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March 1, 2013

Canadian Manufacturing

Productivity will be crucial to growth in 2013.

The Canadian manufacturing sector ended 2012 in a sluggish state, posting an annual sales decline of 2.6%. It was the worst year for Canada’s factories since the 2008–2009 recession, mostly because of what happened outside the country’s borders: the year-long concern over the U.S. presidential election and fiscal cliff, the lingering Euro crisis and China’s slowdown all contributed to Canadian businesses’ slowdown and caution.

Yet, we expect a bounce-back for Canadian manufacturing in 2013 for several reasons.

First, much of the global uncertainty has been addressed. With China’s leadership transition now over, there should be modest acceleration in Chinese economic growth through 2013. In Europe, an increasingly better balance between growth and austerity should result in the end of the EU recession this year. And, in the United States, the fiscal cliff was averted through a bipartisan deal.

Plus, U.S. export demand is expected to pick back up. Fueled by a continuing housing recovery and unleashed pent-up consumer demand, the expanding U.S. economy will provide coattails for Canadian manufacturers to ride.

 

The Problem With a Strong Dollar

There is one problem, though: the strength of the Canadian dollar, or as we call it up north, the “loonie.” The loonie has been close to parity with the U.S. dollar for some time. A strong currency is often associated with a strong economy, but for exporters it means a tough sell abroad because our goods are then relatively more expensive. 

In the short run, growth in U.S. demand will be a more dominant driver of Canadian export growth than the exchange rate. But, the exchange rate’s influence is expected to grow over time, as our U.S. trading partners look for cheaper-priced goods or more discounts.There is one problem, though: the strength of the Canadian dollar, or as we call it up north, the “loonie.” The loonie has been close to parity with the U.S. dollar for some time. A strong currency is often associated with a strong economy, but for exporters it means a tough sell abroad because our goods are then relatively more expensive.

47% of firms say the Canadian dollar’s strength is among their most pressing issues

 

A recent survey from the spring of 2012 conducted by the Canadian Manufacturing Coalition revealed 47% of firms say the Canadian dollar’s strength is among their most pressing issues, including increased competition in their primary markets and attracting or retaining workers.

At the same time, our strong currency makes imported goods more of a bargain and most of our new equipment comes from other countries. Consequently, we expect firms to increase their purchasing of machinery and equipment that will increase their productivity and hence their competitiveness.

At the same time, our labor productivity, which has been a chronic problem, has been improving, and that may help. At the end of Q3 2012, labor productivity in the Canadian manufacturing sector increased 4.2%—more than triple the 1.3% pace in the United States. The problem is that this progress has been offset by compensation costs that are also increasing faster north of the border at 4.9%, annually, compared to 2.9% in the United States. As a result, Canadian manufacturers’ unit labor costs actually increased 0.7% in the past year. Although this is still below the 1.5% U.S. rate, it emphasizes the need to maintain high productivity growth to deal with both a strong dollar and escalating wages.

 

A Smaller Segment

 

For quite a while, Canada has been trying to become less dependent on the United States for trade and economic growth. 

 

The manufacturing sector’s share of the Canadian economy fell from about 18% in 2001 to less than 13% in 2012. Of course, not all of this was due to the strengthening loonie. The global shift in manufacturing production to China and other emerging markets was also an important factor.

For quite a while, Canada has been trying to become less dependent on the United States for trade and economic growth. Our feeling is that diversifying the economy can only strengthen its resilience and flexibility. The persistently strong Canadian dollar is pushing this diversification as many Canadian manufacturers increasingly seek new customers outside the United States. Although trade diversification is a slow process, less than 73% of Canada’s merchandise exports are now U.S.-bound, down from more than 84% in 2001.

Looking ahead to 2013, the improving U.S. housing, motor vehicle and factory sectors should ripple across the border resulting in increased Canadian manufacturing activity. However, with the loonie expected to remain strong and domestic labor market pressures persisting, Canada’s manufacturers will have to continue focusing on productivity gains and other efficiencies to have a strong year.


Michael Gregory, CFA, is head of Canadian rates strategy, managing director and senior economist at BMO Capital Markets.