Loonie tunes: Industry exposure to the rising exchange rate

by Z. Ghanem and P. Cross*

After hitting a low of US63 cents late in 2002, the loonie began a swift ascent to parity with the US dollar late in 2007. The 50% increase in a such a brief period had little impact on overall growth, which hovered around 3% in each of the last four years, while the unemployment rate slid steadily below 6%, its lowest in a generation.

But while the overall economy was unperturbed by the rising exchange rate, there were large distributional effects. Industries that import many products benefited from steadily falling import prices. However, many exporters found their earnings squeezed, as foreign currency received from exports bought progressively fewer Canadian dollars.

This paper explores a new approach for looking at which industries stand to ‘gain or lose’ as the exchange rate rises. Using the Input/Output (I/O) tables, we examine which industries are most dependent on export markets for their output. This is a starting point for evaluating potential gains or losses from a rising loonie, although the actual outcome for any industry ultimately depends upon its specific market conditions: the strong dollar, for example, has not stopped oil and aerospace exporters from posting record sales and profits.

The I/O tables can also be used to trace imported inputs by industry. The higher the share of imports in all inputs, the more an industry should benefit from falling import prices as the dollar rises.

Finally, comparing exports of outputs and imports of inputs by industry yields a measure of the net exposure each industry has to the exchange rate. Industries most vulnerable to a rising dollar are those with a large export dependency but little offset from imported inputs. The best-positioned industries are those that use large amounts of imported inputs and sell mostly in domestic, not export, markets.

Not all export and import prices are tied to changes in the US dollar. Still, countries whose exchange rate are fixed to the US dollar (including China, which until recently maintained a fixed exchange policy with the US greenback) accounted for 86% of Canada’s exports and 66% of imports in 2004 (using customs basis data). Non-US trade was concentrated in areas such as agriculture, crude oil, metals, autos and machinery. Moreover, the Canadian dollar has risen appreciably against almost all major currencies in recent years, so this comparison of exports and imports by industry remains a useful guide to the industrial distribution of the effects of the soaring loonie.

Before proceeding, a few comments are needed on the I/O data and their limitations. All data are in current dollars. Exports are on a gross basis, which includes both their direct and indirect import content. Intermediate inputs are direct purchases of items expensed in the current year: they include raw materials, parts and services, but not capital investments. The sum of all inputs (intermediate and primary, which includes labour and capital) equals total output, so calculating both the share of exports in output and imports in all inputs uses the same denominator.

Retailing is a special case. Inputs in the retail industry do not include imports of finished goods (such as clothing and TVs) that are sold directly to consumers, since they are not inputs in the actual production of retail services (inputs include electricity, advertising and labour). As such, the obvious benefit to retailers from lower prices for imported finished goods is not captured in this analysis.

Like most I/O calculations, the data are compiled at a very detailed level of 300 industries, (which is why the latest estimates for 2004 were only recently published), and then aggregated to 59 major industries. We convert these into 24 industry groups to facilitate analysis: for example, leather, clothing and textiles are grouped together in clothing manufacturing. The industry detail is available only from 1997, due to the introduction of the new industry classification system (called NAICS). We extrapolate these results to 2006 by using published export and import values, while assuming the underlying I/O structure of production remained the same.

Export dependency by industry

Overall, Canadian industry earned 20% of its income directly from exports in 2004. This share rose from a low of 14% at the trough of the recession in 1991 to a high of 23% at the peak of the ICT boom in 2000. The 20% share of exports in direct output is less than the 31% share of direct and indirect exports in output. For example, the share of forestry output exported directly in the form of logs is relatively small at 4%. But including logs that have been processed into lumber by the wood industry boosts the share of direct and indirect forestry exports to 68%. Similarly, utilities export relatively little of their electricity directly abroad (about 5%); but including power output embedded in energy-intensive goods such as aluminum and other metals boosts their overall exposure to export demand to 28%. For other exports, such as transportation equipment, the difference between direct and total export demand (which includes direct and indirect) is much smaller.

To examine the impact of the exchange rate on industry fortunes, we look at both direct and total exports. The interpretation of the impact of indirect exports on an industry’s revenues is not always as straightforward as for logging. Many services (like banking or lawyers) are exposed to a wide range of export industries, and have been able to thrive in recent years by concentrating on growth areas, such as energy and mining. As well, their revenues from these services are denominated in Canadian dollars, so the exposure to exchange rate risk is very indirect and likely quite small. We note in the text where indirect effects are significant (mostly in the goods-producing industries).

Not surprisingly, industries vary greatly in their dependence on exports. Manufacturers and commodity producers are the leading exporters. Manufacturers of transportation equipment (mostly autos and aerospace) relied directly on exports for 73% of their output, the most of any industry in 2006. Several other manufacturers rely on exports for nearly half their output, including machinery and equipment, chemicals, metals, wood and paper, and clothing. Mining and oil and gas directly export about half their output, while the indirect effects (when their products are refined and then exported) lift their total reliance on exports to 80% of their revenues.

