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Article Excerpt
The Study in Brief
Commentators and politicians alike continue to argue that Canada should diversify its trade away from the United States, by far its largest trading partner, reasoning that dependence on the US leaves Canada vulnerable. This Commentary represents a modest start at evaluating whether the current state of affairs is an economic problem and whether the government can, and should, attempt to diversify trade for economic reasons. The intention is to provide policymakers and commentators who contemplate geographic diversification--for either political or economic reasons--with a better awareness of the economic implications of such a strategy.
The findings might surprise the proponents of diversification. By loosely borrowing from investment portfolio theory, using export volatility and growth as measures of risk and return, the study assesses Canada's geographic trade mix from both a trade growth and stability perspective. The study does not uncover any evidence that the mix is economically problematic, on either grounds. It finds that concentration in the US market has not been associated with greater export volatility. Canadian exports to the US are relatively stable, have lower overall risk relative to other markets, and have relatively high records of growth. And Canada already benefits from lower risk through diversification across US regions, whose imports from Canada do not behave perfectly in parallel. Moreover, diversifying away from the US is unlikely to reduce overall risk significantly, since US import performance tends to move in parallel with those of Canada's other major trade partners. Policy-led diversification could even increase volatility and lower exports and income, making Canada worse off in economic terms.
Though Canadian businesses overwhelmingly trade and invest in the US market, Canadian trade and investment are less concentrated in the US than is commonly cited--official statistics overstate the concentration, and the share of US exports in overall Canadian production is much lower than their share of Canadian trade. Further, Canada-US trade as a share of Canada's total trade is declining, as trade with other countries rises faster than trade with the US. For example, 79 per cent of Canada's exports of goods and services now go to the US, down from 81 per cent in 1999, and 67 per cent of Canada's imports of goods and services now come from the US, down from 75 per cent in 1999.
The study points out that individuals and businesses--not governments--determine trade patterns. Instead of trying to orchestrate or change their decisions, Ottawa should turn its attention to providing market information not easily accessible to businesses, and addressing barriers to trade and investment where Canadian firms are already significantly engaged--and payoffs are likely to be greatest. Then businesses can expand opportunities, both in the US and in other regions. However, removing remaining barriers to Canada-US trade must remain the top priority for Ottawa, since trade volumes with the US will continue to represent the majority of Canadian trade.
The hoary question of Canadian trade policy is alive and well; and the answer apparently eludes us still. Should Canada diversify its trade away from the United States to reduce this country's dependence on that market? Does that dependence make Canada politically and economically vulnerable? In recent years, policymakers have discussed "the need to diversify Canada's trade" on Parliament Hill (Standing Senate Committee on Foreign Affairs 2003). Pundits, including several potential Liberal Party leaders (e.g., Ignatieff 2006), have opined in the media about the need to reduce economic dependence on the US. The federal Conservative party's 2004 election platform aimed to diversify both export products and markets, while the party's most recent election platform avoided the term diversification and emphasized "the need to establish trading relationships beyond North America."
There are both political and economic motivations in the desire to diversify trade. Some commentators worry that economic dependence on the US will require Canada to adopt US positions, such as those on marijuana, management of forest resources, and international operations including the war in Iraq. Others are concerned that economic dependence on the US puts Canada in a "vulnerable position ... regarding possible US security and trade actions" (Standing Senate Committee on Foreign Affairs 2003). Still others have a more general concern that too much trade with one partner leaves the country economically vulnerable. This paper attempts to more systematically evaluate concerns that the current share of Canada's trade that takes place with the US makes it economically vulnerable. Policymakers evaluating policy options aimed at diversifying trade, including political dimensions, will then have a better understanding of any economic tradeoffs involved.
Since geographic diversification is the main public preoccupation, this paper focuses on that concern, but also briefly addresses the related questions of diversification by sector and within the US. Proposals for geographic diversification tend to lack specific details but they generally refer to reducing Canada-US trade as a proportion of Canada's total trade. Also, public concern tends to focus on export concentration, with a lesser concern about the majority of Canadian imports being from the US. The paper accordingly concentrates on exports with some brief discussion of imports and investment. These are important parts of the same picture, especially with production increasingly fragmented across international borders.
The paper first examines what is meant by diversification, and the reasons why commentators raise it as a goal. Then, the paper examines why growth in trade is important, what has determined Canada's trade patterns to date, and the extent to which Canadian trade and investment are actually concentrated on the United States. The study then assesses whether the current state of affairs is problematic from an economic point of view. I use a rough analogy between risk and return in investment portfolios and volatility and export growth in a country's export portfolio to determine whether Canada's export mix--with sales concentrated in the US market--places the country at significant risk or presents a significant economic problem.
