Does the Canadian economy suffer from Dutch Disease? 1

Transcription

1 Firs draf no o be circulaed or cied wihou auhors approval. Does he Canadian economy suffer from Duch Disease? 1 by Michel Beine Universiy of Luxembourg, Luxembourg & CES-Ifo, Charles S. Bos VU Universiy Amserdam, The Neherlands and Serge Coulombe Universiy of Oawa, Canada January 2009 Absrac We argue ha he failure o disenangle he evoluion of he Canadian currency and energy and commodiy prices from he US currency leads o poenial wrong conclusions regarding he case of a Duch disease in Canada. We propose a new approach aimed a exracing currency componens and energy and commodiy prices componens from observed exchange raes and prices. Then, we analyze firs he separae influence of commodiy prices on he Canadian and he US currency componen. Second, we esimae he separae impac of he wo currency componens on he shares of manufacuring employmen in Canada. We show ha 63 percen of he manufacuring employmen loss due o exchange rae developmen beween 2002 and 2007 are relaed o a Duch disease phenomenon. The remaining 37 percen can be ascribed o he weakness of he US currency. Keywords: Duch disease; Naural resources; Exchange raes; Currency componens; Bayesian Economerics. JEL classificaion: C11;F31;O13;O51 1 The views expressed in his paper are he auhors and do no necessarily reflec hose of Indusry Canada. addresses: [email protected]; [email protected]; [email protected]. The auhors hank Rober Vermeulen for assisance and Ram Acharya for providing us daa.

2 Inroducion The Duch disease refers o he case where a resource boom in an economy leads o a real exchange appreciaion and o he crowding ou of he radable manufacuring secor. As pu i by Krugman (1987), he ineresing quesion is why should his phenomenon be regarded as a disease? According o Krugman, i becomes a disease when he manufacuring secor does no come back afer he resource boom. Various forms of nonconvexiies are all good reasons why i migh be he case. For insance, Krugman (1991) and Venables (1996) emphasize he idea of criical mass and sugges ha here are levels below which furher conracion of an indusry is difficul o reverse. Furhermore, Krugman (1987) sugges ha deindusrialisaion migh be derimenal in he long run for he whole economy since he manufacuring secor is characerized by learning by doing effecs. The underlying mechanism of he Duch disease is ha he real exchange rae of he resource rich economy ends o appreciae srongly wih he rise of he expor revenues from he resource secor. In urn, he appreciaion harms he economy s expors from he manufacuring secor leading, over ime, o de-indusrializaion. 2 The name of he phenomenon comes from a 1977 aricle in The Economis ha described he shrinking of Neherlands manufacuring secor following he discovery of imporan reserves in naural gas. 3 Beween 2002 and 2008, he specacular rise in commodiy and oil prices has led o an imporan developmen of he Canadian energy and commodiy secors. This is illusraed by he specacular developmen of he Ahabasca oil sand in he Norhern par of he province of Albera. While he exracion from oil sand is difficul and cosly, he rise of he oil price o new high levels has riggered an imporan expansion of he exracion and expor of he oil. This has in urn led o a big increase of Albera nominal GDP per head, o a specacular improvemen of he provincial public finance and o imporan spillovers for he oher provinces. 4 During he same period, he Canadian exchange rae appreciaed and he manufacuring secor has conraced. While he rise of he energy and commodiy prices brings obvious benefis for Canada as a whole, i has raised also a lo of concerns of policy makers and economiss. Mos of hose concerns are associaed o he possibiliy ha he Canadian economy is subjec o he Duch disease phenomenon. From he recenly observed decrease in manufacuring employmen, mos of he analyss ake nowadays for graned ha he Canadian economy 2 Classical references on he Duch diseases also include Corden and Neary (1982) and Corden (1984). 3 The Duch disease migh be seen as one paricular mechanism explaining he so-called naural resource curse, i.e. he observaion ha counries rich in naural resources end o exhibi poor performances in erms of economic developmen. See on his among many ohers Sachs and Warner (1995, 1999), Gylfason (1999, 2001) and Sijns (2005). 4 Beween 2004 and 2006, ne inerprovincial migraion o Albera accouned for an increase of 114,000, or 3.3 %, of Albera s populaion. A he peak of he oil boom in 2006, weekly flighs were esablished beween For McMurray in Norhern Albera a he har of he Ahabasca and S. John s Newfoundland via Torono. 2

3 is negaively affeced by he appreciaion of he Canadian dollar (agains he USD). They also srongly believe ha he Canadian dollar is mosly driven by oil and commodiy prices. 5 In he meanime, he brual fall of he oil price and oher commodiy prices following he worsening of he financial crisis in he fall of 2008 have pu a sudden deah o he Canadian resource boom. Despie a sligh depreciaion of he Canadian dollar saring in he fall of 2008, he Canadian manufacuring secor was furher shaken by he worsening of he US economy. A growing academic lieraure also addresses relaed quesions o he Duch disease hypohesis. For he issue a sake here, here are wo ineresing and complemenary srands in he lieraure. A firs srand ess wheher he CAD/USD exchange rae is driven in he long run by oil and commodiy prices. 6 Basically, hese analyses revisi he Amano and van Noorden (1995) exchange rae equaion. Wih some nuances, hose papers conclude ha he CAD/USD has become over he recen period a currency driven up and down by he evoluion of commodiy and oil prices. A second srand (Coulombe e al., 2007, Acharya and Coulombe, 2008) aims a capuring he impac of flucuaions of he CAN/USD on he evoluion of Canadian manufacuring oupu and employmen. I provides srong evidence in favor of a subsanial adjusmen in erms of employmen o he big appreciaion of he Canadian dollar over he period. In his paper, we revisi he issue of a Duch disease affecing he Canadian economy. We firs argue ha he evidence provided by he exising lieraure is insufficien o assess he imporance of such a phenomenon in Canada. The main reason is he following. Basically, wo condiions need o be fulfilled before ascribing he recen evoluion of he Canadian manufacuring secor o a Duch disease. Firs, he evoluion of Canadian currency should be clearly driven by he evoluion of energy and/or commodiy prices. Second, ha par of he appreciaion associaed o commodiy and/or energy prices should affec negaively he Canadian employmen in he manufacuring secor. By simply looking a he bilaeral CAN/USD, he exising lieraure is unable o exrac he par of he evoluion affeced by commodiy and oil prices. By definiion, an appreciaion of he bilaeral CAN/USD is driven by he srengh of he CAD currency bu also by he weakness of he USD whose evoluion migh be independen of hose commodiy prices. Our resuls suppor his conjecure. Therefore, from he observed evoluion of he CAN/USD, one needs o disenangle he variaion of he CAD ha migh be relaed o he variaion of commodiy prices from he one associaed o he evoluion of he USD. Even in he presence of a Duch disease effec, a failure o disenangle boh currency componens will lead o a possible bias in he esimaion of he magniude of he effec. The drawback of using he radiional approach based on he use of he bilaeral exchange rae is paricularly serious since he recen period ( Q3) exhibis hree concurren evoluions: an appreciaion of he Canadian dollar in effecive erms, a sharp depreciaion of he USD in effecive erms and finally a srong increase in commodiy 5 See for insance he papers and ranscrips of oral inervenions of he Torono conference in January 2008 eniled Implicaions for Canada of a High-valued Canadian Dollar. Has he Canadian Economy Caugh Duch Disease? The ranscrips are available a 6 See among ohers Mayer and DePrao (2008), Issa e al. (2006), Bayoumi and Mulheisen (2006), Heliwell e al. (2004). 3

