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11-010-XIB
Canadian Economic Observer
August 2007

Feature article

Not Dutch Disease, it’s China Syndrome

by Ryan Macdonald*

Resource-producing industries occupy a unique niche within a modern economy. Their output is an important input for production, their commodities experience volatile price changes on world markets, and their extraction processes require large amounts of investment. Moreover, discovering resources typically requires large-scale investment in exploration activity.

When a new resource is found, or the price of a resource commodity increases rapidly, a resource boom often is triggered. The boom draws labour and capital toward the resource sector, and can mean adjustment for other sectors within an economy. One resource boom that has garnered considerable attention occurred following the discovery of offshore oil and gas in the Netherlands in the 1960s and 1970s. The discovery generated a resource boom that led to an appreciation of the Dutch guilder and a drop in manufacturing output and employment.1 Since this event, the combination of a booming resource sector, a rising currency and a resulting decline in the competitiveness of non-resource sectors has been referred to as “Dutch Disease”.

This paper provides a brief, and necessarily simplified, overview of some broad trends in the Canadian economy that accompanied the recent surge in commodity prices and the exchange rate.  It is not intended as a definitive account of recent structural changes and their causes, especially in manufacturing.  But it will inform readers of the broad changes occurring in our economy, and better prepare them to understand the unfolding discussion about these structural shifts.

The increase in world commodity prices that began in 2003 has generated a resource boom in Canada. Although metals prices also contributed to the boom, the rise in the price of oil has been particularly important. Its price has risen substantially, doubling from $20 US to $40 US per barrel between 2002 and 2004, before hitting a peak of over $75 US per barrel in 2007. The combination of rising prices and new extraction technologies made the more-intensive and thus costly oil extraction from the oil sands of Northern Alberta feasible.2 The increase in commodity prices was accompanied by a considerable appreciation of the Canadian-U.S. exchange rate, reaching $0.95 US in 2007, up nearly 50% from $0.63 US in 2002. The post-2002 commodity price and exchange rate movements for Canada, at first glance, do seem to resemble the events that precipitated adjustments in the Dutch economy. 

However, while the Dutch case involved the discovery of a new resource, the Canadian case stems from the integration of emerging nations, symbolized by China, into the global economy.  The integration of China had the effect of a large productivity increase in the global manufacturing sector. It increased the supply of manufactured products on the world market and the demand for inputs. As noted in The Economist (2005), the integration of China has simultaneously lowered the prices of consumer goods and raised resource prices.

The combination of price changes initiated by the integration of Asian countries into the world economy helped accelerate widespread restructuring of the Canadian economy.  The resource sector boomed, attracting labour and investment.  Many non-resource sector industries are also exhibiting growth as the increased income in the resource sector is spent.  Throughout this reallocation, manufacturing has borne the brunt of job losses.  However, the impact has varied within manufacturing.  In a few industries (notably forestry and textiles) the resource boom and higher dollar accompanied an ongoing restructuring.  Other industries, such as machinery and equipment, computers and electronics, primary metal and fabricated metals have expanded their output since 2003, feeding the resource sector and domestic demand in general.

Incomes rose and, due to the stronger dollar and lower import prices, their purchasing power goes further.  Unemployment is at record lows and the labour force has demonstrated flexibility in migrating to areas of the country with the strongest labour markets.  Expanding on these trends for manufacturing output, employment, incomes, and migration, this paper describes the Canadian resource boom adjustment, a case study we characterize as ‘China syndrome’, not Dutch disease.3

Figure 1

Manufacturing output up as resources boom

One of the main symptoms of Dutch Disease is a simultaneous drop in output and employment in the manufacturing sector. However, the reality is that from 2003 to 2006 manufacturing output in Canada expanded by 1.3% (Figure 1), thus differentiating the Dutch and Canadian experiences. The increased level of manufacturing output stemmed from durable goods production, which rose 4.8%.  Non-durable goods output fell by 3.4% during the same period.

