CURING THE DUTCH DISEASE IN CANADA

Célestin Bimenyimana and Luc Vallée

The rapid rise in prices since 2002 has created a resource boom in western Canada and led to the rapid appreciation of the . A strong dollar, however, threatens to erode Canada’s manufacturing sector, which greatly depends on exports. This phenomenon, referred to as the Dutch disease, poses a particular policy challenge in Canada due to the country’s geography and its jurisdictional asymmetries. Whereas the need for remedies prevails, traditional solutions fail. Solutions must account for the particularity of the disease in the Canadian context.

La croissance rapide des prix des matières premières depuis 2002 a créé un boom pétrolier dans l’Ouest du pays et mené à une rapide appréciation du dollar canadien. Toutefois, un huard fort menace d’étouffer notre secteur manufacturier qui dépend largement des exportations. Ce phénomène, communément appelé « syndrome hollandais », représente tout un défi en termes de politiques publiques, en raison de la géographie du Canada et de l’asymétrie de ses juridictions. Les remèdes traditionnels n’ont pas produit les effets attendus. Or, pour être adéquates, les solutions devront tenir compte de la particularité du contexte canadien.

he term Dutch disease refers to the phenomenon tual retrenchment in the resource sector or whether compe- whereby a country’s specialization in the exploitation tition from China and other emerging nations has definitely T and export of natural resources leads to the apprecia- rendered such businesses powerless to compete in world tion of its currency and the subsequent decline of its manufac- markets, even if they were able to benefit from a weaker dol- turing sector. More specifically, a resource boom, due either to lar. In other words, is Canadian manufacturing losing low- a major discovery or to a significant increase in the price of the value-added manufacturing jobs with limited potential to resource, results in high demand for the currency of the help Canada compete on world markets? Or is the Dutch dis- resource-rich country. As its value appreciates rapidly, local ease destroying the fabric of an otherwise thriving and manufacturers find it difficult to compete both domestically dynamic manufacturing sector crushed by a quickly appreci- and abroad. The main symptom of the Dutch disease is there- ating currency and unfavourable financial conditions? fore a contraction of the manufacturing output and employ- Arguments about the existence of a classic case of Dutch ment. The phenomenon was first observed in the case of the disease in Canada notwithstanding, it remains that persist- Netherlands in the 1960s (hence the name Dutch disease) fol- ently high commodity prices have precipitated a resource lowing an important discovery of oil and gas in the North Sea. boom in western Canada and a strong appreciation of the Canada is a resource-rich country, and has traditionally Canadian dollar. This phenomenon, without a doubt aided been a major producer and exporter of oil, and by increased competition from China and other emerging a number of minerals. The concurrent resource boom in countries, is causing Dutch disease-like symptoms in the western Canada followed by the rapid appreciation of the Canadian economy, where manufacturing is undergoing Canadian dollar since 2002 and the subsequent decline in major structural changes. Whether or not Canada’s experi- the relative size of the manufacturing sector, mainly located ence exactly resembles that of the Netherlands, facts on the in and , re-ignited the debate about whether ground strongly suggest that Canada might suffer from its Canada has contracted the Dutch disease. own strain of the Dutch disease. Relevant to the debate is the issue of whether recently Making the affliction particularly acute is Canada’s closed businesses in the Canadian manufacturing sector unique geography. As the resource boom and the manufac- would have been able to take up the slack caused by an even- turing bust are occurring in different parts of the country, the