4 and oil prices. By looking a he relaionship beween he CAN/USD and he commodiy prices, he analysis implicily assumes ha hose prices will affec symmerically he wo currencies. We show ha his assumpion is highly rejeced by he daa and as a resul, ackling his issue requires anoher approach. Will he use of effecive exchange raes do he job? Effecive exchange raes are very ofen used as indexes of he srengh of a paricular currency. Unforunaely, in he case of he Canadian dollar, he effecive exchange rae will be almos similar o he bilaeral CAN/USD as a very large par of he Canadian rade is wih he US (in 2006, he US supplied 65% of he Canadian impors, and purchased 79% of Canada s merchandise expors). 7 As a resul, he use of he Canadian effecive exchange rae would be subjec o he same previously menioned problem. In his paper, we provide anoher approach ha aims a solving his issue. Using he original Bayesian approach of Bos and Shephard (2006), we exrac from a se of bilaeral exchange raes currency componens capuring he srengh of he currencies such as he CAD and he USD. Imporanly, our mehod is fully independen on he rade weighs ha are usually used o define effecive exchange raes. Thereafer, he US componen is use o exrac he effec of he USD from he energy and commodiy prices. Then, i is firs possible o assess wheher and how much each currency componen is associaed o he evoluion of he commodiy prices. In urn, his approach allows us o quanify he par of he recen loss of he Canadian manufacuring employmen associaed o he recen increase of he commodiy prices, accouning for he movemens of he CAD and he USD ha are unrelaed o he evoluion of hose prices. Our analysis provides simple bu imporan figures and conclusions concerning he case for a Duch disease in Canada. Firs, we show ha he recen dramaic appreciaion of he CAD/USD exchange rae (around 50%) migh be decomposed ino a 62% appreciaion of he Canadian currency and a 38% depreciaion of he USD currency. Second, he decomposiion of he Canada-US bilaeral exchange rae ino a USD and a CAD componen shed new ligh on he relaionship beween he Canadian exchange rae and energy and commodiy prices. Third and more imporanly, given he esimaed respecive responses of he Canadian employmen o he evoluion of each currency componen, we find in he end ha only 54% of he CAD/USD appreciaion ha affecs Canadian employmen migh be ascribed o he rise in commodiy prices. Finally, our approach allows o idenify he manufacuring secors ha have been subjec o he Duch disease, i.e. hose in which he decrease in aciviy migh be direcly relaed o he rise in oil and commodiy prices. This paper is organized as follows. Secion 2 repors some sylized facs emphasizing he need of a new approach. Secion 3 presens he economeric approach and repors he exraced currency componens. Secion 4 revisis he AvN equaion using our new approach. Secion 5 analyses he impac of he evoluion of he currency componens on he Canadian manufacuring employmen. Secion 6 concludes. 7 The empirical analysis of Coulombe (2007) illusraes well how he 1989 Canada Unied Saes Free Trade Agreemen has exered a significan posiive long-run effec on GDP per capia. 4

5 2. Sylised facs The case of a Duch disease in Canada has been recenly revisied due o he concurren evoluion of a se of macroeconomic and financial variables. Figures 1 o 3 depic he evoluion of he key variables involved in he debae. Figure 1 displays he evoluion over he las 35 years of he bilaeral CAN/USD exchange raes, boh in real (red line) and nominal (green line) erms. The figure plos he number of Canadian dollar per US dollar. The dramaic appreciaion of he Canadian currency agains he USD is easily idenified for he las par of he period. Beween he beginning of 2002 unil he end of 2007, he Canadian dollar appreciaed by abou 49% agains he USD. 8 A second ineresing observaion is ha he real appreciaion of he CAD agains he USD comes almos exclusively from he nominal appreciaion of he exchange rae. Indeed, he evoluion of relaive prices beween Canada and he US explains virually nohing in he real evoluion of he CAD/USD exchange rae. For he analysis of he Duch disease, his implies ha we should be indifferen working wih he real or he nominal exchange rae. Figure 1: Nominal and Real CAD/USD exchange rae Figure 2 plos he evoluion in real erms of energy prices and hose of he oher commodiies. Boh indices are deflaed using he US price index. The dramaic rise of oil prices and commodiy prices beginning in 2002 is also highly visible from he plos. For he oil price, he level in real erms reaches an all-ime high, even when compared o he level in he afermah of he second oil shock. For he commodiy prices, he recen rise appears more o be par of a caching-up process in hisorical erms. 8 Acually, using daily daa and aking he minimum value of he rae in 2002 and he maximum one in 2007, he maximal nominal appreciaion amouns o 56%. 5

6 Figure 2: Evoluion of real log-commodiy prices: all commodiies and energy Figure 3: Share of Canadian manufacuring employmen Figure 3 repors he evoluion over ime of he Canadian employmen in he manufacuring secor as a share of oal employmen. The figure makes clear ha he recen decrease in he relaive par of he manufacuring secor is no an excepional even. Like oher indusrialized counries, due o he developmen of services, he share of Canadian manufacuring oupu ends o decrease in he long run. Neverheless, he sriking poin is he relaive quickness a which his share decreased afer The hree join evoluions afer 2001, i.e. he appreciaion of he CAD/USD, he srong increase in commodiy and energy prices and he quick decrease in he size of he manufacuring secor show ha here is a poenial case for a Duch disease in Canada. This has led a lo 6

7 of policy makers o express big concerns abou he seriousness of such a phenomenon in Canada. To wha exen can we ascribe he decrease in manufacuring employmen o he rise in oil prices? A firs and imporan sep is o es wheher he evoluion of he Canadian currency has been driven by he rise in commodiy an oil prices. As menioned above, mos of he analyses have relied on he bilaeral CAD/USD, eiher in nominal or real erms. Such an approach exhibis one imporan weakness. The evoluion of he CAD/USD is driven no only by he evoluion of he Canadian currency bu also by he evoluion of he US dollar which is unlikely o be driven by economic condiions in Canada. Had he USD been quie consan over he invesigaed period, such an analysis could do he job. The big problem is ha i is far from being rue, especially over he sub period of ineres. Figure 4 shows he evoluion of he nominal effecive exchange rae of he USD over he period. I is obvious ha he USD has depreciaed significanly over he period agains mos of he currencies of he US rading parners, including of course he CAD. The weakness of he US currency has been widespread over his period and needs o be analysed separaely from he evoluion of he Canadian currency. Will a separae analysis of he Canadian effecive exchange rae and he US effecive exchange rae solve his problem? Unforunaely no. The reason is ha given he very high proporion of he Canadian rade wih he US, he effecive rae for Canada will be quie close o he bilaeral CAD/USD. Afer 1996, he weigh of he USD used in he compuaion of he Canadian-dollar Effecive Exchange Rae Index (CERI) amouns o abou 76 percen. This weigh would be even more imporan if we were using he real proporion of he rade wih he US. This share has indeed increased over he las 30 years due o he implemenaion of he Canadian-US Free Trade Agreemen (see Beine and Coulombe, 2007). This is especially rue afer 1995 when he major par of he inegraion process has been compleed. Figure 5 confirms ha using he Canadian effecive rae is useless. Over he las 15 years, one canno see any significan difference beween he nominal bilaeral CAD/USD rae (CAD/USD, red line), he nominal effecive rae (Nom Eff CAD, green line) and he real effecive exchange rae (Real Eff CAD, blue line). As expeced, he correlaion beween he 3 raes has increased over ime, reflecing he high degree of inegraion beween he Canadian and he US economies. 7

