S. goods priced specifically for Canada because the exchange rate conversion did not make sense. You saw a lot of cars re-exported to the U.S. because of the price gap. I am sure that you have noted in the last few months that all of a sudden comments like that have been strangely absent from the general discussion.
You can look at the relationship between non-energy commodity prices — and we show in the chart there a trade- weighted basket of those — and the Canadian dollar. However, it is not the only factor. Other factors impinge on it, but I would suggest a number in the low 70s is about right. That would be consistent with other types of analyses.
How will we know when it is overvalued? Quite simply, when people go to Buffalo to buy goods, we will know. We are not there yet. I would suggest that in general, something in the low 70s is about right, although I may be taking a few too many strides at once. We are moderately overvalued at the present and the fact that we came from a position of significant under valuation has to be recognized in the assessment of the trade impacts in the current context.
In terms of our economy vis-à-vis the U.S., it is worth noting that an exchange rate is a relative phenomenon. We do not have to do good things. If someone does bad things, we are relatively better off. We would suggest, as Mr. Drummond mentioned, that the strengthening in the Canadian dollar this year is largely a reflection of weakness in the U.S. and not of our own strength.
However, it is occurring at a time when the economy is structurally stronger and better balanced than that of the U.S. In recent years, we have gone to becoming a much smaller net debtor. Collectively we are one-half the net debtor that we were for most of the post-war era and we are a less of a net debtor than the U.S. is. They are moving to a position of greater vulnerability and that path looks inexorably up, given their 5 per cent current account deficit to GDP. A sector-by-sector comparison of the Canadian consumer and the U.S. consumer will show you that we have a smaller interest burden than do the Americans. Our corporate balance sheets are better; our profit shares are higher; and our fiscal situation in aggregate is better than that of the U.S. The prospects going forward are also better.
It is an uncomfortable position. We are out of our comfort zone vis-à-vis the U.S. but we are truly the ones in the driver's seat at this time. We spent most of our adult lives with the U.S. being in a financially and fundamentally better position than we have been. That is no longer the case.
If there is ever a time for an unexpected rise in the Canadian dollar to occur, you want that to be when you are at the top of your game and not at the bottom of your game. I would argue that this is one of those times. Specifically, for corporations, the fact that profits are strong allows them more ways to adjust. If their share was extremely weak and profits were tight, some of the model results would come through on a one-for-one basis. There are more options now and the adjustments that will result, in terms of employment and other factors as a result of our relatively strong profit picture, will be either delayed and or muted.
Despite the drop in the dollar, our competitiveness has been slowly leaking due to a decade of productivity weakness vis-à-vis the U.S. In round numbers, an 80-cent dollar now would be about — from a competitor's point of view — as uncomfortable as a 90-cent dollar was 10 or 12 years ago.
Nonetheless, I am surprised by the lack of howling out there and, anecdotally, the lack of comments I hear about how bad it really is. I would expect to have heard more at current levels. If you had asked me at 63 cents what the general commentary and state of affairs out there would be at 75 cents or 76 cents, I would have expected to hear far more howling than we have heard. That is partly because it is occurring during a period of good performance in the economy and a relatively good performance vis-à-vis the U.S.
The noose will be much tighter than you might think at current levels. If all this had happened 10 years ago, you would have found people forecasting that the dollar would go back down. No one is forecasting that these days. Moreover, they are preparing a battle plan for a dollar that is in the 70s and probably near current levels. That is unlike the late 1980s when the dollar appreciation occurred over a number of years. There was always a hope, I recall, that it would just turn around and go back down so that our problems would be over. It did not turn around and all of a sudden, the competitive position had eroded, in a cumulative way, very substantially. It was then very late in the game to make a substantial adjustment.
Perhaps the most important point I want to make is on the next two slides — the situation of the current account adjustment in the U.S. It is worth noting that in the current context, the U.S. dollar is depreciating. The U.S. did a study of 25 episodes of current account adjustments in industrialized countries over the last two decades. As I mentioned earlier, the main message that came out of it was that it was not declining imports that helped the current account recover; rather, it was rising exports.