Figure 1

Not all manufacturers rely on exports extensively. Food processors earned about one-fifth of their revenue from abroad, partly reflecting the perishable nature of goods such as bread, meat and dairy products. Petroleum refiners (mostly in eastern Canada) shipped 21% abroad. At a detailed level, printing, beverage and tobacco have the lowest orientation to exports, partly reflecting the predominance of local tastes for these products (notably cigarettes, newspapers and magazines).

Conversely, some services have a relatively large export orientation. Transportation services had the most dependence on exports of any service at almost one-third of output (their indirect exposure lifts this to nearly one-half). Pipeline transport leads the way at 50%, reflecting deliveries of oil and gas to the US. Air transport as well as sightseeing and motion picture and sound recording both get about one-third of their revenues from abroad. Export-driven demand for truck transport has fallen to about one-third from nearly 40% in the 1990s, partly reflecting lower exports to the US recently (notably of autos, where the number of vehicles shipped south of the border fell 24% between 1999 and 2006).

Table 1 Exports as a share of output (%)

Business services get 10.4% of their income directly from exports (and nearly one-third after adding in indirect effects), although this was down 3 points from the peak of the ICT boom in 2000 (computer design and programmers are in this group). Wholesale trade and warehousing also rely on exports for about one-fifth of their business. Recreation (notably gambling) and accommodation and food look to foreign visitors for about 10% of their market.

But large swathes of the service sector have little dependence on export markets. Personal care and repair services rely on domestic demand for 95% of their business, while broadcasting and telecommunications have a similar orientation. Finance, insurance and real estate remain largely (95%) domestic concerns. And of course most government, health and education functions remain overwhelmingly oriented to Canadian needs.¹ Together with construction (the one goods industry with virtually no exports), these industries with almost no exposure to exports account for nearly half (48%) of GDP.

A few industries boosted their orientation to direct exports between 1997 and 2004. The largest increase was for clothing in the late 1990s, when exports jumped to almost 50% of output largely due to a lower exchange rate. Oil and gas export demand also rose rapidly after 1997. However, most industries saw little change in their export share of output, including most services.

The primary sector was mixed. Forestry and fishing exports rose four points, although the overall direct share remained low at 10%. This is because most of the raw output of this industry is sent to manufacturers for further processing before being exported; adding this lifts their export share to 68%. Farming saw exports slump, mostly in 2003 and 2004, when an outbreak of mad cow disease led to an embargo on Canada’s cattle exports. Exports began to recover rapidly by 2006.

Transportation equipment posted the only other notable decline in export share, from a peak of 79% in 1998 to 73% in 2006 (still the highest export orientation of any industry). This decrease coincided with the increase in production in Canada by Asian-based producers. This led to a displacement of sales of vehicles imported from Asia to domestically produced vehicles.

Imported inputs

Overall, Canadian industries imported 10.6% of all their inputs² in 2006, below their recent peak of 12.9% in 1999. The drop was led by a 10-point contraction in the machinery and equipment industries, the second largest users of imported inputs (at 37% in 2000). This reflected the implosion of the ICT sector after the high-tech bubble burst in 2001. Still, almost all industries have lowered their use of imports, consistent with the findings from last month’s study of the import content of exports.³ The rise in the dollar after 2002 slowed, but did not reverse, the decline in the use of imported inputs (lower import prices after 2002 helped raise the volume of imported inputs).

Table 2 Imports as a share of total inputs (%)

Transportation equipment, the largest importer of inputs at 43%, posted a small decline. The drop in autos was driven by cuts to auto output and the growth of Asian transplants. Several of our largest manufacturing exporters rely on imports for about one-quarter of their inputs. Besides autos and machinery and equipment, this includes petroleum refining, clothing, and other manufactured goods. Chemicals as well as metal manufacturers sourced about 20% from abroad, including bauxite imported to make aluminum and ores destined for smelting and refining.

Conversely, several large exporters buy relatively few imported inputs. Canada’s oil and gas and mining industries are different from the norm in the OECD region, as most member countries rely heavily on imported inputs⁴ because they do not share our natural resource endowment. Canada, of course, has an ample domestic supply of these goods, and imports only about 5% of inputs for these goods. Manufacturers of forestry products import about one-tenth of their inputs.

Most other sectors imported about 10% or less of their inputs, ranging from agriculture and forestry to government. Among service exporters, transportation goes abroad for only 7% of their inputs. Business services import less than 6% of their inputs, and were on a sharp downward trend. Finance had the lowest share of any industry at 2%. As mentioned earlier, no distinct upward trend was evident in any of these import shares, even after the dollar began rising in 2003.