8 Figure 4: US nominal effecive exchange rae Figure 5: Evoluion of CAD exchange raes : nominal CAD/USD, nominal effecive CAD and Real effecive exchange rae. Using he radiional measures of exchange raes, he issue seems o lead o a non soluion conundrum. Indeed, wha we need is o have an index of he Canadian currency ha is fully independen of he US currency. This paper offers a soluion by relying on a new approach o measuring currency evoluion. This approach has been iniially developed by Bos and Shephard (2007) and has been successfully applied in a number of exchange rae problems like he one concerning he impac of FX cenral bank inervenions (Beine, Bos and Lauren, 2007). For our purpose, he major advanage of his approach is ha i allows o exrac currency index (called hereafer currency componens) ha are 8

9 independen from any weighing scheme such as he rade weighs used in he effecive exchange raes. This approach and he resuling oupu are presened in he nex secion. 3 Exracing currency componens 3.1 Modelling he level and he volailiy of currency componens Following Bos and Shephard (2006), who build forh on work by Mahieu and Schoman (1994), we exrac he movemens in levels of currencies by describing he logarihm of he exchange raes as he difference beween currency facors. For a sysem of k exchange raes agains a common denominaing currency, here would be k+1 of such currency facors. Though i is no possible o exrac precisely he level of he k+1 facors ou of k observaions of exchange raes, he movemens of he exchange raes are informaive abou he relaive movemen of he underlying facors. Take for insance a siuaion in which he U.S. dollar is, on a specific day, weakening 5% agains boh he Briish pound and he Japanese Yen. Then his seems o imply ha he U.S. currency facor dropped 5%, wih he pound and yen remaining sable. If he dollar only dropped relaive o he pound, bu no o he yen, hen he movemen is more likely o have resuled from a (relaive) srenghening of he pound. To be able o quanify such movemens, a formal model is described in Appendix 1. In shor, he model assumes : a random-walk ype behavior for he currency componens, independen of he oher currencies; his auomaically implies a correlaed sysem of random walks for he log-exchange raes, as ofen found in pracice; he variances of he random walk incremens are allowed o vary over ime as well, o allow for ranquil or more hecic periods in each of he currency markes. The underlying sysem for he volailiies is an inegraed sochasic volailiy model, for each currency separaely; he daa se incorporaes as well wo series on he log-prices of Canadian commodiies and energy, boh expressed in U.S. Dollars. The model inerpolaes he monhly price series, and splis he prices ino a pure price componen and a second componen due o changes in he U.S. Dollar; hough such a model is no perfec, as e.g. i does no model explicily he jumps in he exchange rae when he Ausralian dollar is devaluaed in he earlier years of he sample, i gives a sufficienly rich descripion of he exchange rae movemens for he presen purpose; esimaion is performed using a Bayesian Markov Chain Mone Carlo MCMC) mehod. This resuls in an esimae of he poserior mean (and also spread) of he currency level and volailiy facors, which can be used in a subsequen analysis of he Duch disease in Canada. For furher deails on he precise specificaion, and he esimaion procedure, see Appendix A. 9

10 3.2 Resuling currency facors, In he subsequen analysis, we use daily exchange raes of he U.S., Ausralian and Canadian dollars, and he Japanese Yen and Briish pound, over he period of 7/1/ /1/2007, for a oal of 9326 days. Saring in 1972, we use he price of (Canadian) commodiies and energy expressed in U.S. Dollars, available a a monhly frequency a he firs working day of he monh. Figure 6: Evoluion of U.S. (op) and Canadian (boom) currency level (lef-hand axis) and volailiy (righ-hand axis) facors Figure 6 displays he facors for he U.S. and Canada, over he full period. For he oher currencies, similar facors are exraced bu no displayed here. The op panel displays he currency level facor (on he lef-hand scale), ogeher wih he volailiy facor (agains he righ-hand scale) for he Unied Saes. Iniially, lile movemen is seen, wih few variaions unil The level of he US componen reflecs he seady appreciaion of he USD beween 1980 and 1985, leading o he Plaza and he Louvre agreemens and he subsequen depreciaion of he US currency unil The momens of he sharp depreciaions correspond o he sudden spikes in he exraced volailiy. The period of was excepionally ranquil for he dollar, wih virually no movemen as also refleced by he low volailiy over hese years. This appears o have been a period when he oher currencies seem o have evolved raher independenly vis-a-vis he dollar, wih few occasions where e.g. all oher currencies los ground implying a global appreciaion of he dollar. Aferwards, he dollar increased in srengh unil 2002, followed by a seep decline of he value of he dollar agains mos oher currencies. The las wo years, his decline coninues, hough a a lower volailiy han in he period of For Canada, here are fewer ousanding feaures. Uncerainy in he earlies periods was relaively low. A srong depreciaion occurred hroughou , wih sabiliy following hrougou he 1980s. Uncerainy for he Canadian currency over

11 was considerably higher han for he U.S.; his may parly have been caused by he fac ha he Canadian dollar is no such an imporan currency inernaionally. From roughly 1990 onwards a very slow bu seady decline of he value of he currency is visible. Around 2003 however, he Canadian dollar sared is rise agains oher currencies, only broken by inermediae spells of uncerainy and emporary depreciaion. Figure 7: Evoluion of he commodiy (op) and energy (boom) log-prices, ogeher wih corresponding price facors In Figure 7 he evoluion of prices is displayed. The commodiy and energy prices in Canada are originally expressed in U.S. Dollars, a a monhly frequency. The sae space modeling approach allows o inerpolae he series o a daily frequency, and o exrac from i he dollar effec. The figure displays in he op panel he log-price of Canadian commodiies, which, adaped for he U.S. currency facor, delivers he commodiy price facor. The difference beween he price and he facor is precisely he value of he U.S. facor of he op panel of Figure 6. From Figure 7, i is seen how commodiy prices did rise over he years, bu in he laer years an imporan par of he price hike was caused by he U.S. dollar weakening in value. The final value of he commodiy facor is for insance only marginally higher han is value in The price hike of energy however was far larger in magniude. Even afer adaping for he currency effec, he resuling increase is sill of around 120 poins over he laer 13 years of he sample. As he prices are expressed on a logarihmic scale (muliplied by 100), his increase in he energy price since 1984 corresponds o a rise of roughly 120% over he period. 11

