Adjusting To The Value-Added Economy by Benjamin Tal, Royce Mendes and Nick Exarhos

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1 In Focus November 25, 215 ECONOMICS Adjusting To The Value-Added Economy by Benjamin Tal, Royce Mendes and Nick Exarhos Avery Shenfeld (416) Benjamin Tal (416) Andrew Grantham (416) Royce Mendes (416) Nick Exarhos (416) com/res/eco/ecoresearch. html The Canadian manufacturing sector lost more than 1% of its capacity during the dark days of the loonie s overvaluation and the new capacity that will soon emerge will be very different than what was lost. Intellectual-capital intensive operations will take centre stage, with a growing portion of capacity not visible or entering traditional macro-economic models. The face of the firms operating in that space will also continue to change rapidly as they focus increasingly on creating solutions as opposed to just building products. The role of services in supply chains, which is already much larger than traditional measures suggest, will grow even larger. But, with these changes, there will be challenges. While new technologies increase opportunities for new firms, they also heighten competitive forces that threaten established players. Companies will have narrower windows to capitalize on proprietary know-how or products. Furthermore, because resource use will gain importance, deciding on which part of the value chain firms target will be decisive in their viability. Current financing avenues and educational models are also not fully equipped to effectively support the new wave of entrepreneurialism. The Emerging Firm The types of goods and services that are driving activity in many advanced economies is changing rapidly. That s especially true for tradable goods and services. With emerging markets able to manufacture a variety of products at more competitive prices than Canada, the mix of firms in our nation has been changing. New Canadian firms have needed to focus on higher-value added products and solutions to differentiate themselves in global supply chains. With many advanced economies undergoing a similar shift, it s important to understand the characteristics of these new firms, which will no doubt be different than the ones you learned about in your Economics 11 textbook especially with regards to technology and capital. Technology and Connectivity The ever changing technological landscape is leading increasingly to a higher level of cooperation between small and larger firms. The theme here is that each participant provides a specific expertise as it relates to a project. This kind of cluster of competencies and strategic alliances will be temporary in nature, and at the end of a particular project will dissolve and may or may not cooperate again. The same forces are already leading to the evolution of a new type of operation the virtual enterprise in which clusters can be created quickly, work intensely on a given project, and upon completion can be dissolved and cease to exist. As long as the project is alive, the entities included in these strategic alliances can, for a time, perform almost like a traditional business. As a result, more small businesses in Canada will become virtual corporations, stopping and starting on a project-by-project basis. This means that in the future, it will be CIBC World Markets Inc. PO Box 5, 161 Bay Street, Brookfield Place, Toronto, Canada M5J 2S8 CIBC (416) CIBC World Markets Corp 3 Madison Avenue, New York, NY 117 (212) 856-4, (8)

2 even more difficult to identify exactly what a firm is. It is also likely that home-based firms will increase their partnership with non-home-based firms to collaborate on individual projects. Increased connectivity will both allow and require small businesses to be more responsive to their customers particular needs. The development and design of new customized products will give small firms an advantage and, at the same time, put pressure on them to produce with greater speed than ever before. Small businesses must diversify to a greater extent to maximize their ability to respond rapidly to new demands for products and services. A side effect of these technological advances is that in order to compete effectively in the rapidly changing economic environment, big businesses are now having to subdivide their internal functions into what are essentially self-contained units that function in many ways like small businesses. Servicing The World Global communication has also allowed firms to specialize, especially in the service sector. As a 214 report from the IMF aptly says More and more services can now be unbundled: a single service activity can be divided up into tasks done at different geographic locations. Goods producers can take advantage of similar unbundling. That means focussing on high-value added products and solutions in Canada can still allow domestic firms to be a part of supply chains with lower-value added parts (Chart 1). Simply put, a shift toward high value-added firms won t isolate Canada from other industries. Chart 2 Service Exports Are More Stable Exports, C$ Bn Services (L) Goods (R) Monthly Standard Deviation of Y/Y Growth (2-214) 1% 9% 8% 7% 6% 5% 4% 3% 2% 1% % Merch. Exports Serv. Exports Any discussion regarding Canada s international trade position often gravitates, by default, to merchandise trade. Trade in services is usually nothing more than an afterthought. That tendency should change. Exports of Canadian services have risen faster than exports of goods over the past decade, and more importantly, service exports are three times less volatile than merchandise trade (Chart 2). Increasingly, firms use reliance on services exports that supplement their products as a natural smoother of the economic cycle. The 28 recession hardly dented the trajectory of services exports but was very visible in goods exports. The main factor behind that relative stability is the more diversified geographical distribution of tradeable services (Chart 3, left). The US accounts for just over 5% of Chart 1 Value-Add Can Be Split Around The World Chart 3 Service Exports Are More Geographically Diverse Amount of Value-Add R&D,Design, etc. The Smile of Value Creation Manufacturing, Standardized Services, etc. Marketing, Advertising, Logistics, After-Sales Services, etc Herfindahl-Hirschmann Index of Export Concentration Distribution of Service Exports other Central/ East Asia Europe US Advanced Economies Emerging Markets Advanced Economies Goods Services Source: IMF, Mudambi (27), CIBC 2