POLICY OPTIONS 75 NOVEMBER 2011 Célestin Bimenyimana and Luc Vallée

concurrent reallocation of resources because of the country’s geography, currency. The rapid increase in world and jobs from manufacturing to servic- certain regions of Canada suffer the commodity prices from 2002 to 2007, es and resources, which would normal- adverse consequences of a resource and again since 2009, has indeed has- ly occur in a small country like the boom almost immediately, not only tened both a resource boom in Canada Netherlands, largely fails to take place. once the resource boom has faltered. and the appreciation of the Canadian Normally, the more serious impacts This is because the loss of jobs in man- dollar, as can be seen in figure 1. associated with the Dutch disease would ufacturing and lower economic growth While a strong currency is a chal- be expected to occur in the future, once occur in a concentrated fashion in cer- lenge to all exports, the rapid increase in the resource boom has run its course. In tain regions of the country that are natural resource prices gave a competi- the short run, there would merely be a unable to benefit from the boom tak- tive advantage to resource exports rela- tive to that of Canada’s Arguments about the existence of a classic case of Dutch manufactured goods. Consider, disease in Canada notwithstanding, it remains that for instance, Canada’s top two export products, crude petrole- persistently high commodity prices have precipitated a um oil and motor vehicles. The resource boom in western Canada and a strong appreciation price of crude oil rose from of the Canadian dollar. US$25.9 per barrel in 2001 to US$72.3 per barrel in 2007; substitution of jobs from manufacturing ing place in a distant region, due to a during the same period, the Canadian to the booming resources and services lack of labour mobility between dollar appreciated from US$0.63 to sector. It’s only in the longer run that regions separated by thousands of kilo- US$1.03. Although the appreciation of the loss of jobs and lower GDP growth, metres and regulatory and cultural bar- the Canadian dollar diluted the actual oil which would follow an eventual riers. The unfortunate nature of the price upsurge in $C terms, the price still unavoidable retrenchment of the disease in Canada thus poses particular increased from $C43 per barrel to $C70 resource boom, would be aggravated as challenges to both monetary and fiscal per barrel. On the other hand, according an atrophied manufacturing sector policies. to data from the International Trade would fail to fill the void left by the The initial problem with the Center, the unit value of Canada’s car weakening resource sector. Dutch disease is that massive exploita- exports also rose in US$ terms from tion and export of natural resources US$16,405 in 2001 to US$18,748 in n Canada, these long-term effects erodes the competitiveness of the man- 2007. In Canadian dollars, however, this I are a concern. For example, the ufacturing sector through the apprecia- translates into a substantial decline from heavily concentrated resources-based tion of the exchange rate. $26,039 to $18,201. economy of may dispropor- Foreign-exchange earnings of a It should therefore be no surprise tionately suffer from an eventual end resource-rich country increase rapidly that, over the 2001-2007 period, the of the resources boom — and it did, to as a result of rising resource export rev- value of Canada’s crude oil exports a certain extent, in 2008 and 2009. Yet, enues, leading to the appreciation of its increased from $16 billion to $41.8 bil-

FIGURE 1. COMMODITY PRICES AND THE CANADIAN DOLLAR EXCHANGE RATE, 2000-09

WTI crude oil spot price IMF World commodity price indices Canadian Dollar Effective Exchange Rate Index (CERI) 100 300 130 All index Metals index 250 Energy index 80 120

200 110 el 60 arr b r 150 100

40 1992=100 2005 = 100 US$ pe 100 90

20 50 80

0 0 70 1999 2001 2003 2005 2007 2009 1999 2001 2003 2005 2007 2009 Dec 00 Dec 02 Dec 04 Dec 06 Dec 08

Sources: Energy Information Administration; International Financial Statistics (IFS) IMF; , CANSIM Table 176-0064. WTI = West Texas Instruments

