Stephen S. Poloz
Senior Vice-President and Chief Economist
May 12, 2005
Productivity Upturn Ahead *
Canadians have developed quite the inferiority complex when it comes to productivity, and no wonder. Usually when we talk about Canada 's productivity performance we use words like lacklustre or even dismal, whereas everyone knows the U.S. is experiencing a productivity miracle. How can we compete with that?
True, slow productivity growth has been a major blemish on Canada 's otherwise spotless economic record. But that is all about to change.
Conditions are ripe for a significant improvement in Canadian productivity in the next two years. These conditions have been present before, but rarely all at the same time, like now. They are four in number.
Condition number one: the global economy is in the best shape it has been in for at least eight years. Canada is very dependent on a healthy world economy for its continued prosperity. Canadian exporting companies have been struggling for years, precisely because the global economy has been staggering from one crisis to another. But it is back to full health.
EDC's country-by-country and sector-by-sector analysis of the global economy adds up to another two years of above-trend growth for 2005-06. This represents a significant upgrade from our forecast of six months ago. The world economy is still slowing down from the too-hot pace of 5% in 2004, but we are expecting growth of 4.2% this year and 4.1% next year, which is still a bit above trend. This will put a solid foundation under Canadian exports we are expecting export volumes to grow by about 3% this year and next. This is quite a bit slower than last year, but still quite positive, and the softness is actually concentrated in a few sectors.
Condition number two: Canada has good domestic economic fundamentals. Companies are seeing decent growth from both their domestic and foreign customers. Accordingly, we are forecasting growth for Canada of 2.4% this year, and 2.9% in 2006.
The expansion of 2004 allowed many companies to mop up their idle capacity, which is the first phase of a productivity upturn. Indeed, although Canada as a whole saw very little productivity growth in 2004, the manufacturing sector increased its productivity by 4.6%. They did this by increasing their capacity utilisation from 81.7% to 88.5%, which is about as high as it gets. That means that the additional growth we are forecasting for 2005-06 will require investment in new capacity, which will be newer and even more efficient moving productivity even higher.
Which brings us to condition number three: the money is available for investments in new capacity or equipment upgrades. Profitability improved significantly last year, with profits up by 40% in the manufacturing sector alone. Borrowing costs are very low, and likely to remain so.
Condition number four: the Canadian dollar is enjoying considerable global purchasing power right now, which reduces the cost of making investments. There are two dimensions to this productivity-enhancing effect of the strong dollar.
The first dimension is domestic. A lot of the machinery purchases made in Canada are imported, which means that the strong dollar is reducing the costs of these purchases. Recent surveys show that total investment intentions for 2005 are at an all-time record of $100 billion.
The second dimension of the strong dollar effect is foreign. Investing in foreign countries to take advantage of low-cost suppliers is much easier to do when the Canadian dollar is strong. This allows Canadian exporters to offer a lower price to their customers, thereby increasing sales and profits. And, outsourcing the low-productivity parts of their operations to foreign suppliers directly increases the productivity of the Canadian operation.
Canadian companies invested nearly $60 billion abroad during 2004, and we are forecasting continued high rates in the next two years. These investments are expected to boost Canadian productivity significantly.
There is substantial evidence that this is how the U.S. manufacturing sector created its productivity miracle. Today, more than half of all U.S. imports represent within-company trade by multinational companies. By globalising their operations in this way, companies can maximise specialisation and efficiency in each aspect of their business. U.S. companies went global in a big way during 1998-2002, when the U.S. dollar was very strong. Canadian companies held back, because the Canadian dollar was weak, making the cost of such investments prohibitive.
Now, the time is right to activate those plans. In most cases, these investments will be in developing countries where production costs are very low. Fortunately, the developing world is in the best shape in over eight years. They are growing rapidly, and investing heavily in new infrastructure. Political risks are still high in some areas, but for the most part they are receding.
Foreign investment capital has already returned to the developing world, after hiding for years in the U.S. Treasury market. This is why the U.S. dollar, which rose to historic highs during the series of international crises from 1997 to 2001, has come back down to more reasonable levels. That decline in the value of the U.S. dollar is symptomatic of not a loss of faith in the U.S. , but a restoration of faith in the rest of the world. Global capital markets should continue to flow well during the next two years, and Canadian companies will be participating.