All of the drop in imported inputs so far this decade was from the US. Autos and machinery and equipment initially led this decline after 2000. All but two sectors joined in shunning US imports after the exchange rate with the US began to rise in 2002. Meanwhile, imported imports from the rest of the world have edged up in recent years.

Broadly speaking, what emerges for import use by industry is a sharp split between manufacturers and the rest of the economy – most manufacturers import inputs extensively, while the rest of the economy essentially does not. This suggests that imported inputs gave many manufacturers a built-in ‘hedge’ against exchange rate movements: while the rising dollar squeezed export earnings, at least some offset is provided by lower prices for imported inputs. The next section looks at how big is this offset.

Comparing exported outputs and imported inputs

Comparing exports in output with imports in inputs yields a first approximation of the ‘net’ exposure of each sector to exchange rate movements. This analysis is first done by subtracting the share of exports in outputs from the share of imports in all inputs. We then repeat this comparison using the absolute levels of export earnings and imported inputs by industry, to eliminate cases where the share is relatively small.

(a) Shares

Seven sectors had at least a 20-point gap between the shares of exported outputs and imported inputs, leaving them potentially exposed to the negative effect of the rising dollar with little offset from imports. Among manufacturers, the wood and paper industries had the largest net exposure, with a gap of 36 points between exported outputs and imported inputs. This helps explain the woeful financial condition of these industries. Exports directly account for 48% of their output, mostly denominated in US dollars. Even worse, the US dollar price of their products has been falling, reflecting weak demand for lumber and newsprint. Meanwhile, these industries got little relief from lower import costs, since they import only 12% of their inputs.

Table 3 Difference between export and import shares (%)

However, a large reliance on exports relative to imported inputs does not always imply hard times for an industry as the dollar rises. Oil and gas and mining have the largest net exposure to fluctuations in the dollar, at 46 and 43 points. Adding in indirect exports lifts these net positions to 63 and 47 points, the most of any industry. However, these industries overall have done well recently, as the US dollar prices of their commodities (especially metals and oil) have risen faster than the rising loonie has depressed export revenues. As a result, export revenues have continued to increase. The other primary industries (farming, fishing and forestry) all have a large surplus of exports over imports, especially after adding in indirect exports.

Transportation equipment, metal manufacturers, and machinery and equipment are the other major sectors with more than a 20-point surplus of exports over imports. Autos and machinery and equipment have struggled as the exchange rate rose. Most other manufacturers have a slight excess of exports over imports. Transportation services were close behind, although they benefited from strong demand (especially for rail and water transport of raw materials as well as business and personal air travel) and continued to prosper.

Construction stands out as the goods industry with the most to gain from a higher dollar, with a 10-point gap between the share of imported inputs and exported outputs. Construction exports virtually nothing, while importing around 11% of inputs. Utilities have little direct exposure, but are vulnerable due to their reliance on demand from energy-intensive exporters.

Petroleum was the only manufacturer with a higher share of imported inputs over exported outputs. Oil refiners have clearly prospered from rising prices in Canada for their output, while the loonie helped dampen the rising cost of crude oil imports. As a result, profits have soared since 2003.

Clothing was a unique case: although its exports have risen, the loss of market shares in both Canada and the US to Asian imports has severely squeezed profitability and led to many factory closures. These shutdowns probably explain why clothing (including textiles) manufacturers imported less after 2002. This raised their net difference between exports and imports from 9% in 1997 to 25% in 2006, the largest increase of any industry group.

Government services import a larger share of inputs than their exported outputs, notably health and education. Most commercial services have a slight excess of imports over exports (although this is reversed by taking into account their indirect exposure to exporters they service). This includes business services, finance and recreation. Finance, insurance and real estate has the lowest reliance on imported inputs (at 2%), below even municipal government and postal services. Wholesale and retail trade undoubtedly benefited from lower import prices, even if many of these were imports of finished goods (and hence excluded from the I/O calculation of imports for intermediate inputs).

The trend by industry of the net difference between the share of exported outputs and imported inputs has been quite consistent. Clothing saw the largest increase since 1997 due to rising export shares and lower imports. Oil and gas was next, with an increase of over 6 points due to a much faster gain in exports than imported inputs. Machinery and equipment also saw a large gain due to lower imports, having reduced its use of imports when the market for telecom equipment collapsed after 2000.

Seven sectors, mostly exporters, have reduced the gap between the share of exports in output and imports in inputs in the past decade. However, most of these declines were marginal.