Canadian and American companies are so integrated that, to the extent that the U.S. is able to have higher exports because of their weaker dollar, we will participate in that even if their imports stagnate. People have not seen that result. A big cut in imports has not solved previous current account episodes.
This study also showed that, by and large, the size of the current account reflects relative demands and not so much the exchange rate. How Canada and the U.S. grow together will probably have a stronger impact on the trade position than on the specific level of the dollar. In the context of the dollar being within shouting distance of fair value — given that it is hard to peg a number for that — I would argue that the relative domestic demand of performance between the two countries will be more important in shaping our ultimate trade performance than the exchange rate.
Speaking to that integration mode, a large percentage of our exports are, in fact, imports. Many of these model simulations tend to overstate the impact on trade because they will have certain export sensitivity. However, in the import equations there will be no reference to the fact that if exports go down, then imports will go down as well. Over time, this integration has increased and, thus, the effect — the likely overstatement compared with the current context — is likely higher. You can see that it ranges from 56 per cent in motor vehicles and parts all the way down. These are the industries with more than 30 per cent content. However, it is big and the end result is that our net exposure, if you will, to the U.S. is considerably less than that 36 per cent figure you might get from just looking at the GDP accounts.
Finally, we want to bring into context that overall trade — its goods and its services — matters. One imbalance is the very high level of goods exports but services deficit. Over time, a more appropriately valued currency would help bring those two lines closer together. That is a desirable objective.
A more appropriately valued currency will mean that we are buying foreign companies instead of foreign companies scooping us up. If we do it prudently, we will receive a stream of income over the long term that will moderate our services deficit. It will presumably keep us honest in terms of productivity growth, which will allow us to have a rising fair value for the exchange rate over time and keep us prosperous from that point of view.
The rapid and significant rise that we have had, although not sharply divergent from fair value, gives us an opportunity to kick-start a more virtuous circle — one with which the Canadian experience has not been familiar over the last several decades. If there were a silver lining, that would be it.
The Chairman: Thank you, Mr. Vasic; that was most interesting.
Senator Graham: When Mr. Jim Stanford from the Canadian Auto Workers appeared before the committee, he suggested that the proper place for the dollar was at 72 cents. Mr. Vasic, you are now suggesting in the low 70s. Mr. Drummond, do you have a figure to offer to us where you would like to see the dollar?
Mr. Drummond: You changed the question a little bit where I would like to have the dollar. I would actually disagree with the approach that others have taken. I do not think there is a single number that is constant over time. As Mr. Vasic acknowledged, with the deterioration of our productivity performance vis-à-vis the United States, in essence an 80-cent dollar today is similar to what a 90-cent dollar was 10 years ago. This is a fluid concept.
I will relate an interesting experience that I had when I worked for the Department of Finance during that appreciation in the second half of the 1980s. We used to visit corporations every quarter. The standard question we asked was at what level of the dollar did they feel competitive. When we started this, the dollar was at 73 cents and the answer was 75. The next quarter, the dollar was 75; the answer was 77. Then it was 77; the answer was 79. We went up in two-cent increments until we got to 85; no one said higher than 85. That was over a two-year period, they adjusted their answer from 75 to 85. It is a fluid motion.
In respect of the concept of purchasing power parity — that is, what is the exchange rate that would equate our costs with other countries, — if you look at the OECD or IMF estimates will be in the high 70s or 80s. Some very crude anecdotal evidence suggests that is probably not far off. We still have a trade surplus. It has been deteriorating, but that would suggest that the dollar is not particularly high. You can relate it to personal anecdotal evidence. Has anyone here gone anywhere else in the world and felt compelled to buy anything? I do not think so. If you go to Europe, you will find that everything in Britain, for example, is the same price it is here, but it has a pound stuck in front of it, therefore it costs double. You can go to the electronics district in Tokyo and I bet you will come back and wait and buy it at Future Shop.
There is nothing magical about a particular level of the dollar. There is no single answer where you are competitive or not. The issue that confronts the Canadian economy right now is the speed. If people had adjusted their business's plans to be comfortable at a 63-cent dollar — one would hope that many did not — they will not be comfortable in a 10-month period. Yet, can they be comfortable in two or three years? Probably. There is a greater degree of chance of that.
