Twenty years after the Free Trade Agreement was negotiated in October 1987, and 19 years after its implementation in January 1989, Canada’s experi- ences offer lessons to allay trade fears, but much work still remains to be done by governments and businesses.
The twin threats of protectionism and policy compla- cency are among the biggest risks facing the Canadian, US and global economies in the years ahead. Much of this con- cern stems from fears about the massive trade shock that the rise of South Asian economies has dealt to the global econ- omy and a political environment that is offering uncertain directions in terms of future policy.
It is within this context that powerful lessons derived from the performance of the Canadian economy after the implementation in 1989 of the Canada-US Free Trade Agreement and the 1994 North American Free Trade Agreement are usefully considered. Few countries have provided as shining an example of how to adapt and prosper in a post-freer trade world as Canada. The harsh- est critics of those agreements stoked fears that would be ultimately dispelled. Life not only went on for the Canadian economy in a freer-trade world ”” Canadians have prospered.
It is not even imperative to demonstrate that all of this was due to the FTA and NAFTA ”” which would surely be a stretch. After all, there were many competing influences such as a recession in both Canada and the United States in the early 1990s and greater forces of globalization at play throughout this period to name just two. Rather, we only need to demonstrate that the most exaggerated fears failed to arise. Furthermore, while there have definitely been some irritants in specific sectors like the isssues of softwood lum- ber and BSE, the focus in assessing the overall success of the post-FTA and NAFTA environment clearly has to be on the bigger picture.
Similar fears are often manifest in today’s discussions on the impact of South Asia’s rise on Canadian and US busi- nesses. Amidst the twin effects of South Asia’s economic rise and 9/11-induced security concerns, US and Canadian poli- cymakers risk shunning increased ties with the rest of the world. Further global and domestic policy reforms remain dangerously stalled. US security concerns in particular add a new dimension that is represented by a thin grey line between national secu- rity concerns and the creation of barriers to trade in capital, goods, services and labour.
However, there is some mixed evi- dence that points to the need for more policy reforms. For example, even within our own borders, Canadians have yet to achieve free trade on goods, services, capital and labour nor have we achieved a level regulatory field across some key indus- tries. On a grander scale, the Doha Round of World Trade Organization talks remain stalled indefinitely by the first world’s inability to break an impasse over agricultural subsidies and the tendency of emerging markets to protect domestic industries like banking and telecommunications.
While governments deserve considerable credit for turning around Canada’s inflationary and fiscal deficit picture in order to set a more orderly macroeconomic backdrop for business, much further work remains to be done. This includes addressing barriers to competitiveness such as high and inappropriate forms of business taxa- tion, infrastructure deficiencies, chal- lenges to seamless borders, skill shortages and ensuring fair protection of intellectual property rights.
The dominant message within the North American political environment of the next few years remains that few would be well served by efforts toward impeding the advancement of freer trade principles. Few people should have come to know this better than Canadians.
The 1988 Canadian federal elec- tion was fiercely fought over the proposed Canada-US Free Trade Agreement, and the North American Free Trade Agreement between Canada, the United States and Mexico sparked a sense of déjaÌ€ vu with the 1993 federal election. Some of the most exaggerated fears have been clearly discounted by history, including the draining of our lakes and rivers to meet the water needs of Americans, the loss of our cultural identity and the inability to have independent domestic and foreign poli- cies. In addition, eight key myths that were promoted at the time have been dis- pelled in economic terms.
Myth 1: Production would shift south A popular argument lead- ing up to the 1989 FTA was that, in being a small market, the only reason for global companies to have a domes- tic presence in Canada was to hop- scotch trade barriers such as tariffs, voluntary export restraints and import quotas by producing in Canada for consumption in the same market. By corollary, it was feared that removing such barriers would cause production to retreat south as US companies bumped up production runs state- side by small amounts in order to export into a mar- ket only one-11th the size of their own.
