Executive summary

In this paper we focus on the challenges that the manufacturing sector has faced over the last half century by examining long-term trends and short-term shocks that affected the industry. We focus first on the issue of deindustrialization and whether there is evidence of the industry being in long-term decline. Deindustrialization is almost always examined using a relative metric such as the share of manufacturing in nominal GDP or the share in total employment. In Canada, these shares have fallen over the last 45 years, though somewhat less than in many other industrialized countries.

There are two reasons why the share of value-added (GDP) is a poor measure for determining if deindustrialization is occurring. First, the share of GDP depends not just on how the manufacturing sector performs, but also on how all other areas of the economy perform. Second, shares reflect the fact that the nominal value of GDP has both a volume and a price component: movements in each have different implications for the deindustrialization hypothesis. Analysis of nominal GDP or employment shares tends to overlook the effect of the relatively large productivity growth in manufacturing on relative prices of this sector. Declines in relative prices are not indicative of a sector that has become moribund; rather they indicate that manufacturing has been undergoing rapid technological change.

Next, we examine how the manufacturing sector has responded to specific shocks during the last 45 years: from exchange rate movements, trade liberalization and business cycles. Economic shocks emanating from these sources can accelerate, decelerate and even reverse the declines in manufacturing's share of economic activity.

Looking at long-and short-term influences on manufacturing, the picture that emerges is not one of large-scale deindustrialization in Canada. Rather, manufacturing volumes between 1961 and 2005 kept pace with overall growth in the volume index of GDP. Manufacturing adapted to long-term changes in the economic environment, showing considerable resilience in the face of diverse challenges stemming from demand shifts, relative price shifts and changes in tariff regimes.

Throughout the investigation into the challenges manufacturing has faced in the last 45 years, several questions are explicitly addressed:

1. Is Canada de-industrializing?

No. Discussions of deindustrialization in Canada focus on a supposed decline of the manufacturing sector. This dialogue relies upon statistics showing that manufacturing accounts for less and less of the total value of the Canadian economy's market output, and that the share of the value of GDP accounted for by manufacturing has been falling since 1961.

The fact that manufacturing's share of the value of goods produced fell does not imply that the absolute or relative size of the volume of goods has fallen, which is at the core of the deindustrialization debate. The decline in the share of the value of GDP accounted for by the manufacturing sector is not simply caused by a decline in the goods produced, since the value of GDP is comprised of both a relative price and a relative volume component.

The decline in relative overall value originating in the manufacturing sector comes from relative price declines and not relative volume declines. For Canada, relative volumes were essentially unchanged between 1961 and 2005. On the other hand, relative prices fell by 0.9% per annum, making them the primary source behind the declines in Canada's manufacturing share of the value of GDP. There is little evidence—when relative volumes are considered—that manufacturing was in a long-run decline.

2. Why are relative prices of manufactured goods falling?

Manufacturing is the major source of productivity growth in the Canadian economy. Firms pass this productivity growth on in the form of lower price growth. As a result, prices of manufactured goods do not rise as rapidly as the overall price level; hence, a relative decline in manufacturing prices occurs. Between 1961 and 2005, manufacturing prices rose at an average annual rate of 3.5%, compared with 4% for services and 4.5% for goods. These relative price declines led to decreases in the share of nominal GDP accounted for by manufacturing.

3. Do the processes behind the share changes lead to smooth changes over time?

No. Between 1961 and 2005, changes in exchange rates, business cycles and trade liberalization accelerated, decelerated and reversed the share declines experienced. The result is an uneven adjustment, a process that has also occurred in other member countries of the Organization for Economic Cooperation and Development (OECD).

4. How do exchange rates affect the share of manufacturing in nominal GDP?

Exchange rate fluctuations affect the speed of relative price changes. The manufacturing sector has had to adapt to several exchange rate cycles over the study period. The cycles are associated with changes in the competitive pressures faced by Canadian manufacturers, as their domestic and export prices come under more (or less) pressure as the Canadian dollar appreciates (or depreciates) against the U.S. dollar.

One exchange-rate cycle corresponded directly to the period (the 1980s and 1990s) when Canada's share of manufacturing in GDP performed well. Canada's relatively 'superior' performance, compared to other OECD countries with respect to the share of the value of GDP produced in manufacturing, stems primarily from a different trend in relative manufacturing prices in the 1980s and 1990s. The downward trend in relative manufacturing prices in Canada tracked that of the United States in the 1960s and early 1970s, but then underwent a hiatus in the 1980s and 1990s. During this period the Canadian dollar underwent a long-term depreciation against the U.S. dollar that reduced competitive pressures on Canadian manufacturers. At this time, Canadian manufacturing relative prices stopped declining at the same rate of other countries.

This emphasizes the general problem of using the share of industry value added to infer whether or not the manufacturing industry is maintaining production levels. Prices are an important determinant of the share of value added originating in the manufacturing sector. When there are exchange rate shocks prices can deviate from their long-term trajectory in a small open economy like Canada's. During the 1980s Canadian manufacturing prices deviated from their long-term trend (U.S. levels), and this contributed to a slowdown in the long-term decline in the share of manufacturing value added, creating the appearance of Canada's performance being superior to that of other countries.