I am not so stuck on the notion that 76 cents is an overvaluation. I think there will be a difficult transition period for many corporations that will last for a year or two, until they are comfortable with that level. I would suspect, just as the answer was in the late 1980s, if you asked the question in two years if they are comfortable with 76, they will probably say ``yes.'' The dollar may not be at 76 cents. If the U.S. dollar continues to weaken, we could well have an ``8'' in front of it by that time.
Senator Graham: Recently in this committee I recalled when the value of the dollar reached 93 cents in 1977. Tom Kent addressed a group of parliamentarians, and when the dollar was at 93 cents, he suggested it should be pegged at 75 cents.
Where do you see the dollar at the end of this year and at the end of next year?
Mr. Drummond: I would not put much stock on my answer because my record on forecasting the dollar has been terrible. In the face of continuous laughter for last three years, I was forecasting that the dollar was going to strengthen. I was almost wishing that certain groups would not invite me back any more, because they kept throwing that back in my face. When the dollar finally goes where I was forecasting, it went up three times as fast in one-third the period of time. With that background, you realize that I am not that confident.
The backdrop is that you have to believe the U.S. dollar will continue to weaken. They have that huge current account deficit — over 5 per cent of their economy — and now their federal government is running about 5 per cent deficits; almost all of their states have deficits. There is no reason to think Canada will not be on the upside of that. We are roughly in fiscal balance. We have current account surpluses, higher interest rates and commodity prices are firm. The direction will be up.
My cop-out to that answer, as I indicated, everyone wants to talk about the dollar and China. That is the first question. I always tell people that if they have a business plan, they have to test it against an 80-cent dollar in a fairly short period of time. I am not saying that is my forecast. I am not coming across very many people who are expecting it to go down. I am coming across many who think it will flatline. That is fine to forecast, but they have to test it. We could be there in the blink of an eye.
We last did a forecast in September and we had it going to 78 cents by the mid-point of next year. Again, I did not anticipate that when I left my office at noon today we would be slightly above 76.5 I think the dollar will be up. Certainly, my advice to every Canadian corporation and to the bankers who deal with them is that I would hope they have business plans with which they are comfortable at 80 cents. If they are not, they will have to make adjustments.
Mr. Vasic: Let me address that point on the fair value. If you asked me today what is a correct number, I would say in the low 70s. As I mentioned during my presentation, it is a moving target so I will not repeat all that.
I would refer you back to the chart I presented on manufacturing unit labour costs. While the dollar will never be correct at any given moment, if you look at the data for the 18-year period between 1985 and the present and ask what level of the dollar gives you the average level of competitiveness for that period, the figure works out to about 70 cents —which is also the number that the commodity price index points to. With a change in productivity going forward, that can go up. If it keeps being weak, that can go down. That point is worth noting.
Our forecast for the dollar was about 77 cents. Would we raise it? Yes. In general — as I mentioned at the beginning — this is all about the declining U.S. dollar. That is plain and simple. Our forecast for the U.S. dollar is to go to $1.32 versus the euro. Again, we have a global team; this is our global forecast.
The Chairman: It was only $1.08 as of September 1.
Mr. Vasic: It was $1.20 earlier. It was 82 cents a couple of years back.
This is about the weakening of the U.S. dollar. The historic record for current account adjustments in developing or industrialized countries shows that there are significant depreciations. The evidence would suggest that this depreciation is not yet over. Thus, we have $1.32.
The question is: How much does the Canadian dollar participate? What will change, if you looked at the first part of this year, the appreciation in the Canadian dollar was almost as large as the U.S. dollar's depreciation versus the euro. From where we are now, that ratio will probably moderate. If we got another 10 per cent or 20 per cent on the euro, we will maybe get a quarter of that on the Canadian dollar.
What does the Bank of Canada do about all of this? I would argue that if they really believed their own models, they would have been cutting rates furiously already in the wake of a 20 per cent appreciation. Nonetheless, looking at the cumulative effect, and if the U.S. dollar were to drop another 20 per cent, or so, they will come in and start slowing the rise. That would be factor moderating the rise in the Canadian dollar from here.