12 Figure 8: Evoluion of he currency componens : USD and CAD Figure 8 plos he evoluion of he exraced USD and he CAD componens over he full period ( ). Two main commens are in order. Firs, our esimaed componens fully confirm ha he sharp appreciaion of he CAD/USD exchange rae is he resuls of wo concomian evoluions. The srong appreciaion over he period is indeed he oucome of a sharp srenghening of he Canadian currency bu also of ha of a weakening of he USD currency wih respec o he oher major currencies of he world. Second, our esimaions allow o exrac he conribuion of he wo componens o he appreciaion of he CAD/USD over his period. Acually, 62% (resp. 38%) of he 50% appreciaion of he bilaeral exchange rae is due o he srenghening (resp. weakening) of he CAD (resp. USD) componen. Previous approaches based on he bilaeral rae would end up ascribing he variaions in commodiy and energy prices o he oal appreciaion of he CAD/USD. We challenge his view and argue ha his needs o be esed. While he evoluion of Canada as a ne exporer of primary producs raises a case for he CAD o be a commodiy currency over he las 25 years, here is lile economic raionale o believe ha he USD has been driven down by hose prices. Alernaive explanaions, recenly proposed for insance by Obsfeld and Rogoff (2007) and emphasizing he role of he US exernal imbalances can be considered. 12

13 4. Has he CAD become a commodiy currency? 4.1 The relaed lieraure : he Amano-van Noorden equaion Mos of he empirical approaches esing he deerminans of he CAD/USD dollar rely more or less on he early conribuion of Amano and van Noorden (1995). Basically, Amano and van Noorden (1995) (AvN hereafer) uses an error correcion model of he CAD/USD real exchange rae (over he 1973 M M2 period) in which he long-run evoluion depends on he prices of he expored energy and non energy commodiies. The shor-run dynamics depends furhermore on he differenial Canada-US ineres rae which is found o be saionary (I(0)) 9. The main findings are he following. Firs, here is a long-run relaionship beween he real exchange rae on he one hand and he energy and non energy prices on he oher hand. The speed of adjusmen o he long-run equilibrium is such ha he equilibrium is resored afer abou wo years. Furhermore, erogeneiy ess rule ou any long-run reverse causaliy from prices o exchange raes. The second resul is a puzzle. While an increase in non energy prices end o appreciae he CAD, a raise in energy prices is found o depreciae he loony in he long run. Finally, in line wih inuiion, an increase in he ineres rae differenial ends o appreciae he CAD. Basically, he empirical subsequen analyses of he CAD/USD updae he esimaions of Amano-van Noorden (1995) and revisi he equaion in differen direcions. Basically, heir findings sugges ha he long-run relaionship beween energy prices and he exchange rae is subjec o srucural break(s). Issa e al. (2006) find ha he AvN equaion does no provide any explanaory power over he period. Heliwell e al. (2005) do no find any robus relaionship beween commodiy prices and he CAD. From preliminary daa inspecion, hey do no consider a role for energy prices. Maier and DePrao (2008) find some evidence of a srucural break in he relaionship around They documen ha afer 2002, he relaionship beween energy prices and he exchange rae migh have changed, from a negaive o a posiive impac. The relaed quesion, which is unaddressed by he auhors, is why 2002 would be associaed o a srucural break. Bayoumi and Mülheisen (2006) provides an answer by inroducing he Canadian ne expor posiion of energy goods. These ne expor posiions are found o influence he long-run dynamics of he exchange rae and influence he way energy prices impac he rae in he shor run. They sugges ha he magniude of he producion and expors of he energy goods migh condiion he relaionship beween he commodiy prices and he CAD/USD. The exracion of each currency componen allows us now o revisi he influence of he commodiy and energy prices on he value of he CAD currency. To ha aim, we follow 9 More precisely, he ineres rae variable involves he differenial beween he shor run- long run differenial beween Canada and he US. 13

14 he AvN approach and assess is relevance on each of he currency componens, i.e. he CAD (denoed by eca ) and he USD (denoed by eus ) componens. For he sake of comparison, we also provide he same analysis on he bilaeral real exchange rae CAD/USD. I is denoed by r. We consider hree differen periods : (i) he full period ranging from 1972Q2 (he saring period of he AvN analysis) o 2007Q4; (ii) he 1972Q2-1993Q4 period which is he period of invesigaion of AvN; (iii) he 1983Q1-2007Q4 period during which Canada has become a ne exporer of energy goods (see Bayoumi and Mühleisen, 2006). The resuls repored below are obained wih quarerly daa. Neverheless, i should be emphasized ha we have srikingly similar resuls using monhly daa. 10 The saring underlying ECM equaion of our analysis is wrien as : Δ x = γ γ Δpe γ Δpne γ idiff αx β pe β pne + ε (1) 1 e ne id 1 1 e 1 ne 1 where x sands eiher for r, eca or eus. pe and pne are he real energy and non energy prices and idiff is he differenial beween 3 monh nominal ineres raes in Canada and he US. The consrucion of he variables and he daa sources are deailed in Appendix 2. For he sake of inerpreaion, we define each dependen variable such ha an increase of is value corresponds o a depreciaion. An increase in r, eca and eus herefore corresponds respecively o a real depreciaion of he Canadian dollar agains he USD, o a depreciaion of he Canadian currency and a depreciaion of he US dollar. This means ha if energy prices and non energy prices should go hand in hand wih he Canadian dollar in he long run, we should have posiive values for β e and β ne. Equivalenly, if increases in energy prices, in non energy prices and in he ineres rae differenial end o appreciae he Canadian dollar in he shor run, we should have posiive values for γ e and γ ne, γ id. 10 These resuls are no repored here o save space bu can be provided upon reques. This is no surprising given he fac ha wih long-run analyses involving I(1) variables, wha maers is more he ime span raher han he frequency of he daa (See Oero and Smih, 1999 on his). 14

15 Table 1 : Shor and long-run deerminans of CAN/USD real exchange rae Parameers Variables 1972Q2-2007Q4 1972Q2-1993Q4 1983Q1-2007Q4 γ Consan *** C (0.016) (0.017) (0.020) γ Energy SR 0.078*** e (0.020) (0.020) (0.020) γ Non energy SR 0.140*** ne (0.041) (0.041) (0.041) γ In diff SR *** 0.007*** id α (0.0015) (0.002) (0.0015) Speed of adj *** (0.039) (0.043) (0.043) β Energy LR *** 0.020** e (0.016) (0.006) (0.010) β Non energy LR *** 0.142** ne (0.016) (0.017) (0.060) R DW Nobs Tables 1, 2 and 3 presen he esimaion for r, eca and eus. Basically, Table 1 reproduces (wih he closes possible definiion of he daa) he approach of AvN and updaes he esimaions. The esimaions over he period are fully in line wih he resuls of AvN. They sugges a good fi o he exchange rae daa and leave open he puzzle of he uninuiive sign for β e. The resuls over he oher sub periods urn ou o be much less promising. The hypohesis of a long-run equilibrium relaionship beween he real exchange rae and he commodiy prices is rejeced, eiher over he full period or over he las period. The esimaions sugges ha he AvN equaion involving he bilaeral CAD/USD is quie unsable. Even over he during which Canada has become a ne exporer of energy producs, he speed of adjusmen remains insignifican. From he subsequen analysis, we argue ha such a failure o find some long-run relaionship is due o fac ha he bilaeral rae is parly driven by he USD whose evoluion is independen from he dynamics of he energy and commodiy prices. Table 2 provides he same resuls for he USD componen. For he full period and he las period, he esimaions srongly rejec any long-run relaionship beween he commodiy prices and he USD componen. The AvN equaion explains virually nohing of he US componen, as refleced by he very low R 2. The speed of adjusmen o he long-run equilibrium is no significan over hose periods. For he specific period, we find evidence of a long-run correlaion beween he USD and he energy prices. Ineresingly, a rise in real energy prices is found o appreciae he USD componen. This resul concurs wih Amano and van Noorden (1998) ha show a posiive long-run impac of oil prices on he US real exchange rae over he same period. This migh explain why in he AvN equaion applied o he bilaeral rae, one finds evidence ha a rise in he 15

