Depreciation of Canadian dollar: Lifeline for some manufacturing industries Summary The Canadian dollar has been losing ground to the greenback. In the present study, our working assumption is 10% depreciation from its average value of US$0.9630 in 2013Q3. The higher an industry s net exports coefficient, the more its profit margin on operations localised in Canada improves following a depreciation of the Canadian dollar. We calculated the net exports coefficient for 82 separate manufacturing industries and 12 industries extracting oil, gas and mineral ores. The operations localised in Canada of the computer and electronic products industry have been in the red for the past seven quarters. Starting from operating losses representative of that period, a 10% depreciation of the Canadian dollar would barely return this industry to profitability. Results would be more convincing for pulp and paper mills, as a 10% depreciation of the loonie would push their operating margin to 3.2% from the a situation of a cumulated operating loss over the last four quarters. In 2013Q3, the primary metals industry enjoyed a slim profit margin of 0.8%. A 10% depreciation of the loonie would push this margin to 3.1%. The loonie s depreciation has a proportionately lesser impact on the profit margin of the motor vehicles and trailers industry despite the fact that a strong share of its production is exported. Indeed, this effect is offset in part by the fact that a strong share of its inputs is imported. Mining and oil & gas extraction industries have in general large net export coefficients. Except gold and silver ore mining and support activities to mining and oil & gas extraction (contract drilling and other support activities except geophysical surveying), they therefore strongly benefit from a depreciation of the Canadian dollar. Profit margin of manufacturing sector 1 February 4, 2014 In the United States, the profit margin of the manufacturing sector is on a growing trend since 2003, excluding the hiatus of the economic recession. In Canada, the same cannot be said. In the last quarter of 2002, the manufacturing sectors of the two countries had very similar profit margins. A gap began to open as of the first quarter of 2003, coinciding with the Canadian dollar s entry into a phase of appreciation against the greenback, which lasted until the beginning of the U.S. recession. Thus, the Canadian dollar went from an average of US$0.6371 in 2002Q4 to US$1.0185 in 2007Q4, that is, an increase of 60% in five years! Chart 1 Manufacturer profit margin, Canada vs. United States, and exchange rate of Canadian dollar U.S. cents per $CAN 105 100 95 90 85 80 75 70 65 60 Shaded area: recession in United States Canadian dollar appreciated 60%! Profit margin (%) 10 9 8 7 6 5 4 3 Exchange rate (L) 02 03 04 05 06 07 08 09 10 11 12 13 NBF Economy and Strategy Group, data via Statistics Canada, Bank of Canada, and U.S. Census Bureau Back then, the Canadian manufacturing sector exported about 50% of its production to the United States. Most of the time, these exports are paid for in U.S. dollars, which Canadian manufacturers must then convert into Canadian dollars. Hence, for the same amount of sales in the U.S. market, a given percentage appreciation of the Canadian dollar translates into a corresponding percentage reduction of revenues in Canadian dollars. 1 In this section, the manufacturing sector excludes petroleum and coal products. Profit margin is defined as operating profits (before taxes and interest charges) over operating income, and covers only operations conducted on the national territory. ECONOMY AND STRATEGY GROUP 514.879.2529 Stéfane Marion, Chief Economist and Strategist General: National Bank Financial Markets is a business undertaken by National Bank Financial Inc. ( NBF ), an indirect wholly owned subsidiary of National Bank of Canada, and a division of National Bank of Canada. This research has been produced by NBF. National Bank of Canada is a public company listed on Canadian stock exchanges The particulars contained herein were obtained from sources which we believe to be reliable but are not guaranteed by us and may be incomplete. The opinions expressed are based upon our analysis and interpretation of these particulars and are not to be construed as a solicitation or offer to buy or sell the securities mentioned herein. Canadian Residents: In respect of the distribution of this report in Canada, NBF accepts responsibility for its contents. 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Though it does not explain everything, the loonie s strong appreciation from 2003 to 2007 was doubtless a factor that significantly limited our manufacturers sales growth measured in Canadian dollars. Incidentally, in 2007Q4, when the loonie exceeded parity with the greenback, sales were below their level registered in 2002Q4. Over the same period, sales growth among U.S. manufacturers attained 34%. Chart 2 Manufacturer sales, Canada vs. United States In national currency Billons of CAD Billions of USD 1,400 196 (right-hand scale) 192 1,350 Shaded area: recession in United States 188 184 1,300 180 176 1,250 172 1,200 168 164 1,150 160 156 1,100 (left-hand scale) 152 148 In Canada, sales in 2007Q4 1,050 144 were below those recorded 1,000 140 five years earlier. 