In fact, as figure 1 demonstrates, this did not happen. In the last 12 years, Canada has outperformed the US economy 50 percent of the time with steady outperfor- mance for four straight years from 1999 to 2002. This demonstrates at least an equal ability to grow the output of goods and services in Canada as in the United States. Even Canada’s challenged manufacturing sector has weathered the storm with a similar performance to manufac- turers in the United States both in terms of manufacturing as a share of the GDP (figure 2) and manufactur- ing employment as a share of total employment (figure 3). Throughout this period, services employment and output displaced some of the role of manufacturing in both coun- tries. Indeed, further evidence has demonstrated that Canada remains a net beneficiary of onshoring and offshoring activity whereas this has been a more heated source of debate in the United States. This evidence demonstrates that economics is not about carving up fixed pies whereby one country’s gain has to come at the expense of another when barri- ers to trade are lowered or eliminat- ed. Rather, trade agreements typically mean that countries are free to focus on the industries they serve the best.
Myth 2: Exports would evaporate Directly related to the first fear was the view that, as production shifted south, Canada’s exports would sharply contract and the nation would possibly face a bal- ance-of-payments crisis. Figures 4a and 4b go a long way toward dis- pelling this concern. After the FTA and NAFTA, exports would come to be a powerful and needed source of growth as the domestic economy languished in the early 1990s. Due to manufacturing’s weight on their respective economies and their prox- imity to the United States, Ontario and Quebec were the first to benefit from freer trade in the 1990s but the following decade has seen all Canadian provinces also jump on the bandwagon.
There was a surge in all merchan- dise trade activity in Canada, both imports and exports (figures 4a to 4d), following the FTA signing in 1989, including an additional accel- eration in trade following the NAFTA signing in 1994. The recent modera- tion in exports is likely a sign that Canada has almost fully exploited the initial impact of this larger mar- ket for its goods as cyclical forces of a stronger Canadian dollar become more influential. Mexico, however, is now challenged by the rise of South Asian nations much more directly than either Canada or the United States as it loses some of its claim to being the first choice for low-margin, mass-produced commodities requir- ing low labour costs.
While it’s clear that trade has increased, it is nonetheless important to acknowledge the potential effect of double-counting in the trade num- bers. Because of the specialization in production, several intermediate products may pass back and forth across the border before ending up in one finished product. Therefore, Canadian export numbers may be overstated to the extent that they reflect this double-counting. However, studies that attempted to measure this impact still found strong growth in net exports for many industries.
Myth 3: Why invest in Canada? If production and export activity were feared to dry up, why invest in Canada instead of tapping into the US market? The first two myths did- n’t materialize, making the rejection of this one nearly a forgone conclu- sion. Even though firms no longer needed to locate within the Canadian market in order to serve Canadian demand, foreign direct investment (FDI) in plant and equip- ment still flowed in, confirming Canada’s ability to attract and retain foreign investment. While FDI as a share of GDP was virtually flat at 20 percent leading up to NAFTA, figures 5 and 6 reveals that Canada’s FDI share has since risen to 32 percent. Strong economic growth, favourable domestic demand, competitive direct and indirect labour costs and a favourable investment climate have continued to attract investors into Canada. Canada’s ability to retain investment in the face of heightened international competi- tion is a reflection of its ability to compete on the open market with- out protection.
Myth 4: Politics would require a strong Canadian dollar A strong Canadian dollar versus its US counterpart rings familiar to busi- ness ears of past and present. In 1991, the currency peaked at 89 US cents, although it went on a wild ride in the intervening period. At the time, it was alleged that one of the unwritten conditions for US willingness to engage in freer trade with Canada was that policymakers in Canada would have to maintain a strong currency in order to detract from the country’s export competitiveness.
