Canada's Real Trade Surplus Has Turned into a Deficit

The massive appreciation of the loonie has made Canadian products uncompetitive in many foreign markets, leading to ongoing layoffs in the manufacturing sector. The textile/clothing and pulp/newsprint industries have been especially hurt, as the currency pressure added to other already-existing idiosyncratic challenges. Many producers, however, dug in their heels and survived in the high-dollar environment by moving to higher value-added products, raising productivity, shifting labor-intensive production offshore, or incorporating more imported inputs in the production process. The huge discount on U.S. dollar-priced machinery and equipment, low interest rates, and strong global growth have aided this retooling process.

A Natural Hedge. Ostensibly, one weakness of Canadian exporters is their over-reliance on U.S. demand. The U.S. market accounts for more than 80% of Canadian exports, leading to an old adage, "When the U.S. sneezes, Canada catches cold." As the import content of exports has increased, however, the hit on Canada from a negative foreign demand shock has declined. To be sure, the demand for exports is adversely affected as always. But the offsetting decline in imports is now greater, since more of them are embedded in a unit of exports than before.

The increased import content has not only raised the natural hedge against external demand shocks, but also against further currency appreciation. While a given appreciation of the dollar still reduces the price competitiveness of Canadian exporters, this is now mitigated to a greater extent by the fact that the cost of U.S. dollar-priced inputs is proportionally lower.

New Vulnerabilities. The increased reliance on foreign suppliers in emerging markets, such as China and India, and the shift in the economy's composition towards domestic demand have created a new set of vulnerabilities for Canada. The management of the complex cross-border and cross-cultural supply networks at the company level is becoming an important determinant of Canada's international competitiveness. The cross-border aspect of the supply networks highlights the importance of stable government-to-government and business-to-government relationships, which can sometimes be a challenge when governments change.

The accommodative monetary policy has fostered strong growth in household balance sheets. Both debts and assets have risen relative to personal income, with the former at a slower pace than the latter. The resulting wealth effect has contributed to strong consumer spending growth. As the size of household balance sheets has increased, so has the economy's vulnerability to interest-rate movements.

While there is nothing to worry about if the Bank of Canada is aware of this heightened sensitivity to interest rates and the fixed-income market responds in a predictable fashion to adjustments in the policy rate, it could become a problem if, for some reason, financial markets became unglued. Unlikely to happen? Think again. Just as everybody has been surprised by the low long-term interest rates around the globe over the past few years, we could easily face a nasty surprise of higher-than-expected long-term interest rates sometime in the future. Potential catalysts include a meltdown in the greenback and global inflationary fears. A spike in long-term interest rates would leave Canadian consumers with long-term debt contracts more exposed than a decade ago, while possibly exerting negative pressure on the prices of such assets as real estate.

Consider Short-Term Debt. Given that foreign demand shocks and unexpected exchange-rate movements could now have a smaller influence on Canada's macroeconomic activity than before, the need for adjustments in monetary policy should be less. This implies lower volatility and uncertainty in short-term interest rates. Furthermore, if consumers are worried about a disorderly depreciation of the U.S. dollar or global inflationary pressures that have the potential to boost long-term interest rates, they could be better off by shifting their exposure from long-term to short-term interest rates. In an environment of global upward pressure on long-term interest rates, the Bank of Canada would be expected to push short-term rates that much lower to compensate for the fact that it would have little control over the far end of the yield curve.

Global Insight expects the real trade balance to decline further over the medium term, as the economy keeps adjusting to the persistently high Canadian dollar. If our forecast proves correct, the allure of short-term debt to households, governments, and businesses will increase. Domestic demand will become more sensitive to changes in monetary policy. The economy's vulnerability to foreign demand and exchange rate fluctuations will shrink further. And the dependence on, and the complexity of, global supply networks will deepen.