CHAPTER 4:
MANUFACTURING SECTOR'S
RESPONSES TO ITS CHALLENGES

The rapid appreciation in the value of the Canadian dollar in the past four years along with higher and unpredictable energy costs and strong competition from emerging economies, such as China and India, have had a negative impact on profitability in many parts of the Canadian manufacturing sector. Subsectors particularly hit hard by these economic shocks are those with a high exposure to trade and international competition: forest products, particularly pulp and paper, textiles, apparel, transportation equipment, particularly automobiles and shipbuilding, chemicals and consumer products to name but a few. Industries less exposed to trade and international competition have fared much better.

Particularly informative (in the aggregate) is the Bank of Canada's series of business surveys (from autumn 2003 to spring 2006) on the impact of the appreciation of the Canadian dollar. From these surveys, one finds that the percentage of natural resource and manufacturing firms reporting an adverse impact ranged from 75% to 85% in this period and that this percentage declined with time. The percentage of natural resource and manufacturing firms reporting a favourable impact ranged from 10% to 17% and this percentage increased with time. Presumably, these latter firms had a low export sales intensity and benefited from lower imported input costs. By contrast, only about 50% of firms reported an adverse impact while about 22% of all firms reported a favourable impact, and both these statistics remained relatively constant over the period.

Further scrutiny of the surveys reveals a trend to more types of negative effects, spreading from export markets to domestic markets. All of the surveys indicated the principal effect of the rise in the Canadian dollar on those adversely affected was to lower profit margins on exports, though the percentage of firms suffering from this effect had fallen in this period from a peak of 80% in winter 2004-05 to 69% in spring 2006. The second most important effect was felt on lower export volumes (in the range of 17% to 28% of adversely affected firms) until winter 2004-05, when a number of other effects, such as lower domestic profit margins, lower domestic prices and lower domestic sales volumes, overtook lower export volumes in importance. This trend suggests that increased foreign competition in Canadian markets led to lower domestic prices and that the loss of export sales and reduced profitability across the manufacturing sector probably rippled through to lower domestic sales.

What is particularly interesting is the extent of measures taken by firms adversely affected by the rise in the Canadian dollar. In spring 2006, reported actions taken in descending order of importance were: increasing financial hedging, improving productivity or reducing costs through measures other than investing in machinery and equipment, increasing inputs/processing abroad, lowering labour costs, increasing investment in machinery and equipment, raising selling prices and reorienting production (see Figure 20).

Figure 20

Source: Bank of Canada, Adjusting to the Appreciation of the Canadian Dollar, Supplement to the Spring 2006 Business Outlook Survey, April 2006

Given the speed of the rise in the value of the Canadian dollar, it is not surprising that a number of firms negatively affected by this rise did nothing, choosing instead to ride out the currency shock with the same business plan. Improving productivity and reorienting production — that is, shifting from unprofitable or less profitable to more profitable products and/or consolidating production at fewer but more productive sites while closing and shutting down less productive facilities — remained popular actions among firms adversely affected throughout the period. Financial hedging[29] grew to be the most favoured response by 2006, followed by increasing inputs/processing abroad — a natural hedge. Two other responses — lowering labour costs and raising prices — peaked in 2004 and have since declined. Raising prices was impossible for a number of firms in the early stages of the appreciation, as their prices were set in U.S. dollar terms and locked in by contract for a period of time.

Of particular concern to the Committee is the decision to lower labour costs through employee layoffs. Statistics Canada reported that employment in the manufacturing sector stood at 2.1 million in December 2006, up 10,000 over the previous month but down 59,300 in the past year. Job losses since the fourth quarter of 2002 have totalled 208,900 or 9.2% of total employment in manufacturing, with job shedding peaking in 2005 at 100,400. These job losses have occurred across all parts of the manufacturing sector, but have been particularly marked in clothing and textiles, computer and electronic manufacturing, electrical equipment and appliances, transportation equipment, and wood and paper products. Similarly, manufacturing job losses have been experienced in most provinces, but Ontario and Quebec have been hit particularly hard.

To further improve productivity and decrease costs, Canadian manufacturers have increased capital spending substantially. Although job losses in the sector have been substantial, output levels have not declined by as much because of these investments as well as the reorientation of production cited above; manufacturing labour productivity thus increased at an average annual rate of 5.7% in 2005, which is almost three times the average for the business sector as a whole (compare Figures 9 and 14).

With worldwide demand for energy growing and relatively few new oil and gas fields being discovered, energy reserves have been waning while the prices of energy commodities have been rising briskly since 1998. However, with the phenomenal growth of the energy-thirsty Chinese and Indian economies, energy prices have soared since 2002. Not surprisingly, the tripling of light fuel oil and natural gas prices spawned a new round of energy conservation and an energy-efficiency drive within Canadian industry not seen since the "Energy Crisis" of the late 1970s. This drive has been executed largely through investments in new technology and the turnover of capital and the replacement of old, inefficient production systems.

Finally, the emergence of China in the Canadian market is a challenge for many Canadian manufacturers, particularly those whose goods have a medium to high labour content. By and large, manufacturers have chosen one of two strategies: (1) innovate and shift to more capital-intensive methods of production based on the relatively lower cost of capital in Canada than in China; or (2) outsource the labour-intensive activities or undertake some other form of partnering arrangement that incorporates Chinese competitive advantages.

[29] Financial hedging refers to firms locking in future prices today (by contract) in face of persistent and expected future appreciation of the Canadian dollar.