May's Investment Outlook

Golden Capital Securities

Investment Outlook

May 2001

With the wrap up of the Quebec Summit the leaders of the Western Hemisphere's democratic countries decided to push ahead with the development of potentially the world's largest trading block. The plan is to create a Free Trade Area of the Americas by 2005 that will have few restrictions on the movement of goods from one country to another. Tariffs and duties are generally considered economically inefficient and their elimination would facilitate the movement of goods to larger markets, at lower prices, with increased competition. Increased trade should also mean more jobs, higher incomes and higher standards of living.

Why then were thousands of people protesting what appears to be good for all everyone? Many of the protesters argue that "corporate globalization and the unbridled pursuit of profit are eroding the rights of workers, feeding social injustices and damaging the environment" (Globe and Mail). Unfortunately, the economic models tell us that while the overall benefit of more liberalized trade may be positive, there will always be some groups that will be worse off than they were before. It is the displaced groups that usually protest - whether for change or for the status quo. Conversely, one doesn't hear many people parading around chanting "We made a lot of money, our lives are better than a year ago - Yay us!"

Duties, tariffs and quotas have all been enacted by governments as restrictions on international trade in efforts to protect the groups that would be hurt if an economy or industry was immediately opened up to more liberalized trade. The idea being that the tariffs will protect inefficient or immature industries while they become more efficient or gain critical mass. However, tariffs and protectionism insulate inefficient companies and industries from competing on a global level, discouraging them from becoming the global powerhouses that the protection was suppose to encourage.

In some cases, protectionism does actually work. Few people believe that Bombardier (BBD-TSE) would have grown into the diversified and financially viable company it is today if it hadn't been for the subsidies and grants that it received from the federal and Quebec provincial governments. However, now that the Company is competitive on a global stage, it is trying to compete without this assistance and running into problems with companies that are still receiving assistance from their governments - like Embraer of Brazil in the regional jet marketplace. Now that Bombardier has achieved that global critical mass, it is being hurt by similar incentives and governmental help that allowed it to grow and become globally competitive in the first place. The World Trade Organization is currently deciding at what point the governmental support must stop.

Actually, Bombardier is the exception to the rule. In many cases tariffs give companies and industries a reason to not even attempt to improve themselves competitively as they have no incentive to spend their capital on infrastructure to improve their efficiency. In this sense, tariffs and quotas actually increase inefficiencies and lack of competitiveness by discouraging growth and competitiveness. Canadian fishing, farming and car assembly have each received incentives and support for their industries, with little or no benefit to the end consumer, and in the case of the Canadian milk and egg marketing boards, cost Canadians dearly.

Traditionally, the Canadian economy has been seen both domestically and internationally as almost solely resource based, with a large percentage of that production being exported to our American friends to the south. Thankfully, this resource bias is no longer the case. In 2000, just under 30% of our exports were from resource, energy and agricultural sources. The other 70% was from goods that had been processed or constructed. As a country we should be aiming for as high of a ratio of manufactured goods as possible. Primary resources have little or no value added before they are shipped to other countries for further processing. The margins on primary resources is generally very low, but increases as further processing and effort is placed into the good. Why should some other country process Canadian resources and accrue greater marginal profits on it than Canadians?

As a national goal, we should aim for near 100% secondary or tertiary treatment on our exports. The only goods that should leave Canada unprocessed are those resources that are used with no further processing before they reach their end manufacturer or consumer. Over the last decade, Canada has slipped from the third most wealthy country to the fifth, based on per-capita GDP. A further slip could occur unless we find ways to increase the "value added" on our products. However, to realistically achieve this level of processing and manufacturing, Canada must be able to do it at least as well, better and/or cheaper than our customers can do it themselves. This is where innovation comes into the picture.

So what does innovation require? First, an educated work force. Canada has a very high level of post-secondary education, with schools that lead the world in research and development. Funding for both traditional universities and modern technical colleges are needed to train workers for the jobs that will make Canada competitive.

Secondly, the technical knowledge to create these changes. Once we have funded the schools to create the workers of the future, we need to give them the resources with which to create the technology, the goods and the services that will further enhance the Canadian Economy on a global stage. Funding for research and development projects that hold the potential of new products or improved manufacturing should be given the utmost attention.

Finally, incentives to enact the changes that are developed. Companies, particularly in industries that are protected, should be given indirect incentives (tax relief on investment, low interest loans) to increase the efficiency and competitiveness of their businesses towards a global level. Venture capital, a key component in innovation, must be made available to early stage companies. VC money is currently severely lagging that of our American counterparts, even after the tech melt-down.

Our view on improving innovation is really quite simple: Personal and Corporate income taxes must decline. Add to that, a re-orientation of the tax system away from income and investment-based taxes towards a more consumption-based tax structure. This redirection of the principal source of tax revenues would further assist the development of Canadian industry by encouraging investment. However, overall tax revenues would not decrease over the medium to long-term due to the investments in innovation and expansion would generate higher absolute taxes, even while the marginal rates would be lower.

By reducing personal and corporate taxes, Canada will be able to retain our existing highly trained talent and innovators, perhaps even attract talent from other countries - a reversal of the Brain-Drain - and a resulting increase in the tax pool. As the talent pool increases, Companies wanting to take advantage of that pool will not be scared away by high Corporate taxes and may expand or move their facilities to Canada - further increasing the tax pool. With highly trained individuals and new and expanding companies coming to Canada, investors in search of new opportunities will invest in Canada in support of these new ventures, allowing the workers to earn more, companies to grow faster and the government to garner even more in tax revenues - All the while with lower marginal rates.