3 Canadian service exports notably below the 75% share seen in merchandise exports (Chart 3, right). So why don t tradeable services get the respect they deserve? The obvious answer is that they are simply too small to noticeably influence the macro picture. After all, according to Statistics Canada, tradeable services account for only 16% of gross exports. How is it possible that services represent such a small fraction of exports while accounting for 7% of GDP and over 8% of all jobs (Chart 4)? The answer, your economics 11 professor would say, is that most services are untradeable. After all, you cannot export a haircut. But that might have been more the case twenty years ago than it is today. Globalization rapidly accelerated fragmentation of production and supply chains have become global value chains wedding intermediate goods and services. However, why can t we see it in the statistics? When in doubt, it s often tempting to blame Statistics Canada. But, other official statistics agencies also focus only on the direct sale of Canadian services from home and via foreign affiliates. Furthermore, official statistics grossly and routinely overstate the volume of merchandise exports due to the fact that goods exports are counted each time they cross a border or across supply chains, while services do not generally cross borders as many times. In addition, the direct measure of trade in services ignores the value-added services that are embodied in the final product such as design, engineering and marketing. Those two shortcomings have the same end-result. They understate the share of services in gross exports. Chart 4 Share of Services in the Canadian Economy Chart 5 Share of Services Exports in Gross Exports 5% 45% 4% 35% 3% 25% 2% 15% 1% 5% % Direct Service Exports (StatCan) Value Added Service Exports (OECD) Source: StatCan, Conference Board of Canada, OECD (TIVA), CIBC So what s the right number? Recently released information from the OECD reveals a picture that is more consistent with common sense. As first recognized by The Conference Board of Canada, according to the OECD s TIVA database, which captures embodied exports in addition to direct exports, the share of services in Canadian gross exports is not 16% but more than 4% (Chart 5). If tradeable services were important in the past, they will be even more important in the future. Most of the discussion regarding the Trans-Pacific Partnership (TPP) focuses on the impact on industries such as dairy, autos or forestry, but the potential impact of the deal on tradeable services could be very significant. The agreement covers a broad range of services through a negative list approach Chart 6 Value-Added Services in Gross Exports (TPP Members) % in Employment in GDP in Exports Singapore New Zealand U.S. Japan Australia Canada Malaysia Mexico Vietnam Chile Brunei Year: 211 % 2% 4% 6% 8% 3 Source: OECD (TIVA), CIBC

