Mark Carney: Dutch disease
Remarks by Mr Mark Carney, Governor of the Bank of Canada and Chairman of the
Financial Stability Board, to the Spruce Meadows Round Table, Calgary, Alberta,
7 September 2012.
* * *
Introduction
Some regard Canada's wealth of natural resources as a blessing. Others see it as a curse.
The latter look at the global commodity boom and make the grim diagnosis for Canada of
"Dutch Disease."1 They dismiss the enormous benefits, including higher incomes and greater
economic security, our bountiful natural resources can provide.
Their argument goes as follows: record-high commodity prices have led to an appreciation of
Canada's exchange rate, which, in turn, is crowding out trade-sensitive sectors, particularly
manufacturing. The disease is the notion that an ephemeral boom in one sector causes
permanent losses in others, in a dynamic that is net harmful for the Canadian economy.
While the tidiness of the argument is appealing and making commodities the scapegoat is
tempting, the diagnosis is overly simplistic and, in the end, wrong. Canada's economy is
much more diverse and much better integrated than the Dutch Disease caricature.
Numerous factors influence our currency and, most fundamentally, higher commodity prices
are unambiguously good for Canada.
That is not to trivialise the difficult structural adjustments that higher commodity prices can
laissez-faire
bring. Nor is it to suggest a purely response. Policy can help to minimise
adjustment costs and maximise the benefits that arise from commodity booms, but like any
treatment, it is more likely to be successful if the original diagnosis is correct.
The global outlook
The global economy is experiencing a broad-based deceleration from an already modest
pace.
A new normal for the United States
The U.S. recovery is following the same dreary path of other advanced economies that have
experienced financial crises. GDP growth has averaged just 2.2 per cent since the trough in
2009. Indeed, it is only with justified comparisons to the Great Depression that the success of
the U.S. policy response is apparent.
The only good news is that some progress on repairing balance sheets is being made.
U.S. banks have substantially increased their capital (common equity to total assets is up by
more than 25 per cent). American households have recovered more than two-thirds of the
$16 trillion fall in their net worth in the aftermath of the crisis, though we estimate that it will
take several more years for households to make up the balance.
Despite this, total debt in America has barely fallen from its peak of 250 per cent of GDP - a
level last seen in the Great Depression. This is because U.S. government debt has increased
$4 for every $1 reduction of household debt. Such treading water will persist for some time
since private domestic demand is still not sufficiently robust to outweigh an aggressive fiscal
tightening.
Bottom line, with less capital investment and more structural unemployment, the Bank
estimates that the U.S. economy will remain over $1 trillion smaller in 2015 than we had
projected prior to the crisis (Chart 1).
Even in this room, that is a big number.
An existential crisis in Europe
Europe is stagnating with GDP still 2 per cent below its pre-crisis peak and private domestic
demand a stunning 6 per cent below. A tough combination of fiscal austerity and structural
adjustment will mean falling wages, high unemployment and tight credit conditions. As a
consequence, Europe is unlikely to return to its pre-crisis level of GDP until a full seven years
after the start of its last recession.
Given ties of trade, finance and confidence, the rest of the world is feeling the effects.
Europe's contraction is driving banking losses and fiscal shortfalls. But these challenges are
merely symptoms of an underlying sickness: a balance of payments crisis.
To repay the creditors in the core, the debtors of the periphery must regain competitiveness.
This will be neither easy nor quick.
The burden cannot solely be on increasing unemployment and reducing wages in countries
like Spain. An increase in German wages (and inflation) would ease the transition, especially
if the structural reforms now under way across the deficit countries actually boost
productivity.
Important measures have been announced over the summer to begin to restore the single
financial market, break the toxic links between banks and sovereigns and, potentially, help
ensure that all euro-area countries can finance at more sustainable rates.
