Cheap dollar drags on investment: report

By Steven Lamb | October 13, 2006 | Last updated on October 13, 2006
2 min read

Contrary to popular opinion, the current high value of the Canadian dollar is beneficial to the economy, with weak currency holding back investment and productivity, according to a report by the Conference Board of Canada.

“Policies that weaken the exchange rate have important — perhaps unintended — consequences for industry investment, productivity and economic growth,” says Constance Smith, co-author of the study and a professor at the University of Alberta. “These findings should sound a warning bell for policy-makers concerned about Canadian competitiveness.”

Traditionally, a weaker Canadian dollar has been seen as boosting exports to the U.S., thus propelling growth in the Canadian manufacturing sector. But the new report, entitled The Exchange Rate and Wages: How They Affect Capital Investment, claims a stronger dollar enhances productivity by making capital expenditures more affordable.

“Investment in physical capital is an important driver of productivity growth, and lagging labour productivity explains much of the Canada-U.S. income gap,” Smith says.

The study examined data from 17 developed economies in the OECD, from between 1970 to 2001, and found that even a short-term depreciation in currency can have lasting impacts on productivity.

Among the countries studied, a 10% currency depreciation resulted in a 2.9% drop in investment for the total economy. But this impact was not spread evenly across all industries. Construction, for example, experienced a 7.5% decline in investment and the mining sector saw a 6.3% drop.

Meanwhile, three other sectors experienced virtually no investment decline over the short term: community, social and personal services; manufacturing; and transportation, storage and communication.

The negative impact of even a short-term depreciation could be felt over a much longer time horizon, especially in the service sector.

“Although the exchange rate has an insignificant long-run effect on investment in most individual sectors, the significant short-run response is often large and, at times, persists for three years or more,” the report says.

Financial services, wholesale and retail trade, hospitality, and social services saw the negative effects drag out over at least five years. These sectors are mainly reliant on the domestic economy and derive little or none of the benefits enjoyed by the export-reliant sectors. Manufacturing and transportation saw only an insignificant negative impact.

But while the impact of exchange rates is significant, the report says an even greater drag on investment comes from increases in real wages. The effect is not immediately apparent, however.

“The impact of a 1% increase in the real wage on investment in manufacturing is not significant until the fifth year,” the report says. “In the long run, the 1% increase in the real wage leads to a 0.9% decline in investment in the manufacturing sector.

“In the long run, a 1% increase in the real wage leads to a 1.32% decline in investment in the total economy.”

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Steven Lamb