16 energy prices ended o depreciae raher han appreciae he CAD agains he USD. Said differenly, he uninuiive sign of he impac of he energy prices in he original AvN migh be due o some correlaion beween he USD and he oil price. Neverheless, he relaionship beween he USD and energy prices seems specific o he Amano-van Noorden period. For he full period and he recen one, o he exen ha he USD componen migh be explained, he invesigaion should look a alernaive deerminans han hose involving he commodiy prices. One alernaive explanaion suggesed by he work of Obsfeld and Rogoff (2004) is he evoluion of he US curren accoun defici. To es for such a relaionship and given he failure of commodiy prices o explain he evoluion of he USD componen (a leas in he long run), we consider he inclusion of he US curren accoun as a share of GDP. Preliminary ess confirm ha his variable is saionary. This makes sense given he naure of his variable. Therefore we consider he following alernaive specificaion for he USD: Δ eus = γ γ Δpe γ Δpne γ idiff γ usca + ε (2) 1 e ne id 1 usca 1 where usca is he US curren accoun as a share of GDP a ime. Columns (6) and (7) in Table 2 repor he esimaes over he period. In column (6), OLS esimaes are repored while in column (7), we use insrumenal variable esimaion using usca 2 o preven any endogeneiy issue of he curren accoun variable wih respec o he USD currency. The esimaions suppor he idea ha he evoluion of he USD is driven more by US domesic variables such as he US ineres rae and he US curren accoun. The curren accoun is significan a he 5% level. The inclusion of he curren accoun in he specificaion significanly improves is goodness of fi. Is sign is consisen wih he idea ha he adjusmen of exernal imbalances migh be done by a change in he USD currency. Since he curren accoun collec imbalances wih all US parners, one should expec our currency componen o capure he necessary adjusmen beer han he CAD/USD. Given he size of he Canadian economy, he evoluion of he US curren accoun is exogenous for Canada. Therefore, one can claim ha par of he depreciaion of he CAD/USD is due o facors on which he Canadian economic policy has virually no impac. 16

17 Table 2 : Shor and long-run deerminans of US componen Parameers Variables 1972Q2-2007Q4 1972Q2-1993Q4 1983Q1-2007Q4 1983Q1-2007Q4 1983Q1-2007Q4 OLS OLS OLS OLS IV γ Consan * ** ** C (205) (0.421) (0.267) (0.306) (0.299) γ Energy SR 0.971* e γ Non ne energy SR (1.060) (0.968) (1.211) (0.012) (0.013) (2.308) (2.709) (3.117) (0.031) (0.032) γ In diff SR ** 0.159** 0.232*** 0.224*** id γ Cur ca accoun α Speed of adj (0.061) (0.082) (0.079) (0.082) (0.075) ** ** (0.396) (0.404) * (0.023) (0.033) (0.043) β Energy LR * e β Non ne energy LR (0.256) (0.404) (0.354) (0.447) (0.713) (0.928) R DW Nobs Noes: Newey-Wes sandard errors beween parenheses *, ** and ***denoe significance a he 10, 5 and 1% level. Columns (3-6) : OLS esimaions. Column(7) : IV esimaion, usca 1 insrumened by usca 2 Le us urn now o he evoluion of he CAD. Table 3 provides he resuls of he AvN framework for he CAD componen. The resuls conras wih hose applied o he bilaeral rae and he USD in many ways. Firs, over he period, here is no long-run relaionship beween he Canadian currency and he commodiy prices. The α parameer is no significan a usual levels. This conrass wih he findings of he bilaeral rae and he USD componen. Our findings can explain he so-called AvN puzzle, i.e. he seemingly uninuiive sign for he long-run effec of energy prices on he CAD/USD. This uninuiive sign is relaed o a posiive correlaion beween he USD and he energy prices and has nohing o do wih he evoluion of he CAD over his period. Economically, his makes sense since over his period, Canada was no an imporan ne exporer of oil and gaz. This conrass wih he mos recen period, i.e. afer 1983 (column 17

18 (5)). The esimaions repored in he las column show ha over he period, he AvN equaion explains srikingly well he evoluion of he CAD componen wih hose of he energy and non energy commodiy prices. An increase in hose commodiy prices is found o lead o a long-run appreciaion of he CAD currency. They also lead o some appreciaion in he shor run. Table 3 : Shor and long-run deerminans of CAN componen Parameers Variables 1972Q2-2007Q4 1972Q2-1993Q4 1983Q1-2007Q4 γ Consan ** 3.884*** C (1.195) (1.132) (1.22) γ Energy SR 0.029* * e γ Non energy ne SR (0.017) (0.017) (0.015) 0.068** ** (0.032) (0.045) (0.043) γ In diff SR id (0.010) (0.125) (0.120) α Speed of adj *** (0.032) (0.047) (0.034) β Energy LR *** e β Non energy ne LR (0.005) (0.008) (0.005) ** 0.043** (0.014) (0.012) (0.014) R DW Nobs Noes : Newey-Wes sandard errors beween parenheses *, ** and ***denoe significance respecively a he 10, 5 and 1% level. 18

19 Le us summarize he main findings and implicaions. Firs, we find ha he uninuiive sign for he long-run impac of energy prices on he real CAD/USD in he original AvN equaion is due o he fac ha over his specific period, here is a posiive correlaion wih he USD currency while no correlaion wih he CAD currency. In conras, over he las period, we have exacly he opposie siuaion: he commodiy prices affec he srengh of he CAD currency while hey have no effec a all on he USD. This is line wih he fac ha Canada has become in he meanime a ne exporer of commodiies. These findings suppor he case of a Duch disease in Canada. Neverheless, one should qualify his phenomenon of parial as only abou 63% of he srong appreciaion of he CAD/USD is due o he increase in commodiy prices. 5. The evoluion of he CAD and he Duch disease (Serge) 5.1. Specificaion and esimaion echniques The effec of currency componens on he Canadian manufacuring secor is esimaed using an adapaion of he ime-series and cross-secion empirical Error Correcion Model used in Acharya and Coulombe (2008). We pool annual Canadian and US daa for 21 indusries over he period. The endogenous variable, sca i, is he share of employmen in Canadian manufacuring indusry i (share of oal indusry employmen) a ime. The change in scai is regressed on he lagged share of employmen in US manufacuring susi 1, he lagged Canadian and US currency componens, he firs difference of he firs hree conrols, on is lagged level, cross-secion fixed effecsγ i. The coefficien on he firs difference of he Canadian componen was never significan and was dropped. Theε i is an idiosyncraic error erm: Δ sca = αsca + β sus + β eca + β eus + β Δ eus + β Δ sus + γ + ε (3) i i 1 1 i 1 i2 1 i i i i Variable susi 1, which has boh a ime-series and and a cross-secion dimension, is designed o conrol for srucural changes and long-run rend ha are indusry specific. This variable, which is always highly significan, capure he effec of many poenial conrols ha are ime specific and indusry specific. Is inclusion in he adjusmen model allows o capure unobserved facors explaining he differenial evoluion beween Canadian and US manufacuring employmen. The wo currency componens appear o perform quie well in his role. In he homogenous specificaion (Table 4), he βi2 and βi3are consrained o be he same across he i s. In conras, he effecs of he currency componens are allowed o vary across indusries in he heerogeneous specificaion (Table 5). Resuls from he heerogeneous specificaions clearly indicae ha he effec of currency componens varies across indusries. However, in he heerogeneous specificaion, he effecs of he currency componens are no esimaed very accuraely given he limied number of ime 19