All of these measures need to be fully implemented, not just announced. In that regard, the
Bank very much welcomes yesterday's announcement by the European Central Bank (ECB)
of significant new measures to address convertibility risk and improve the transmission of
monetary policy. However, it will take some time to restore market confidence, and it will take
years for fiscal and structural adjustments to work. Moreover, the discussions over the
federal institutions that may be ultimately required to support a durable monetary union are
still in their infancy.
Emerging-market economies
In China and other emerging economies, the deceleration in growth in recent months has
been greater than anticipated, reflecting past policy tightening, weaker external demand and
the challenges of rebalancing to domestic sources of growth.
Real GDP in China grew 7.6 per cent in the second quarter - the slowest pace in three
years. Recent data suggest continued softening in this quarter.
In part, this reflects a welcome policy-induced slowdown from the increasingly unsustainable
rates of growth in recent years. With large vulnerabilities building in the housing sector,
evidence of overinvestment increasing, and inflation above target, Chinese policy-makers
appropriately responded by tightening monetary and macroprudential policies.
Less anticipated has been the extent to which weaker external demand, especially from
Europe, has weighed on export growth.
More recently, in light of slowing growth and moderating price pressures, the People's Bank
of China has eased monetary policy and the fiscal stance has been relaxed. In both regards,
authorities retain considerable additional policy flexibility. The Bank of Canada expects
Chinese growth to average about 7.5 per cent over the next few years, materially below the
unsustainable double digit rates seen since the trough of the crisis.
The diagnosis
Why we expect commodity prices to remain elevated
Given the strains on global growth, commodity prices have fallen 13 per cent since their peak
in April of last year and can be expected to remain volatile.
Nonetheless, prices are still about 25 per cent above their longer-term averages in real
terms.
In fact, real prices for energy and metals have been well above their long-term averages for
more than 7 years, and real food prices are now at their highest level in 35 years (Chart 2).
Throughout the current, decade-long boom, the scale of price increases has been higher,
and the range of affected commodities broader, than in previous upturns. Since 2002, prices
for metals and grains have more than doubled, while crude oil prices almost quadrupled.
The question is whether such strength will persist.
The Bank's view is that a large, sustained increase in demand is the primary driver of
elevated prices. The breadth and durability of the commodity rally underscore this
conclusion.
Rapid urbanisation underpins this growth. Since 1990, the number of people living in cities in
China and India has risen by roughly 500 million, the equivalent of housing the entire
population of Canada every 18 months (Chart 3). Despite the current, sharp cyclical
slowdowns in China and India, this secular process can be expected to continue for decades.
So, even though history teaches that all booms are finite, with convergence to Western levels
of consumption still a long way off, the demand for commodities can be expected to remain
robust and prices elevated.
In Canada, the impact of rising commodity prices has been reinforced by strong growth in the
supply of some commodities. Oil is now our most important commodity by value (Chart 4),
with its share rising over the past 15 years from 18 per cent to 46 per cent of total Canadian
commodity production.
The declining importance of manufacturing
Coinciding with this period of elevated commodity prices, the share of the manufacturing
sector in Canadian GDP has declined since the turn of the century from 18 per cent to
around 11 per cent.
For the promoters of Dutch Disease, this is the "a-ha" fact, with the coincidental relationship
described as causal. With a broader view, however, it is evident that the decline in
manufacturing is only partially in response to the rising exchange rate and, in fact, is part of a
broad, secular trend across the advanced world (Chart 5). Major forces of globalisation and
technological change have dispersed manufacturing activity across borders, increasingly
concentrating the highest value-added stages of production in advanced economies.
In 1970, Canada's manufacturing-to-GDP ratio was 6 percentage points below the average
of members of the Organisation for Economic Co-operation and Development (OECD).
Today, it is 3 percentage points behind. Likewise, the share of jobs in manufacturing has
declined, but not as steeply as it has in our commodity-importing neighbour to the south
(Chart 6). Although the adjustment has been difficult, it has occurred over a longer period of
time than the boom in commodity prices and, in general, Canada has not lost ground relative
to other advanced economies.
What drives the currency?
