A follow-up to Prof Gordon's blog entry on Dan Trefler's op-ed. There are (at least) three traps you can fall into when analyzing the effects of changes to the Canadian-U.S. exchange rate on Canadian business. In my view the Trefler op-ed falls into at least two of the three traps. After the break I will discuss the three traps and consider the exchange rate at the industry level.
The three traps that, in my view, are easy to fall into are as follows:
- Conflating the issue of a high Canadian dollar with a rising Canadian dollar. (I plan on writing a separate piece on this in the future).
- Considering transactional exposure to the exchange rate from a gross revenue perspective rather than from a net perspective.
- Failing to realize that a rising Canadian dollar has asymmetric effects on different industry types.
If we correct for the 2nd and 3rd trap, the story becomes quite a bit different.
Most businesses operating in Canada can be thought of falling into one of four broad types:
- Resource extraction
- Manufacturing
- Non-exportable services (hairdressers, plumbers, restaurants, brick and mortal retail, etc.)
- Exportable services (the kind I discussed on Saturday)
This isn't a perfect way to divide businesses – some service companies are a combination of exportable and non-exportable. Agriculture is a bit of a hybrid between resource extraction and manufacturing. But the classification works in broad strokes.
Now consider the effects of a rising Canadian dollar on the four industry types:
1. Resource Extraction
Resources are typically priced in U.S. dollars, but use a fair amount of labour, which is priced in Canadian dollars – a currency mismatch between revenues and expenses. Ceteris paribus a rise in the Canadian dollar is a bad thing, as there is a net transactional exposure. However, the value of the Canadian dollar and currency prices are heavily positively correlated, so there is typically an increase in revenue when the Canadian dollar rises as the rise in the commodity price typically more than makes up for the rise in the Canadian dollar.
Since resource extraction companies are typically more profitable during periods of a high Canadian dollar, they have more money to invest in innovation. As well, since the U.S. dollar is lower, the price of importing new machinery and technology from the U.S. falls, which should also allow for increased innovation in this sector.
2. Manufacturing
I believe the Trefler piece is off the mark because it confuses gross and net transactional currency exposure. A manufacturing company's net currency exposure depends on what proportion of their revenues and expenses are priced in U.S. dollars. A manufacturer that gains 80% of their revenue from exporting to the U.S. will actually gain from a weaker U.S. dollar if more than 80% of their costs are denominated in U.S. dollars. It's a simple point but it's easy to overlook.
The largest Canadian dollar expense that manufacturers will have is labour. The more labour intensive a manufacturer is, the higher proportion of their costs will be in Canadian dollars, and the more harm they will face from a rising loonie. But a lot of the really labour intensive manufacturing left a long time ago to lower labour cost countries such as Mexico and China. Most of the surviving manufacturing firms are higher tech, lower labour, and thus face a low net currency exposure as long as their transactional currency exposure is well managed.
Thus it is not clear that a higher Canadian dollar is necessarily bad for Canadian manufacturing. Manufacturing has taken a big hit in the last couple of years, but it would appear to have more to due from slow U.S. demand than currency movements. As with resource extraction a higher Canadian dollar also allows for increased importing of American technology and equipment, which should increase innovation.
3. Non-exportable services
Non-exportable services have all or almost all of their revenues priced in Canadian dollars, but may have some of their expenses priced in U.S. dollars (raw material, equipment, etc.) so a rising Canadian dollar works in their favour. A rising Canadian dollar should increase innovation in this area.
4. Exportable services
I discussed this at length in Why a Dying Manufacturing Industry Leaves Canada More Vulnerable to Dutch Disease so I will not repeat the argument. We saw that companies in this sector face a rather large transactional currency exposure that does not work in their favour when the Canadian dollar rises. If the loonie keeps rising, this sector will face a great deal of difficulty and so we should expect slow (if no) job growth and innovation.
