Exports represent about 43 per cent of the Canadian economy today, versus 25 per cent in 1990. That makes us seemingly more vulnerable to an overshooting Canadian dollar – but the situation is not so simple.
Imports have risen almost as much as exports as a share of the economy since 1990. This is because Canadian companies increasingly are incorporating foreign companies into their supply chains in order to boost profit margins. A side effect is that they must do international trade before they even have a completed product, and then trade again to get the product to their customers.
Another benefit of this globalization process is that exchange rate movements are increasingly a two-edged sword. Yes, a higher Canadian dollar means a Canadian exporter receives fewer Canadian dollars for each U.S. dollar sale. But their imported components cost less at the same time. Failing to take account of those supply-chain relationships can lead to erroneous conclusions as to which sectors of the economy will be hit hardest by a rising dollar.
Consider a pure resource exporter, whose costs are all in Canadian dollars and whose price is dictated, in U.S. dollars, by global market conditions. All other things equal, a 10-per-cent rise in the dollar reduces that exporter’s profit margin by 10 per cent, a major hit. But contrast that with a manufacturer that sources 35 per cent of its inputs abroad. In that case, the rising dollar clips revenue, but reduces costs at the same time, for a much smaller net effect.
What this means is that the first negative impact of a stronger dollar is borne by those sectors with low imported content. This is especially true for the service sector, such as tourism and business services (such as engineering or consulting services), and much of the resource sector. But as we move up the manufacturing scale, we find chemical and fabricated metal products with foreign content above 30 per cent; textiles, clothing, industrial machinery, telecommunications and electrical equipment above 35 per cent; and computer equipment on the order of 60-per-cent foreign content.
Motor vehicles have 63-per-cent imported content, with auto parts at 38 per cent.
Accordingly, the sectors most exposed to an overshoot of the Canadian dollar are those with low imported content and narrow profit margins, such as the service sector. The resource sector does as well, but it also faces the prospect of rising international prices for its product, which will help restore profit margins as the world economic recovery unfolds. In contrast, the manufacturing sector has almost no pricing power.
With an average profit margin in late 2002 of 6.8 per cent, the manufacturing sector has some ability to squeeze margins. However, those profits are concentrated in the beverage and tobacco, energy, minerals and machinery sectors. Those manufacturing sectors with below-average profit levels and relatively low import content – and therefore the most exposed – include processed foods, wood and paper, furniture, electrical appliances and clothing.
The situation is ripe for an overshoot of the Canadian dollar, which could slow Canada’s export and GDP growth. Longer term, a stronger Canadian dollar will promote increased investment and more outsourcing of low-value component manufacturing.
(Stephen Poloz is vice-president and chief economist for Export Development Canada. He can be reached at spoloz@edc.ca)