5. How have business cycles affected the share of manufacturing?

The Canadian manufacturing sector is affected by business cycle shocks emanating from the United States. As a general rule, when manufacturing in the United States performs relatively well, manufacturing in Canada also does well and vice versa. Business cycle fluctuations, therefore, affect the speed of relative volume changes.

To investigate this relationship, the paper tracks annual changes in the relative volume of Canadian manufacturing against the U.S. Federal Reserve Manufacturing Capacity Utilization (CAPU) Rate Index. Between 1961 and 2007, Canada responded closely to changes in United States capacity utilization. During periods when U.S. CAPU is above its long-run average, Canadian manufacturing volumes rise faster than overall GDP. When U.S. CAPU drops below its long-run average, Canadian manufacturing volumes decline relative to overall GDP.

In Canada and the United States, manufacturing is more cyclical than the overall economy. In Canada, the manufacturing sector has been even more volatile than the manufacturing sector in the United States. Between 1961 and 2007, the standard deviation of the manufacturing sector's growth rates in Canada was about 10% higher than those of the United States, but the performance was very different in the first half and the last half of the period. In the first half of the period, Canada was more stable than the U.S. In the last half, it became more volatile than the U.S.

6. How has trade liberalization affected manufacturing's share of GDP?

Trade liberalization has dramatically reshaped the Canadian manufacturing sector's opportunities in U.S. export markets and heightened the intensity of competition from foreign producers. The Auto Pact in 1965, the General Agreement on Tariff and Trade's (GATT) Kennedy Round (1964-1967) and the Tokyo Round (1973-1979) of tariff cuts were followed by the 1989 Free Trade Agreement (FTA) with the United States and the North American Free Trade Agreement (NAFTA) between Canada, Mexico and the United States in 1993. The most dramatic episode was the adjustment to the free trade agreements that Canada underwent in the mid-to-late 1990s.

The largest relative and absolute gains in manufacturing output occurred during the mid–to–late 90's. As a consequence, the share of manufacturing in GDP rose through the 1994 to 2001 period as Canada adjusted to expanded trade opportunities.

7. Did NAFTA have any other effects on manufacturing shares?

Yes. It was predicted that NAFTA would bring benefits to those industries where access to larger markets would reduce costs because of the exploitation of either scale or scope economies. Between 1994 and 2001, durable goods industries expanded their shares within manufacturing, while the share of non-durables contracted. In this respect, the Canadian manufacturing sector began to resemble that of the American manufacturing sector (as did the Mexican manufacturing sector). By 2005, the composition of the manufacturing sector had changed considerably from 1961, with most of the change occurring after the introduction of NAFTA.

8. What can we say about manufacturing overall?

Manufacturers in Canada have proven to be resilient and adaptive. Over the past 45 years, manufacturers have dealt with oil shocks, Canadian and U.S. recessions, trade liberalization (including the introduction of NAFTA), and the largest resource boom since the end of the Second World War. The resource boom was associated with a dramatic change in the relative prices of outputs and inputs and an unprecedented appreciation of the Canadian dollar. Throughout all of these events and in the face of intense international competition and rising resource prices, Canadian manufacturers raised their productivity by an annual average of 1.1%, shifting manufacturing shares in durable goods industries to resemble that of the United States.

Between 1961 and 2005, the volume of manufactured goods produced, relative to total goods and services, was approximately constant. More important, the actual volume of goods produced (the volume index of GDP in manufacturing) increased. The rate of increase was also positive during the 1990s after the implementation of NAFTA. During this time, growth was positive in non-durables (even though its share diminished) and in the durables sector (whose share increased). Productivity performance in durables was superior to that of the non-durables sector over most of the period.

In the years since the technology bubble burst in 2001 and during the resource boom, manufacturing growth averaged 0.4% per annum between 2002 and 2007. The compositional shift, towards durables and away from non-durables, continued. Durable goods volumes tended to increase over this period while non-durable goods production declined. Between 2001 and 2007, the volume index of GDP expanded across most durables industries and declined across most non-durables industries.

Despite the relatively high productivity growth in manufacturing, the demand for inputs used in manufacturing has grown. Over the half century examined, both labour and capital inputs (defined as labour and capital services) increased in almost all industries. The exceptions are labour inputs in beverages, leather and clothing—three non-durable industries. While hours worked have declined in the post-2000 period in both durables and non-durables, the shift from a lower skilled, lower paying workforce to a more highly educated one that began before 2000 has continued after 2000. Throughout the period, capital inputs have increased across all industries—even in those three non-durable consumer goods industries that have seen labour input decline. More importantly, the growth of capital inputs is greater than the growth in labour inputs, with capital services-labour ratios increasing universally across all industries. Over the period from 1961-2005, capital services increased more than 2.5 times the rate of labour services.