I would take a couple of Mr. Drummond's points to heart. First, our currency is not as volatile as most. Given the potential for large movements elsewhere, Canadians in general must be braced for potentially big movements in our dollar. We had a taste of it earlier this year.
Senator Di Nino: There have been opinions expressed that the weak U.S. dollar is a policy shift by the Americans. I have heard once or twice the words ``deliberate policy shift by the Americans.'' I would like your comments on that.
Additionally, if that is indeed what is happening, has our government — not the Bank of Canada — addressed the issue with some of its own shifts in policies to try to modify and affect the imbalance that may be created by that?
Mr. Drummond: I am fascinated, but totally mystified, by these accounts of strong-dollar and weak-dollar policies from the U.S. I do not think they ever had a strong dollar policy and I do not think they now have a weak dollar policy. It is just all words.
Words might count for something. If you thought that you were going to get a sudden drop in the value of the U.S. dollar and they had been saying that they welcomed a strong dollar, you might assume that they would intervene and not allow that. However, what did they have policy wise? They drove their interest rates down about to the lowest level in the world. That is not very friendly for their dollar. They have not done anything in particular. They have allowed themselves to go from a huge fiscal surplus — temporarily — to a huge fiscal deficit. That is not very dollar friendly. I do not think that they did in action supported that strong dollar.
Every once in a while, occasionally the Prime Minister, but more particularly the various treasury secretaries, said that they welcomed it and recognized that there are values from it. If you took the counterpart in Canada, every once in a while, not very often, we seem to have statements by people of authority in Canada that seem to not welcome a stronger value of the Canadian dollar. However, our policy was probably more in line to generate a stronger dollar than was the U.S. dollar.
Ultimately I do not think it is the words that matter. These are just words in both cases. It matters what your policy is and what your economic conditions are. The economic conditions and the policies in the United States are unambiguously lined up to have a weaker currency. In Canada, they are unambiguously lined up at the moment to have a stronger currency. I just find it is pure silliness. You hear while you are setting up heading for a $500-billion deficit in the United States you are massively consuming more than you are spending. The treasury secretary will say they still have their strong dollar policy. If there ever was a strong dollar policy, it certainly has gone out the window a long time ago.
Mr. Vasic: I would agree that in the U.S. there was deliberate stimulus because two years into a presidential cycle there were no jobs. The the short answer was that rates were driven lower, we had a stock market crash, and government spending was escalated for a number of reasons. Even if it very narrowly was to get U.S. job growth back up, all of that is dollar unfriendly, and you have to say that was the right direction. People have been forecasting a weaker U.S. dollar for some years.
This is sort of the opposite of Mr. Drummond's others' forecasts of the Canadian dollar. The demise of the U.S. dollar was predicted some years back and began about 18 months ago. That is the way it always happens. It happened in 1985, 1986, 1987, or 1983-84, the dollar kept going up and everyone said it would go done, and finally eventually it did go down. Some policy statements effectively blessed the decline to some extent.
There are events and rhetoric and when it is convenient, people draw connections between the two. Clearly, the U.S. policy actions were there to generate stimulus. Part of that stimulus package in terms of fiscal and monetary is a low dollar and all of that contributed to each other.
In Canada, it was the same. Given our relatively better performance, we were set up certainly for a less stimulative policy — especially when the banks started raising rates a year and a half ago — nevertheless it was appropriate. By extension of the U.S. dollar's weakness, we strengthened. That must always be kept in mind. We do not necessarily have to but we did, given our position of economic strength.
Senator Di Nino: For the record, I would like to your opinions on two phrases: ``fixed rate'' and ``common currency.'' Can you both make comment on that?
Mr. Vasic: I would be opposed to a fixed rate. Again, the floor moves, and you are never going to get it right anyway. That is 100 per cent clear. Nobody can forecast the dollar. You are never going to get it right, and it will have some unintended consequences that people do not expect.