76 OPTIONS POLITIQUES NOVEMBRE 2011 Curing the Dutch disease in Canada lion, whereas revenues from motor vehi- Canada (Quebec and Ontario). In Asian countries grew at annual rates cles’ exports declined from $41 billion to 2009, the manufacturing sector repre- above 6 percent for the past decade. $32.6 billion. And, accordingly, crude oil sented about 15 percent of total GDP As a result, fast-growing Asian replaced motor vehicles as Canada’s top and 84 percent of total exports in cen- infrastructure, industries and house- export product in 2006 (see figure 2). tral Canada, against 7.8 percent and 28 hold consumption help drain energy Rising oil prices ensured output percent respectively in Alberta. The and natural resources, as data from the and employment growth in the petro- mining and oil and gas extraction US Energy Information Agency suggest. leum industry. In contrast, given the industry, on the other hand, account- For instance, between 2005 and 2007, rapidly appreciating Canadian dollar, ed for 19 percent of GDP in Alberta China and India accounted for more most manufacturing firms have had to and 67 percent of total exports, but than 60 percent of the rise in world oil consumption. The initial problem with the Dutch disease is that massive exploitation and export of natural resources erodes the parked by increasing S demand from emerging competitiveness of the manufacturing sector through the economies, global demand appreciation of the exchange rate. for raw materials continues to grow rapidly and to push improve productivity substantially only 0.4 percent and 7 percent of total prices upward. Hence, after losing and reduce production costs in a short GDP and exports respectively in cen- momentum during the 2008-2009 time frame to compensate for their tral Canada. recession, commodity prices and the loss of competiveness. For many, these With such contrasting realities, Canadian dollar have surged again in efforts were not sufficient to remain when the price of raw materials rises the recent recovery. The world oil price competitive, while others did not have quickly, especially in the case of oil, is holding its ground around $100 per the resources to engineer the necessary Alberta experiences a resource boom barrel, and at US$1.03 in early May productivity enhancements. driving the appreciation of the 2011, the value of the Canadian dollar The effects of higher raw materials Canadian dollar, which, in turn, hurts was back to its November 2007 level, prices and of a stronger Canadian dol- the economies of Quebec and Ontario. which it surpassed at US$1.06 in July. lar on various sectors of the economy Between 2001 and 2007, the Manufacturing, however, has not are a particular concern for regional Canadian dollar appreciated strongly. fully recovered. In fact, it continues wealth distribution. In Canada, 95 per- During this period, manufacturing out- losing ground. Canada’s manufactur- cent of oil reserves are located in put fell by 1 percent in Quebec while ing output decreased by 12.6 percent Alberta, whereas 75 percent of manu- employment dropped by 2.3 percent between the second quarter of 2007 facturing output is produced in central (annualized rates). Similarly, in (recent peak) and the first quarter of Ontario, manufacturing output fell by 2011. Despite manufacturing GDP FIGURE 2. CANADA’S TOP TWO EXPORT 0.5 percent and employment decreased growth since the second half of 2009, PRODUCTS (2001-2010) by 2.4 percent over the same period. In albeit at small rates, the sector’s share contrast, all sectors of the economy of total GDP has remained below 13 70 experienced growth in output and percent for the past two years. From employment in Alberta (see table 1). 2009 to 2010, manufacturing employ- 60 Most economists agree that the ment decreased by 2.1 percent, even as

50 2001-2007 rise in commodity prices, total employment grew by 1.4 percent. which led to the appreciation of the It is therefore increasingly relevant t C$ n e 40 Canadian dollar, stems from the rapid for policy-makers to seriously consider urr growth of emerging Asian economies. various policy options to address the 30 s of c According to IMF statistics, developing adverse consequences of the appreciat- n

Billio 20 TABLE 1. REAL GDP GROWTH, BY SECTOR, ANNUALIZED RATE, 2001-07 (PERCENT) 10 Quebec Ontario Alberta Canada 0 2001 2003 2005 2007 2009 Manufacturing -1.0 -0.5 3.8 0.0 Crude oils and oils obtained Natural resources 1.2 1.0 1.7 2.1 from bituminous minerals Services & construction 2.9 3.1 5.4 3.3 Motor vehicles – spark ignition – All industries 2.0 2.3 4.0 2.7 cylinder capacity more than 3000 cc Source: Statistics Canada, CANSIM Table 379-0028, ISQ, Banque des Données des Statistiques Officielles sur Source: Industry Canada, Trade Data Online (TDO). le Québec.