20 series observaions a hand. In he homogenous specificaion, he mean effecs of he currency componens are esimaed more accuraely since he slope coefficiens are esimaed using boh he ime-series and he cross-secion dimensions. Cross-secion fixed effecs are included in all esimaion o conrol for some of he unobserved indusry heerogeneiy. Noe ha ime dummies canno be included since he currency componens have only a ime series dimension. Indusry specific ime rends are capured by he susi 1variable. In he homogenous specificaion, resuls are presened for Pooled Leas Squares (PLS) and for Ieraed Feasible Generalized Leas Squares (IFGLS) esimaes. PLS resuls are presened wih Panel Correced Sandard Errors ha are robus o heeroskedasiciy. This approach is recognized o provide sandard errors ha do no lead o overconfidence (Beck and Kaz,1995). 11 IFGLS esimaions accoun for cross-secional heeroskedasiciy and provide a slighly differen picure from a quaniaive poin of view on he long-run elasiciies. We provide resuls for long-run elasiciies compued from he poin esimaes of specificaion (3). For he homogenous specificaion, he long-run elasiciy of he share β of US employmen is simply ˆ 1. For he Canadian currency componens, he αˆ ˆ β elasiciy is: 2 misca ˆ where misca is he mean across boh and i of he α manufacuring indusry share of Canadian employmen. The US currency componen elasiciy is measured accordingly wih ˆ β ˆ 3 insead of β 2. For he heerogeneous specificaion, he long-run elasiciies of he Canadian currency componens for indusry i are compued as: ˆ βi2 msca ˆ where m α isca sands for he mean share across ime of indusry i. The US currency componen elasiciies are measured accordingly wih ˆ β insead of ˆ β.in Tables 4 and 5, elasiciies are repored in absolue values. i3 i2 All poin esimaes form he homogeneous specificaions repored in Table 4 display he inuiive signs and are highly significan. The long-run elasiciy of he share of US employmen is well lower han 1, ranging beween 0.5 and These indicae ha he indusry shares of Canadian manufacuring do no move one for one wih he US shares. 11 The poenial drawback of boh PLS and IFGLS is ha he poin esimae of he lagged dependan variable in equaion (3) can be biased (Nickell, 1995). Non-repored resuls using Kivie-correced esimaions provide however very similar resuls. Refer o Acharya and Coulombe (2008) for Kiviecorreced esimaions. GMM esimaions are inefficien wih such a small number of cross secions. 20

21 Table 4: Effec of currency componens on Canadian indusry employmen: homogeneous specificaion Parameers Variables PLS IFGLS α Lagged share of employmen *** (0.0322) *** (0.0289) β Share of US *** *** 1 employmen (0.0302) (0.0257) LR elasiciy β CA currency *** *** 2 comp. LR (0.0005) (0.0004) LR elasiciy β US currency *** *** 3 comp. LR (0.005) (0.0004) LR elasiciy β ** * 4 (0.0007) ( ) β *** *** 5 (0.1349) (0.1208) R DW Nobs Noes: Sample, wih 21 indusries. Panel correced (cross-secion weighs) sandard error for PLS esimaions beween parenheses, *, **, and ***denoe significance respecively a he 10, 5 and 1% level. Ineresingly, an appreciaion of he Canadian currency componen and a depreciaion of he US currency componens ranslae ino a decrease in Canadian manufacuring employmen shares. The poin esimae of he US componen is larger (in absolue value) han for he Canadian componen bu he difference beween he wo is no significan. The long-run elasiciies of he wo currency componens esimaed from PLS are 1.6 and 2.1 for he Canadian and he US respecively. These numbers are smaller from IFGLS esimaions (1.1 and 1.4 respecively) suggesing ha he poin esimaes of currency componens from PLS migh be driven-up by he presence of ouliers. 21

22 Table 5: Effec of currency componens on Canadian indusry employmen: heerogeneous specificaion Indusry CA currency comp. LR elasiciy US currency comp. LR elasiciy Food Manufacuring Beverage and Tobacco ** 1.8 Texile Mills *** Texile Produc Clohing Manuf ** 2.0 Leaher & Allied Prod Wood Produc *** *** 1.5 Paper *** Prining ** ** 1.6 Peroleum and Coal Chemical Plasics and Rubber *** Non-Meallic Mineral Primary Meal * 1.3 Fabricaed Meal *** Machinery *** ** 1.2 Compuer and Elecro ** Elecrical Equipmen Transporaion Equip *** ** 0.85 Furniure ** ** 1.8 Miscellaneous * α *** R DW 2.32 TSCS obs 399 Cross-secion obs 21 Noes : Sample wih 21 indusries. The effec of oher conrols in specificaion (3) no displayed. Whie cross-secion sandard errors beween parenheses. *, **, and ***denoe significance respecively a he 10, 5 and 1% level. The insignifican LR elasicies are no displayed Poin esimaes of he currency componens ha vary across indusries are displayed in Table 5. The speed of adjusmenα is also repored and he poin esimae (0.335) is around wo imes larger han in he homogenous specificaion. This implies ha he indusries appear o adjus more rapidly when hey are allowed o reac differenly from exchange rae changes. Despie he lack of accuracy inrinsic o he esimaion of he indusry-specific slope coefficien wih jus 21 cross secions a hand, 19 currency effecs (ou of 42) are significan a leas a he 10 % level and only one has he counerinuiive sign. From he poin of view of he long-run elasiciies, he hree indusries ha are he mos affeced by he Duch disease are: exile mills, machinery, and compuer and elecronics wih elasiciies ranging beween 3 and 6.9. Plasics and rubber, fabricaed meal, and furniure are indusries ha are also more affeced han he average by he Duch disease wih elasiciies around 2. The manufacuring indusries: paper, prining, ransporaion 22