Accordingly, Canadian companies are well-positioned to take advantage of a solid global economy, good domestic fundamentals, low financing costs and a strong Canadian dollar, to elevate their productivity onto a whole new level. In effect, we are suggesting that they will increasingly use international trade as a tool of supply, a tool that boosts efficiency, rather than simply as a channel for final sales.
A positive message, to be sure. And possibly at odds with what you have been hearing and feeling out in the business arena. What we are hearing is that the world economy is slowing down, that high oil prices and debt are choking economic growth, that inflation and interest rates are on the rise, and that the U.S. dollar is facing its ultimate demise. All of this sounds like big trouble for Canadian exporting companies, so it is essential that we understand the reasons behind these worrying developments, and what they might mean for us.
Let's begin with the global slowdown. True, we are in the midst of a significant slowing of global economic growth. We forecast that moderation last year, when our forecast theme was High Tide. The world economy almost always overshoots its long-term trend when it recovers from a slow patch and growth becomes synchronised across countries, as it did during 2004. Last year's 5% growth rate simply could not be sustained, without causing an outbreak of inflation and a big rise in interest rates.
So the moderation that we see happening right now is a very positive development. Of course, to an individual company, it may simply feel like business is slowing down, which is worrying. But the fact of the matter is, the most exciting part of the business cycle is behind us. From now on, growth will be slower, credit risks will be a bit higher, and companies will be downgraded. Our forecast theme last fall was Not Too Hot, Not Too Cold, which still describes what we see for 2005 quite well.
You can see signs of the slowdown almost everywhere. The U.S. economy is slowing from 4.4% growth last year to 3.5% this year, Mexico from 4.4% to 3.7%, Canada from 2.8% to 2.4%. Japan from 2.6% to 1.3%, China from 9.5% to 8.6%. The U.K. is slowing quite noticeably, continental Europe less so. Central and Eastern Europe from 7.3% to 5.6%, led by Russia . South America is slowing from 6.2% to 4.3%. In fact, the only economies that are picking up speed are in the Middle-East and Africa .
This moderation in global demand is having predictable effects on resource markets. Metals prices have begun to roll over, and we are expecting them to be lower pretty well across the board by next year. Lumber prices will ease back as well. Pulp and paper will probably continue to edge higher, though, because they are always the last prices to rise during a global commodity upturn.
Oil prices are obviously much higher than we were expecting last year. It seems that we have to accept that we have moved into a higher-price era, although it is difficult to reconcile that with the laws of supply and demand. There is certainly a risk premium embedded in today's oil prices, yet for the past two years we have been through wars, hurricanes and other disruptions without the end user ever being caught short. The system works, and we expect the risk premium to decline over time.
Furthermore, global economic growth is slowing, and the U.S. dollar is stabilising, and these together should lead oil prices to drift lower, averaging $45 this year and $38 next year. Even at these prices we expect a big increase in investment by suppliers, and expect consumers to cut back on other spending to pay for their fuel. Nevertheless, as we have seen in the past year, the fallout from higher oil prices is much lower these days than it used to be the entire world uses about one-third less oil per dollar of GDP than it did 20 years ago.
The growth we have been experiencing has mopped up a lot of excess capacity around the world, and that has the central bankers on the outlook for inflationary pressures. Interest rates are on the rise pretty generally around the world in order to pre-empt an inflationary outbreak. Given that economic growth is already moderating, there is every reason to expect this strategy to work. On top of that, the forces of globalisation continue to keep a lid on inflation in the goods sector in fact, deflationary forces are still very active in a lot of sectors.
Over the next 12 months, then, we expect the U.S. will need to raise interest rates by a further 75-100 basis points, and Canada to raise rates by less than that. Bond markets should sustain very limited damage in this environment, but we do expect some further widening of developing market interest rate spreads as economic growth settles onto a lower, sustainable path, and global capital flows do the same.
Indeed, the flow of money around the world has almost completely normalised in the past few months. Looking back at the past few years, almost every major economic event can be traced to the flow of money. Remember how the 1990s were going to be Asia 's decade? That view attracted such a flow of investment into Asia that a bubble formed, and then at the first hint of trouble the money left town, causing the 1997 Asian crisis. Same thing for Russia in 1998, then Latin America in 1999. The world economy slowed in the wake of these crises, and the main reason was that the money all flowed back into the U.S. for safekeeping. Each of these monetary waves pushed the U.S. dollar higher.