The coincident strength of commodity prices and the Canadian dollar in recent years has
been treated by some as prima facie evidence of Dutch Disease in Canada. But this
diagnosis ignores the fact that the Canadian dollar is influenced by a diverse set of factors.
Commodity prices do play a role. Canada is a net exporter of commodities while our main
trading partner, the United States, is a net importer. This causes our respective terms of
trade to move in opposite directions in response to commodity-price changes. As a result,
the Canada-U.S. exchange rate tends to appreciate when global commodity prices rise
(Chart 7).2
But this is just the beginning of the story, accounting for about one-half of the appreciation of
our currency over the past decade. Other factors also play important roles.
Since 2002, the U.S. dollar has depreciated against many currencies, including those of both
commodity exporters and importers. The Canadian dollar has appreciated against the
U.S. dollar by an amount similar to that of the currencies of two major commodity importers,
Japan and the euro area (Chart 8).
Overall, the Bank estimates that about 40 per cent of the appreciation of the Canadian dollar
since 2002 is due to the multilateral depreciation of the U.S. dollar.
The balance of the appreciation reflects forces other than U.S.-dollar weakness and
commodity prices. In particular, a variety of attributes make Canada an attractive investment
destination, including our sound public finances, resilient financial system, and credible
monetary policy.
These strengths limit the downside risk associated with Canadian assets, making Canada a
rare safe haven in a risky world.
This status is reflected in the behaviour of Canadian 10-year yields, which tend to decline at
the same time as risky assets such as global equity prices. This correlation suggests that
money flows into Canadian bonds in response to increases in perceived risk. Indeed, by this
measure, Canada's safe-haven status is second only to the United States and the United
Kingdom (Chart 9). This was not always the case. During the Great Moderation, this
correlation was essentially zero (Chart 10).
How commodity revenues affect our economy
The symptoms we are seeing are not those of Dutch Disease but rather of structural changes
in the global economy to which Canada must adjust. Although these changes create
pressure, their overall impact is positive.
Analysis using the Bank of Canada's main projection model - the Terms-of-Trade Economic
Model (ToTEM) - illustrates how different types of shocks to the supply and demand for
commodities impact the Canadian economy.3
Regardless of the cause of a commodity-price increase, Canada's improved terms of trade
cause income, wealth and GDP to rise In all cases, the Canadian dollar
(Chart 11).
appreciates, but its adverse impact on our non-commodity exports is partially offset by the
fact that a stronger currency reduces the cost of productivity-enhancing machinery and
equipment and imported inputs to production.
Consider three different cases that cause energy prices to rise 20 per cent, or roughly the
increase that occurred between mid-2010 and 2011.
When the source of the commodity-price increase is stronger U.S. demand,4 the impact on
Canadian GDP is greatest: just over a 3 per cent increase after five years, equivalent to
about $57 billion. This is because the improvement in Canada's terms of trade is strongly
reinforced by greater demand for our non-commodity exports. In fact, this additional demand
more than offsets the competitiveness losses in manufacturing and services stemming from
higher wages, higher resource prices and a stronger dollar.
This scenario is the commodity cycle as we used to know it. It is fast becoming a historical
artefact.
When, as is now the case, stronger demand from emerging Asia is the cause of the rise in
energy prices, the net increase in GDP is about 1 per cent after five years, or one-third of the
impact of the U.S. demand shock. This more muted response is because Canada has
relatively little direct exposure to these export markets. Therefore, there is less additional
demand to offset the competitiveness effects.
Finally, an increase in commodity prices driven by a transitory reduction in commodity supply
generates the smallest GDP benefits, about 0.2 per cent in the first year. In this case, the
adverse impact of the appreciation is reinforced by the decline in economic activity in the rest
of the world caused by the supply disruption.
The run-up in oil prices in the past few weeks is an example of a commodity shock that
provides only marginal benefit to Canada.
In all three cases, the impact of increased economic activity in Canada on underlying inflation
is largely offset by an appreciation of our exchange rate. This helps limit the direct impact of
higher commodity prices on the prices all Canadians pay for food, gas and other
commodity-intensive goods.
