COMMENT: Who is most vulnerable to the rising dollar?

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OTTAWA, Ont. — Seeing the Canadian dollar rise from U.S. 62 cents to 75 cents last year was one thing. But this year’s rise to 85 cents is another thing altogether, putting pressure on a number of export sectors.

What is different between the rise in the Canadian dollar from 62 cents to 75 cents, and the rise from 75 cents to 85 cents? In the first phase, the dollar rose from 62 to 75 cents because the world economy was recovering from near-recession and returning to normal growth patterns. Investors regained their confidence in overseas markets, and most currencies rose against the U.S. dollar as a result. Hence, the decline in the U.S. dollar during 2003 reflected not a loss of faith in the U.S., but a restoration in faith in other economies unambiguously, a good thing.

This return to normal growth patterns around the world pushed up demand for Canadian exports, including natural resources. Accordingly, Canadian companies saw two things happen at once: more demand for their exports, and a higher currency. The net effect this year has been higher exports, for most sectors a return to normal after three years of depressed global conditions.

But the further rise in the dollar from around 75 cents to 85 cents has been different. For the most part, it is a function of high oil prices, but it has also been compounded by a fairly general bout of uncertainty and speculation against the U.S. dollar. This time, most Canadian exporters are being hit by the higher dollar without the benefit of an offsetting rise in the demand for their products.

The exception, of course, is the energy sector. Accordingly, the present situation is not dissimilar to Dutch Disease, a term coined in the 1970s when the rise in oil prices boosted the value of the Dutch Guilder and put the squeeze on the Dutch manufacturing sector.

What happens next depends on how vulnerable each sector is to currency volatility. Exchange rate vulnerability is correlated with three characteristics. First, companies with a relatively high labour content are more vulnerable because they face tougher competition from lower-wage offshore markets. Second, companies whose products have a relatively low content of imports are vulnerable, for they do not get the benefit of lower input costs when the dollar rises. And third, companies with narrow profit margins are less able to absorb the stronger dollar those with healthy profits can take a hit and then restore their profit margin gradually over time.

An examination of these three characteristics across 27 sectors of the Canadian economy produces a short list of particularly vulnerable sectors. These include: (1) clothing, leather and textiles; (2) furniture; (3) fabricated metals; (4) electrical appliances; and (5) services, especially tourism. On top of this, most of these sectors are related to demand by consumers, where export growth has been slow and is expected to remain so.

The bottom line? Moderating world economic growth and lower oil prices should bring the Canadian dollar back down in due course. How much fallout there is will depend on how long the episode lasts but either way, companies need to prepare for more such volatility in the future.

Stephen Poloz is the Senior Vice-President and Chief Economist , Export Development Canada.

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