Executive summary

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The Canadian dollar has gone through several cycles of appreciation and depreciation relative to the U.S. dollar. It first appreciated in the early 1970s, after a period of a fixed exchange rate against the U.S. dollar. It depreciated between the mid-1970s and mid-1980s; this depreciation was followed by an appreciation in the late 1980s. The Canadian dollar then experienced a long period of depreciation over almost the entire decade of the 1990s; since 2002, the Canadian dollar has appreciated considerably, from US$0.64 in 2002 to US$0.93 in 2007.

The Canadian manufacturing sector has also had to adapt to increasing trade liberalization. The Kennedy, Tokyo, and Uruguay rounds of international-trade liberalization led to falling tariffs in the 1960s, 1970s, and 1980s. The Free Trade Agreement between Canada and the United States of America (FTA between Canada and the United States), which came into force in 1989, and the North American Free Trade Agreement (NAFTA), which came into force in 1994, followed up with even larger tariff reductions than had been experienced in previous decades.

Plants may respond to exchange-rate movements and tariff reductions in many ways. They may expand/contract existing operations, enter/exit domestic or foreign markets, relocate their production facilities, or consolidate operations through mergers/acquisitions. This paper focuses on the linkage between changes in the exchange rate and plant exit. We ask which plants are more likely to exit when the Canadian dollar appreciates or depreciates against the dollar of its largest trading partner—the United States. In examining the effect of exchange-rate movements on plant exits, we also control for other factors that may influence plant closure. These include falling tariffs as well as a set of plant characteristics, such as age, size, productivity, export status, and ownership-control status.

Plant exit plays an important role in resource reallocation and industrial renewal. While plant closure results in job losses, the "creative destruction" associated with plant turnover may also trigger innovation and improve productivity by replacing the least productive with more productive plants. Understanding the factors contributing to plant closure has important implications for industrial, trade, and foreign-direct-investment policy.

Using Canadian manufacturing plants over the period 1979-1996, we provide empirical evidence regarding the simultaneous effect of tariff reduction and exchange-rate fluctuations on plant survival. We find:

1. Currency appreciation increases the probability of plant death while currency depreciation increases the probability of survival. The effect is not uniform across plants: plants that are less efficient experience an increase in their shutdown probabilities when the Canadian dollar appreciates.
2. A decline in tariffs raises the probability of plant death, in particular for plants that are less efficient.
3. Overall, for the period under examination, tariff reduction has a greater effect on plant exit than do exchange-rate fluctuations. On the one hand, for the period from 1984 to 1990, the rate of plant failure due to tariff reduction is about 2.6 times that of plant failure due to exchange-rate appreciation. The real depreciation of the Canadian dollar from 1979 to 1984 and from 1990 to 1996, on the other hand, decreases the exit rate. However, this decline only partially offset the increased exit probability due to tariff cuts that occurred at the same time. During the implementation of NAFTA, in the 1990s, the Canadian economy experienced a substantial depreciation in its currency that offset about 17% of the effect of falling tariffs during this period.
4. There are significant and substantial differences between exporters and non-exporters, and between domestic- and foreign- controlled plants. Exporters and foreign-owned plants have much lower failure rates; however, their survival is more sensitive to changes in tariffs and real exchange rates.