If at all true ”” and there is no known credible reason for believing this ”” then it has often been quipped that the execution of such a policy was rather inept. It wouldn’t be long after its peak before the currency would go into a decade-long slide, dipping to as low as 62 US cents in February of 2002. In fact, in a demonstration of how malleable this argument was, it was then asserted by some American com- mentators that the Government of Canada had then shifted to a soft-dol- lar policy in order to stimulate exports. The currency would then go on a breakneck recovery to the mid-90s US- cent range today.
There is no doubt in our minds that this has been a fully market-driv- en ride. Both economists and central bankers know full well the futility of attempting to target exchange rate policies within flexible exchange rate regimes over the long-run. Commodity prices, interest rate spreads, overshooting in the US dol- lar against every major currency dur- ing its investment bubble and relative fiscal policies were the strongest fundamentals behind the oscillations in the Canadian dollar throughout this period.
Myth 5: Jobs would dry up Canadian job fears created by the FTA debate would soon be mir- rored in the United States in the debate over NAFTA. Along with the feared shutdown in production on the Canadian side of the border, there was supposed to be a massive wave of permanent job losses. Further, with wages in Mexico lower than in both Canada and the United States, there was a fear that post- NAFTA many jobs in Canada and the United States would relocate to Mexico and have a depressing impact on wages. This notion was never clearer than in the comment made by a US presidential candidate at the time, Ross Perot, when he said that the United States would hear a ”œgreat sucking sound” emanating from south of the American border as companies relocated in search of cheaper labour.
Despite such animated fears, the evidence suggests that this has not at all been the case (figure 7). To be fair, some industries gained while others lost. For instance, studies have shown that the decline of Canadian tariffs has accelerated the exit of low produc- tivity businesses, with associated job losses. The net picture has neverthe- less been overwhelmingly positive. The United States has witnessed an unprecedented wave of job creation that has driven its unemployment rate to post-war lows in the past decade. In Canada, a similar story unfolded as the nation witnessed its unemploy- ment rate go along the long path toward a 32-year low. This suggests that other positive factors affecting the labour market such as the shift toward services and the high demand for skilled workers have largely out- weighed the negatives from domestic trade barrier reductions. Sustained demand for higher educated workers has even resulted in a skilled labour shortage in recent years driving wages up for consumers, and challenging business competitiveness.
Myth 6: Canada is for sale A large part of the FTA debate was centred on the removal of ownership restric- tions. There was a fear that US com- panies would buy up their affordable Canadian counterparts, pulling prof- its and interest flows out of Canada. However, an analysis of merger and acquisition (M&A) deals in Canada shows a very different picture despite the headlines covering just the megamergers. To be fair, one cannot entirely dismiss such concerns given that many of our top companies have changed into foreign hands, especially within the past two years. The role of small- and medium-sized enterprises, however, has balanced out the overall picture.
Looking at the total number of M&A deals since the NAFTA agree- ment took effect in 1994, there have been more foreign companies pur- chased by Canadians than Canadian companies purchased by foreigners. This is true whether looking at all non-US companies, or just by look- ing specifically at transactions involving US firms (figure 8). In both cases, more Canadian companies are doing the acquiring, and the trend has been largely increasing since NAFTA took place.
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To get a sense of the magnitude of the companies involved, it is useful to also look at the dollar volume of these deals. Since Canada tends to have more small businesses, it is likely that much of the M&A activity is concen- trated among these firms. When con- sidering the direction of deal flows between Canada and all non-US com- panies, the net dollar value of deals is flowing out of Canada in the past two years and is positive for 2007 as of mid-year (figure 9).
When just looking at US compa- nies, however, although there have been more fluctuations, the net sum shows that the dollar weight of deal flows has been in Canada’s favour between 1994 and 2006. So far, 2007 has been the exception, albeit a sig- nificant one, largely attributable to a handful of megadeals involving US acquirers, notably private-equity firms that have exponentially increased their activity in the recent years. Nonetheless, the long-term evidence strongly supports the argu- ment that Canada has resisted becoming a branch plant economy and that, instead, it has been very active on its own in acquiring foreign firms. The swing in net deal flows with non-US foreigners over the past three years, however, is clearly not an FTA/NAFTA matter.