The findings should allay fears about Canada's current geographic trade mix. The conclusions include the following:
1/ While official statistics show that 85 percent of Canadian goods exports go to the US, and Canadian trade is and will continue to be primarily concentrated in the US market, Canada's economic links are more diversified than widely understood.
* Trade with the US as a share of Canada's total trade has been declining in recent years, and official statistics understate Canada's trade outside the US, while overstating trade with the US.
* Canada's exports are already well diversified across US regions, and those regions' import behaviour is not identical, so growth in one may offset a downturn in another.
* To the extent that Canadian exports are used as inputs into US exports to the world, they are driven by global, and hence more geographically diversified demand.
2/ Canada's geographic export concentration on the US does not appear to be associated with either greater export or income volatility. Canada's experience over the last 10 to 15 years has put the country in a relatively good position, with exports to the US generally offering the desirable combination of moderate export growth and low volatility, relative to other export markets.
3/ The analysis shows that a policy of reducing Canada's trade with the US relative to other trading partners--if effective--would not necessarily make Canada better off and might instead significantly increase volatility without proportionate trade growth.
4/ Finally, the efficacy of government efforts to change trade patterns is questionable. Individuals, rather than governments, determine economy-wide trade patterns. This, combined with the fact that geographic proximity drives most trade and that much of what Canada makes is not easily traded outside its immediate neighbourhood, is why past efforts to change trade patterns have failed. As risks and opportunities rise over time in non-US markets, businesses will adjust and take advantage of those opportunities.
There are significant policy implications. Instead of trying to change trading and investment decisions made by Canadian businesses and individuals, Ottawa should turn its attention to providing market information not easily accessible to businesses, and addressing barriers to trade and investment where Canadian firms are already significantly engaged and payoffs are likely to be greatest. Then businesses can expand opportunities, both in the US and in other regions. The inescapable reality is that Canada's trade is and will be concentrated in the US market for the foreseeable future. The top priority of policymakers must be mitigating risks within the Canada-US economic relationship.
What Do We Mean by Diversification and Why Consider Pursuing It?
The main reason to diversify is, in simple terms, to reduce the risk of having all of one's eggs in the same basket. According to modern portfolio theory, diversifying one's portfolio of stocks helps spread risks between countries, currencies and markets. Moving from a concentrated portfolio to a diversified one can produce the same returns for less risk. The key to reducing risks for the same return is that the more diversified portfolio contains assets that do not behave exactly alike, and so when one falls, another can offset it.
Though the analogy is imperfect, one can apply this same reasoning to a country's export portfolio. An export mix that is diversified across regions in which imports do not follow exactly the same path could result in lower volatility for a given rate of growth, compared with a concentrated export mix. It seems reasonable to assume that, all else equal, less volatility is better than more, as it allows businesses to plan and not get caught unprepared when exports fluctuate significantly in either direction. Later in the paper, I investigate whether moving from the current trade mix to one that depends less on the US market is likely to actually reduce volatility while achieving comparable export growth.
Why Care About Growth in Trade and What Determines Trade Patterns?
Before investigating whether Canada's current trade mix is problematic, it is useful to briefly consider why trade is important, why Canada's trade patterns are what they are, and why, assuming it were desirable, it would be difficult to change them.
Canadian policymakers should view trade not as an end but as a means for achieving key national economic objectives, such as enhancing Canadian living standards. The boost to trade under the Canada-US Free Trade Agreement greatly enhanced Canadian labour productivity beyond what it would have been, which translated into higher living standards (Trefler 2004). Exports significantly increase the growth potential of a small economy like Canada's, and imports also advance Canadian prosperity. Though import growth may displace some Canadian sales, imports of machinery and equipment can be productivity enhancing. Imports that are used as inputs into goods that are later sold or exported also improve the competitiveness of Canadian companies, and imports increase competition and result in lower prices for consumers. Government may also view mitigating export volatility as an important additional economic objective, insofar as export volatility may affect income volatility.
There are several theories about what determines trading patterns. According to David Ricardo's model of trade, countries specialize in exporting goods and services in which they have a comparative advantage and import those in which other countries have a comparative advantage. An alternative theory, the Heckscher-Ohlin model, proposes that countries' relative capital and labour endowments determine what they trade. According to this...
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