Then, during 2002 the world economy began to heal itself, and during 2003 the money all started to flow back out to the developing world. By 2004, everything was back in full swing developing market stocks were up, interest rate spreads were much lower, and of course the U.S. dollar went back down, too. During 2004 this process probably got a little carried away. But in the early months of 2005, interest rate spreads in the developing world have widened out a little, and the U.S. dollar has recovered a bit of its value, as investors find the right balance between risk and return.
Our interpretation of this is that the U.S. dollar rout, if it can be called that, is over. Risks have returned to normal, and global capital flows have returned to balance. Those who still believe that the U.S. dollar must fall are worried about the large U.S. trade deficit. However, as we have been arguing for the past year, the trade deficit that we agonise over is simply not reflective of today's reality. Today, the U.S. economy is much bigger than the one that appears inside the geographic lines on the map. At least half of the U.S. trade deficit is inside of multinational companies, who trade around the world with themselves. The traditional tools that economists use to understand international capital flows are still based on geography, but business is no longer. In our view, the U.S. trade deficit is not a danger to the world, nor to the U.S. dollar.
Which brings us to the Canadian dollar. Our dollar's decline to around 62 cents was simply the mirror image of the U.S. dollar's ascent during the crisis-ridden period. The dollar's recovery to around 75 cents during 2003 reflected the return of the world to full health. But its rise above 80 cents was essentially an overshoot, due to above-normal global economic growth, commodity prices and oil prices.
Forecasts of 90 cents or parity for the Canadian dollar are based on the assumption that the U.S. dollar must decline significantly further. Remove that assumption, and the traditional fundamentals for the Canadian dollar come to the fore. And with commodity prices easing back, oil prices likely to drift lower, and U.S. interest rates above Canadian rates, the Canadian dollar should be falling, not rising. We are expecting it to average between 77-79 cents during the next 12 months. Longer term, an improved productivity performance over a period of years could cause the Canadian dollar to drift up, but it would do so very slowly.
These are the ingredients we need to lay out a forecast for Canadian exports for the next couple of years. We are expecting export volumes to grow by about 3% in both years, not a stellar performance, but positive. That will translate into export revenue growth of 4% this year, and flat growth in 2006, because of our forecast that many of our resource exports will bring in lower prices in 2006.
Geographically, we are expecting the growth in exports to be mainly in the developing markets. Exports to the U.S. , for example, will grow by only 3% this year, while exports to the developing world will average 8-10% growth. This follows a very strong year for those developing markets in 2004. For example, our exports to China rose by over 50% in 2004, Mexico 33%, the Middle East by 33%, Russia by 25%, South America by 25% and India by 12%. This year, we are expecting double digit growth in exports to most of these regions, and we are even expecting 4% growth in our trade with Africa .
Sectorally, growth is going to be concentrated in the machinery and equipment and services sectors, because global growth is shifting from consumer spending over to investment and infrastructure spending. For example, exports of advanced technology equipment rose 8% last year, and we expect another 6% this year; telecom equipment, 11% last year followed by 7% this year. The resource sector will continue to do well, as lower prices will not begin to bite into revenues until the second half of the year. Services will also do well, with 6% growth forecast for this year, 5% next year. The soft sectors will be aerospace, consumer goods, motor vehicles, and forestry, which is mainly due to softer lumber exports.
Now, clearly there are a lot of ways in which this forecast could fall off the rails. The world is not perfect by any means. The world has taken longer to slow down than we believed last year, and this is increasing the risk that we will need a more pronounced interest rate cycle. The U.S fiscal deficit is attracting a lot of debate, and it is possible that it will contribute to a higher interest rate scenario, although we do not think so. Oil prices could shoot higher, of course. Exchange rates could be very volatile in this environment. Companies should do what they can to formulate contingency plans should any of these risks be realised.
The bottom line? The world is not perfect, but it is in the best shape it has been in several years. Our international trade is growing again, after three years of decline while the world struggled to recover. Increasingly, that growth in trade will reflect our efforts to use trade as a tool of supply, rather than simply a channel for increased sales. At EDC we call this integrative trade, because it integrates both traditional export sales and foreign investment into one business strategy, a strategy that will produce improved productivity and international competitiveness. Given the continued risky global environment, the investment decisions necessary to generate those productivity improvements will be difficult ones to make. In this, I wish you good luck.
* Export Development Canada, 151 O'Connor, Ottawa , K1A 1K3 ; email@example.com. Notes prepared for remarks during the Spring 2005 Let's Talk Exports cross-country tour. Please check against delivery. The views expressed here are those of the author, and not necessarily of Export Development Canada.