Currency flows and flaws: Brenner

Much has been written on the “Dutch Disease” – how countries relying on their natural resources often fall on hard times, failing to develop. A Chinese observer, Laozi, in 81 BC had this to say: “A country is never as poor as when it seems filled with riches” (in Yan Tie Lun, A Discourse on Salt and Iron).  Only these days, the natural riches are oil (in Canada, Norway, Russia, Middle East) and in Australia, iron ore.

It is possible too that the quote refers to the purchase of luxuries items in corrupt countries, $500K Mille watches or Prada items, that can either disguise corruption.  Perhaps not surprisingly, Prada has not being doing well since its IPO, the main reason being China, where, not accidentally perhaps, part of the Communist party has declared fight against corruption.  The decline in real estate and land prices has been related to deep seated corruption in China too – by now officially recognized.  What is the link between China clapping down on corruption and resource rich countries?

The impact of the Chinese policies radiate around the world: Much of its domestic slowdown is real estate, impacting many sectors, resources and luxury being prominent.  Australia and Canada have suffered since they have continued to rely on their resource sectors the last two decades. Canadian and Australian currencies in this floating world continued to be strongly correlated with commodity prices prices.

Below are excerpts from my March 8, 1999 Forbes article, “Currencies Don’t Lie,”  on why this was and stayed so, though official statistics have been showing diminished roles to the natural resources in these countries.

“The value of the Canadian dollar (in U.S. dollar terms) correlates almost perfectly with commodity prices. During 1998, for example, the Commodity Research Bureau’s index of raw materials prices dropped from around 280 to 230, climbing recently to 240 before dropping back to 230.

The Canadian dollar followed, dropping from 71 cents to the U.S. dollar to the 65 cent area.

On first impression, this is surprising. Canada is a G7 country, not one with an economy based on natural resources. Canada’s federal and provincial governments are among the world’s top per capita spenders on education, which should boost the country up the value-added chain. One would expect that critical masses of educated Canadians would either add value to Canada’s exports or attract financial capital — thus pushing up the demand for Canadian dollars. Yet the currency’s correlation with the CRB index shows that global capital is flowing to Canada mainly for its natural resources and investments in companies with little pricing power.

… Returns on Canada’s vast investments in human capital are not showing up in Canada. They do not show up for two reasons. One: A significant number of Canada’s brightest, best-educated and most productive people have been moving to the U.S. and are not being replaced by people of similar caliber. In Canada’s relatively egalitarian universe, the fact that some individuals can be worth hundreds of millions of dollars (as reflected in market values of companies when they quit, join or start up a company) is kept out of sight.

I recently asked several students graduating with degrees in computers and electronic engineering where they will pursue their careers. Not one said Canada. All said they received offers of far more interesting work in the U.S. and at double or triple Canadian salaries.

In other words, Canada invests in education, the U.S. collects the dividends. The 10% decline in real disposable incomes in Canada over the last ten years (in the U.S. they increased by 10% over this period) reflects the combination of high taxes and the departure of “the vital few.”

There is a second reason the Canadian dollar does not reflect the country’s investment in human capital. Even when smart Canadians stay home, the country’s savage tax rates prevent them from realizing their potential. Depending on the province, marginal income tax rates in the 45% to 55% range (federal and provincial combined) are levied on incomes of just $40,000. Combine this with high capital gains taxes (in the 33%to 40% range), and what incentive is there for Canadians to work harder and smarter and finance more risks — especially when the U.S. has been pursuing fiscal policies conducive of entrepreneurial capitalism? (In the U.S. one stays in the 28% marginal income tax bracket until one’s income reaches $100,000, capital gains taxes are in the 20% range and there is the tax-exempt Roth Individual Retirement Account, as well.) …

… Unlike polls and statistics, currencies don’t lie. In the future look for even stronger correlation between commodity prices and the Canadian dollar, as Canada slips further into its high-taxed, bureaucratic stupor. Just add the price of water to the commodities index, political grandstanding on prohibiting its export notwithstanding.”

Though things have changed in the last 16 years that elapsed since I wrote the above, US and Canadian fiscal policies got closer, the fact remains that Canada is a resource-based country.  True, taxes increased in the US and they were lowered a bit in Canada, and the 2008 crisis took its toll on the US.  The expansion of Canada’s financial sector did not change matters significantly, since the loans were advanced to the natural resource sector or myriad of service and equipment companies backed by revenues from this same resource sector – as were the expanding government bureaucracies too.  And the US, its increasing fiscal and monetary mistakes notwithstanding, continues to attract the “vital few” and capital from around the world. In the land of the blind, the one-eyed stays king.

China’s currency problem is different from Canada’s.  Whereas China justifiably anchored its currency in the US dollar when pursuing its drastic transformation from central planning, assuming that the dollar would stay a stable anchor, that did not happen. The last few years, the dollar became a volatile, but overall strengthening currency.  Whereas the US, having deep financial markets can deal with this, China, with a shallow capital market and virtually no debt market – faces a tough problem.

Reuven Brenner holds the Repap Chair at McGill University’s Desautels faculty of Management. The above draws on Brenner’s Force of Finance (2001).

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