(b) Levels

Of course, comparing the ratio of exported outputs and imported inputs could be misleading if industries export a great deal but purchase relatively few inputs in dollar terms (or the opposite). The absolute level of exports and imports is also relevant. Comparing the total level of exports and imported inputs alters the results slightly. Subtracting the dollar values of exports from imported inputs shows that oil and gas producers had the largest direct net exposure to changes in the exchange rate, at $45 billion in 2006, and $84 billion including indirect effects. This represents a nearly seven-fold increase from $13 billion in 1998, reflecting the boom in energy prices which left this industry more than able to overcome the revenue depressing effect of a rising loonie.

Table 4 Exports minus imports ($ millions)

At the other extreme, construction emerges as the largest beneficiary from a rising dollar, with imported inputs $23.5 billion larger than their exports in 2006 (which are negligible). On top of this, the downward pressure on interest rates from the stronger loonie was a further stimulus to demand for construction not studied in this paper but clearly of benefit to this industry.

Most of the other industry results broadly accord with the analysis of the share of exports in output and imports in inputs. Transportation equipment and lumber and paper have large net exposures to a rising exchange rate, with a surplus of exports over imported inputs of $37 billion and $27 billion respectively in 2006. Transportation services had a net exposure of $20 billion, split about evenly in three among trucking, pipelines and air transport (the latter two have overcome this potential problem thanks to strong demand). Chemicals (including plastic) have a net exposure of $19 billion, nearly equal to machinery and equipment. Including indirect exports would boost these to nearly $40 billion, equal to manufacturers of metal and forestry products.

Business services (notably for building and architectural projects) have a large $7 billion excess of exports over imports due to rising exports in recent years. Food and beverage manufacturers have a relatively large surplus of about $8 billion, while accommodation and food services were about half that. Agriculture ran a steady $5 billion excess of exports over imported inputs before exports strengthened in 2006. Mining other than oil and gas has doubled to $12 billion directly (and $22.6 billion in total), thanks to surging metal prices. The large gap between import and export shares for utilities translated into relatively few dollars in absolute terms.

Most services import more than they export, and so stand to benefit from a rising dollar. The public sector gains the most, as it imports almost $20 billion of inputs but exports little. Net imports total about nearly $10 billion for government and $8 billion for health care, largely reflecting imports of computers and other equipment. Interestingly, education imports less than $1 billion more than it exports, partly a reflection that on-line exports have grown rapidly in recent years while most of its inputs are labour. Communication and retail trade have the largest net imports among commercial services.

Other than construction, only a couple of goods-producing industries import more than they export. Petroleum refining leads the way at $9.6 billion, as they import crude oil (especially into eastern Canada) while gasoline exports are low. Utilities have swung from net exporters at the height of California’s energy crisis in 2000 and 2001 to net importers, partly reflecting Ontario’s dependence on imported coal to fuel its generating plants.

Overall, the picture that emerges from analyzing both the absolute level and the share of exported outputs and imported inputs is the same. Construction profits the most as it reaps the benefit of lower prices for imported inputs while selling its output almost entirely in Canada. Most services oriented to domestic demand stand to benefit from lower import prices, apart from transportation and business services (where demand has been robust anyway). Resource-based industries have much larger exports than imported inputs, but have been insulated from the negative impact of the rising loonie by stronger commodity prices (with the very notable exception of forestry products).

Manufacturers stand out as the most at risk to the rising exchange rate. While strong demand has helped some overcome this disadvantage (notably aerospace, machinery, metals and petroleum) others remain highly exposed. In most instances, firms have responded by reducing their net exposure by importing more lower-priced inputs to offset the squeeze on export revenues from a higher dollar.

Conclusion

This study has shown that the net exposure of exported outputs and imported inputs is an important, but not dominant, determinant of industry fortunes. For nearly half the economy, exports are almost irrelevant to demand. In particular, construction and most services have profited from strong domestic demand and lower import prices. Most other sectors that have fared well in recent years have benefited from soaring commodity prices for oil, metals and grains. Others that have suffered the most – notably forestry products and textiles and clothing – have been the victims of events specific to those industries. Changes in the exchange rate have exacerbated but not fundamentally changed their direction.

Many manufacturers have a built-in hedge in their cost structure that helps compensate for the depressing effect on revenues of a rising exchange rate. While the soaring loonie has slowed export earnings, this has been partly offset by lower prices for inputs they import. This helps explain how manufacturers have adapted to the stronger exchange rate, maintaining output steady since 2003 while stepping up investment plans into 2008.

Of course, Canadian exporters can protect themselves in other ways against the effect of the rising exchange rate besides using imports more or concentrating on domestic rather than export market. The most obvious is diversifying their exports away from the US market. This option gained traction as the loonie rose: the US share of exports peaked in 2002, before falling by nearly ten points by 2007. Most of this drop occurred in the last two years. Another tactic is to invest on both sides of the border, or locate business in many countries. This is related to the broader strategy of raising productivity and cutting costs.

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Notes