Investment in Capital Assets and a further incentive to continually innovate should be the goal of the Canadian federal and each of the provincial governments. Instead of protecting industries, the Governments should be encouraging companies to invest in ways to make themselves more efficient, more competitive and more profitable. Educational funding, tax incentives, grants, low interest rate loans are all methods by which the Government can invest in the future of Canada. Ireland did it very well, Alberta has got it right (a large reserve of oil and natural gas helps too), even Regan Economics in the 1980's were based on these principals. B.C. and the rest of Canada now need to implement the same changes. If policy makers took a vision of longer than one term in public office, we could create globally competitive companies that will be larger, employ more people, earn larger profits and (very importantly for the government) pay more in taxes - the benefit being that further services and funding could be provided at a lower tax rate due to the larger tax base.

And that's the view from the soap-box in the West.

So we're headed towards a global trading area, one in which Canada is incredibly innovative and profitable - THEN WHY IS OUR DOLLAR STILL AT 64 CENTS??????

To compete on the global stage what a country would ideally want is a strong economy and a weak currency. A strong internal economy would provide healthy incomes for the citizens, near full employment, profits for the corporations and tax revenues for the government. A weak currency would make their goods for export relatively cheaper and decrease the demand for imports - further supporting the domestic economy.

However, the likelihood of this maintaining itself for a period of time is very low; it could happen for limited periods of time, but not for meaningful, economic periods. As exports pour out of the country, companies would be receiving foreign currency which they would have to convert into their domestic currency - selling the foreign, buying the domestic - forcing up the exchange rate. Additionally, foreign investors would want to invest in these rapidly growing businesses and would need to buy the Country's currency to purchase the stock, further pushing up the exchange rate.

Interestingly, this is exactly the situation that the Canadian Dollar has been in recently. Over the last couple of months, we've had a stronger economy (at least statistically) than the Americans, but our currency has remained well below the 80 cents that is its theoretical value based on Purchasing Power Parity. Two of the major mitigating factors against the return to true spending power parity has been the US Dollar as a store of value and the highly liquid US Stock Markets. Each of these factors has encouraged investors to use American based investment products over other currencies.

It has really only been against the US Dollar that our Dollar has slipped, mind you we haven't really suffered. With 87% of our trade going to the US, which includes a $92B trade surplus, the low dollar has added dramatically to the earnings of Canadian exporting companies.

Again, on a relative basis the Canadian Dollar has done reasonably well when compared to major currencies other than the US Dollar. The strength of the Greenback has really affected other major trading partners. The British Pound (GBP --) has lost around 10% of its value versus the US Dollar over the last 52 weeks, compared to only about 3% for the Euro (EUR --), although it had been down by as much as 11% late last year. Continued weakness in the Pacific Rim has continued to plague both the Japanese Yen (JPY --)and the Australian Dollar (AUD --)as both are off around 15% presently, compared to around 20% at the beginning of April.

Below is an inverse chart of the US Dollar versus these currencies. The higher the percentage, the worse the currency has performed vis-a-vis the US Dollar

Source: Bigcharts.com

In a recent paper by Don Drummond, Chief Economist of TD Bank Financial, he put forward several possible alternatives for the drooping dollar. Some were more feasible than others, but here is a summary of his suggestions.

Creation of a fixed exchange rate. This method has worked in the European Union as they head towards the single currency, but failed horribly in Argentina. Canada could establish a fixed exchange rate to the US Dollar as we have very similar economic cycles, but we would then be required to have similar economic and monetary policies to the United States in order to maintain the similarity of the cycles. We would lose a great deal of our economic autonomy as interest rates, government spending and therefore tax rates, would have to be very similar.
Monetary Union with the US. Probably the most unlikely of the bunch. Again, this is what will happen in the EU once the Euro is the commonly used currency on the continent. However, for North America this is highly unlikely - can you see Americans giving up their Greenback for, say, a NACU (North American Currency unit)?
Dollarization. Similar to monetary union, only Canada would begin using the US Dollar as its currency. Panama already officially does this, as well as a host of other countries that do it unofficially. Relatively easy to enact, but then we would lose Monetary Policy, money supply, as an economic tool.
Currency Board. The Bank of Canada (BoC) is doing this to a degree now. As the dollar slips on the international money markets, the BoC steps into buy up the excess supply, conversely selling if the dollar gets too high. However, International Currency traders have significantly more power and dollars behind them than the BoC could ever hope to have. George Soros, the international financier, made several fortunes betting against the Bank of England on the British Pound. Needless to say, he won many of those battles.

Mr. Drummond does give some very practical suggestions to the Government of Canada on some techniques that could be used to stimulate the Canadian economy, thereby hopefully enhancing the attractiveness of the Loonie.

Decrease the level of National, Provincial and Municipal debt
Decrease the Marginal Tax rates
Decrease Corporate Taxes
Eliminate capital taxes
Control government spending
Orient government spending towards growth rather than support
Orient taxes towards consumption and away from investment

The problem will not be an easy one to solve. The Loud Minority will always attempt to have their way. But if you take one thing away from this piece, it is that tax cuts and increased spending can occur simultaneously! It won't happen in the first year, it may even take 5, but it can occur if we make the decision that short-term pain can result in long-term gain.

Until next month.