Canadian Prime Minister Jean Chretien rushed to become the first foreign leader to meet with newly elected President George W. Bush when he assumed office; Canada's foreign affairs minister, John Manley, was the first foreign minister to meet with newly appointed Secretary of State Colin L. Powell. The visits underscored the critical importance that the US holds for Canada as its largest trading partner, a relationship worth $1.3 billion a day in trade across the border.
Canada's economy is growing steadily stronger and business conditions are more favorable than they have been in years. But Canada's dependency on the US, which consumes almost 86 percent of total Canadian exports, means that Canada's newfound economic success could come to an abrupt halt as the US economy slows. Two factors-ongoing Canadian government reforms and growth in Canada's Internet economy-could soften the blow to Canada as the US economy sinks.
The Canadian economy grew steadily through the final quarter of 2000, despite the contraction in US demand. Productivity rose 2.1 percent from third quarter 1999 to third quarter 2000, the best annual performance since 1997. Annual wage increases averaged 3 percent for the same period, leaving unit labor costs up by about 1 percent for the year. Unemployment stands at 6.8 percent, its lowest level in years (see Figure 1); inflation is rising, but at controllable rates. As Canada moved into the first quarter of 2001, the impact of the slowdown in the US registered in aggregate data, but most major indicators held steady. According to the Conference Board of Canada, overall Canadian economic growth was damaged by the slowdown in the US during winter 2001, but a recession is not in the cards. (See Figure 2.)
"At a time when the US economy is slowing and exporters are hurting, the federal government appears to be riding to the rescue," says Paul Darby, director of the Conference Board's economic forecasting group. "Recent changes in taxation, combined with the spillover from the 2000 budget, have created cuts in personal income tax, boosting household spending power in Canada." The January 1, 2001 cut in income taxes by the federal and some provincial governments boosted incomes across most groups. The Conference Board predicts that real consumer spending will weaken this year, a result of the impact of high interest rates on large-ticket, consumer durable items and slow employment growth in the first quarter. (See Figure 3.) Tax cuts, however, will increase disposable income by almost a full percentage point. Darby predicts that Canada will post average annual real GDP growth of 2.9 percent for 2001, following 5 percent growth in 2000.
The French-based Coface Group, in a somewhat more optimistic forecast, predicts that Canadian GDP will grow 3.4 percent in 2001, with unemployment dropping slightly to 6.7 percent. Growing Canadian consumer and business confidence, Coface predicts, will soften the impact of a slowing US economy. Growth still centers on the telecommunications and computer industries, offsetting declines in the auto sector and weakness in the natural resources sector outside energy. Soaring energy demand has spurred new oil drilling and supported strong oil sales, which account for most of Canada's trade surplus. Power producers in western Canada may collect huge profits from selling excess electric power to strapped companies in California.
Growth within Canada may be offset, however, by rapid declines in exports to the US. Canada depends heavily on the US as the prime market for its exported goods, and this dependency has increased in recent years. In 1995, the US consumed 77.5 percent of all Canadian exports. By 1999, it accounted for 85.8 percent. Canada runs a large positive trade balance with the US, but a negative trade balance with all other trading partners. (See Figure 4.) If Canadian exports to the US decline, Canada's overall balance of trade will slip into deficit territory.
Canada maintains relatively liberal trade policies and has provided favorable access to its markets for the least developed countries. However, high levels of protection still exist in some sensitive sectors, such as certain agricultural products and textiles and clothing. Eventually, Canada will have to accelerate the reduction of tariffs on these products and provide more duty-free access to improve resource allocation within Canada, and to end intermittent trade disputes with potentially important trading partners. With exports to the US likely to decline, Canada will have to renew its efforts to build stronger trade relations with countries in the European Union and Asia, to stave off a downturn at home. (See Figure 5.)
Reforms Pay Off
Although Canada is highly vulnerable to a slowdown touched off by US contractions, it is in a far better position to manage economic turbulence than it has been in the past, largely because of its ongoing efforts to end a pattern of rising deficits, pay down debt, cut taxes and lower inflation. In 1998, Canada ended its budget deficits and is now reducing its huge debt, which stands at about half of GDP, down from a crushing 71 percent in 1995. In addition to reductions in personal taxes, the Canadian government cut the average capital gains rate to 23 percent-- lower than the US. Within the next two years, average corporate tax rates will fall to 32 percent, also lower than US rates.
Monetary policy in Canada closely followed policy in the US from 19981999, but has now diverged. When the US Federal Reserve cut rates twice in January 2001, the Bank of Canada held steady, reflecting the stronger Canadian economy and continuing concern about inflation. The slight rebound in the Canadian dollar, boosted by the bull market in Toronto and the strong economy, could be a lasting trend. (See Figure 6.)
Canada's economic and fiscal policies received high praise in a January 2001 report from the International Monetary Fund. The report commends the Canadian government for its comprehensive income tax reforms and budget reductions, its attempts to increase competition in financial services, and its successful efforts to lower inflation and unemployment. The IMF cautioned, however, that Canadian monetary policy would need to be eased in the event of a substantial US economic slowdown. The IMF also noted that Canada's corporate income tax cuts would significantly enhance the competitiveness of Canadian firms.