4 which means that all service sectors are covered by the agreement with the exception of the few sectors that are listed by a country. Provisions such as the standstill and ratchet mechanisms will work to ensure that current trade policies regarding tradeable services and future liberalization in that space are irreversible. Using the value-added approach we can learn from Chart 6 that Canada s share of services in gross exports is lower than the average seen in other developed TPP countries. That is mainly because of value-added tradeable business services which accounts for only 8% of gross exports notably lower than the 2% share seen in the UK and 15% in the US and Germany. This lower share might reflect some technical factors such as the growing role of inter-company pricing in global trade which on average tends to impact Canada more than many other countries (for reasons beyond the scope of this discussion) and more fundamental reasons such as the mix of products and comparatively low levels of research and development activity. The Sharing Economy The higher value-added businesses of the coming cycle will make better use of not only proprietary business practices and resources, but also make the most of available infrastructure. That includes things like roads, railways and airports. It also captures the still-growing realm of information technology and the internet. The internet first connected us so that we could share digital goods, be it or images. In the past few years, however, new businesses have emerged which have helped individuals share physical goods. Using the advances made in smartphones, and their portable nature, the sharing economy has made it easier to share our cars, and even our apartments. Individuals are now making better use of their resources, By optimizing the time when they are using them and when they can offer them up to others. But that dynamic has yet to translate fully to enterprises. In the future, businesses will sprout up enabling firms to share their physical capital and services. Be it warehousing, or other goods used in firms logistical processes, the high value-added businesses of tomorrow will use these new technological avenues to make better use of their resources. In addition to connecting people to better exchange information, new technologies are allowing the collection and analysis of what s being shared. Big data has already allowed researchers and businesses to better understand complex problems. By being able to store and access data remotely, the cloud is giving managers and workers accessible ways of looking at problems from many angles. These gains in analytics are part and parcel of optimization asset use. Capital Usage Sourcing and deploying capital will become increasingly important. The ratio of service providers employing highly skilled workers and supplying specific niche solutions is likely to increase so that overall capital intensity in advanced economies decreases over time. Moreover, rather than accumulating large amounts of capital to make the most of use of highly skilled labour, goods producers will rely on proprietary products and technology in advanced economies to gain competitive advantages while outsourcing low-skilled labourintensive work to emerging markets. As a result, research and development will be combined with enhanced global communication to allow for this specialization. Solutions vs. Goods In effect, the net result will be that these new firms will carve out the more lucrative part of the value chain. Less labour-intensive production will focus on product conceptualization rather than manufacturing. On the opposite end of the spectrum, firms in developed countries will also be responsible for the marketing and distribution of the products to customers. By focusing on the intellectual property aspects of the value chain, the types of firms that will sprout up will also be more scalable in nature than before. Unlike nuts and bolts production, ideas and processes have negligible marginal costs to production. That ability to more rapidly and cheaply spread the ideas will allow firms to sell their solutions to markets globally. Small Businesses Are Getting Smaller In recent years, we have seen an unmistakable trend in which small businesses are getting smaller. Most of the growth in SME business formation over the past decade has been concentrated among enterprises with fewer than fifty employees. The number of larger small businesses was hardly changed during that period (Chart 7). 4

5 Chart 7 Small Businesses Are Getting Smaller Dec-5 Jul-6 Feb-7 Sep-7 Firms by Employee Size Apr-8 Nov-8 Jun-9 Jan-1 The dominance of very small businesses is not surprising if one considers that establishing and running a small business is now significantly cheaper and easier than in the past. New and rapidly changing technologies, and the power of e-commerce are emerging as important forces that impact the very decision to start a business and allow enterprises to level the playing field with larger firms. Not surprisingly, the highest concentration of micro businesses is in the professional, scientific and technical services sector. The fact that many of the firms in this emerging economy will be in the early stages of maturation, suggest that this trend is likely to continue. Having access to capital and incubators will be important in the success of Chart 8 SMEs Are Responsible for Almost Half of All R&D Spending Aug-1 Mar-11 Oct-11 May-12 Dec Jul-13 Feb-14 Sep-14 Percentage of Total Expenditures on R&D by Firm Size Apr-15 these smaller companies. To truly take advantage of the emerging environment, firms will need to invest heavily in research and development. Fortunately, Canadian SMEs already account for about half of all R&D spending in the country (Chart 8). That will give them a competitive advantage moving forward. But things like incubators for small firms can create a symbiotic environment that provides benefits that are greater than the sum of its parts. There are several Canadian business incubators that help start-ups connect with potential customers, advisors and financiers. By connecting firms and investors, they help entrepreneurs network, and transfer know-how. In this country, organizations operate independently, mirroring in part how new firms source financing. However, without having a central body coordinating resources, particular incubators are sometimes in a position to compete with each other for resources and even entrants into their programs. But there are examples of countries organizing incubators in different ways. In Germany, there is a federal organization that promotes the establishment and growth of innovation centers. The BVIZ aims to promote the knowledge and technology transfer, as well as firm creation for the national well-being. This more central, and more cooperative method has yielded solid results. There are currently 15 innovation centres associated with the BVIZ, which has helped grow over 17, companies, and is currently helping almost 6, new ones. There s no cut-and-dry issue as to which will yield more fruit in the years to come. Canada is blessed with some of the world s finest research universities, and a strong financial industry able to steer capital in the direction of the best ideas. Furthermore, informal trade organizations often fill the gap left by the lack of a central overseer. High Value-Added Firms Need Highly Skilled Workers Large (5+) 51% Small (1-99) 31% Medium (1-499) 18% 5 High-value added firms are often skill-intensive. That means higher education, in many cases, is a requirement for those who wish to take part in these new types of firms. And on paper Canada looks good. Canada ranks first among all OECD countries in the proportion of year-olds who have completed tertiary education despite the fact that the cost of that education is also among the world s highest roughly double the OECD average (Chart 9).