When commodity prices increase, revenues from the resource sector spread through the
Canadian economy via three channels: fiscal redistribution, especially by the federal
government; personal wealth increases, through income and ownership of stock; and
interprovincial trade.
It is important to recognise that, for almost all the provinces, trade inside Canada has grown
fast enough to offset a significant portion of the declines in international trade. Central
Canada, for instance, suffered a real decline in international exports of $18 billion between
2002 and 2008, which was almost entirely offset by increases in interprovincial exports of
$16 billion.
Some of this reflects increased sales to Western Canada from Central Canadian machinery
makers, primary metal producers, and chemical companies.
Much of the gains in interprovincial trade volumes were in services rather than goods, which
was where most of the declines in international exports occurred. Well-paid services, such as
professional, mining, and financial services, play a significant role in increased trade between
Central Canada and Alberta (Charts 12 and 13).
Improving Canada's economic health
Recognising that higher commodity prices are good for the Canadian economy does not
mean that policy has no role. The first objective of policy, of course, should be to do no harm.
This brings me to the exchange rate.
Should the bank lean against the exchange rate?
Some have argued that the Bank of Canada could improve welfare by leaning against
commodity-driven movements in the nominal exchange rate.
It is important to remember that with changes in the terms of trade, adjustments will follow. It
is only a question of how. Our floating exchange rate helps to achieve the appropriate
adjustments without forcing very difficult changes in the overall levels of wages, output and
prices.
We can use ToTEM to simulate the effect of the Bank leaning against a commodity-driven
exchange rate appreciation through a reduction to the policy rate. In the short run, stabilising
the nominal exchange rate helps to support non-commodity exports as well as Canadian
producers who face competition from imports. But, ultimately, this effort is futile. Over time,
wages and inflation rise, causing the real exchange rate to appreciate. Non-resource
exporters are faced with the same competitiveness challenges as they are today.
Moreover, this leads to a sustained period of above-target inflation, which begins to unhinge
inflation expectations. Monetary policy eventually has to tighten aggressively to restore price
stability. The cost of this misadventure is lower output of about 1 per cent and higher volatility
in inflation, output and employment than when the exchange rate is allowed to do its work
The outcome could be even worse if the Bank cannot quickly re-establish its
(Chart 14).
credibility after betraying earlier commitments to Canadians.
So, in general, the Bank does not intervene, except in exceptional circumstances, such as if
there were signs of a serious near-term market breakdown or if extreme currency
movements seriously threatened the conditions that support sustainable long-term growth of
the Canadian economy.5
The Bank does take the exchange rate into account in setting policy. The persistent strength
of the Canadian dollar has been one of the reasons why monetary policy has been
exceptionally accommodative for so long.
Improve our exposure to countries driving the commodity cycle
Economic activity in our major trading partners - particularly the United States - is no longer
the main driver of commodity demand growth.
Research at the Bank and elsewhere suggests that, while oil and metals prices have
historically moved with the business cycle in the advanced world, this relationship has broken
down over the past decade. In particular, industrial activity in emerging Asia now appears to
be the dominant driver of oil-price movements (Chart 15).6
Our reliance on the United States, which still takes nine times as many of Canada's exports
as fast-growing emerging-market economies, is an issue only if we expect U.S.
underperformance relative to both history and the rest of the world to continue. Unfortunately,
that is what we must expect for some time, as the United States goes through a difficult
adjustment process.
In this context, the only way to recover the beneficial correlation between commodity prices
and demand for Canadian manufacturing exports is to diversify our export markets toward
fast-growing emerging markets. That is one of the many reasons why Canada is pursuing an
aggressive, emerging-market-focused trade strategy.
Capture more value added in Canada
Our challenge is to develop our commodities intelligently and sustainably. Eastern Canadian
consumers are importing oil and paying the global price, at an average $35 premium to the
price received by Western heavy oil producers over the past year. New energy
infrastructure-pipelines and refineries could bring more of the benefits of the commodity
boom to more of the country.
