Saturday, October 24, 2015

A growth plan for Canada

I try to remain apolitical on this blog, but for your weekend reading, here is my analysis of the challenges for the new government and my thoughts on the way forward.

On Monday, Canada elected a centre-left Liberal government, with Justin Trudeau as the new Prime Minister. Expectations are high and they are likely to come down to earth in the next few years. Bloomberg recently highlighted analysis by HSBC Canada David Watt of the challenges facing the Trudeau government:
"Until Canada overcomes its productivity and competitiveness hurdles, it will continue to feature cyclical behaviors similar to those of emerging-market economies," Watt wrote.
Watt had the same reservations about productivity that I did (see my past post, Uh-oh, Canada!):
In his report, Watt joins some of his peers in arguing that an economic acceleration south of the Canadian border doesn't pack the same punch it once did. Bank of America Merrill Lynch Canada and U.S. Economist Emanuella Enenajor has detailed how Canada's sensitivity to U.S. domestic demand has been on the decline, while Steven Englander, Citibank's global head of G-10 currency strategy, has connected the subdued performance of Canada's non-energy exports to the ascendance of Mexico in U.S. manufacturing. Mexico now benefits handsomely from its proximity to the U.S. and enjoys its position as an integral part of many supply chains.

Canada's weakened currency has helped the nation increase its cost competitiveness with the U.S., Watt acknowledges, but hasn't significantly shifted the calculus.

Generally speaking, HSBC economists have found little evidence of exchange rate depreciation fueling export growth since the financial crisis. And some contend the weak exchange rate actually impedes productivity growth. The increase in competitiveness through lower labor costs masks productivity shortcomings, while the soft domestic currency makes importing such materials more expensive, the thinking goes.
As an investor, I would like to see the government, any government, take steps to boost Canadian competitiveness. The "old" ideas of the former Conservative government of "get government out of the way of business" only goes so far.

The Harper-led Conservative government cut taxes and shrank services in the last 10 years, but the market did not show the desired response. A BCG study showed that Canadian manufacturing costs becoming uncompetitive with its NAFTA partners, the US and Mexico. Let's call the Harper small government plan Growth Plan 1.0.

Indeed, Macquarie recently called for a minimum target on the CADUSD exchange rate of 69c in order for Canada to be competitive:

The Liberals campaigned on a plan of running modest deficits to invest in infrastructure and stimulate growth. Call that Growth Plan 2.0. (Incidentally, I believe that one of the failures of the Tory campaign is to properly explain why deficits matter. The Trudeau plan of borrowing when the market will lend you money at 2% or less to invest in growth producing infrastructure is arguably sound.) While Growth Plan 2.0 is certainly an improvement over 1.0, the Liberal approach is very Keynesian. Though it will undoubtedly provide a short-term boost, it doesn't address long-term productivity issues facing Canada.

Growth Plan 3.0
What we need a Growth Plan 3.0 that focuses on improving productivity and innovation, which leads to sustainable quality growth. We don`t need the same-old-same-old innovation solutions of research and development tax credits, nor will the tired approach of squeezing labour costs in export industries like autos be sustainable in the long-run. It only leads to playing the game of competing with Emerging Market economies, where Canadian workers get paid at EM wages scales.

We need to think outside the box. As an example, Michael Porter showed back in the early 1990`s that Germany was able to remain a high wage country but enjoyed good growth. The secret was to create higher value-added jobs, rather than to compete with low-wage countries engaged in low value-added manufacturing.

A cheap but effective method might be to adopt the American model of the DARPA challenge to jump-start innovation. A senior DARPA official explained it this way:
DARPA’s role is to spur innovation. And we do it by focused, short term efforts. We pick things that are not impossible, but also not very low risk. So we take very high risk gambles, and those risks have tremendous payoffs. So if we’re successful it means that these robots are actually going to be able to make a difference. In particular, in disaster scenarios making society more resilient. The lesson of the original challenge [DARPA Grand Challenge - driverless cars] is that persistence pays. It’s important if you know the technology is almost there and you can sort of see the light at the end of the tunnel, a little bit of persistence will pay off. What I’m hoping for in the trials is that some of the teams will score some points. I don’t think that any team is going to score all the points that there are. Maybe no teams will even score half the points that there are. But I think some teams will do moderately well. My expectation is that the robots are going to be slow. What we’re looking for right now is for the teams to just do as well as roughly that one year old child. If we can get there, then we think that we have good reason to believe that some of these teams with continued persistence for another year will actually be able to demonstrate robots that show the utility that these things might have in a real disaster scenario. DARPA is in the innovation business, not in the development business. So, what we do is we wait for technology to be almost ready for something big to happen, and then we add a focused effort to catalyze the something. It doesn’t mean that we take it all the way into a system that’s deployed or to the marketplace. We rely on the commercial sector to do that. But we provide the impetus, the extra push the technology needs to do that.
Using a Michael Porter framework of development economics, the intent of a DARPA challenge is to create clusters of expertise. There is no point in trying to re-create Silicon Valley in your own back yard, but you can focus on specific industries that are already clusters of expertise in your regions. Examples include autos in southern Ontario, aerospace in Quebec, oil service and exploration in Calgary, mining in British Columbia and so on.

The federal government could create Canada Council administered DARPA challenge-like prizes aimed at specific problems in targeted industries, e.g. nano materials technology for the auto or aerospace industry, to encourage universities to take the lead in research. If a breakthrough were to occur, then the existing private-public partnership structures already in place at the universities can do the rest. Such an approach would be a low-cost way of encouraging innovation that highlight Canadian expertise.

Imagine, for example, if UBC became a global leader in earthquake-proofing buildings. It would create an engineering industry and expertise in the region that would be second to none. It would mean good jobs that would have no worries about competing with low labour cost countries like Mexico. What would that kind of growth be worth?

Is there anybody listening?

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