136 950 132 128 900 02 03 04 05 06 07 08 09 10 11 12 13 NBF Economy and Strategy Group, data via Statistics Canada and U.S. Census Bureau After the recession, the profit margin of the Canadian manufacturing sector improved so much so that the gap with its U.S. counterpart shrank to a low of 47 basis points in 2011Q2. This occurred despite a Canadian dollar that had bounced back above parity in the quarter after falling to US$0.80 at the start of 2009. This strengthening of the profit margin can be explained above all by the solid performances of various sectors led by motor vehicles and parts, primary metals, chemical products, plastics and rubber products, and forest products. In particular, an increase in international commodity prices during this period (e.g., 56% for lumber, 71% for pulp, and at least 100% for metals) more than offset the resurgence of the Canadian dollar. In the first quarter of 2012, the profit margin of Canadian manufacturers suffered a sharp decline and never recovered thereafter despite a slight depreciation of the Canadian dollar. The drop was concentrated in some of the 12 groups of manufacturing industries for which Statistics Canada publishes seasonally adjusted profit margins 2 on Canadian operations, in particular primary metals and computer and electronic products. In 2013Q3, the profit margin of the former had sunk to nearly 0. For the latter, it has been negative since 2012Q1, sales having fallen more than 40%. Excluding these two groups, the profit margin of the Canadian manufacturing sector has fluctuated trendlessly since 2011. 2 Remember that for the moment we exclude petroleum and coal products from the manufacturing universe. Chart 3 Canada: profit margins in manufacturing sector 20 15 10 5 0-5 -10-15 -20-25 -30 % Computer and electronic products Shaded area: recession in United States Other industry groups* 2007 2008 2009 2010 2011 2012 2013 * Excluding petroleum and coal products NBF Economy and Strategy Group, data via Statistics Canada. Primary Metals Impact of loonie s depreciation on Canadian manufacturers The profit margins of Canadian manufacturers on their Canadian operations are known up until 2013Q3. Over this quarter, the exchange rate stood on average at US$0.9630. For the sake of discussion, we assume a depreciation of 10% from that level, after which the exchange rate will stand at US$0.8667. It is only natural to wonder to what extent the manufacturing industries, particularly those most vulnerable at present, will benefit from this depreciation, assuming that it will be reflected directly in their results. For the purposes of this simulation, we need to know for each industry the share of production that is exported and the share of inputs that is imported. To the extent that imported inputs are paid in US dollars, a depreciation of the loonie means an increase in the price of these inputs for the importing Canadian industry. This counters the positive impact of the depreciation on export revenues. Only if an industry is in a net exports position (more exports than imported inputs) will it benefit from a depreciation of the Canadian dollar. We use the export and import multipliers (direct effects only) per industry. These are estimates by Statistics Canada of the share of the value of production exported and the share of inputs imported. The latest multipliers available are those derived from the 2009 input-output tables. These multipliers are available for no less than 82 manufacturing industries. For each of these industries, table 1 in the appendix 3 gives the export and import multipliers and the difference 3 From this point forward, the petroleum and coal products industry is reintegrated in the manufacturing sector. February 4, 2014 2
between the two, which is referred to as the net exports coefficient. We then grouped these 82 industries into 20 categories, that is, those for which Statistics Canada reports quarterly profit margins. In order to derive aggregate data for categories of industries, we have applied the multipliers to the value of production of each industry according to the 2010 input-output tables. Knowing the profit margin at the start and the export and import multipliers, it is possible to calculate the impact on this margin of a depreciation of the Canadian dollar, all other things remaining equal. For industries where the profit margin was unknown, we assumed it to be 0 at the start 4. Dark red lines in the table correspond to industries with a negative net export coefficient. From the point of view of net exports, these industries do not benefit from a depreciation of the exchange rate. We also included in the table data related to domestic market penetration by foreign competitors (imports as a percentage of the apparent domestic market in 2012) and share of labour costs in value of production (according to the input table for 2010). It is important to realize that even industries that have no exports are affected by a change in the exchange rate if they face foreign competition for their products in the domestic market. In these cases, when a depreciation of the Canadian dollar raises the price of imported goods paid for in U.S. dollars, the local industry normally gains an advantage. Even if the imported goods were paid for in Canadian dollars, the foreign producer would receive fewer U.S. dollars (or a smaller amount of USD-pegged currency) in return for its Canadian dollars, which would once again be in the local industry s favour. Extracting natural resources Table 2 in the appendix shows the net exports coefficient for activities realized in Canada for 12 industries related to oil and gas extraction and mining. Conventional oil and gas extraction comprises establishments primarily engaged in the exploration for, and/or production of, petroleum and natural gas from wells in which the hydrocarbons will initially flow or can be produced using normal pumping techniques. Non-conventional oil extraction comprises establishments primarily engaged in producing crude oil from surface shales or tar sands or from reservoirs in which the hydrocarbons are semisolids. Support activities for mining and oil and gas extraction 4 It can be demonstrated that the impact on the profit margin of a change in the exchange rate is (1-margin at the start)*v(e-i)/(1+ve) where v is the % variation of the exchange rate (negative in the case of an