Conclusion
A rising Canadian dollar does cause Dutch Disease problems, but fortunately it is limited to one sector. While we should not expect to see a great deal of job growth or innovation in that sector if the loonie continues to rise, there is no reason we should not see innovation and job growth in resource extraction, manufacturing, and non-exportable services.
Worthwhile Canadian Initiative 
Nicely done.
Thanks! The fact I teach an entire course on this stuff helps.
Since resource extraction companies are typically more profitable during periods of a high Canadian dollar, they have more money to invest in innovation.
I’m wondering if you’re not mixing up cause with effect. Ie profitable resource extraction => higher Canadian dollar.
While we should not expect to see a great deal of job growth or innovation in that sector if the loonie continues to rise, there is no reason we should not see innovation and job growth in resource extraction, manufacturing, and non-exportable services.
Depends. Is it more economic on a micro level to just develop more resources rather than innovate?
“I’m wondering if you’re not mixing up cause with effect. Ie profitable resource extraction => higher Canadian dollar.”
I was very careful to use the term ‘correlated’ because I don’t want to imply any particular causal relationship. The statistical relationship is enough for our purposes.
“Depends. Is it more economic on a micro level to just develop more resources rather than innovate?”
You can have innovation in the resource sector – they’re not mutually exclusive.
Why are you saying that job growth and innovation go in the same direction?
Could not a company facing price pressure caused by currency shifts respond by increasing innovation? To the extent that a rising currency makes labour more expensive than capital we would expect to see innovation and investment designed to reduce the labour component of costs. Eventually this can be crushed and moving production to a lower wage environment (either move the firm or it goes out of business) happens, but it’s not a necessary outcome.
In the first case, jobs don’t grow (or are even reduced) but output stays steady or grows due to increased innovation. In the second case they are indeed both reduced.
@JVFM
Depends. Is it more economic on a micro level to just develop more resources rather than innovate?
Depends on your market position. Often the biggest players that own resource rights to a large area do just take the easy oil and move on to the next site. But, up and coming companies don’t have the resource rights, so they use other techniques. Some now-dominant companies like CNRL made their name by buying up “used” fields on the cheap and applying modern technology to extract more energy. Cenovus is also a big on innovation.
The same question could apply to manufacturing “is it more economic on a micro level to just produce more rather than innovate?” In both cases producing more using existing methods can increase the bottom line, but not the return on investment. There’s always pressure in every industry to generate more revenue with less investment, and innovation (in the long run) is the only way to do that.
You can have innovation in the resource sector – they’re not mutually exclusive.
True, but this is the typical industry argument: When profits are low (commodity prices are low) then the company can’t afford to invest.
When profits are high (commodity prices are high) there is an opportunity cost argument – “make hay when the sun shines.”
That’s why regulation , limiting rate of development, or public pressure is important in some primary industries to foster innovation. Otherwise it won’t happen.
Also a high dollar can transfer sourcing decisions – ie picking up Korean steel instead of Ontario steel – in pipe, fabricated vessels etc.
Is it not also worth noting that exchange rate fluctuations do not take place independently of domestic monetary conditions in both countries? For example, other things being equal, one might expect faster monetary growth in the depreciating country which would tend to increase the price of their products (both exports and products for domestic consumption) in the domestic currency (through inflation). Wouldn’t one also expect the cost of capital to fall with an appreciating currency?
In other words, the exchange rate is not equivalent to the terms of trade.
More fundamentally, does the concern on the part of many countries with the trade-related impacts (as opposed to monetary policy implications) of their exchange rate not stem in large part from a confusion between absolute and comparative advantage?
JvfM: “When profits are high (commodity prices are high) there is an opportunity cost argument – “make hay when the sun shines.””
You’re going to have to explain the opportunity cost argument to me – I don’t follow.
Jim: “Why are you saying that job growth and innovation go in the same direction?”
Agreed – they don’t necessarily have to.
“Could not a company facing price pressure caused by currency shifts respond by increasing innovation? To the extent that a rising currency makes labour more expensive than capital we would expect to see innovation and investment designed to reduce the labour component of costs. ”
I’m sure many do – I’d expect it’s the exception rather than the rule, but it’s an interesting empirical question.
