by Michel Beine, Charles S. Bos,† and Serge Coulombe†† University of Luxembourg, Luxembourg, and CES-IFO

† VU University, Amsterdam, The Netherlands†† University of Ottawa, Ottawa, Canada

serge.coulombe@uottawa.cahttp://aix1.uottawa.ca/~scoulomb/

Does the Canadian Economy Suffer from Dutch Disease?

The so-called Dutch disease phenomenon is one mechanismexplaining the natural resource curse (Sachs and Warner, 1995 a.o.).

Dutch disease : the expansion of the resource sector leads to anappreciation of the real (effective) exchange rate that crowds out thetrade exposed manufacturing sector.

Krugman (1987, p.49): "The interesting question is why it should beregarded as a problem. ... . The worry seems to be that when thenatural resources run out, the lost manufacturing sectors will notcome back".

Many people take for granted that the Canadian economy has caughtDutch disease, i.e. that the big drop in the size of the manufacturingsector is due to the strong appreciation of the CAD. This appreciation being driven by the strong increase in energy and commodity prices.

People looked at solutions to deal with the Dutch disease (e.g.subsidies to the manufacturing sector, currency union with the US,creation of a Southern Ontario Development agency)

Is that true ? 2 conditions : (1) the CAD is driven by energy and/orcommodity prices; (2) the recent appreciation led to a decrease in theactivity of the manufacturing sector. We test whether the 2conditions are fulfilled.

We argue that by failing to take into account the autonomousmovements of the USD, the existing literature is unable to fullyaddress the issue . A new approach is needed.

The recent appreciation of the CAD against the USD

The boom of commodity and energy prices

Big drop in the manufacturing employment share

Is it enough to conclude in favour of a DD ?

3 concomitant evolutions: boom in commodity & energy prices, appreciation of the CAD/USD and squeezing of the manufacturing sector.

Is it enough to conclude in favour of DD? No.

One has to test whether the CAD is driven by the commodity & energy prices. The Amano-van Norden (1995) equation

One has to account for the autonomous movements in the USD since the USD affects both the CAD/USD exchange rate and commodity and energy prices.

One has to relate the dynamics of the manufacturing sector to the part of the CAD/USD explained by the commodity & energy prices

Generating currency, energy and commodity prices, components

We extract currency components (factors) capturing the strength of the currencies from a set of bilateral exchange rates

The extraction does not rely on any (exogenous) weighting scheme such as the trade weights

Use of Bos and Shephard (2006) Bayesian approach

k exchange rates (k=5) .> k + 1 (USD, CAD, Euro, JPY, UKP, AUD)

Daily frequencies and averaged out at macroeconomic frequencies

Details in the paper

CAD and USD components

Resulting price factors (nominal)

Use of the factors

63% (37%) of the 50% appreciation of the CAD/USD over 2002-2007 is ascribed to the appreciation (depreciation) of the CAD (USD) currency.

2 phases : 2002-2004 : 63% due to USD depreciation ; 2005-2007 : 93% due to CAD appreciation.

Over the recent period, the increase of the commodity and energy prices has also been boosted by the fact that they were expressed in USD which tended to globally depreciate (useful because in traditional analysis, USD as the numeraire on both sides of the equation).

Step 1 : test whether the CAD currency has become a commodity currency .> revisting the Amano-van Noorden (1995) equation using the CAD, the USD and the commodity and energy prices factors

Step 2 : test whether the share of Canadian manufacturing employment reacted to the variations of the CAD and the USD factors. And if yes, how strong are both effects?

Step 1: Revisiting Amano-van Norden (1995)

We consider a similar framework as AvN (Error Correction Model):

CAD/USD and the real energy and commodity prices in USD (AvN), the CAD and USD factors and the commodity and energy prices factors.

3 periods : 1972-2007 (full period), 1972-1993 (AvN), 1983-2007 (Canada as a net exporter of energy)

be and bne are expected to be positive if higher prices tend to appreciate the CAD (or the USD); in AvN, bne> 0 but be< 0 . We will explain why !!

1 1 1 1 1t e t ne t id t t e t ne t tx pe pne idiff x b pe b pne

Main results for the CAD/USD

We reproduce the main AvN results : over 1972-1993, positive long-run impact of non energy prices, negative long-run impact of energy prices. ECM provides good fit to the data.

Over the full period, very low explanatory power (in line with the recent literature, see for instance Mayer and DePratto, 2008).

Over the most recent period (1983-2007): no explanatory power in the long run.

If we stick to the AvN, first condition for the DD is not fulfilled.

Main Results for the USD

No explanatory power of commodity prices in the long run for the full period and the recent one

Over the AvN period, moderate positive LR correlation between

energy prices and the USD component: in line with AvN. Might explain why energy prices tended to depreciate the CAD against the USD. To be checked using the CAD component.

OLS and IV results support the case for a moderate role for the US current account defficit .

The dynamics of the USD has nothing to do with commodity prices and is influenced by factors unrelated to Canadian economic conditions or policy.

Main results for the CAD

Over the AvN period, no impact of energy prices. Consistent with the explanation of be < 0 by AvN: this is due to the USD !!

Over the AvN period, positive impact of commodity prices but rejection of a long-run relationship. Robust with separate cointegration tests

Over the period during which Canada has been a net exporter of commodities : strong explanatory power of non energy and energy prices with positive signs.

The CAD currency is driven up by the commodity prices

Unsurprisingly, mixing up the 2 sub-periods does not lead to good results in terms of explanation.

Step 2 : estimating the impact on Canadian manufacturing employment

We estimate the impact of CAD and USD factors on the evolution of share of employment in 21 Canadian manufacturing industries over 20 years (1987-2006) using a TSCS error correction model.

Two different specifications: bik = bk (homogeneous), bik unconstrained

long-run elasticities display intuitive signs (positive for USD, negative for CAD)

sus capture the impact of many unobserved factors peculiar to the rest of the world (US) that are industry specific and move over time.<

We account for unobserved heterogeneity across industries

2 estimation methods (PLS and IFGLS)

1 1 1 2 1 3 1 4 5it it it i t i t t it i itsca sca b sus b eca b eus b eus b sus

Separate influence of USD and CAD useful for 2 reasons

CAD variation will affect position of Canadian exporters with all competitors.

USD variation will affect all competitors on US market including Canadian exporters

The CAD is driven by energy and commodity prices , not the USD

Assessment of the importance of the DD phenomenon Decomposition of explained variability : 41% USD, 53% CAD, 5% US shares.

Findings

LR elasticities of both components slightly higher than 1 (IFGLS)

Suggest that the CAD component was responsible for the deindustrilization of the Canadian economy but that the depreciation of the USD worsened the situation

Heterogeous specification allows the classification of industries in terms the sensitivity to exchange rate developments (only one case of counterintuitive sign)

Out of 21 industries: 6 affected by the CAD only, 3 affected by USD only, 5 affected by both; 7 unaffected . Partial Dutch disease phenomenon.

Most affected by the DD : textile, Wood, printing, machinery, computer, transportation, furniture; except for printing, all classified as highly exposed to IT

THE END

Results for the CAD/USD (AvN)

Results for the USD component

Results for the CAD component

Homogeneous specification

Heterogeneous specification