Research Blog: Trade and productivity

The StatCan Blog begins a new feature: a guest post on research at Statistics Canada will be published every quarter. Our first post is from Beiling Yan, senior analyst in the Economic Analysis Division, Statistics Canada.

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The movement toward freer trade between Canada and other countries has opened the Canadian economy to new trading opportunities.

Economics teaches that there should be a close relationship between the openness of a country to international trade and its productivity performance.

The Canadian evidence

What is the evidence that freer trade has had an impact on Canada's productivity and economic performance?

The Economic Analysis Division of Statistics Canada has published several studies showing that changes in the trading environment have contributed to productivity growth.

Study results reveal a close link between trade intensity and aggregate productivity in Canada. In the 1990s, both grew quickly. This period coincided with a weaker Canadian dollar—which increased the competitiveness of the Canadian manufacturing sector—and the implementation of the North American Free Trade Agreement in 1994.

In contrast, during the post-2000 period, when the trading environment between Canada and its chief trading partner, the United States, changed as a result of the “thickening” of the Canada–U.S. border after 9/11 (Brown 2015; Globerman and Storer 2008; Moens and Gabler 2012) and the significant appreciation of the Canadian dollar relative to the U.S. dollar, both trade intensity and productivity fell.

Increased exports and imports

With freer trade, Canadian producers have increased both their exports to and their imports from other countries.

Statistics Canada studies have found that both increased exports and increased imports have improved the productivity performance of the Canadian manufacturing sector.

Exporters have contributed significantly to economic activity: on average, over the period from 1974 to 2010, 35% of Canadian manufacturing firms were exporters, but they contributed more than 72% of total manufacturing employment and 79% of total shipments. Exporters were the dominant source of aggregate productivity growth, accounting for almost 75% of aggregate labour productivity growth in the manufacturing sector in the 1990s (Baldwin and Gu 2003).

In addition, imports have been an important source of productivity gains for the Canadian economy. Increasingly sophisticated foreign intermediate inputs have facilitated the production of more sophisticated Canadian products that incorporate these inputs as intermediate products. As a result, two-thirds of Canada's effective productivity growth from 2000 to 2007 can be attributed to intermediate inputs produced abroad and imported to support production by Canadian firms (Gu and Yan 2014).

Higher firm productivity

Greater access to foreign markets resulting from trade liberalization allows firms to increase their productivity through three routes:

• First, firms achieve greater product-line specialization and benefit from economies of scale. As product lines are rationalized and as plants grow larger, unit costs are reduced, and the competitiveness of Canadian firms increases. Several studies provide evidence that implementation of the Canada–United States Free Trade Agreement resulted in a significant reduction in the diversity of products being produced by Canadian manufacturing plants and a substantial increase in the length of production runs for the smaller set of products (Baldwin et al. 2002, 2005, 2006).
• Second, trade facilitates the transfer of knowledge from foreign sources to Canadian firms. Evidence suggests that new exporters are 37% more likely to use foreign technologies than non-exporters. In addition, exporting is connected to an increase in the incidence of research and development (R&D) collaboration agreements with foreign buyers. Firms that begin to export are also more likely to begin conducting R&D (Baldwin and Yan 2016). Importing can also enhance firm productivity by allowing Canadian firms to access foreign inputs and technologies that are unavailable or more expensive domestically.
• Third, international markets are often more competitive than protected domestic markets and, as such, exert more pressure on Canadian producers to increase efficiency and become more productive.

While the productivity benefits that come from accessing new markets are impressive, they do not happen automatically.

• Firms must innovate and spend more capital per worker by making new investments to adjust to international markets.

• Businesses that succeed abroad are more adaptable and innovative and introduce new products and processes (Baldwin and Gu 2004a; Lileeva and Trefler 2010).
• Businesses that succeed abroad also invest in advanced technologies, R&D and training—all activities that develop their capacity to learn from, and adopt, international best practices (Baldwin and Gu 2004a).

The macro environment

Conditions in the macro environment that are beyond the direct control of Canadian firms also affect the ability of businesses to exploit the advantages offered by trade liberalization. Changes in the macro environment, such as tariffs and exchange rate movements, have had an impact not only on the degree of experimentation but also on the magnitude of market share gains in foreign markets and associated gains in productivity.

• The depreciation of the Canadian dollar in the 1990s served to reinforce the positive performance of Canadian exporters in that decade.
• In contrast, the productivity benefits normally experienced by new exporters were much reduced after 2002, when the Canadian dollar appreciated significantly (Baldwin and Yan 2015a, 2012a, 2012b, 2011; Baldwin, Gu and Yan 2013).

Industrial restructuring

Trade liberalization also raises productivity via industrial restructuring. As tariffs are reduced, the least productive firms exit and the most productive firms expand. Aggregate productivity improves as a result of this restructuring, which sees the least efficient contract and the most productive expand. This reallocation of production between plants is estimated to have accounted for 50% to 60% of the productivity gains in Canada's manufacturing sector associated with the Canada–U.S. tariff cuts that took place in the 1990s (Baldwin and Gu 2004b; Trefler and Melitz 2012).

The key insights from firm-level empirical Canadian research are that adapting to new, larger markets promotes productivity growth and that broader macroeconomic conditions, as well as firm-level factors (such as the ability to adapt, invest and innovate), affect successful expansion into new markets.

For more details on the main findings of Statistics Canada research on trade and productivity, please refer to “Empirical evidence from Canadian firm-level data on the relationship between trade and productivity performance” by John Baldwin and Beiling Yan, Economic Analysis Research Paper Series, Statistics Canada, 11F0027M, no. 97, 2015. The paper is also published by the Institute for Research on Public Policy.