Exchange Rate Appreciation and Manufacturing Investment

An interesting article just published by my friend Robert Blecker (American University) reinforces our concerns regarding the long-run impact of the loonie’s recent appreciation on the size and competitiveness of Canada’s manufacturing industry.

Here’s the formal citation & abstract:

The Economic Consequences of Dollar Appreciation for US Manufacturing Investment: A Time-Series Analysis

Author: Robert A. Blecker a

Affiliation: a American University, Washington, DC, USA

Published in: journal International Review of Applied Economics, Volume 21, Issue 4 September 2007 , pages 491 – 517

Abstract

This article analyses the effects of the real value of the dollar on investment in US domestic manufacturing using aggregate data for 1973-2004. Econometric estimation shows a negative effect that is much larger than has been found in any previous study. The exchange rate affects investment mainly, although not exclusively, through the channel of financial or liquidity constraints, rather than by affecting the desired stock of capital. Counterfactual simulations show that US manufacturing investment would have been 61% higher and the capital stock would have been 17% higher in 2004 if the dollar had not appreciated after 1995.

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Blecker extends previous research on business investment by including BOTH current cash flow (proxying the liquidity constraint faced by investing firms, in the Fazzari tradition) AND the exchange rate itself (via its influence on expected future profitability, trading off reduced cost competitiveness at home and abroad, against reductions in the cost of imported inputs). He finds a very strong negative correlation between real appreciation and manufacturing investment, due mostly to the liquidity channel.

The U.S. dollar appreciated against its trading-partner currencies by about 25% between 1995 and 2002 (measured on a trade-weighted basis). Blecker’s coefficients suggest this reduced the flow of manufacturing investment by over 35%, and the end-point (in 2004) manufacturing capital stock by 15%.

In contrast, our currency (again, on a trade-weighted basis) has appreciated ove 40% in real terms since 2002. That would imply a decline (versus the counterfactual base case) in manufacturing investment of closer to 50%. We haven’t (thankfully) seen anything like that yet. But Blecker’s evidence suggests clearly that Canada’s manufacturing sector will pay a very large, very long-lasting price for this epidose of appreciation.

6 comments

  • Except that this is a US study. The link to Canada – which imports a lot of capital equipment from the US – is hard to make. The appreciation of the Canadian dollar has helped reduce the cost of capital goods: see the August 21 StatsCan Daily. Which is at least a partial explanation for why real expenditures have been growing faster than real GDP over the past 5 years.

  • Oh. You’re talking about manufacturing. But even there, the story is similar. Yes, employment has fallen. But output has managed to hold its own, and even increase a bit (See the ‘Not Dutch disease, it’s China syndrome’ Statscan study in the August 16 Daily). How? By substituting capital for labour.

  • Stephen,

    I have a couple of quibbles with your “improved productivity” story.

    First, manufacturers are not substituting capital for labour. According to Don Drummond, “in spite of the massive job shedding that [manufacturing] has seen the M&E capital intensity level is on a downward trend. Clearly then, this is the result of falling capital stock.”

    Second, rising commodity prices automatically increase output values from resource-processing industries, which account for a large share of Canadian manufacturing. When commodity prices rise more than the general price level, even the real (inflation-adjusted) value of a given volume of output from oil refineries, mineral processors, steel mills, etc. increases. However, labour productivity is about comparing output volumes (as opposed to values) with employment. To quote Drummond again, “this sector has experienced dismal productivity growth since 2002 and experienced one of the largest declines in the pace of output per hour . . . short-term savings seem to have trumped long-term productivity growth as an objective for manufacturers.”

    http://www.td.com/economics/special/rs0807_inv.pdf

    Generally, I agree that Canadian manufacturers’ extensive use of imported inputs insulates them from exchange-rate fluctuations to a greater extent than American manufacturers. However, the Canadian dollar has appreciated much more than the American dollar.

    http://www.progressive-economics.ca/wp-content/uploads/2007/07/WeirImportContent.pdf

  • What I was thinking was based on the following exercise with the following variables:

    – Cansim v4421052: Mfg sector stock of machinery and equipment
    – Cansim v2363391: Mfg employment
    – The CAD-USD exchange rate.

    The capital stock numbers are annual, so everything else is annual. If you plot the capital/labour ratio against the USD over the period 1981-2006, you get a graph of two series that cohere pretty well: a trough around 1985-6, a peak in 1991-2, a trough in 2002-4, and ending with a sharp jump in both over the past few years.

  • OYEBANJI ANU OPEYEMI

    The US dollar to united state economy is quit a thing to write home about, but to some developing country the distancs is too much and is not encounraging.
    also in the level of exchange the developing country find it difficult to breakeven in their area of business cos of the devalueation and evaluation cos by $us

  • It is an amazing spectacle watching the run that the Canadian dollar has went on over the past couple of years. What is more bewildering is the reaction our government at various levels have had to its appreciating valuations. Someday down the winding road, future economists will look back on this episode and footnote it with a star, or potentially just a bold font, with the explanation that it was the causal factor in bringing about the next major downward shift in our economy. It is with a whimsical pride, that we hear analysts talk of dollar parity and the great benefits we all will have. Making the situation worse, it is quite apparent that we cannot get our importers off there price cutting asses and make the commodity price adjustments, to the proper level. It is laughed off as some notion of price stickiness. How about calling it what it is, pillaging of the consumer.

    Many hard working people are not only lose their high paying manufacturing jobs and are subjected to more precarious, lower paying work; they get further jilted by being ripped off at the till through unchecked looting of price imports.

    It is these longer term trends and the decisions that gerenate them that are presently being made in our economy that are worrisome. Decisions such as the distribution of manufacturing assets: upgrades, reductions, expansions and greenfield sites. The appreciated dollar is a huge disincentive for many of these decisions.

    This is not to say we should forever be wary of a high dollar. However, it is the speed in which it appreciated that places components of the economy is such a disparate state. There is no fluidity to the change, just a major shock to the whole system. Of course expecting some kind of slow moving transition would be most unpolanyi-like thinking, and therefore, potentially given the free marketeers at the helm, this is what we should be factoring into our decisions and economic models. I will admit though, I will be the first to admit that factoring shocks into predictive models is like putting your foot back on after you shoot it.

    paul t.

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