“Is it not also worth noting that exchange rate fluctuations do not take place independently of domestic monetary conditions in both countries? For example, other things being equal, one might expect faster monetary growth in the depreciating country which would tend to increase the price of their products (both exports and products for domestic consumption) in the domestic currency (through inflation).”
U.S. and Canadian inflation rates typically don’t differ by more than a percentage point, so if there is an effect, it’s rather small. If we were talking about Canada and, say, Mexico it would matter a great deal more.
You’re going to have to explain the opportunity cost argument to me – I don’t follow.
OK. When I was first employed in the O&G industry, ages ago, I worked in reservoir engineering, where one did economic forecasts of differing development scenarios. The bottom lines were typically NPV and ROR. So, when senior management went through the budgeting exercise at the end of the yr., the manager of Reservoir Engineering would dip into his drawer of investment opportunities. The ones with the highest positive economics for the corporation would proceed, and be developed. The others delayed until economics were more favourable, or the properties were sold off.
Take someone in the primary industries (I’ll use oil sands, as not unexpected). So, going forward in say 2011. Assume I’m the CEO of a fictional “Mooninc” oil sands company. I have access to $10 billion in capital. An investment in reducing operating expenses returns me 20% ROR and $11 billion NPV. Expanding production using the same existing technology yields me 35% ROR and $20 billion NPV. I’ll go with the latter.
To go with the former, my opportunity cost would be 15% ROR and $9 billion NPV (these are all fictional numbers only for illustrative purposes, obviously).
“Take someone in the primary industries (I’ll use oil sands, as not unexpected). So, going forward in say 2011. Assume I’m the CEO of a fictional “Mooninc” oil sands company. I have access to $10 billion in capital. An investment in reducing operating expenses returns me 20% ROR and $11 billion NPV. Expanding production using the same existing technology yields me 35% ROR and $20 billion NPV. I’ll go with the latter.”
Wow. If I was a shareholder of a company that was leaving a 20% ROR and $11 billion NPV on the table, I’d be livid. But I’m sure it happens.
Wow. If I was a shareholder of a company that was leaving a 20% ROR and $11 billion NPV on the table, I’d be livid. But I’m sure it happens.
Where economists fall short. This was an either/or proposition. If all of the projects (industry wide) that had better returns progressed, inflation/cost overruns would kill the economics of this one.
“This was an either/or proposition.”
Only because you defined it as such. Though I could see situations where you clearly couldn’t do every possible profitable project, lest you become over-leveraged.
Here’s another undefined either/or proposition. Work in the oil sands projects, or feed off crime? From this week’s Macleans:
ALBERTA
Alberta followed B.C. as the province with the largest one-year drop in its CSI [Crime Score Index] score. Bucking the long-term trend in decline is the northern boom town of Fort McMurray. Alberta’s oil sands capital has grown at the same dizzying pace as its defining industry—nearly 10 per cent a year over the decade. Crime has grown in tandem. It ranked 30th of the top 100 on the CSI in 1999. It worsened to 23rd in 2004, and five years later it ranks fifth, 68 per cent above the national score.
The oil and related service industries draw a transient workforce: disproportionately foreign or displaced young men, with some Aboriginals from outlying communities and plenty of Newfoundlanders. Most have big incomes and plenty of free time. The city’s rocket-like rise in the crime indices is the classic dark-side-of-the-boom-town story.
http://www2.macleans.ca/2010/10/14/the-worst-of-the-west/2/
Yes,”over-leveraged” it seems.
Neil writes: “But, up and coming companies don’t have the resource rights, so they use other techniques. Some now-dominant companies like CNRL made their name by buying up “used” fields on the cheap and applying modern technology to extract more energy.”
I posted a reply to this earlier, but it appears to have been lost in cyberspace.