Myth 7: Canadian businesses would be hard-pressed to restructure NAFTA may have contributed to strong market forces, but ultimately accelerated a necessary reshaping of Canada’s business community. As more fully argued by the RBC in 2006, the 1990s brought forward a sharp rise in the number of small businesses in Canada, while this decade is shaping up to be all about their maturation to a more powerful growth phase. The forces of creative destruction have been at work in the Canadian economy.
Micro-, small-, and medium- sized employers now lead big compa- nies on productivity growth and they have done this in part by slowing the pace of new business forma- tions and employment gains while retooling and driving efficiency improvements (figure 14). This is the maturation to a new cycle of growth from the foundations established during the wave of business start-ups in the 1990s, although the slip among large businesses is a risk.
Myth 8: Governments would see their tax bases shrivel As production, exports, foreign direct investment and jobs were supposed to retreat south of the border, Canada’s fiscal position was feared to be a bleak pic- ture. Canada’s fiscal back was, indeed, up against the wall by the mid-1990s, but this reflected forces in play long before freer trade arrived. What is noteworthy is that there has been a marked turnaround since the mid- 1990s as the federal government has reported a long string of consecutive budget surpluses. The federal debt-to- GDP ratio in Canada fell below US levels in 2003-04 for the first time in 25 years. Canada’s net foreign debt as a share of the economy went from more than 40 percent in the mid- 1990s to about one-quarter of that share today. These broad fiscal improvements have strengthened our international fiscal credibility and proven that our tax base remains a solid support to the Canadian econo- my. Compared to other countries, Canada is the envy of many other nations; it is the only one of the G7 to be running a surplus on a consolidat- ed, all-government basis (figure 10), and it currently stands as the only G7 country to record a surplus in each of the past three years.
Despite laudable progress in meet- ing the freer-trade challenge, some evidence remains mixed. They point toward the need for further comple- mentary policies that could unleash Canada’s full freer-trade potential.
Still under-investing: Canada has always tended to under-invest in pro- ductivity-enhancing machinery and equipment compared to the United States and little of late challenges that long-standing shortfall. Relative to the respective sizes of the two economies, M&E spending in Canada has tended to lag US levels (figure 11) despite the confluence of factors that should be supporting a much stronger invest- ment performance than stateside. The Canadian dollar’s rise, record high cor- porate liquidity in Canada that lies beyond reasonable precautionary needs, low debt-equity ratios and excellent interest coverage lend sup- port through strength in balance sheets across many sectors.
Large-firm productivity: Whereas small- and medium-sized businesses in Canada are successfully engineer- ing a wave of creative destruction, big business is slipping. Average annual compound growth in labour productivity at business establish- ments employing over five hundred workers stands at a paltry one-half of 1 percent per year so far this decade. Faster SME productivity growth has positioned smaller firms to be nipping at the heels of bigger producers.
Slipping share of in-bound North American foreign direct investment: Although Canada has definitely witnessed a pick-up in the pace of foreign direct investment relative to the size of our economy post-NAFTA, we have not kept up with a broad-based global expansion of this type of investment. Forces beyond NAFTA such as the emer- gence of China have led companies around the world to engage in more cross-border investment, and the fact remains that Canada’s share of global FDI continues to slip, albeit at a slower pace, indicating that we have been able to keep our share relative to the global stock fairly steady in recent years after huge deteriorations during prior periods.
Notwithstanding the accomplish- ments of the Canadian economy, pol- icy-makers cannot afford to be complacent and assume that they have handed businesses all they need in order to drive a freer-trade prosper- ity agenda. Complementary policies are stalled.