6 Chart 9 Canada Leads the Way in Tertiary Education Source: OECD, CIBC In the two years since we examined the narrowing premium on education in Degrees of Success: The Payoff to Higher Education in Canada, the humanities and social sciences, so-called soft subjects, remain highly popular and fast-growing degrees. On average those fields offer the least both in terms of financial rewards and economic advancement, while academic disciplines of science, technology, engineering and mathematics (STEM) and commerce pay for themselves compared to a high school diploma, even after factoring in tuition. Yes, it pays to have a Bachelor s degree. The more you learn, the more you earn. University graduates make 5% more than someone with no post-secondary education and nearly 25% more than those with college diplomas. Chart 1 Narrowing Income Premium Gap between University and College Graduates 1 5 Certificate/ Diploma Programs Percentage of Adults Who Have Completed Tertiary Education (25-64) Growth in Real Average Weekly Wage by Education (22-214) 15 % High school University degree Ratio: Real Average Weekly Earnings (University graduates to Certificate/Diploma Holders) But, that education premium in Canada already lower than the OECD average is vanishing relative to its cost (Chart 1). In the 199s, the differential in the jobless rates for high school and university graduates was quite large, but now the university grad unemployment rate has slimmed to just a 1.7 percentage point gap. The same goes for the gap between university and college graduates. Compared to having a college diploma, the university premium has narrowed to a slim.6 percentage points. There is a significant and growing mismatch between the skills possessed by the workforce and the needs of employers for skilled talent. It is getting harder and harder for university graduates to find jobs that match their skills, while on the flip side, many jobs in the new emerging economy go unfilled for the lack of adequate talent. Too many students are getting a Liberal Arts degree for the sake of simply getting a Bachelor s degree only to discover upon graduation that they either lack the skillset to obtain a job prompting them to enroll in specialized college programs or they end up taking a job for which they re overqualified. A recent federal parliamentary report found that about 4% of recent university graduates are overqualified for their jobs, saying they could not find the jobs they wanted and could not wait for jobs they wanted. It s not so much that having a degree matters but the type of the degree that matters. That said, what s clearly been emerging for some time now is that for Canada s economy to achieve sustainable growth in the future, it is not even the degree that matters but rather the diploma. Increasingly, a community college education and the skilled trades are becoming a valuable and necessary driver of the new emerging economy. Instead of taking four years to enter the labour market, university graduates heading off to college to hone skills now don t enter the workforce for yet another one to two years. This hurts Canada s competitiveness and economic growth. The public and private sectors need to do more to support universities and colleges to promote entrepreneurialism, while new funding models need to emerge to nurture and support the next champions of industry and commerce. The educational system also needs to do a better job teaching youth in the STEM disciplines so that students begin gravitating towards those programs. According to the OECD, Canadian adults rank at the OECD average in