Beyond government reforms, the other bright spot on the economic horizon is the potential for significant growth in online commerce. Online business-to-business trade in Canada will reach C$272 billion in 2005, representing 18 percent of the C$1.54 trillion total in Canadian B2B transactions, according to Forrester Research, Inc. On a provincial basis, Ontario and Quebec will emerge as online leaders. "Although only 16 percent of Canadian companies have a clear B2B strategy, they will increasingly recognize the benefit of the Net and come to depend on it to plan, source, distribute and sell products over the next five years," says James Sharp, a Toronto-based analyst for Forrester. "Ontario and Quebec will take the lead in online business trade, accounting for C$193 billion of the total C$272 billion in 2005."
In 2005, more than 92 percent of Canada's online B2B trade will occur in four provinces: Ontario, Quebec, Alberta and British Columbia. Forrester predicts that Ontario will see C$69 billion of motor vehicle trade shift online by 2005. Computing and electronic supply chains will account for 29 percent of Quebec's total online trade. Alberta's online petrochemical trade will hit C$23 billion by 2005, and rapid adoption of online B2B trade by electronics and automotive firms will account for 45 percent of British Columbia's 2005 online B2B trade. According to Stuart D. Woodring, vice president of research for emerging Internet economies at Forrester, "Astute Canadian executives will recognize the need for a scalable, nonstop e-business infrastructure, as well as the need to react to unrelenting change pervasive in today's dynamic Internet economy." According to the Conference Board, total real IT capital stock in Canada increased from C$44 million in 1980 to C$80.4 billion in 1999. Despite this rapid growth, current Canadian IT capital stock is equal to 5.7 percent of total capital stock, compared with about 13.5 percent in the US. "One way we could look at this is to say that IT capital, as a share of capital stock in Canada, is about where the US was 20 years ago," says Jim Frank, vice president and chief economist for the Conference Board. (See Figure 7.)
Investment in IT capital spurs greater productivity gains and GDP growth rates than investment in non-IT capital. Canadian gains in productivity have lagged behind those in the US. According to the Information Technology Association of Canada, the Canadian IT industry contributes C$116.4 billion in annual revenues and C$30.8 billion in exports to the Canadian economy. As Internet growth and IT spending expand, Canada should see higher productivity growth and better business returns.
Improvements in the regulatory environment will also spur e-business growth. Companies that hold a Canadian trademark or service mark now benefit from additional intellectual property protection under the Canadian Internet Registration Authority (CIRA), established in December 2000 as the regulator of the dot-ca top-level domain. Holders of Canadian marks worldwide are eligible to register new dot-ca web sites. The Ottawa-based nonprofit agency replaced the University of British Columbia as the keeper of the dot-ca domain last year, and immediately loosened restrictions on registering dot-ca names. Under the old restrictions, only companies that were federally incorporated or registered Canadian trademark owners could register, and only one domain name per organization was allowed.
Under the new CIRA rules, trademark owners can register an unlimited number of names so long as the domain names include their complete corresponding trademark. Only 150,000 domain names are currently allocated in the dot-ca system, but dot-ca registration will soar under the new regulations. Although companies looking for dot-com names are often disappointed, the higher availability of the dot-ca names may provide a solution. In addition, CIRA believes that many companies feel they will benefit from the dot-ca identification with Canada, which is generally well respected in the business world.
A recent Conference Board report, however, warns that Canadian companies must become more innovative to compete abroad. "Canada's innovation performance is relatively weak compared to other G7 countries and smaller open economies, like Finland and Sweden. And the overall innovation gap between Canada and other competitor countries is getting wider," says Gilles Rheaume, vice president for policy, business and society at the Conference Board. Rheaume believes that collaboration-the ability to create linkages among all players in the economy-is critical to building a high performing, innovative business environment.
The Conference Board's report analyzed the availability and use of opportunities for partnerships, alliances and collaborative efforts to enhance companies' internal abilities to innovate. Successful innovators are likely to be involved in collaborations with other private companies, universities and government research laboratories. The Conference Board recommends specific actions to improve Canada's level of innovation, such as increasing investment in research and development, as well as developing a role for governments, universities and employers in expanding the number of engineers, scientists and technical workers in the labor force.
Coface reports that payment behavior in Canada has been satisfactory, notwithstanding occasional incidents in the clothing and sporting goods sectors. Coface notes, however, that at a time when spending by US households on consumer goods is softening, particular vigilance should be exercised with regard to Canadian companies that depend to a large extent on trade with the US. Coface also advises exporters to be careful given the difficulties in obtaining reliable financial information on companies in Canada, as well as the moderate increase in business failures observed in 2000, a reversal of the trend from 1998-1999. (See Figure 8.)
In Dun & Bradstreet's country risk ratings, Canada is listed as DBIc, just below the US with its DB 1b. The DBI rating indicates the lowest level of business risk for exporters and investors, with each letter quartile representing a slightly higher level of uncertainty within the numerical risk rating. Canada shares the DB I c rating with France, Germany, Switzerland, the UK and other stable western European nations.
The continued growth and solvency of Canadian firms will depend on Canada's ability to steer a course that reduces Canadian dependency on the US economy, takes a more aggressive approach to IT investment and Internet growth, and consolidates the reforms geared to lower the tax burden and reduce debt. Until then, credit managers should closely monitor the impact of the US slowdown on Canadian firms, with careful attention to the companies and sectors that are most dependent on US sales.
Fay Hansen is a business and finance writer based in Cresskill, NJ.…