11-010-XIB
Canadian Economic Observer
November 2006

The changing composition of the merchandise trade surplus

by P. Cross* and D. Wyman

After peaking at $71 billion in 2001, Canada’s merchandise trade surplus has since hovered around $65 billion. This apparent stability, however, masks several new trends in the commodity composition of this surplus. This paper updates a 2002 study¹ of the sectoral breakdown of the trade surplus, highlighting several structural changes in Canada’s trading relationship with the world and what we produce and consume. In 2002, the trade surplus was rising because of gains in five of the seven largest sectors; now, the surplus is being sustained by gains in just two sectors (energy and industrial goods) offsetting declines for consumer goods, autos, forestry, food and machinery and equipment.

The merchandise trade surplus is the largest part of the overall current account balance. Traditionally, surpluses in Canada’s trade in goods accompanied deficits for services (notably travel) and for investment income.

It is worth re-emphasizing the cautionary note sounded in the 2002 study about the interpretation of sectoral trade balances. The benefits of trade come from the increased specialization and productivity arising from more exports and imports, not from a surplus of exports over imports in any particular sector. Clearly, the surge of Canada’s energy exports in recent years has boosted our standard of living. But that standard has also benefited from the rising purchasing power of consumers as import prices fell. Similarly, increased spending by firms on imported machinery and equipment enhances their ability to compete both in Canada and abroad.

Therefore, the following discussion of the trend in sectoral trade balances since 2002 is not a litany of positive and negative contributors to our economy. Rather, it shows how the Canadian economy is re-allocating resources as the global economic landscape shifts. As such, this study does not reflect other structural changes in Canada’s economy unrelated to trade flows, such as the housing boom since 2001 or the increased public spending on health and education.

Overview

The trade balance by sector reflects a country’s industrial structure and spending patterns. Since these underlying determinants usually change only slowly over time, sectoral trends in the trade balance typically persist for long periods. This is particularly true for Canada. Of the seven sectors, three have always posted a trade surplus since 1971. These three are rooted in our traditional resources of forestry, energy and agricultural products. Conversely, Canada has always run trade deficits for machinery and equipment and consumer goods.

Autos and industrial goods were the only sectors that posted both surpluses and deficits over the past 35 years. Even these reversals were the exception rather than the rule, and tended to be bunched together in two short periods. The auto sector posted chronic deficits from 1972 to 1981. Since then, it has consistently posted surpluses, with the exception of 1986 and 1987. Industrial goods (which include metals and chemicals) posted surpluses in 32 of the last 35 years, with the three deficits occurring consecutively from 1998 to 2000 (when metals prices were low and steel and chemical imports high).

The bulk of this paper is devoted to analyzing specific factors behind the trend in each sector’s trade balance. Before undertaking this detailed analysis, Figure 1 provides the broad trends in the trade balance for the seven major sectors. It shows that Canada’s overall merchandise trade surplus is increasingly reliant on growing surpluses in energy and industrial goods (mostly metals) for growth. Not coincidentally, these are the only two sectors where export earnings rose after 2002.

Figure 1

The trade balance in the other five sectors has been squeezed by falling exports and rising imports (with the exception of autos, where imports also declined).

The strong appreciation of the Canadian dollar after 2002 had a major impact on prices outside of energy and industrial goods. Exports for the other five sectors actually rose in volume over the last four years, but these gains were offset by lower prices received by producers when they converted their export earnings into Canadian dollars. Meanwhile, prices fell across the board for all non-energy imports since 2002, a reflection of the loonie’s appreciation and low inflation in most of our major trading partners.

Along with the rising dollar, the other major shift in international trade in recent years has been the integration of China into the world economy. This has been most evident in the growing tide of consumer and investment goods arriving in Canada, often at lower prices. Rapid industrialization in China and other Asian nations also helped trigger the boom in commodity prices in recent years, notably for energy and metals.

The stable pattern of sectoral trade balances makes some of the recent changes all the more remarkable. Autos, which in 1999 had the largest surplus of any sector except forestry, swung to outright deficit in the summer of 2006. The surplus in energy surpassed forestry for the first time ever in 2001, and by last year was nearly twice as large at $53 billion. Rising commodity prices have also pushed the surplus for industrial goods to a record high so far in 2006. Fuelled by the income generated from the boom in energy and metal prices, consumers and businesses in Canada have gone on a spending spree. This has sent the deficit in consumer goods to new highs, while the deficit for machinery and equipment was the largest so far this decade. These deficits would have been even higher, if not for the dampening effect on prices of the rising exchange rate.