23 equipmen, and miscellaneous, are also affeced negaively and significanly by he Duch disease. All he affeced indusries, wih he excepion of prining, are highly exposed o inernaional rade. 12 There is no sysemaic paern beween he degree of echnology inensiy (following he OECD classificaion for low- medium- and high-ech indusries) and he degree of exposure o he Duch disease. The elasiciies for he long-run effec of he US currency componen for he eigh indusries for which he effec is significan vary beween 0.85 and 2. Wih he excepion of beverage and obacco, prining, and primary meal, he oher indusries affeced by he US componen are highly exposed o inernaional rade. Again no relaionship is observed beween he degree of echnology inensiy and he exposure o he US componen. The indusries ha are affeced by he wo currency componens wih he inuiive signs are: prining, machinery, ransporaion equipmen, and furniure. The indusries ha are only affeced by he US currency componens are: beverage and obacco, clohing manufacuring, and primary meal. The indusries ha are affeced only by he Canadian currency componens are: exile mills, compuer and elecronics, plasics and rubber, fabricaed meal, and paper. Indusries ha are no affeced by boh currency componens are: food manufacuring, exile produc, leaher & allied produc, peroleum and coal, chemical, non-meallic mineral and elecrical equipmen. Finally, he poin esimaes repored in Table 4 coupled wih he respecive appreciaion of he Canadian componen and he depreciaion of he US componen observed beween 2002 and 2008, can be used o provide he comparaive conribuion of hese wo facors o he exchange rae effec on Canadian manufacuring employmen over he recen period. Wha comes ou of he exercise is ha around 54% of he decline in employmen relaed o exchange rae developmens comes from he appreciaion of he Canadian componen and he remaining 46% from he depreciaion of he US componen. This resul is driven by he fac ha, over he period, he change in he Canadian componen was much larger han he change in he US componen. Conclusion In his paper, we have invesigaed o which exen he Canadian economy has been subjec o he Duch disease phenomenon. We argue ha he use of he bilaeral CAN/USD exchange rae is likely o mislead he analysis he Duch disease in he case of he Canadian economy. The reason is ha he evoluion of he CAN/USD exchange rae migh be driven by facors ha affec only he USD. The use of he effecive exchange rae of he Canadian dollar is of lile help o solve his issue since i is highly correlaed wih he CAN/USD bilaeral exchange. In his paper, we propose a new soluion ha allows o disenangle exchange raes ino currency componens capuring he srengh of he respecive currencies. Imporanly, he decomposiion is independen of he rade weighs usually used o define effecive exchange raes. 12 We follow here and hereafer he axonomy esablished by Dion (1999) o classify he indusries according o heir degree of rade exposure. 23

24 Our resuls challenge he conclusion of he Amano-van Noorden (1995) exchange rae equaion linking he evoluion of he CAD/USD o he price of oil and naural resources. They also bring new insighs abou he deerminans of he CAD. Firs, we show ha he counerinuiive sign of he oil price in he CAD/USD exchange rae of Amano and van Noorden (1995) is exclusively due o a posiive correlaion of he USD wih he oil price over his paricular period ( ). Second, we show ha over he recen period during which Canada has been a ne exporer of oil and primary producs (1983 onwards), he Canadian currency has been driven up by he prices of commodiies. In conras, he evoluion of he USD seems disconneced from ha of he prices of oil and primary producs bu driven raher by US specific facors such as he evoluion of he US curren accoun defici. Using our decomposiion, we show ha he appreciaion of he CAD explains abou wohirds of he sharp appreciaion of he CAD/USD over he period. The sharp depreciaion of he USD over he same period explains he res of he appreciaion of he CAD/USD. In urn, boh evoluions are responsible for he losses in he Canadian manufacuring secor, wih roughly similar quaniaive effecs bu wih some differences a he indusry level. All in all, his allows o asses o which exen in he recen period, he Canadian economy has been subjec o he Duch disease. Neverheless, i is also clearly show ha he depreciaion of he USD worsened he siuaion. The subsanial appreciaion of he CAN/USD beween 2002 and mid-2008 has been followed by a sharp depreciaion of abou 20 percen in he las quarer of Over he same period, he price of oil and he oher commodiies go back o very low levels. 13 The recen developmens illusrae well why he Duch disease should be aken ino accoun o undersanding he evoluion of he Canadian economic srucure and he fuure of is well being. As poined ou a he beginning of his paper, he Duch phenomenon becomes a disease if he manufacuring secor does no come back when he resource boom is over. Had he Albera s resource boom lased for 100 years, he appreciaion of he Canadian currency and he shrinking of is manufacuring secor migh have been viewed as an opimal marke adjusmen wih limied role for governmen inervenion. In conras, id he Albera s resource boom is already par of hisory, he Duch phenomenon may have already become a disease ha challenges economic policy. We believe our paper migh be of some help for undersanding he recen evoluion and fuure challenges of he Canadian economy. References Acharya, R. and S. Coulombe (2008), Exchange Rae, Energy Prices and Employmen Resrucuring in Canada, Mimeo, Indusry Canada Augus. 13 In January 2009, he price of a barrel of ligh swee crude oil was under 40 USD, coming from 145 USD in June 2008 and he CAD/USD was jus above

25 Amano, R.A. and S. van Noorden (1995), Terms of Trade and Real Exchange Raes: The Canadian Evidence, Journal of Inernaional Money and Finance, 1995, Amano, R. A. & van Norden, S., "Oil prices and he rise and fall of he US real exchange rae," Journal of Inernaional Money and Finance, 17(2), Akinson, G. and K. Hamilon (2003), Savings, Growh and he Resource Curse Hypohesis, World Developmen, 31(11), Bayoumi, T. and M. Mühleisen (2006), Energy, he Exchange Rae, and he Economy: Macroeconomic Benefis of Canada s Oil Sands Producion. IMF Working Paper 06/70. Beine, M., Bos, C. and S. Lauren (2007), The Impac of Cenral Bank FX Inervenions on Currency Componens, Journal of Financial Economerics, 5, Beine, M. and S. Coulombe (2007) Economic Inegraion and he Diversificaion of Regional Expors: Evidence from he Canadian U.S. Free Trade Agreemen, Journal of Economic Geography, 7, Bos, C. S. and N. Shephard (2006). Inference for adapive ime series models: Sochasic volailiy and condiionally Gaussian sae space form. Economeric Reviews 25(2 3), Coulombe, S. (2007), Globalizaion and Regional Dispariy: A Canadian Case Sudy, Regional Sudies 41 (1), Corden, W.M. (1984). Booming Secor and Duch Disease Economics: Survey and Consolidaion. Oxford Economic Papers 36 (1984), Corden, W.M. and J.P. Neary Booming Secor and De-Indusrialisaion in a Small Open Economy. The Economic Journal, 92 (368) pp Coulombe, S., R. Lamy and S. Rogers (2007). Adjusmen in High Trade Exposed Manufacuring Employemen in Canada, Indusry Canada, Mimeo. Dion, R Trends in Canada s Merchandise Trade. Bank of Canada Review, Winer: Gylfason, T. (2001), Naural Resources, Educaion and Economic Developmen, European Economic Review, 45, 4-6, Harvey, A. C. (1989). Forecasing, Srucural Time Series Models and he Kalman Filer. Cambridge: Cambridge Universiy Press. Issa, R., R. Lafrance and J. Murray (2006): The Turning Black Tide: Energy Prices and he Canadian Dollar, Bank of Canada Working Paper Jacquier, E., N. G. Polson, and P. E. Rossi (1994). Bayesian analysis of sochasic volailiy models (wih discussion). Journal of Business and Economic Saisics 12(4), Kivie, J. F On bias, inconsisency and efficiency of various esimaors in dynamic panel daa models. J. Economerics. 68(1): Krugman, P. (1987), The Narrow Moving Band, he Duch disease and he Compeiive Consequences of Mrs. Thacher, Journal of Developmen Economics, 27,