We are not that far away from a common currency in any event given the integration of the economies. Having a floating dollar and some scope for adjustment is a far better alternative to locking it down because as soon as you get into fixed rates you have to get into discussions about changing fixed rates on occasion and so on. In the end, while these fluctuations are unexpected — they are large and uncomfortable at periods of time — that is probably still better than having various people looking at what the rate should be, and that will always be with a much longer lag than would be desirable and that would occur in the marketplace.
The current situation is just fine, and with more experience one will get used to fluctuations in the currency, just as you get used to fluctuations in everything else. For some reason Canadians delude themselves into believing that these numbers should change very little over time. That is just not the experience. Everywhere else in the world you can get used to things that move around, and we can get used to fluctuating temperatures that no one in the world can understand but we have done that. Therefore I do not think it is that big a deal.
Mr. Drummond: I would remove fixed exchange rate completely out of the argument. It does not make any sense at all. To fix exchange rate you have to make something else variable, and in that case, you have to totally dedicate your interest rate policy to fixing the exchange rate. That gives you the worst of all worlds.
The interest rates can wreck havoc on your domestic economy much more readily than the changing of exchange rates. In trying to address a situation that some might think is undesirable, you create a much worse situation. I would argue they have not worked and ultimately if your economy's policies and the markets are moving against it the world's history has shown that no one has ever been able to hold the fixed exchange rate; ultimately it gives. Everyone will remember the most graphic example in Sweden when they tried to fix it and they hit 600 per cent on their overnight rates at one point to try to hold that fix. We do not want that.
I am glad you did not ask monetary union because we get that a lot. There is no prospect of a monetary union. I assume you recognize that for the Americans to hand in their dollars and take back something that has one-third of the Canadian flag and one third of the Mexican flag is highly doubtful. There is nothing in it for them.
It would be a common currency but let us clarify; common currency means us using the U.S. dollar. People cite precedents such as Panama, which is using a tiny amount. Would we use 10 per cent of the U.S. currency, would we go down on hands and knees and beg them to allow us to be part of their cheque clearing system? Would we beg them to allow their central bank to be the lender at the last resort? That is a lot to stomach.
There is only one reason to have our own currency, and that is the structure of the economies is different. Fourteen per cent of our output is in natural resources, while theirs is 8 per cent. That is a substantial difference but 50 per cent of our trade surplus comes from commodities. They are, of course, a net importer. A clear example of the impact of that it came in 1997 with the Asian crisis: commodity prices plummeted. That hurt us but it helped them. Our trade went in the opposite direction and our exchange rates went in the opposite direction. We got exactly the type of buffering response that we had. I think there is still some value.
You are in the political arena. If you think free trade was an emotive issue in Canada, try us using the U.S. dollar. I got a taste of that right in this city where we wrote a report in April 2001 that said there was not a case for using the U.S. dollar and the editor of the Ottawa Citizen put a title on the front page that implied we were in favour of a common currency. I have a count of the number of people who e-mailed and phoned and wrote letters that they were dropping their account to the TD Bank. That gave me a taste of what anyone will encounter if they go down that road in the next little while.
If we ever go to using the U.S. dollar, it will be when our economies are very closely aligned. We are not there. In fact, there is no guarantee that we ever will be. People are saying that surely we are converging because our dependence on natural resources is going down. In fact, one percentage point worth of GDP is going down in our natural resource concentration every 10 years. However, that is at exactly the same pace as the United States.
Twenty years ago, we were 16 and they were 10. Now we are 14 and they are 8. We are moving alongside with quite substantially different structures. We are struck with the floating exchange rate. That is the best of the options now.
Frankly, the attention focused on it is overblown. The issue is the productivity gap between the two economies. If we could fix that, the dollar would take care of itself, and we would care a lot less about it.
The Chairman: I understand that no one has ever been able to predict short-term valuations on currency. As you say, for years now, people have been saying that the Canadian dollar is undervalued, and it stayed undervalued for various reasons explained to us by the Bank of Canada. Mr. Murray indicated the four reasons: demand in the U.S., inflation, interest rates, and commodity prices. That is the underlying analysis that affects the dollar.
What about the regional effects of the currency change in Canada? Take, for example, the softwood lumber in B.C., which is so heavily dependent upon lumber exports.
Would you like to get something on the record on that?