Energy

In 2001, for the first time, the trade surplus for energy products surpassed forestry. Since then, the predominance of energy has become even more pronounced, with the surplus reaching a record $53 billion last year, the most ever for any sector. The 2005 increase was driven by natural gas exports², which jumped to $35 billion (twice their level in 2002) as prices surged following the damage done to rigs by hurricanes along the US Gulf Coast last fall.

The downside of the reliance on natural gas was revealed when prices fell sharply in 2006 after a record warm winter created a glut that persisted all year. As a result, the monthly surplus for natural gas has been cut in half, from $4.5 billion in the immediate aftermath of hurricane Katrina to just over $2 billion.

Still, the overall surplus for energy products has improved so far this year from last year’s record. In fact, to date in 2006, the energy surplus was equivalent to Canada’s entire trade surplus. Partly, this reflects a drop in the trade balance for most other sectors except industrial goods. But it is also due to continued high oil prices: the trade surplus for crude oil and petroleum products in the first 8 months of 2006 is running twice as high as last year, reflecting record prices. This has offset much of the weakness in natural gas (by May, the surplus for crude oil was nearly equal that for natural gas).

Figure 2

Canada has not always had a surplus in petroleum products. From 1976 to 1982, it ran deficits in petroleum trade, reflecting the heavy dependence of eastern Canada on oil imports. For the next 15 years, the surplus for petroleum products was comparable to that for natural gas. Natural gas took off after 1998, driven by the development of new fields in Canada and additional pipeline capacity to the US. But petroleum has recovered recently. This partly reflects the development of the oilsands, as conventional oil and gas output began to decline, as well as the relative strength of oil versus gas prices this year.

At $3.3 billion, coal exports were small compared with oil and gas. However, by 2005 they were the fastest-growing energy export, doubling over the last two years due to rising prices, largely reflecting Asian demand. In fact, coal exports in 2005 surpassed electricity exports for the first time on record. Coal prices have moderated so far this year.

Forestry

The importance of the forestry sector in Canada’s trade surplus continues to shrink. After peaking at nearly $40 billion in 2000 and 2001, its surplus fell slowly to $33 billion last year, and so far this year is on track to hit a 12-year low of $31 billion as exports have fallen by $2.5 billion. The initial drop originated more in pulp and paper, where the surplus fell from $24 billion in 2000 to $18 billion last year. This industry was the victim of lower prices (partly due to the rising dollar) and a structural decline in US newsprint consumption (down 25% since 2000 as the Internet supplanted print media).

Figure 3

More recently, lumber has been the major drag on forestry products. Its surplus had fluctuated around $15 billion after 2000, as strong US housing demand compensated for the rising dollar and the softwood lumber dispute. But by August 2006, the monthly trade surplus for wood products fell below $1 billion for the first time since early 2003, due to the downturn in US housing. Some recovery may occur before the implementation of a tax on softwood lumber exports in mid-October, but this is unlikely to reverse the longer-term trend to smaller surpluses.

Autos

The most spectacular change in the sectoral trade balance has been in the auto sector. This sector had consistently run surpluses since 1987. This culminated in a record high surplus of over $20 billion in 1999 and 2000, as surpluses of almost $40 billion for vehicles offset the chronic deficit in auto parts.

After 2000, the automotive surplus fell steadily to less than $10 billion in 2005 (entirely due to vehicles, as the deficit in parts has trended down slowly). By July and August of 2006, the monthly trade balance in auto products had turned negative. The downturn this year reflects the slump in US auto demand for many of the large vehicles made in Canada. As well, strong sales in Canada have boosted vehicle imports. Unlike forestry, several new investments in the auto sector offer hope for a turnaround in the short-term.

Figure 4

Auto exports nearly tripled in the 1990s, hitting a record $97.9 billion in 2000. Since then, they have declined steadily to an annual rate of $83.3 billion so far this year. Almost all of this drop was due to lower prices as the dollar rose, while the volume of shipments has been steady.

Conversely, the volume of auto imports has risen 12% since 2002. Partly, this reflects consumers and producers taking advantage of a 14% drop in the cost of auto imports. Most of the increase in the volume of demand was for trucks and SUVs, up 45% versus a slight drop for cars, driven by changing tastes in Canada and the recent entry of Asian producers into this market segment.

Consumer goods

One trend that has persisted over time is a growing deficit in consumer goods. This sector has posted higher deficits every year on record back to 1971, with two exceptions (1982 and 1996). Just in the last five years, the deficit for consumer goods has risen by nearly one-third to $32 billion, and is on track to exceed that in 2006.