7 literacy scores and below average in numeracy scores and while 15-year-olds score significantly above the OECD average in mathematics, their average math scores have deteriorated in the past decade. Canadians may be among the world s most educated, but when compared to the OECD, Canada also has the highest share of university graduates earning less than half the median income. Part of the problem isn t just the degree, per se. It s also the composition of the workforce. More than 2% of Canadians with a degree or diploma are immigrants, and that share rises with the level of education. Half of all PhD holders in Canada are foreign born. Yet, the unemployment rate among immigrants is notably higher than among Canadianborn individuals with similar educational degrees and they also earn less. No less than 5% of degree holders who obtained their education outside of Canada earn less than the median income. That s notably more than the 3% among Canadian-born graduates. A Bachelor s degree in commerce earned abroad yields 4% less than the same degree earned in Canada. While in health and social sciences, the gap is only 1%, it balloons to 7% for engineering graduates. This troubling trend reflects many factors, such as the low return on immigrants foreign work experience, difficulties with foreign credential recognition, concerns about the quality of skills learned abroad and low proficiency in English or French. Both the shift away from immigrant-source countries where languages, educational outcomes and systems are similar to Canada s and the lack of public and private sector policy to address these issues has only served to exacerbate the problem. One of the challenges is that companies also need to think differently. The private sector needs to reevaluate how it values education, training and skills. Typically, companies promote employees on the basis of their education so that a university degree is perceived as trumping a college diploma. But for Canada s economy to prosper, that old-school mindset needs to change. Another key driver that s diminishing the education premium is the field of study. We examine Statistics Canada and other calculations that attempt to compute an annualized average return on investment (ROI). For students shelling out thousands in higher-learning costs, the ROI in humanities and the social sciences is significantly below that from specialized and professional fields, such as medicine, law and engineering. As many as 45% of Canada s recent graduates have degrees in psychology, humanities, social sciences or education, all fields where 7 they re earning less than the median income. In the past decade, with the exception of commerce, there has not been a meaningful influx of students into degrees with more advantageous outcomes. The risk attached to the investment on a higher education has never been higher. On both ends of the spectrum, Canada is experiencing a significant shortage of supply. The only way to improve participation rates in these fields is a combination of increased public and private investment, new funding models to encourage entrepreneurism, improved quality and equity of learning opportunities, developing an information infrastructure system to identify emerging trends in the labour market needs, and a much simpler and efficient credential recognition process for new immigrants. These are but a few remedies. Financing The Emerging Enterprise Given that many of these new firms will be at the smaller to medium end of the spectrum, having access to credit could be somewhat of an issue. While it may not be as significant as in other jurisdictions, it s true that a challenge for smaller firms, especially new ones, is gaining access to credit. A survey by PWC published earlier this year found that financing remains the biggest challenge for about onethird of Canadian tech startups. With most of these startups having fewer than 25 employees and $1 mn in revenue, it s understandable that access to both debt and equity would be limited. Most early stage funding for these firms come from family and friends or angel investors investors who are Chart 11 VC Funding Rebouding 2,5 2, 1,5 1, VC Funding ($, millions) Source: Industry Canada, CIBC

8 Chart 12 VC Funding Focussed on Later Stage Firms Chart 13 US An Important Source of VC Funding 14 Stage of VC Funding 12 VC Funding by Location ($ mn) Source: Industry Canada, CIBC Seed and early stage Expansion Later stage willing to provide early patient capital. Despite many new initiatives by different levels of government, funding from the public sector remains underwhelming. Nevertheless, a growing source of funding has been coming from the venture capital industry. Following some lean years in the aftermath of the financial crisis, VC funding for SMEs has grown and is an important part of financing for many of these firms (Chart 11). However, there are drawbacks for some firms. VCs remain focussed on later stage funding. That means that financing for early stage startups remain limited in many capacities (Chart 12). Another telling sign that the Canadian market is not yet fully mature is the growing amount of funding coming from abroad. Both Industry Canada data and the PWC survey suggest that US VC financing is an important avenue for Canadian startups (Chart 13). That leaves open the possibility that new forms of domestic funding, especially for early stage firms or those that do not have clear plans to come to market, could be useful in financing these new firms. One form of financing that has emerged in recent years is crowdfunding. In an industry report, Massolution estimates that crowdfunding could grow from $16.2 bn in 214 to $34.4 bn in 215. In this type of financing, firms can post descriptions of their projects or companies on various websites to directly ask retail investors for money often in exchange for an equity stake. Usually the money comes in small individual investments, but adds up to a 2 Source: Industry Canada, CIBC Canada United States Other Countries Unknown lot because of the amount of users. This has been a new development of the sharing economy and has, in some ways, filled gaps left by traditional financing sources. Nevertheless, there are some issues with crowdfunding. The main problem being that the industry, because it is still in it s infancy, does not have adequate regulations in place to protect consumers/investors. A variety of provinces will be limiting the amount of funding an individual can provide through this source. But, investors are still left to their own devices to do their own due diligence, something in the investing world that is usually left up to professionals. Another issue with crowdfunding is that companies that are themselves still in their infancy will have to deal with a large number of retail investors, again something usually left up to professionals. An idea that has been launched in other major financial centres may be a useful guide to bridging the gaps better than crowdfunding. Other countries like the UK have set up growth capital funds for SMEs. The Business Growth Fund in the UK, pooled 2.5 bn of committed capital from the five largest banks in the nation to provide patient growth capital to companies with revenues between 5 mn and 1 mn. Canadian banks could follow this guide and draw capital from investors who want to have exposure to startup companies. As the intermediary, banks would shoulder the responsibility for finding appropriate investments and the companies would only have to deal with the banks as their investor. That would remove some of the issues with crowdfunding, while still filling the gap in funding for startups and providing investors a vehicle for exposure. 8

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