Other new markets can be found at home. For example, as of November 2011, 255 Ontario
firms were suppliers to the Canadian oil sands.7 As well, Ontario's exports of mining-related
services to Alberta grew 44 per cent in the last year measured. Capturing more of the value
added in commodity production, from energy to agriculture, remains a tremendous
opportunity for all of Canada.
We should also recognise that, in an era of high resource prices, better operating efficiency,
improved resource management and products with a more sustainable environmental
footprint make commercial and social sense. Advances in building energy efficiency,
enhanced farm yields and power plant performance would pay immediate domestic
dividends.
However, the real prize may be in emerging markets, which contain an estimated 85 per cent
of the resource productivity opportunities in the world.8
Improve interprovincial mobility
Crucial to capturing value added in Canada is ensuring that workers across the country can
fully utilise their skills. A common complaint, especially in this province, is the lack of skilled
labour. Research by the Bank of Canada and others shows there are implicit and explicit
barriers created by provincial borders; for example, differences in occupational licensing,
which deter interprovincial migration.9 The New West Partnership Trade Agreement could be
an important step to bringing down such barriers. For Canada as a whole, amendments
agreed to in 2009 to the Agreement on Internal Trade (AIT) to encourage interprovincial
mobility of regulated professionals and skilled trades have similar potential, if implemented.
Increase skills to compete
With technology and trade transforming the workplace, the need to improve skills across the
spectrum of work has never been greater.
First, we need to continue to improve the skills of our managers. Only one third of managers
in Canada have a university degree, compared with almost half of American managers.10
Second, we need to grow further and target better our already high level of post-secondary
attainment. Even though Canada has the highest level of tertiary education in the OECD,
only 60 per cent of our graduates work full-time, compared with the OECD average of
75 per cent. Further, 20 per cent of university-educated adults earn less than half the median
wage.
Quite simply, we need a lot more graduates in skilled trades as well as sciences, technology,
engineering and math. STEM degree holders earn a $500,000 average lifetime wage
premium and can be up to five times less likely to be unemployed.11 To develop our full
resource potential and to compete in advanced manufacturing, our firms will increasingly
need workers with such skills.
Third, we need to continue to focus on skills upgrading and (re)training for existing workers to
make up for historic underinvestment in these areas.12
Sustained business investment
The scale of the resource opportunity and the challenges of succeeding in a fiercely
competitive global economy are some of the reasons why the Bank expects sustained
business investment.
Since the start of the recession, total Canadian business investment has been below
average, while investment in machinery and equipment has been near average, in
comparison with other postwar recoveries and With the strongest balance
(Charts 16 17).
sheets on record (Chart 18) and benefiting from one of the most resilient financial systems in
the world, the need for Canadian firms to build additional precautionary cash balances
appears limited.
There is a balance between prudence and action. Yes, there are immense uncertainties in
the world economy, but we need to focus on what we can control.
We can't save the Euro, fix America's fiscal cliff or restart their housing market. Should we
just wait out a decade-long deleveraging process in the crisis economies? Should we lower
our expectations? Or should we control our destiny by building on our strengths in the new
global environment?
Conclusion
Building on our strengths requires that we respond appropriately to the opportunities the
global transformation affords us. That starts with recognising that the strength of Canada's
resource sector is a reflection of success, not a harbinger of failure.
The logic of Dutch Disease requires that we undo our successes in order to depreciate our
currency. Taken to its natural conclusion, this logic dictates that we shut down the oil sands,
abandon our resource wealth, have high and variable inflation, run large fiscal deficits and
diminish our financial sector.
Such actions would surely weaken the Canadian dollar, but they would also weaken Canada.
In a world of elevated commodity prices, it is better to have them. Bank of Canada research
shows that high commodity prices, regardless of the cause, are good for Canada. Rather
than debate their utility, we should focus on how we can minimise the pain of the inevitable
adjustment and maximise the benefits of our resource economy for all Canadians.
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