My understanding of CNRL’s early success was a strategy of cherrypicking/luring away top performers from other O&G companies, and enticing them with stock options/profit sharing/success fees. So, the upfront cost of capital declines, and your quality of decision making (and risk taking ) increases.
I notice that CNRL now has a former US ambassador to Canada on its board, to perhaps assist in its oil sands development, perhaps acknowledging its “maturity” or departure from its roots.
JVFM,
Your example works, but only because of your assumption that the returns from increasing production using conventional methods exceed those of reducing expenses or of increasing production by innovating. But is that a universal truth? Probably not. Indeed, in the Canadian oil and gas industry you see a lot of the practice of adopting new technologies to increase production as commodity prices rise, as it because profitable to exploit previously uneconomic reserves using new technologies. Arguably the rise of the offshore oil industry in the 1970s is another example of that practice. You can readily imagine a similar practice in other resource industries (developing new technologies to exploit poorer deposits or deposits that were previously unassessible).
But is that a universal truth? Probably not. Indeed, in the Canadian oil and gas industry
Well, that is the distinction that is important in looking at Canada and its recent rise of the dollar. It’s mostly energy related – and oil related in particular (maybe some mining related – forestry seems to have been in the doldrums for quite some time).
Up until say five years ago, conventional nat gas production was on the decline – hence the importance of the Mackenzie pipeline from NWT, Alaska gas, potential LNG imports. Then, as Wendy pointed out elsewhere, improvements in technology in shale gas production changed the industry I’m not sure this was a Canadian development – more likely Texas area first) That effectively killed off those other development options.
And high prices in oil will make old oil reservoirs in Alberta economic to develop using secondary (waterflood) or tertiary (CO2 miscible flood, for example). Usually, in conventional production, only 30% of OOIP (original oil in place) is recoverable using conventional pump jacks.
But, notwithstanding new economics (through higher prices), and new technologies, the volumes of non-oil sands energy is declining. So, they cannot, on their own, account for the appreciation of the $ and related “Dutch Disease” effects.
Money will flow to where the best returns can be found, and in Canada,today, this seems to be the oil sands and primary mega projects that add hundreds of thousands of barrels/day production increases. This is typically not an area that is known for its innovation. Hopefully, that changes.
Mike, this is a very good piece. I liked your method of disaggregating the various types of businesses and then proceeding to explain the effects of currency appreciation. Puts a complicated topic into perspective.
“Conflating the issue of a high Canadian dollar with a rising Canadian dollar. (I plan on writing a separate piece on this in the future).”
Look forward to this. I am fairly certain I am guilty of this all the time.
“Conflating the issue of a high Canadian dollar with a rising Canadian dollar. (I plan on writing a separate piece on this in the future).”
Yeah, perhaps you could also give some evidence as to why investments in productivity related equipment are necessarily from US based companies.
They aren’t neccesarily, but US companies do sell lots of capital equipment (being 30% of the world economy and all), and in an environment with a falling US dollar buying equipment from US companies is likely to look awfully attractive.
I’m having trouble thinking of an example of an industry where US technology is freely available to both US and Canadian companies, and a Canadian company, with a high dollar, can become more competitive than its American counterpart simply through an investment in equipment. Got one?
Considering that, by some estimates*, Canada has a 20% productivity gap with the U.S., there can be an intermediate goal than becoming more competitive than the U.S.
* Source: http://ideas.repec.org/a/sls/ipmsls/v9y20041.html
Why would I invest? On your list of four groupings – I can write off three due to a high $ (assuming commodity prices are high enough):
Resource extraction, non-exportable services, and exportable services.
Mike
Nice post. As you say, the answer depends on net currency exposures, including the hedging in place by some of these firms. To the extent that net currency exposures are reduced through hedging (whether ‘natural’ or market-based), then the rising loonie may not significantly change their profitability (abstracting from changes in the MTM value of the hedges).
As an example, Australian banks hedge a large proportion of their FX borrowing, so that they are relative immune to changes in the Aussie during the life of the hedge.
Alan