Business taxation: Canada currently has the fifth-highest marginal effective tax rate on capital compared to 36 industrial and leading developing countries studied in a recent C.D. Howe Institute report. This properly measures tax disincentives to invest at the margin by adding up taxes on corporate income, sales taxes on capital goods purchases that represent double taxa- tion when income streams are then taxed further, and the large corpora- tions’ capital tax.
Capital taxes are particularly ill- advised in that they represent double taxation on the lifeblood of a compa- ny after it has already paid taxes on its income streams. Capital taxes are also profit insensitive. They are, how- ever, only a small part of a much big- ger problem with tax competitiveness particularly in Ontario where, if it were a country, the business tax bur- den would top the international fig- ures to the detriment of the province’s competitiveness (figure 13). Further, a growing reliance on profit-insensitive levies is a clear dis- incentive to invest, including soaring business property taxes at the munic- ipal level.
Seamless borders: With more than $1.7 billion worth of two-way merchan- dise trade crossing the US-Canada bor- der every day, reliable and efficient borders are critical to the Canadian economy. But the terrorist attacks on September 11, 2001, served as an impor- tant wake-up call exposing Canada’s vulnerability to inefficient borders. Since then, heightened security combined with inadequate infrastructure and staffing at the borders have increased congestion and disrupted cross-border travel. As well, the advent of just-in-time inventories has left min- imal tolerance among businesses for any production delays. Canada needs to take additional measures, including a continued devotion to upgrading infra- structure, creating alternative border access sites and improving programs like FAST and NEXUS that focus on bor- der pre-clearance.
The latest upcoming challenge is the approach- ing deadline for the Western Hemisphere Travel Initiative (WHTI). The WHTI will require everyone entering the United States to have a passport or authorized travel docu- ment. With only 40 percent of Canadians currently holding a pass- port, the government needs to ensure low-cost and easy access.
Further trade liberalization: Canada’s domestic trade and regulato- ry barriers currently prevent the neces- sary mobility that allows for the efficient use of resources and labour. There have been some steps taken toward reducing these impediments. The B.C.-Alberta Agreement on Trade, Investment and Labour Mobility is one example. Although some controversial details have yet to be sorted out, the objective of the agreement is to help streamline many business functions in these economies and allow for the freer movement of goods, services and investments between the two provinces. Governments of Saskatchewan, Manitoba and Ontario have also considered the benefits of joining the BC-Alberta agreement, which is a welcome and critical step in the right direction.
Much work remains to be done, however, notably in the area of making progress toward liberalizing ownership barriers affecting several Canadian industries. According to the OECD, Canada is among the top countries with regard to restrictions on foreign direct investment, based on various indicators, which also goes in line with Canada’s relative declining attraction force for global FDI (figure 6).
Beyond Canadian trade issues also lie stalled global trade WTO talks within the Doha Round that are on hold at least until after the 2008 US presidential elections and more likely until the end of the decade.
Infrastructure investment: Although there have been some recent encouraging signs, Canada continues to be faced with the chal- lenge of infrastructure shortfalls. Compared to US cities, Canadian cities spend considerably less on infrastructure, which makes it difficult to distribute people and goods throughout cities and to surrounding areas. Part of the difficulty lies in the fact that cities have a limited ability to raise funds, requiring a fuller debate on municipal funding options and private-public partnerships.
Skill shortages: Canada faces a growing skilled labour shortage. Not only are labour shortages already acting as a con- straint for some sectors, but they are poised to become an even greater challenge in the coming years, due to an aging population and low fertility rates in Canada. For this reason, we argued in our 2005 paper ”œThe Diversity Advantage” that Canada must raise immigration rates to as high as 400,000 from about a quarter of a million per year at present. While Canada’s track record is already among the best in the world, there is also room for improvement in terms of policies that do a better job at integrating immigrants.
Intellectual property rights and contract law: Finally, in our view, the absence of a global level playing field on contract law and the protec- tion of intellectual property rights must also be addressed by the Canadian and US governments. One cannot have truly free trade without common acceptance of the rough parameters.