The upward trend for the consumer goods trade deficit was fuelled by insatiable demand for cheaper consumer goods, often made overseas. In fact, the deficit would have been much greater if not for a 16% drop in the price of imported consumer goods since 2002, reflecting both the higher dollar and lower costs in Asia. Lower prices did dampen our import bill for TVs (despite the growing volume of shipments of plasma and LCD units originating in China and Mexico) and photographic goods. Clothing imports increased by $1 billion just in the last two years as importers took a larger share of the market, while household furnishings rose by $0.6 billion. Exports of consumer goods continued to grow slowly, helping to keep a lid on the sectoral trade deficit.

Machinery and equipment

In the late 1990s, the long-term trend to record trade deficits for machinery and equipment came to an end. Deficits have been below $20 billion so far this decade. Partly, this reflects continued high surpluses for aerospace products. As well, the large deficits in the late 1990s for industrial machinery and communications equipment (totalling over $16 billion) have since hovered near $11 billion. Increased imports of industrial machinery were largely confined to excavating machinery, reflecting the mining boom in Canada. Meanwhile, exports hit a new high last year.

Elsewhere, the post-2000 bust in telecommunications equipment affected imports and exports equally, and both have stayed weak. The deficit for office machinery and equipment has been stable at about $8 billion since 2000. The surge in domestic business investment helped raise the overall deficit in machinery and equipment to $16 billion last year, its highest in six years.

Industrial goods

The trade surplus for industrial goods rose steadily after 2001 to $6.1 billion in 2005, its second highest ever. Partly, this was driven by gains for metal ores and alloys as prices snapped out of a prolonged slump. As well, diamond exports grew after new discoveries in the north came on-line, doubling after 2002 to reach nearly $2 billion. Aluminum and gold led the increase in metal alloys.

Industrial goods are on track for a record surplus in 2006. So far this year, the surplus for metals has jumped to an annual rate of $12.1 billion as prices suddenly shot up to record levels. Chinese demand was particularly strong for iron ore and nickel.

Another reason for the improvement in industrial goods was a turnaround for chemicals. This sector has traditionally run a large deficit. But it improved recently, mostly due to sharply higher exports of ethylene glycol.

While rising exports boosted the surplus for industrial goods, imports of these goods have jumped $10 billion since 2003. This is the largest gain among the six non-energy sectors, and exceeds the combined increase for consumer goods and machinery and equipment. This is because prices for industrial goods did not fall, even as the loonie appreciated. As a result, Canadians paid substantially more for metals (often imported to be refined in Canada), steel and chemicals. All these products were in high demand on world markets.

Agriculture

Canada’s traditional surplus for agricultural products has remained between $5 and $7 billion since 2001. While this overall surplus was little changed, trends differed widely by commodity. Most notably, wheat exports continue to trend down, partly due to poor growing conditions and farmers diversifying to other crops. At just $2.7 billion last year, wheat exports were only half their value in 1997.

Figure 5

However, over that same time period, meat exports nearly doubled from $2.6 billion to $5.0 billion, offsetting almost all of the loss of wheat exports. Pork exports led this increase, while packaged beef rose sharply after the US closed its border to our live animals in 2003.

Like exports, total imports of food products have changed little since 2002. Fruit and vegetable imports have risen as the growing appetite of Canadians for these products offset a 7% drop in prices. Increased wine and coffee consumption have raised the bill for imported beverages by nearly one-fifth. These increases were offset by lower meat imports, particularly after the market was flooded by domestic supplies when exports of live animals stopped in 2003.

Conclusion

Canada’s switch from a chronic current account deficit to a surplus in the late 1990s was driven by a burgeoning merchandise trade surplus. At that time, the trade balance was improving for five of the seven major trading sectors (consumer and industrial goods were the exceptions).

Since 2001, most sectors have seen a deterioration of their trade balance. Partly, this reflects lower export earnings as the dollar rose sharply, as well as weak prices for many forestry and agricultural commodities. Strong domestic spending has also pulled in more imports of consumer and investment goods. Only record high surpluses in energy and industrial goods have sustained the trade surplus at a high level.

The shrinking number of sectors sustaining the trade surplus was mirrored by a narrower geographic base. A growing surplus with the US was driven by the increase for energy. This buttressed the overall surplus against declines for other regions, notably Asia which came to dominate our imports of consumer goods and machinery and equipment.

Recent feature articles

Notes