26 Krugman, P. (1991), Increasing Reurns and Economic Geography, Journal of Poliical Economy, 99, Lafrance, R., J. Helliwell, R. Issa, Q. Zhang (2004), Nemo: an Equaion for he Canadian Dollar. Bank of Canada, Mimeo. Mahieu, R. J. and P. C. Schoman (1994). Negleced common facors in exchange rae volailiy. Journal of Empirical Finance 1(3-4), Mayer, P. and B. DePrao (2008), The Canadian Dollar and Commodiy Prices: Has he Relaionship Changed over Time?, Bank of Canada Discussion Paper Nickell, S. J Biases in dynamic models wih fixed effecs. Economerica. 49(6): Obsfeld, M. and K. Rogoff (2007), The Unsainable US Curren Accoun Posiion Revised, in R. Clarida (Eds), G7 Curren Accoun Imbalances, Susainabiliy and Adjusmen, Universiy of Chicago Press, Papyrakis, E. and R. Gerlagh (2004), The Resource Curse Hypohesis and Is Transmission Channels, Journal of Comparaive Economics, 32, Sachs, J.D. and A. M. Warner (1995), Naural Resource Abundance and Economic Growh, NBER Working Paper no. 5398, Cambridge, MA. Sachs, J.D. and A. M. Warner (1999), The Big Push, Naural Resource Booms and Growh, Journal of Developmen Economics, 59, Sachs, J.D. and A. M. Warner (2001), The Curse of Naural Resources, European Economic Review, 45, Sijns J.P.C Naural resource abundance and economic growh revisied. Resources Policy 30 pp Venables, A. (1996), Equilibrium Locaions of Verically Linked Indusries, Inernaional Economic Review, 37,

27 Appendix 1: Economerics of componen analysis The inpu for he analysis of componens is a vecor s = ( s 1,, s k )' of k log-exchange raes si = 100log Si agains a common currency. The common currency will be indicaed by index 0. Each of he log-exchange raes is wrien as he difference beween he currency facor of counry i, e i and he common currency facor, e 0, as in e 1 si = e0 = e1 k e0 e k The vecor of daa is enlarged wih a vecor of log-prices of Canadian commodiies and energy, expressed in U.S. Dollars. If he U.S. is he common currency 0 used above, he full observaion equaion can be wrien as s e1 k y = e0 p = f where p are he log-prices, and f are he corresponding price facors. Noice ha observaions on he log-prices is only available once per monh; for he oher days, he observaions of p are missing. Insead of modeling he log-exchange raes and prices direcly, an independen random walk srucure for he facors is proposed, 2 e = e + η, η ~ N(0, diag( σ )) + 1 e 2 f + 1 = f + ς, ς ~ N(0, diag( σ f )) 2 2 wih diag ( σ e ) a k+1 x k+1 diagonal marix wih elemens σ e on he diagonal. The price 2 facors f have fixed variances wih values in he vecor σ f. As here are only few observaions on he prices available and sochasic volailiy would no be esimable, hese variance are chosen o be fixed over ime. Finally, he disurbances η and ς are assumed o be independen; again, a dependence srucure beween hese disurbances is no esimable from he daa. As volailiies clearly move o differen levels over a sample as long as he one used in he presen applicaion, a non-saionary random walk specificaion for he logvariance is implemened. This inegraed sochasic volailiy model is specified as log σ e + 1= logσ e + ξ, ξ ~ N(0, σ ξ ) Essenially, all log-variances can change over ime independenly of wha happens in he 2 res of he model; he variances of he individual incremens are σ i ξ. For idenificaion, he common currency facor is iniialized a e 01 = 0, leaving he oher facors o sar a he value of he log-exchange rae. The iniial value of he 2 ' ' variances σ e is esimaed along wih he vecor of parameers ϑ = ( σ ξ, σ f )'. Esimaion of he resuling non-linear sae space model (Harvey 1989) is performed using a Markov chain Mone Carlo approach, see also Jacquier e al. (1994). A sraighforward MCMC 27

28 algorihm wih daa augmenaion delivers good convergence properies for he model a hand. Noice ha for esimaion of he parameers ϑ alernaive mehods like simulaed maximum likelihood or GMM-based mehods could be used. These alernaive mehods however are no as ap as he Bayesian simulaion approach for exracing he poserior mean of he currency and volailiy facors. Table 1: Prior and poserior for model parameers Prior Poserior Mean S. dev Mode Mean S. dev 95% HPD σ ξ (U.S.) (0.20) (0.01) [0.266, 0.321] σ ξ (Ausralia) (0.20) (0.01) [0.354, 0.409] σ ξ (Canada) (0.20) (0.01) [0.175, 0.219] σ ξ (Japan) (0.20) (0.01) [0.270, 0.324] σ ξ (UK) (0.20) (0.01) [0.281, 0.332] σ f (Commodiy) (0.55) (0.02) [0.468, 0.539] σ (Energy) (0.55) (0.04) [1.155, 1.321] f The final resuls are colleced by sampling firs a burn-in sample of 1,000 ieraions, followed by a poserior sample of 10,000 ieraions. The sample is no very large, as i was found ha especially he objecs of ineres, he currency facors, converged very rapidly, and a larger sample was no necessary for measuring hese. Table 1 displays he momens of he IG-1 prior densiies for he parameers, and he mode, mean, sandard deviaion and 95% highes poserior densiy regions. Noe ha he prior densiies were chosen based on previous experience, purposely aking priors wih relaively large sandard deviaions, o allow he daa o decide on he final locaion of he poserior densiy. Figure A1 repors he evoluion of he level and he volailiy of he componens of he oher currencies involved in he esimaion, i.e. he Ausralian dollar, he Japanese Yen and he Briish Pound over he period. Figure A1 : Currency componens (levels and volailiy) of he oher currencies 28

29 29

30 Appendix 2. Daa sources and variable definiions. S : vecor of daily exchange raes agains he USD (number of USD for one uni of domesic currency): Canadian dollar (CAD), Briish pound (UKP), Japanese Yen (JPY), Euro (EUR); Ausralian Dollar (AUS); source : Daasream. E : Canadian nominal effecive exchange rae, rade-weighed (code: V37426), source: Saisics Canada CANSIM II. P : Bivariae vecor of monhly commodiy price indexes ; -Toal commodiy price index excluding energy in USD erms (1980=100); code V36383; source: Saisics Canada CANSIM II. -Energy price index in USD erms (1980=100); code V36383; source: Saisics Canada CANSIM II. q 1 us, r = ln( S * ) : log of he real CAD/USD exchange rae where q us, is he US qca, GDP deflaor (2000=100), compued by he raio of gross domesic produc curren dollars (code V121951) and gross domesic produc chained 2000 dollars (code v ); source: Saisics Canada CANSIM II. q is he monhly Canadian GDP deflaor (2000=100), implici price index ca, (2002=100) (code V ); source: Saisics Canada CANSIM II. idiff : 3 monhs ineres rae differenial beween Canada and he US, monhly frequency; compued as idiff = ican ius where ican is he 3 monh prime corporae paper rae (code: V122491) and ius is he US 3 monh commercial paper rae adjused (code : V122141); source: Saisics Canada CANSIM II. sca i : share of employmen of indusry i in oal manufacuring employmen in Canada a ime (annual frequency); source : Labor force survey, Saisics Canada. sus : share of employmen of indusry i in oal manufacuring employmen in he US a ime (annual frequency); source : US Labor Force survey, US Bureau of Labor Saisics. i Ne inerprovincial migraion (foonoe 2) (code v391142); source: Saisics Canada CANSIM II. 30