appreciation), e the export multiplier and i the import multiplier. Assuming the profit margin to be 0, the calculation of the impact reduces to v(e-i)/(1+ve). For the sake of discussion, the imprecision is insignificant for usual values of profit margins. refer to contract drilling and to a wide range of contract services excluding geophysical surveying services. Analysis If we refer to the bottom of table 1 in the appendix, we see that, on the whole, the manufacturing sector exports 41% of its production and imports 26% of its inputs. Moreover, imports account for 55% of the value of demand for manufactured goods in Canada. Labour costs represent nearly 18% of the value of production. In 2013Q3, the profit margin of the manufacturing sector was 5.4%. In principle, given that net exports represent 15% of production, a 10% depreciation of the Canadian dollar should result in this margin widening to 6.8%. Even at this level, the profit margin of the Canadian manufacturing sector would still be below that of its U.S. counterpart. However, this big picture of the manufacturing sector is not characteristic of all the industries taken one by one. Let us take a look at the situation of the most vulnerable among these. The computer and electronic products industries category posted a disastrous operating loss on its Canadian operations in 2013Q3, no doubt not representative. However, the industry also posted operating losses, albeit more moderate ones, in each of the six prior quarters 5, in the order of 2.6% on average. For the sake of our discussion, then, let us consider this rate of loss to be representative. Consequently, given net exports of 34.7%, a 10% depreciation of the Canadian dollar would make operations on the Canadian barely profitable, with a profit margin of 0.7%. The paper industries category posted an overall loss in the four quarters ended 2013Q3 amounting to 0.7% of sales. Given the very high level of net exports at nearly 41% of production, a 10% depreciation of the Canadian dollar would largely be enough for this category of industries to return to profitability, with a 3.2% profit margin. It should be noted that this category comprises two industries: pulp, paper and paperboard, and converted paper products. The high rate of net exports applies only to the former. In 2013Q3, the profit margin of the primary metals industries category stood at a lowly 0.8%. Given its net exports coefficient of 24.6%, a 10% depreciation of the Canadian dollar would, all other things remaining equal, boost the margin to 3.1%. However, such an improvement would apply to only two of the five industries in the category, namely, aluminum and other non-ferrous metals. Instead, given their minimal net exports coefficients, a change in the exchange rate would, in principle, have little bearing on the margins of the iron and steel mills, steel products, and foundries industries. 5 After seasonal adjustment by Statistics Canada. February 4, 2014 3
Over the four quarters ended in 2013Q3, the profit margin of the motor vehicles and trailers industries category reached 2.1%. The improvement to be expected here from a depreciation of the Canadian dollar would be moderate, in the order of 1.5 percentage points, because although the category presents a high exports coefficient, its imports coefficient, too, is well above the norm. The manufacturing sector comprises one category of industries involved in energy, namely, petroleum and coal products. This category notably encompasses petroleum refineries. According to table 1, the latter industry imports more than it exports. One suspects that this mostly applies to refineries in the eastern part of the country, which import most of the crude oil they refine. However, according to table 2, industries which extract crude oil, natural gas and different ores have in general very high net exports coefficients. For this reason, they strongly benefit from the depreciation of the Canadian dollar. Exceptions are gold and silver ore mining and support activities to oil and gas extraction and mining, which focus on the domestic market much more than they export services. Note also that for potash producers, a 10% depreciation of the Canadian dollar would hardly make up for the substantial decline of the World price of potash due to the collapse of a cartel of Eastern European firms. Marc Pinsonneault Senior Economist 514 879-2589 marc.pinsonneault@nbc.ca February 4, 2014 4
Appendix SPECIAL REPORT 1- Impact of a 10% depreciation of the Canadian dollar on the profit margin of 82 manufacturing industries Table continues on next page February 4, 2014 5
Table continues from previous page February 4, 2014 6
2- Impact of a 10% depreciation of the Canadian dollar on the profit margin of 12 industries related to oil and gas extraction and mining Industries Net Impact of a Labour costs Exports 1 Imports 1 exports 10% depre- as a % of ciation 2 output value 3 Conventional oil and gas extraction 52.7 3.6 49.0 4.7 11.2 Non-conventional oil extraction 69.5 8.3 61.1 5.7 6.7 Support activities for oil and gas extraction 0.7 15.2-14.5-1.5 34.6 Coal mining 83.6 3.1 80.6 7.4 13.2 Iron ore mining 83.3 13.5 69.8 6.4 9.4 Gold and silver ore mining 13.0 4.9 8.1 0.8 23.8 Copper, nickel, lead and zinc ore mining 24.9 4.4 20.6 2.0 15.6 Other metal ore mining 68.2 4.4 63.8 6.0 17.0 Diamond mining 98.1 6.1 92.1 8.4 10.4 Potash mining 94.4 4.2 90.2 8.2 11.5 Other non-metallic mineral mining 42.9 6.9 36.0 3.5 21.2 Support activities for mining 5.3 12.4-7.1-0.7 41.1 1 Estimates of exports and imports as a % of output value, according to the 2009 input-output tables. 2 Estimated impact assuming a profit margin at 0 at the start. 3 Wages, salaries and supplementary labour income, as a % of output value according to the 2010 input table. Source: Data from Statistics Canada February 4, 2014 7