The difference between durables and non-durables stems from how their outputs are used, their ability to adapt to higher input prices, and their reaction to foreign competition. In the non-durable sector, industries that competed the most intensely with emerging economies such as China had their usual way of doing business challenged.

Within the non-durable sector, output declined sharply in textiles, clothing and leather manufacturing. This was primarily due to a shift in international policies ushering in a period of liberalized trade for these products. In all three industries, output began declining before the appreciation of the dollar, which then accelerated the process.

Prior to the energy price increases, the pulp and paper industry faced declining demand for its product due to the switch to electronic media and foreign competition. These forces were slowly reshaping the industry. When energy prices rose, driving up the price of industry inputs, and the dollar appreciated, dampening prices of their product, the industry’s restructuring sped up.

There have been similar changes facing the auto industry. A long-term shift in consumer preferences has led to decreased market share for North American makers and increased market share for foreign models. The higher value of the dollar and commodity prices has not been the source of this shift, although it has undoubtedly squeezed export earnings.4

Outside of autos, many durable goods industries saw increased demand for their products because of the investment taking place in the resource sector, or due to growing global demand for intermediate inputs.  Industries such as machinery and equipment, computers and electronics, primary metal and fabricated metal manufacturing have increased output as demand has expanded.  Moreover, the transition to higher commodity prices and a stronger dollar environment that these industries went through was supported by higher demand and falling import prices.

While these short-run adjustments have taken place within manufacturing, their presence does not mean that higher commodity prices and the stronger dollar will lower manufacturing output in the long run.  As Hutchinson (1994) pointed out: “For the economy of the Netherlands, where the term ‘Dutch disease’ was originally applied, very little systematic and long-term net adverse consequences of natural gas development on the manufacturing sector were found”.

The reality is that the Canadian manufacturing sector has not been hollowed out. To the contrary, it has shown resilience in the face of higher prices. While the stronger loonie and high commodity prices have sped up restructuring in a number of industries, they were not the original cause of the change. Throughout the resource boom, manufacturing output has remained steady and productivity has increased. 

Employment and wage growth not confined to the resource sector

Higher commodity prices and the resulting resource boom have acted as a signal for workers and management that they can earn more by moving to the resource sector.  Firms in this sector raised wages, attracting labour to the resource sector even as manufacturing was shedding jobs.

Figure 2

Through the combination of higher wages and increased employment, wage and salary growth accelerated in the mining, oil and gas industries.  It also sped up output in industries that support the resource sector -- construction and services such as transportation and finance and real estate (Figure 2).

These increased wages and salaries, and resulting overall income, have translated into additional demand for goods and services.  The higher incomes have been spent on tradable goods, such as autos, appliances and clothes; and on non-tradables, such as houses and restaurant meals.

The increased demand from higher resource incomes also attracted labour, ensuring employment growth through the entire non-farm economy save for manufacturing. Overall, the emergence of China on the world economic stage has led to a complex reallocation, resulting in an increase in resource and service sector employment in Canada, and a reduction in manufacturing employment, the only non-farm goods sector industry that experienced a loss (Figure 3).

Figure 3

For manufacturing employment, of the nearly 240,000 jobs lost in manufacturing between January 2003 and April 2007, over half of the drop was attributable to the textile, clothing, forestry and transportation equipment industries. As noted earlier, these industries began a period of structural adjustment prior to the resource boom. While the boom and resulting appreciation of the dollar sped up the process, it was not the cause of this restructuring.

For the textile and clothing industries in particular, a new trade agreement came into effect in 1995 which committed trade barriers to be lowered over a ten-year period. Nevertheless, the textile and clothing industries continued to increase their number of employees, peaking in 2000. As a result, in the final years of the implementation period, all of the transition to the new trade environment occurred. The coincidence of the rising dollar exacerbated this contraction.

During the post-2002 boom in commodity prices, the integration of Asia, led by China, dampened world manufacturing prices. It is China, and not the higher Canadian dollar, that appears to have played the larger role in changes to manufacturing. Similar restructuring is ongoing in many advanced countries as companies adjust to the new reality of Asian manufacturing capacity and consumer appetites for these less expensive products. During the same period, the US dollar was depreciating against world currencies, and American manufacturers shed 1.7% of their jobs. In the United Kingdom, 7.8% of factory jobs disappeared, while in Germany, the losses were 3.1%.