POLICY OPTIONS 77 NOVEMBER 2011 Célestin Bimenyimana and Luc Vallée

ing dollar on Canadian manufactur- agenda. According to Alberta’s limited East-West labour mobility due ing. There may be a need to adopt Department of , the province both to the distance and incompatible measures aimed at mitigating certain created a resource fund in 1976, the provincial regulations as well as cul- undesirable effects of the disease Alberta Heritage Savings Trust Fund, tural and language barriers, especially before it significantly and permanent- with the goal “to save for the in the case of Quebec for the latter. ly damages the health of the national future,...strengthen or diversify the The resulting inflation asymmetry economy and strengthens political economy, and…improve the quality of across the two regions is thus a partic- polarization between regions. life of Albertans.” From 1976 to 1986, ular challenge for the conduct of mon- up to 30 percent of the province’s oil etary policy. here are various policy precedents and gas revenues went to the fund but Under its current policy, the Bank of T for dealing with the Dutch dis- contributions ceased in 1987. Moreover, Canada raises or lowers the key overnight ease, but Canada’s unique geography currently, the province does not have interest rate to keep the rate of inflation and jurisdictional context pose a par- any policy aimed at redirecting resource inside its target range of 1 to 3 percent. By ticular challenge to their implementa- revenues toward foreign assets. “keeping inflation low, stable and pre- dictable,” the The effects of higher raw materials prices and of a stronger indicates that it seeks to pro- Canadian dollar on various sectors of the economy are a vide “a climate that is more particular concern for regional wealth distribution. In Canada, favourable to sound, sus- tained economic growth and 95 percent of oil reserves are located in Alberta, whereas 75 job creation.” Over the last percent of manufacturing output is produced in central decade, inflation as measured Canada (Quebec and Ontario). by total Consumer Price Index (CPI) for Quebec and tion. Norway, for instance, uses oil Rather, the province has increased Ontario has been closer to Canada’s core revenues to pay its foreign debt and its spending on infrastructure and CPI. Conversely, total inflation has been has established a petroleum fund, other programs. Such spending has running high in Alberta (see figure 3). which is mainly invested abroad. By created a boom in the housing and From 2005 to 2008, the average annual investing resource revenues in foreign services sectors, putting pressures on unemployment rate remained below 4 assets and thereby avoiding huge consumer prices and wages. This has percent in Alberta but above 6 percent in increases in domestic public spending, led to tight labour conditions and Ontario, Quebec and for Canada as a Norway is able to reduce the inflow of high inflation in western Canada, whole. The situation prevails in 2011. foreign exchange and curb the appre- even as unemployment remains high From February to April, the unemploy- ciation of its currency; it also avoids in central provinces. This labour mar- ment rate in the (Alberta, the state from becoming omnipresent ket dichotomy is in part the result of and ) was below in the domestic economy. However, in Canada, the possibili- FIGURE 3. COMMODITY PRICES AND THE CANADIAN DOLLAR EXCHANGE RATE, ty of implementing such a policy is 2000-09 limited by the fact that the manage- ment of resource revenues falls under Unemployment rate Consumer price index (core CPI) 10 125 provincial jurisdictions. This means that Canada depends on the willing- 9 120 ness of the province of Alberta, which manages 95 percent of Canada’s oil, to 8 115 implement such a policy. However,

t 7 110 addressing the appreciation of the n ce Canadian dollar and its consequences r Pe 6 105 on the national economy, particularly 2002 = 100 in central Canada, is not a priority of 5 100 Alberta. Moreover, Alberta’s manufac- turing industry is heavily tied to the 4 95 fate and activities of its resource sector. 3 90 In other words, the short-term con- 2000 2002 2004 2006 2008 2000 2002 2004 2006 2008 sequences of the Dutch disease are of no Quebec Alberta Quebec Alberta immediate concerns to the province of Ontario Canada Ontrario Canada Alberta and its economic development Source: Statistics Canada, CANSIM tables 282-0008 and 326-0021.

