Canadian Manufacturing in a Pressure Cooker

Many analysts justifiably point to the strong Canadian dollar, high oil prices, the U.S. slowdown—especially in housing—and restructuring by the North American Big Three automakers as the main causes of the recession. For the sake of fully understanding both the current situation and future prospects, however, it is important not to lose sight of the major underlying structural factors that are behind the painful adjustments.

China in World Trade Organization

One critical development hurting Canadian manufacturers is the acceleration of the integration of China into the global economy after China was admitted to the World Trade Organization in 2001. This opened the global floodgates for China's price competitive manufacturing exports. Initially, the Chinese specialized in labor-intensive and low-value-added products such as apparel, toys, and cheap electronics. Recently, however, higher-value-added products such as machinery and equipment have been rising as a share of China's exports. The red dragon has been building capacity in the capital-intensive steel sector and is now whetting its appetite for the global motor vehicle market. The integration of China has put a squeeze on labor-intensive manufacturing in Canada, with the clothing and textiles sector further undermined by the elimination of tariffs on exports from poor nations.

Supercharged Loonie

Another important event this decade has been the downward adjustment of the U.S. dollar due to worries about the sustainability of the fast growing American current-account deficit. The greenback fell 23% between 2001 and 2006 relative to the currencies of the United States' major trading partners and 27% relative to the Canadian dollar. This had the direct effect of pricing many Canadian manufacturers out of the U.S. market. The negative effect was supercharged by the fact that China had a fixed-exchange rate regime vis-à-vis the greenback until June 2005, with a slight pace of appreciation allowed thereafter. Not only did Canadian manufacturers lose price competitiveness with stateside businesses, they also lost ground with Chinese factories competing for the U.S. market share.

Explosive Reaction in Commodity Prices

The accelerated industrialization of China and the weakening of both the U.S. dollar and the Chinese renminbi relative to major currencies fed on each other. This further intensified the development of the resource-hungry—and resource-inefficient compared with the developed world—Chinese manufacturing. Prices of energy and metals skyrocketed in response to the surging demand and inelastic supply, creating unwelcome cost pressures for Canadian manufacturers.

More Painful Adjustments to Come

The manufacturing output and employment losses in 2006 are part of the necessary, if unfortunate, adjustment mechanism to redirect manufacturing toward profitable growth in the future. Many producers have chosen to relocate to other parts of the world, such as the United States, Mexico, or China. Many have shifted to higher-value-added products or processes. And many have invested heavily in machinery and equipment in order to boost productivity and, thereby, lower their costs to a more competitive level.

Sadly, the drive to raise productivity hit serious glitches in 2006. It is puzzling why manufacturing productivity declined last year. Apparently businesses still kept too many workers and/or invested too little in domestic operations. The tightness in the labor market and the relatively high rate of unionization may have resulted in the former, while weak profits at home may have accounted for the latter. Whatever the reason, it is fair to say we will not see a sustainable turnaround in manufacturing jobs and output until productivity starts rising again.

What Lies Ahead?

The U.S. economy will remain in slow motion during the first half of 2007, before picking up later in the year. The North American Big Three auto makers still have some restructuring to do. Combined with the current productivity problems, this means that one should not expect a sustained turnaround of factory employment and output in the early part of 2007. Global Insight expects Canadian manufacturing output to decline 1.3% in 2007 after falling 1.2% in 2006. The weakness will be broadly based, with clothing and textiles, pulp and paper, and furniture showing the largest contractions in 2006–07.

The outlook beyond 2007 is decidedly more optimistic, as Global Insight expects manufacturing output to expand 2.8% per year between 2008 and 2011. The United States will be on the cyclical upswing again. The drag from the three secular trends will lessen. While China's products will continue to present competitive threat, the renminbi is anticipated to appreciate relative to the U.S. dollar. The Canadian dollar's appreciation relative to the greenback is almost over. Commodity prices have generally reached their peak. One fly in the ointment, however, is that the forestry sector will have to contend with a lower, albeit more sustainable, level of housing starts in North America.