Terms of trade growth fuels income growth

In addition to wage and salary growth and higher spending in Canada, the increase in commodity prices, the appreciation of the Canada-US exchange rate and declining prices for manufactured goods also led to significant increase in Canada’s terms of trade (Figure 4).  The terms of trade are defined as the price of exports relative to the price of imports.  When a country’s terms of trade improve, the volume of imports that can be purchased with a given number of exports increases, which raises the quantity of goods that an economy can consume.5 The impact on domestic income is similar to productivity growth. As a result of the resource boom, Canada has been able to turn its exported resources into more imported manufactured products than it could previously. 

Figure 4

The importance of the terms of trade improvement can be understood more clearly when it is recognized that there are two channels though which the resources of a country are transformed into goods and services.  The first is domestic production, where a country transforms its resources into goods and services itself.  This channel is captured by real GDP. 

The second channel is exports and imports. On balance, Canada exports resources and imports manufactured products. When resource prices increase, or the price of manufactured products declines, the number of imports that can be purchased with exports increases.

The advantages that accrue to Canada through the export/import channel are captured more fully by real Gross Domestic Income (GDI) than by real GDP. Real GDI, also called terms of trade-adjusted GDP, represents the change in the volume of goods and services that can be purchased with the income earned through production (real GDP).6

Figure 5

From 2002 to 2005, real GDI outpaced real GDP due to the terms-of-trade improvement (Figure 5). Over 2006, the terms of trade did not contribute noticeably to real GDI growth; however, in 2007 real GDI again began to expand more rapidly than real GDP due to a further improvement in Canada’s terms of trade as resource prices and the exchange rate rose. As a result, from the first quarter of 2002 to the first quarter of 2007, GDI has increased by 21.2%, compared to a 14.0% rise in GDP.

Migrants head west

Resources are not equally distributed, and resource booms are often accompanied by changes in inter-provincial migration.  For Canada, the impact of rising commodity prices, particularly energy prices, is felt most acutely in the western provinces.

Inter-provincial migration statistics show a substantial population inflow into Alberta, and to a lesser extent, British Columbia over the last three years (Figure 6).  Alberta received on average 35,000 net migrants a year from other Canadian provinces from 2003 to 2006.  In the three prior years, Alberta received around 24,000 net migrants per year. In 2006 alone, Alberta received a net inflow of 57,105 people from other provinces, which was the largest inter-provincial movement of people to one province on record back to 1972.

Figure 6

Canada and the “China syndrome”

The integration of emerging nations, such as China, is accelerating the restructuring of the Canadian economy, which dates back several decades. Shifts in wages, prices, industrial structure and population are all being driven by the resource boom associated with rapid growth in Asia. Thus far, there have been relative price movements and some changes in input levels across sectors. These are the most recent stages of a longer-term restructuring of the Canadian economy.

Despite the reallocation that has begun, employment levels are strong. Labour markets in all provinces have coped well with the transition.  Moreover, the type of dislocation implicit in the very term “Dutch Disease” has not been widespread.  In fact, output has been reallocated across industries and productivity has increased.

After 2003, Canada has on balance benefited from favorable global price changes that are supported by strong international demand.  The resource boom has benefited many areas of the economy, either directly or indirectly, while Canadian manufacturing overall has demonstrated resilience and adaptability.7

The Canadian manufacturing sector has shown itself to be diverse enough that manufacturers in some areas have benefited from the resource boom. In particular machinery and equipment, computers and electronics, primary metals and metal fabrication have increased their output following the resource price increases that began in 2003.

The post-2003 Canadian experience, while at first glance seems to be exhibiting symptoms of “Dutch Disease”, is driven by different factors.  Demand for many manufactured products has increased while inflation has remained muted.  The restructuring taking place in Canada, which is being driven by a resource boom, has led to a reallocation of labour and capital. This reallocation towards resource extraction has been encouraged by falling manufactured goods prices and foreign and domestic demand growth.  In Canada’s case, it is better to characterize “China syndrome” rather than “Dutch disease” as the leading cause of  changes in the economic landscape.

