Thanks largely to increases in the value of oil exports, the Canadian dollar has appreciated by 40% against the USD since the beginning of 2002. So you’d think that our manufacturing sector would be getting hammered, right? After all, that’s the classic Dutch disease scenario: the high demand for natural resource exports drives up the exchange rate, which makes the manufacturing sector uncompetitive in world markets. So how is Canada’s manufacturing sector holding up these days?

Here’s a graph of manufacturing output and employment since 2000 (both series have been normalised so that the average in 2000 is equal to 100):

For the first couple of years after the CAD started to appreciate, employment and output moved pretty much together. But in mid-2004, the two series disconnected. Since May 2004, manufacturing output has increased by 5%, but employment has fallen by 8%.

What’s going on?

Firstly, there’s one thing that should be remembered when we look at the effect of the exchange rate on the competitiveness of the manufacturing sector: many of the inputs used to produce manufactured goods are imported. As the exchange rate appreciates, those production costs fall. Similarly, foreign competitors will see the costs of their imported inputs rise as their currency depreciates. These effects can go a long way in offsetting the obvious effect of exchange rate appreciation on competitiveness.

One thing you would expect to see is factor substitution. In the case of the manufacturing sector, this would mean a shift from labour towards capital. Although labour inputs are paid in Canadian dollars, a significant fraction of the capital goods used here are imported from the US. In an earlier post, I noted that expenditures on investment in machinery and equipment have been growing rapidly, and it’s been happening in the manufacturing sector as well; manufacturing M&E stock has increased by 6.9% since 2002. It turns out that this is just part of a trend that goes back at least 20 years. As the CAD appreciates against the USD, manufacturers increase their capital-labour ratios:

Of course, the obverse side of this coin is the reduction of employment in the manufacturing sector by 7% over the past two years. What about those 200,000 lost jobs?

Happily, this adjustment is occurring when the Canadian job creation happens to be quite strong. In the latest Labour Force Survey, the employment rate was 62.9% – an all-time high. So workers who’ve lost their jobs in the manufacturing sector seem to be able to find jobs elsewhere.

Of course, the next question is how well those jobs pay. A proper response to that would require the sort of micro data that I don’t have at hand, but the macro evidence does not appear to be consistent with the hypothesis that the arrival of former manufacturing workers on the labour market note has depressed wages. As noted here, real income and wages are starting to make some gains. Over the past two years, real weekly earnings in the manufacturing sector have increased by about 0.5% a year – reflecting the increased productivity generated by the increased investment spending. But in the economy as a whole, real earnings have grown at the even faster rate of 0.9%.

So although there have been employment losses in the manufacturing sector, these losses have been more than offset by gains elsewhere, and this transition has not been accompanied by reductions in real wages or output. Although the Bank of Canada will no doubt be continuing to monitor the exchange rate, they must be relieved that the effects a 40% appreciation have been – so far! – relatively benign.