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Canadians may learn from the federal budget what tone and direction the Trudeau government will set for the economy as it approaches an eighth year in office. Will they build on the last budget and fall economic statement and move the country further in the direction on an industrial policy to keep pace with the U.S., or will they pivot in another direction?

While it may appear that some things are steadily moving towards some new post-pandemic normalcy, bank failures, talk of recession, the next phase of COVID-19 and a potential election point to some instability. But much deeper forces are at work.

Canada is facing the most profound challenges to its prosperity since the end of the Second World War. The country’s traditional sources of economic growth – a young and rapidly growing population, an expanding oil and gas sector, international trade – are at risk of drying up in the face of powerful forces and trends.

Challenges to Canada’s economic growth

There are four key issues facing Canada’s future growth that, if not addressed by the current government, could have major repercussions on its prosperity. They are its aging population; its shrinking sources of export growth; its reliance on the United States as its number one trading partner; and finally public investments to respond to a volatile global market. Only if Canada defines a next generation industrial policy that goes beyond simply supporting businesses can it address climate change and national security objectives that will ensure economic stability.

Aging population and slowing productivity

The combination of slowing productivity growth and an aging population has led to a secular decline in the rate of growth of the Canadian economy. Real GDP growth has declined by 50 per cent in the 15 years since the global financial crisis of 2008 compared to the 15 years prior to the crisis, from three per cent to 1.5 per cent per year.

Canada already faces severe shortages in health care and long-term care and affordable housing. This is set to get worse. The dependency ratio – those over the age of 65 relative to those aged 16 to 64 – hit almost 52 per cent in 2022, up from a post-war low of just below 44 per cent in 2008.

Statistics Canada projects this ratio to keep rising, reaching nearly 60 per cent by 2030. While increased immigration with a focus on working-age migrants will help, Canada will also need substantial investments in technology adoption and innovation to improve its productivity growth.

Declining export growth

A second factor is the decline of Canada’s export-to-GDP ratio. It has dropped from 40 per cent in 2001 to just over 30 per cent today. This is concerning because Canada’s outsized economy relative to its population is driven in large part by the fact that a large share of the GDP is exported into a global marketplace.

The trade environment is set to become ever more difficult. Countries representing more than 90 per cent of global GDP have committed to reaching net zero emissions by mid-century while an estimated 60 to 70 per cent of Canada’s exports come from transition-vulnerable sectors. They will need to adapt or face decline. Oil and gas will be most exposed in the long-term, but other key sectors (like traditional automobile manufacturing, iron and steel, chemicals) will also face profound, globally driven transformation. Canada will need to adapt its export sectors to a low-carbon world, while gaining a foothold in new markets.

Just as concerning is that the sophistication of our exports has declined steadily over the same period. This has been characterized by a falling share of manufactured goods (for example buses and jet engines) and a rising share of primary products (like oil and gas) in total exports.

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This is concerning because manufacturing and exports tend to generate more growth, higher productivity and greater longer-term prosperity, relative to extractive industries. MIT’s Observatory of Economic Complexity (OEC) tracks knowledge intensities across different countries’ economies. Knowledge intensity is correlated with advanced manufacturing and research and development (R&D) and higher prosperity in the long run. In the OEC’s country rankings, Canada fell from 18th place in 2000 to 29th place in 2020 – just ahead of Thailand, and behind Mexico, and Poland, and well behind most of our G7 peers, as well as South Korea. This is consistent with the fact that Canada’s R&D spending as a share of GDP is less than half compared to the U.S., Germany, Japan and Korea.

Dependence on the United States

It’s not only that one-third of Canada’s GDP is generated by exports, but also that 75 to 80 per cent of our exports go to a single country: the United States. Until the turn of the century, this was viewed as an explicit advantage. However, a series of events – from 9/11 and the global financial crisis to the rise of Trumpism and COVID-19 border closures to the resulting supply chain disruptions, inflation and Buy American – have highlighted our vulnerability to both the U.S. election cycle and a “thickening” of the Canada-U.S. border. The latter has been the largest driver of our declining export-to-GDP ratio since 2001. While U.S. President Joe Biden recently reassured Canada that his objective is shared prosperity, growing Canada’s exports to other parts of the world will improve this country’s resilience.

Public investment by other countries

Fourth, other countries, some with much larger economies, are making substantial public investments to secure their positions in a rapidly changing global economy. The U.S., EU members, Japan, Korea and other countries have put in place large-scale industrial policies aimed at accelerating the net-zero transition, onshoring advanced manufacturing and employment and critical supply chains, and strengthening national security. By far the most relevant of these policies to Canada is the U.S. Inflation Reduction Act (IRA) passed in August 2022.

The IRA includes nearly US$800 billion in spending, tax credits and other measures to encourage private investment in “new and innovative clean energy projects and the decarbonization of existing energy infrastructure.” Europeans have vowed to match (euro for dollar) American spending on industrial policy. Taken together, trillions of dollars are being spent in these countries to secure new sources of growth and prosperity that are clean, high-tech and more inclusive. Canada needs to find ways to compete for investment capital, talent and market share in the race to succeed in the next generation economy.

Traditional policies aimed at boosting economic growth, such as corporate tax reductions or reduced red tape, will not be sufficient to address the scale, scope and urgency of challenges Canada faces. Governments will increasingly need to play a role in accelerating private sector investment. Quebec has been a leader in developing a next generation industrial policy aimed at driving investment in critical mineral, battery and electric vehicle supply chains. The governments of Canada and Ontario have also been active in catalyzing investment in the electric vehicle and battery manufacturing.

Down to the last barrel?

Looking at the expansion of the GST credit

Both the budget and fall economic statement of 2022 unveiled and elaborated on the $15-billion Canada Growth Fund and the $2.6-billion Canada Innovation Corporation. Those had the ultimate objectives to help secure Canada’s longer-term prosperity by driving investment in industries and technologies of the future. Budget 2023 promises to expand on these initiatives with new spending and tax credits.

While there will continue to be calls for government to close remaining gaps following the budget, the real focus will need to be successful implementation. To date, there has been an ad hoc use of government funds to attract private global investment wherever opportunities present themselves, without a transparent framework to guide decision-making or measure success.

The success of next generation industrial policies will depend critically on their design, governance and follow-through. It will also depend on successful negotiations with the U.S. and at the international level aimed at creating global governance structures that support Canada’s export ambitions. Ideally, the post-budget period will offer an opportunity for the federal government to move away from primarily reactive responses to a proactive approach underpinned by a clear understanding of 21st century economic forces and trends.

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Julian Karaguesian
Julian Karaguesian is an economist with 30 years experience in policy analysis and advising the federal government, primarily at the Department of Finance. He has served as a counsellor at the Canadian Embassies in Berlin and Washington and as head of Canada's delegation to the Paris Club. He also teaches part-time at McGill University. He is a former research director at the Institute for Research on Public Policy.

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