Works Cited

Corden, W.M. and J.P. Neary.  1982.  Booming Sector and De-Industrialization in a Small Open Eocnomy.  The Economic Journal.  Volume 92 (368).  Pp. 825-848.

Corden, W.M.  1984.  Booming Sector and Dutch Disease Economics: Survey and Consolidation.  Oxford Economics Papers. New Series.  Volume 36(3).  Pp. 359‑380.

Denison, E.F. 1981. International Transactions in Measures of the Nation’s Production. Survey of Current Business. Volume 61, 5: 17–28.

Diewert E.W., and C.J. Morrison. 1986. Adjusting Output and Productivity Indexes for Changes in the Terms of Trade. Working paper no. 1564. Cambridge,, MA: National Bureau of Economic Research.

Duguay, P.  2006.  Remarks by Pierre Duguay, Deputy Governor of the Bank of Canada to the Canadian Association of Business Economists.  Kingston, Ontario.  August 2006.

Hutchinson, M. 1994.  Manufacturing Sector Resiliency to Energy Booms: Empirical Evidence from Norway, the Netherlands, and the United Kingdom.  Oxford Economic Papers New Series.  Volume 46. (2).  Pp. 311-329.

Kohli, U. 2006. Real GDP, Real GDI, and Trading Gains: Canada, 1981–2005. International Productivity Monitor. Fall 2006. Number 13, 46–56. Ottawa: Centre for the Study of Living Standards.

----------. 2004. Real GDP, real domestic income, and terms of trade changes. Journal of International Economics. Volume 62, 83–106. Amsterdam: Elsevier.

Macdonald, R.  2007.  Real GDP and the Purchasing Power of Provincial Output.  Statistics Canada Catalogue Number 1F0027MIE.

The Economist. 2005.  How China Runs the World Economy.  July 28th 2005 Print Edition.

Recent feature articles


Notes

* Analyst, Microeconomic Studies and Analysis Division,
613-951-5687.
1

The term “Dutch disease” is often used as a harbinger of long-term problems. However, even in the Netherlands the impact of “Dutch disease” was short-lived. As Hutchinson (1994) points out, the volume of manufacturing output recovered quickly from its cyclical low, surpassing its pre-downturn high by approximately 30% six years later.

2

As described in Statistics Canada’s Overview of Energy section on Alberta’s abundant oil sands, available at http://www41.statcan.ca/1741/ceb1741_001_e.htm, “exploiting the oil sands is expensive because, even after extracting the oil sands using mining techniques or recovery using injected steam, the oil must be separated from the mineral matter and the water, and then further refined. It takes roughly two tonnes of oil sands to extract enough oil to fill one barrel. As a result, the oil extracted from the oil sands becomes profitable only when the world price of oil tops $25 US. Since the price of a barrel of oil has increased above that benchmark price, the refining of petroleum from the oil sands has been a viable option.”

3

The analysis will be informed by the booming sector model developed in Corden and Neary (1982) and Corden (1984).

4

The restructuring of the auto industry is concentrated within the Big Three companies while the new domestics, which are facing the same erosion of export receipts as the Big Three, are expanding output and gaining market share. There is a consensus within the auto industry, as well as the textile and newsprint industries, that while the Canadian dollar has indeed exacerbated the situation, it was not the cause of the restructuring in these industries.

5

The importance of terms of trade effects has been noted in Macdonald (2007), Kohli (2006, 2004), Duguay (2006), Deiwert and Morrison (1986) and Denison (1981).

6

For more information see Macdonald (2007) and Kohli (2006, 2004).

7

See for example “Innovative Canadian Oil Sands Manufacturing Opportunities” by Jason Myers at www.nationalbuyersellerforum.ca/presentations/myers/NBSF%20MyerS%20140307.pdf.



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