Mr. Drummond: In my presentation, at the top of page seven, we extended the sectoral analysis of the winners and losers to the structures of the various provinces. We ranked them by which were the sensitive, in the negative sense, to being affected by appreciation. Quebec and Ontario, followed closely by British Columbia and New Brunswick were most sensitive. Those provinces at the least affected end were Saskatchewan, Nova Scotia and Newfoundland and Labrador. It largely ranged by analysis of exposure to exports and exposure to imports.
I do not think the issue is so much regional as it is sectoral. In one region, you can have two businesses operating across the street from each other with totally different results. As was mentioned, you have one system that has totally different results within that. Since the late 1980s, we have seen more and more exporters in Canada that have major import operations as well. They have it on one side and not on the other.
It runs the divide right through the firms and the sectors in Canada. There are the import-sensitive firms, and this is a gift. It is lowering their price of imports. Certainly, a growing company that is importing machinery and equipment — particularly things like computer software — has had a tremendous decline in costs and a huge competitive advantage for that. On the other hand, if a company's costs are fixed in Canadian dollars and it is selling in U.S. dollars, it will take a horrific squeeze on its profit margin. We can line that up province by province, but it is easier to frame the question around how the sectors, rather than the regions, are affected.
The Chairman: I realized that myself as I was asking the question. I was a bit surprised when I saw that Ontario and Quebec — on a regional, not sectoral basis — are more affected than British Columbia, which we think of as being particularly dependent on a particular commodity export. Mr. Vasic, did you wish to comment?
Mr. Vasic: We do not really do regional work.
The Chairman: Can you comment on the sectoral analysis?
Mr. Vasic: Sectorally, we do equity analysis. We have a research department that follows the large publicly traded Canadian companies. For the last 18 months naturally, we have been asking them at various times, what the Canadian dollar does? Foreign investors would if we think the Canadian dollar is going up, how do we ``play'' that?
The answer is that it is tougher than one would think because of all different layers these days. In the old days, it was very simple. You look at the exporters and domestic production, foreign sales and so forth, you get to what I alluded to earlier: those straightforward effects that everyone seems to talk about off the cuff. If you go company by company, the paper and forestry sector had the most significant negative because that is related to domestic production, U.S. dollar cost, and higher debt.
Then it quickly gets fuzzy. They have huge models in all of these companies. They asked the companies what they think because they would know it line by line. It gets harder to decipher. I understood that to indicate that the impacts perhaps are not as substantial as people would like to believe sector by sector. We end up looking at indirect effects that are not part of the pure appreciation.
Perhaps in the cable industry there were some high-debt firms that actually benefited, with domestic audience but foreign debt. That is the other end of the spectrum. Most are frankly somewhere in between. Were they changing their estimates? Not materially. I would say that it became a much more complex issue.
Senator Graham: We hear repeatedly about productivity rates in Canada being consistently below those in the United States. In your estimation, why is that so?
Mr. Vasic: Again, it is difficult to strip out the causes for productivity. However, productivity gains occur when there is pressure to do so. In part, the persistent declines in the Canadian dollar leading to an ``undervaluation'' greased the wheels. That caused us to be not as vigilant as we otherwise would.
I do not believe there is anything set in stone that says that we must have lower productivity gains. You could argue on levels that because of their scale, they should be able to achieve a greater degree of specialization and productivity levels. However, from a growth rate perspective, there is no reason that ours have to grow less than theirs. I think it has been the lack of pressure on the system.
With respect to the policy framework, it is hard to say, but some of the barriers that were there probably in the past contributed. I sense that those have had less of an effect in recent years. The bottom line is that you need pressure on companies to look for those gains, and that pressure has not been there and they have been getting a bit of a free ride.
Mr. Drummond: With respect to productivity, is that it is difficult to analyze that it is an overall number. If you just look at the output per hour of the entire two economies, you would get a 25 per cent to 30 per cent shortfall in Canada. You start to get a bit more. Similar to the exchange rate, you have to look at on a sectoral basis. Not all of our sectors are 25 or 30 per cent below; our natural resource industries are probably equal or perhaps even above. We are not that different on sectoral productivity, although the services sector is somewhat behind.
