The Dutch Disease and Canada

Diane Francis column for Wednesday May 3



Now that Canada's Petro-dollar heads toward parity with the U.S. dollar, every level of government must come up with strategies to provide Canada's manufacturers with tax parity.

If governments don't adjust taxation wise, Canadians may fall victim to the "Dutch Disease" -- or energy exports pushing the currency so high that manufacturers cannot compete.

Some foreign exchange experts think the C$ and US$ may be of equal value by the end of 2006. Others believe it will rise more slowly.

Of course, the situation is not only about the Canadian dollar's strength, thanks to energy exports and prices. It's also about the slide occurring in U.S. dollar values.

Currency parity with the U.S. is a disaster for Canadian manufacturers and exporters which is why Canadian governments must bear the brunt of adjustments that will avert problems that are already being felt.

Make no mistake the U.S. dollar is in trouble which makes the C$ worries worse.
The latest concern to hit investor/exporter radar screens is that the world's oil exporters have begun to have second thoughts about keeping their reserves in the U.S. currency. Their reserves are growing more rapidly than Asia's and in a year or two could even rival Japan's and China's.

The Asians -- China, India, Japan and others -- are slightly diversifying their savings into other currencies, but in general must be committed to holding U.S. dollars in order to keep their currencies down in value for export purposes.

But the energy exporters are a different story and are earning twice as much money from the U.S. economy as are Asia's manufacturers.

According to recent figures from the International Monetary Fund, the Middle Eastern nations have more reserves than China's US$800 billion; Russia has US$200B in reserves and Africa's oil exporters, US$162 billion. Recent reports are that the United Arab Emirates - upset at the Dubai Ports protectionist controversy - have started to place most of their savings in Euros, thus adding to the downward pressure on the U.S. dollar.

In total, developing countries alone now have US$2.9 trillion in U.S. reserves, as of the end of 2005. And this, says the IMF, has pushed down the yields on U.S. bonds, a favorite haven. This means that diversification out of the US$ is more compelling.

As the C$ and US$ move toward parity, Canadian exporters find themselves squeezed: Their costs are borne in higher, Canadian dollars and their earnings are now in less valuable U.S. dollars. And domestic manufacturers here are losing their cost advantage to Americans.

Results are showing. Canadian manufacturing is slowing while U.S. manufacturing is increasing -- a divergence which hasn't occurred for two decades. This week, Canada's Business Conditions Survey covering 4,000 firms said 14% of Canadian companies plan production increases in the next quarter; 27% expect reductions in production and 58% expect the status quo. American manufacturers are mostly predicting growth in output.

The last time Canadian manufacturers lagged their American counterparts was in 1983 during a recession and prime rates of 22%.

As Manufacturers and Exporters Canada has recommended, the federal and provincial governments must quicken write-offs in new machinery and equipment to match U.S. depreciation rates. This will not only help their bottom lines but help them enhance automation and upgrade their technology to overcome the currency-price differential.

Such rules will also help the energy sector.
Canada's oil industry is transforming itself from exploration to "manufacturing" or the upgrading of tar sands and heavy oil deposits. These processes require huge capital expenditures for equipment, technology and infrastructure. They need faster write-offs too.

In addition to faster write-offs, governments must lower corporate income taxes and business taxes of all kinds. Toronto is particularly greedy in levying excessive business taxes.

And the Bank of Canada should also realize that adjustments are needed. It must back off its tendency to be overzealous in raising interest rates. The Canadian dollar doesn't need protection and is able to attract investors because of energy. If anything, the Bank should embark on a strategy of dampening the dollar's value in order to keep the economy - both east and west -- humming.

The "Dutch Disease" awaits ignorant governments unwilling to adjust to new economic realities.