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Craig Alexander is vice-president of economic analysis at the C.D. Howe Institute and former chief economist at TD Bank Group.
The precipitous decline in the Canadian dollar has come as a shock to many businesses. Only a few years ago, forecasters were telling them to come to terms with a currency at par for the foreseeable future. Now, the Canadian dollar is worth close to 75 cents (U.S.) and could fall further. This is welcome news for the near-term economic outlook – the benefits to exporters will exceed the cost to importers, boosting economic growth. This demonstrates the value of Canada's flexible exchange rate regime that acts as a buffer when economic shocks occur, such as the recent tumble in commodity prices. However, there is a potential dark side to a sustained low-valued loonie, as it can erode productivity and dampen innovation, which should be a concern to policy-makers.
The experience of the 1990s and early 2000s, when the currency ultimately plunged to below 63 cents (U.S.), is insightful. The retreating loonie provided support to the domestic economy through a number of channels. It lifted international demand for Canadian exports. It raised corporate profits when export revenues were translated back into the local currency. It increased demand for domestic products relative to foreign imports that were made more expensive in Canadian dollars. However, the currency's weakness went so far and lasted so long that it reduced foreign competitive pressure on Canadian firms. And this had negative consequences.
Some economists became concerned that the perpetually low dollar was contributing to Canada's poor productivity performance. Less foreign competition allowed domestic firms to be complacent. There was strong evidence that Canadian firms invested less than their U.S. counterparts in productivity-enhancing processes and equipment. The weak currency contributed directly to this challenge, since the bulk of machinery is imported. These concerns over the dampening impact on productivity were regrettably coined as the "the lazy manufacturer hypothesis."
The hypothesis was contentious because it implied that companies were not taking actions to maximize profits. But the hypothesis had some element of truth. From 1990 to 2000, the cost of production for manufacturing in Canada (as measured by unit labour costs) expressed in U.S. dollars fell by 2.7 per cent, but a weaker exchange rate accounted for the majority of that decline. Meanwhile, production costs in Canada rose relative to those in the United States when assessed in domestic currency terms, implying that Canada became less competitive. Statistics Canada data on the entry of new firms and exit of existing firms also suggest that the low exchange rate had an impact in sheltering Canadian manufacturers from the full effect of rising global competition.
Competition is key. It is the crucible that forces businesses to change with the times and constantly innovate. Competition drives productivity. There are significant economic costs to having less productive firms protected from competition, either domestic or foreign. This is a difficult message for economists to communicate.
Productivity has a negative connotation to most Canadians. Many think that higher productivity means producing more with fewer employees or working harder, when it actually means being more efficient. The reality is that increased productivity has been the primary driver behind a rising standard of living for Canadians since the end of the Second World War.
The key issue is whether the extent and the duration of the weak currency eroded productivity by sheltering domestic firms from foreign competition. An analysis by Bank of Canada economist Ben Tomlin estimates that a 20-per-cent sustained depreciation in the real exchange rate could result in a more-than-four-percentage-point reduction in plant productivity, which is a meaningful impact.
The research does show that the impact diminishes over the long run. The profits created by being sheltered behind a weak currency eventually attract new companies to enter the market. More firms mean more competition, which drives less-productive companies out of the market or forces them to innovate. But the entrance of new companies and their impact on competition can take years, if not decades, to materialize.
How worried should Canada's next government be about the threat to productivity from today's lower dollar?
The answer is probably not unduly, but it bears monitoring, and the risks increase the lower the currency gets. The Canadian dollar has fallen by more than 25 per cent against the U.S. dollar, but it has gone from overvalued to moderately undervalued. Moreover, the decline relative to many other currencies has been less pronounced. Nevertheless, one of the most daunting challenges facing Canada at the moment is the economy's weak productivity performance, and sheltering low-productivity companies from competition is not helpful.
How should policy-makers respond? Let's start with what not to do.
Monetary policy is not the right tool. The low interest rates established by the Bank of Canada have contributed to the weak currency, but the overnight rate is set to achieve the 2-per-cent inflation target. Canada has been remarkably well served by this approach to monetary policy and any mission creep toward targeting the exchange rate would create unintended and undesirable consequences.
The more appropriate and effective response would be to introduce policies to heighten competition and stimulate stronger productivity growth. Examples of such measures include expanding bilateral and multilateral trade deals, reducing barriers to foreign competition in protected industries and eliminating domestic business subsidies. Moreover, there are a range of policies that could help to boost productivity beyond lifting competition, such as improving infrastructure, heightening incentives for applied research and development and investing in skills development.
In summary, the Canadian dollar's retreat is advantageous, as it will help lift economic growth in coming quarters. However, Canada needs to improve its productivity performance, and the extent to which low-productivity companies are sheltered behind a weak currency is not constructive. There are a range of policies Canada's next government can lean against the potential negative effects on productivity from the weak loonie. And the good news is that the most effective policies have considerable merit beyond just serving this objective. Efforts to raise productivity are ultimately about raising the well-being of Canadians.