The big difference is in manufacturing. Part of the difference is a compositional difference. A leather manufacturer in Canada is not actually that far behind a leather manufacturer in the United States. The really high productivity manufacturers — particularly the high technology manufacturers — are much less important in Canada. We do not produce very many computers. In terms of the output per hour work, that is the highest productivity sector in the United States. The information communications technology-manufacturing sector is 1.4 per cent of our GDP; it is 4.5 per cent of that of the U.S. It is much higher-level productivity in both economies than the rest of the economy. It is just a weighting average. That does not necessarily mean our sector is much behind the productivity of the U.S.
I would say that as a result of entrepreneurial spirit, not government policy, the United States has long been more oriented towards R&D. We know all the studies. Despite a fairly attractive tax system, we have a very low level of R&D in Canada — in the private sector, at any rate. Perhaps that is a bit of a hang-over from more of a branch plant model where the research is done in the mother country. A lot of those innovations that sparked that productivity in the United States in the 1990s came from spin-offs from defence industries, which we have not had. They came out of university labs. Universities are starting to do a lot of research in Canada, but United States universities do 14 times the research of ours. At the commercialization end of it, U.S. universities have 47 times the commercialization revenues of Canadian industries. Where did all the Microsofts and all that development come from? They came out of the university and defence labs. We have not had that.
I would say, as Mr. Vasic said, that one of the catalysts for the increases in productivity since the mid-1990s was the strength of the U.S. dollar. It put them on a treadmill that kept going faster and faster. They had to claw the productivity to get it above. I think the tax element is still at play there. We have a higher tax burden. Again, you do not get far by looking at the total tax burden; I do not think our higher sales taxes are holding back our productivity. However, we do have higher taxes on capital in Canada. That is capital writ large — meaning corporate profits and the capital tax. A number of the provinces still tax capital for their provincial sales taxes. We do not have as generous depreciation schedules. Some of that was being addressed, particularly with Ontario's objective of getting an 8.7 per cent corporate tax rate. Now they are backing up to 14 per cent. That gap is back in our faces and is still quite substantial.
There is no one single answer, unfortunately. It is a lot of things and it would take a fair number of changes — both in policy and in private sector behaviour — to substantially close the gap. It would probably take a number of years as well.
Senator Di Nino: You are probably aware that these hearings are in conjunction with our study on the Free Trade Agreement with the U.S. and the impact that it has had on our economy. The rise in the dollar, obviously, has had an impact on our economy. We are focusing particularly on the impact on our economy, as it deals with the U.S.
Little has been said about the service sector and how the Canadian dollar has affected the economy from the service sector standpoint. Can you add some words to that for our benefit, please?
Mr. Vasic: I am an equity market strategist with a global bank, so I will take a pass on that. However, I want to comment briefly on the entrepreneurial environment in the U.S.
Let us remember in the mid-1980s, when the United States dollar appreciated so strongly, that spirit seemed to be absent. We kept hearing that the U.S. was uncompetitive. There were factory shut downs; the U.S. was saying that it needed to be more like Japan, Germany, et cetera. They were able to use that — and a whole host of other things under the Reagan administration — as a catalyst which then kick-started productivity and kept it going. Obviously, a lot of other things occurred through there. As the appreciation occurred in the late 1990s, you must remember that from the perspective of people buying U.S. stocks and the currency rising, they wanted to know why they had to pedal faster because of that. Yet, the result was they did. They kept that going. It is worth noting that it has not always been the universal mindset or view in the U.S. They were able to adjust to it and the same point can be a catalyst here in Canada as well.
I will have to defer the services question specifically.
Mr. Drummond: I have two points regarding the services sector, vis-à-vis the dollar. First, the service sector is much more oriented than the goods sector towards the domestic market than the goods sector. Across the entire services sector, you would expect to see less of an impact on their economic activity from changes in the dollar. In the parts of the services sector where there is a trade component, it would operate exactly the same as a manufacturer or a natural resource exporter. The obvious example would be in tourism. If the Canadian dollar goes up 20 per cent, then that makes a trip for an American to Canada 20 per cent more expensive. Clearly, we would expect to see fewer of them. Similarly, we will no doubt see more Canadians going to Florida or Arizona this winter, as it has obviously become less expensive for them to do so.