78 OPTIONS POLITIQUES NOVEMBRE 2011 Curing the Dutch disease in Canada

6 percent, but remained above 7.5 per- centages than it did during the 1976- strongly suggests that it is desirable to cent in Ontario and Quebec. 1987 period. The province could also try maintaining a competitive manu- Given the different inflation levels strive to avoid huge increases in pub- facturing industry. However, in the across the two regions, any change — or lic spending other than those particular case of Canada, the pains of no change for that matter — in the Bank required to accommodate population a resource boom — that would nor- of Canada’s overnight rate will tend to growth. This would not only reduce mally be felt only following the end of benefit one region at the expense of inflationary pressures but also allow the boom — are instead experienced another. In its April 2011 Monetary Policy the province to save for the future. In early in other regions of the country as Summary Report, the Bank recognized addition, it would help mitigate the the resource boom is occurring. “upside risks to inflation in Canada” negative effects of the Dutch disease due to “higher-than-projected commod- on Canada’s manufacturing sector. o redress the situation, T the federal and provin- As a result, fast-growing Asian infrastructure, industries and cial governments could adopt household consumption help drain energy and natural resources, strong competitiveness meas- ures through more aggressive as data from the US Energy Information Agency suggest. For R&D investment subsidies instance, between 2005 and 2007, China and India accounted and tax credits. Such meas- for more than 60 percent of the rise in world oil consumption. ures would allow manufac- turing firms to acquire and ity prices and global inflation, and Given the evident decrease in develop more efficient production tech- increased momentum in Canadian manufacturing employment, one nologies in order to remain competitive household spending” as well as “down- pressing need is to provide new job amidst conditions of a strong dollar. side risks to inflation” relating to “head- opportunities for manufacturing work- Government should also encour- winds from the persistent strength in ers. The OECD, for instance, in its age organizational innovation that the Canadian dollar and the possibility 2008 Canada Survey recommends har- would embolden firms to focus on that growth in household spending monization of employment insurance their core competitive advantages and could be weaker than projected.” The between low- and high- unemploy- to abandon unprofitable activities that Bank thus estimated that the risks were ment regions and removing barriers to would otherwise fall prey to lower-cost balanced over the projection horizon interprovincial trade, “especially those producers in emerging economies. and, therefore, maintained the target for that hinder mutual recognition of pro- This may mean that specializing in the overnight rate at 1 percent. fessional credentials (notably in the services to manufacturing industries that This situation maintains favourable building trades).” Increased East-West are booming in emerging markets may credit conditions for central Canada’s labour mobility can reduce unemploy- offer an attractive entry point in the manufacturing firms struggling with a ment and inflation asymmetry across global value chain. Moreover, such spe- strong and appreciating dollar, but it the two regions and facilitate the con- cialized value-added manufacturing also encourages spending everywhere duct of the monetary policy. activities usually are less capital-inten- in the country and thus contributes to Another way to enhance labour sive and are often much less vulnerable increasing inflationary pressures in the mobility is to provide training to low- to competition from emerging nations booming Albertan economy. Yet, had skilled workers losing jobs in the manu- as they require skilled labour. the Bank of Canada focused on pre- facturing industry, in order to help them In Canada, the growth of such com- venting excesses from building in find new jobs in the high-skilled services petitive manufacturing activities would Alberta rather than combating the sector. Alternatively, or in parallel, the not only reduce the East-West economic effects of the Dutch disease in Ontario development of the resource sector in tra- growth divide and wealth disparities, it and Quebec, it would have raised rates. ditional manufacturing regions can cre- would also ensure that, years down the ate new, alternative jobs. This would also road, when the oil boom is over, Canada he more acute challenges posed help diversify Quebec’s and Ontario’s remains competitive in sectors that cater T by the Dutch disease in the economies and provide these provinces to the manufacturing industry. Canadian context make it even more with alternative sources of needed fiscal important to try to find cures. Possible revenues. With a wider tax base, provin- Célestin Bimenyimana is an analyst solutions, however, would likely cial governments would be able to afford and Luc Vallée is chief economist at require the participation of the differ- reducing the tax burden of manufactur- Canada Economic Development (CED). ent levels of governments. ing firms, helping them to improve their The opinions expressed here remain Alberta, for instance, could competitiveness on global markets. solely their own. They thank Diego resume saving resource revenues in its As mentioned earlier, the reality Dubé, Jean Laneville and David Luchuk Heritage Fund and in even larger per- that resource booms don’t last forever for comments.

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