However, particularly in light of competition from China, if we are to be competitive, it will be through the high value-added services. Those are the sectors that are growing more rapidly. There is where the growth in our trade will have to come from. The exchange rate proposition is exactly the same for an engineer consulting trying to do work around the world, as it would be for a manufacturer or natural resource exporter. It is squeezing their profit margins at the moment.
Senator Di Nino: Is there any information available from past fluctuations of our currency to give us an indication as to what one might expect from a very important component, particularly, for example, such as the tourism industry in Ontario? Do we have any information to give us an indication from past periods of fluctuations similar to this?
Mr. Drummond: Yes. The news is not particularly encouraging. If you look at the partial impact of exchange rate and separate out the fact that all travel went down post-9/11, there is a tight and inverse relationship. The tourism balance changes rapidly and fully — the changes are due to the exchange rate. People respond to those different price mechanisms on both sides. When the dollar has weakened, we have tended to get more tourists in Canada and more Canadians taking their holidays in Canada rather than going abroad and vice versa. Everything that has happened in the past suggests that over this winter and next summer we will see a serious deterioration in our trade balance.
Senator Corbin: My question is to Mr. Drummond. In the conclusions in your brief, you mention the importance of trading beyond just the U.S. However, you finally conclude by saying that the U.S. market is still critical. Trading beyond the U.S. is on everyone's wish list. This has been mentioned a number of times in Canada. However, there seem to be impediments.
Are we really locked in, in terms of our trade with the U.S.? It seems, too, we cannot go beyond current trade figures with anyone else. Indeed, does anyone else want to trade with us? There is the European bloc and there are the developing situations in the old Soviet Union and in the Far East. Yet, we do not seem to be going anywhere.
What are the impediments to developing greater trade and other players in your opinion?
Mr. Drummond: The one natural impediment is the distance. Other than the United States, there are different cultural tastes and so on. That is why it is so natural that the United States dominates our trade relationships. They are similar to us. It is right there. It is obviously cheaper to export something from Ottawa to the United States than to British Columbia or Nova Scotia. That is why we get this north-south movement.
However, we have seen big change in our exchange rate and our vulnerability in dealing with the United States suggests that it is worth every effort to expand it somewhat. I do not think we will ever have more than 20 per cent of our trade outside the U.S.; however, it would be nice to get back to that 20 per cent. If you look at Ontario, 94 per cent of its trade is going to the U.S. It is unhealthy to have such a high concentration.
We keep focusing on the trade frictions with the United States. However, Europe has thrown up all kinds of trade barriers to various Canadian products, including wine and at times forestry products. We must establish a more prominent trade relationship with China. I liken this to when Mexico started growing rapidly in the early 1990s. All you ever heard from Canadians was that Mexico is a threat to Canada. No one looked at it as an opportunity. China is the same thing. We are all looking at it as a threat, but they will — albeit at a lower income level — be establishing a middle class. There is, or will certainly be, a market there.
In regard to the question of the services, there is definitely a market there for the professional services — the architects and whatnot. The real estate business in British Columbia is involved in the development of apartment buildings in China. Everyone that I have talked to has been pleased with that arrangement, pleased with the support they have had from the Canadian government, and pleased with their experience with the Canadian government. There are wins to be had there but I must admit that for your group looking at free trade agreements in a global context, it is tough sledding. It is tough enough with the United States, but it is a much harder relationship beyond.
However, the payoff is there and the work must continue on that. That is why, if I had a to make a pitch to you, I would say you should not let the current Canadian fixation on exchange rates divert your attention from the importance and the payoffs from these free trade agreements, not just with the United States but more globally.
The Chairman: It has been interesting and we have some important new evidence in our notes. I want to thank you for coming here today. Our committee is conscious of the need to diversify. We all talk about diversification. We are practical people. We know that the United States starts about 80 kilometres from here. As you said, the proximity is a huge aspect to all of this. Everyone is working to try to get things going in other countries.
Thank you very much.
The committee adjourned.