Proposals for geographic diversification tend to lack specific details, but they generally refer to reducing Canada-U.S. trade as a proportion of Canada's total trade.

The hoary question of Canadian trade policy is alive and well, and the answer apparently eludes us still. Should Canada diversify its trade away from the United States to reduce its dependence on that market? Does that dependence make Canada politically and economically vulnerable?

In recent years, policymakers have discussed the need to diversify Canada's trade on Parliament Hill (e.g., the Standing Senate Committee on Foreign Affairs' 2003 report Uncertain Access: The Consequences of U.S. Security and Trade Actions for Canadian Trade Policy). Pundits, including several potential Liberal Party leaders (e.g., Michael Ignatieff in 2006), have opined in the media about the need to reduce economic dependence on the United States. The federal Conservative Party's 2004 election platform aimed to diversify both export products and markets, while the party's most recent election platform avoided the term "diversification" and emphasized "the need to establish trading relationships beyond North America."

There are both political and economic motivations in the desire to diversify trade. Some commentators worry that economic dependence on the United States will require Canada to adopt U.S. positions, such as those on marijuana, management of forest resources and international operations, including the war in Iraq. Others are concerned that economic dependence on the United States puts Canada in a "vulnerable position ... regarding possible U.S. security and trade actions" (Standing Senate Committee on Foreign Affairs, 2003). Still others have a more general concern that too much trade with one partner leaves the country economically vulnerable.

I have attempted to more systematically evaluate these concerns that the current share of Canada's trade with the United States makes Canada economically vulnerable. My findings ought to give policymakers who are evaluating policy options aimed at diversifying trade - including political dimensions - a better understanding of any economic tradeoffs involved.

Because geographic diversification is the main public preoccupation, the research focuses on that concern, but also addreses the related questions of diversification by sector and within the United States. Proposals for geographic diversification tend to lack specific details, but they generally refer to reducing Canada-U.S. trade as a proportion of Canada's total trade. Also, public concern tends to focus on export concentration, with a lesser concern about the majority of Canadian imports being from the United States. These are important parts of the same picture, especially with production increasingly fragmented across international borders.

The research first examined what is meant by "diversification," and the reasons why commentators raise it as a goal. Then, it examined why growth in trade is important, what has determined Canada's trade patterns to date, and the extent to which Canadian trade and investment are actually concentrated on the United States. The study then assessed whether the current state of affairs is problematic from an economic point of view.

I use a rough analogy between risk and return in investment portfolios and volatility and export growth in a country's export portfolio to determine whether Canada's export mix - with sales concentrated in the U.S. market - places the country at significant risk or presents a significant economic problem. The findings should allay fears about Canada's current geographic trade mix.

More Diversified
Although official statistics show that 85 percent of Canadian goods exports go to the United States, and Canadian trade is and will continue to be primarily concentrated in the U.S. market, Canada's economic links are more diversified than widely understood. For example:

U.S. trade as a share of Canada's total trade has declined in recent years. Official statistics understate Canada's trade outside the United States while overstating trade with its neighbor.

Canada's exports are already well diversified across U.S. regions, and those regions' import behavior is not identical, so growth in one may offset a downturn in another.

To the extent that Canadian exports are used as inputs into U.S. exports to the world, they are driven by global and geographically diversified demand.

No volatility seen
Canada's geographic export concentration on the United States does not appear to be associated with either greater export or income volatility. Canada's experience over the last 10 to 15 years has put the country in a relatively good position, with exports to the United States generally offering the desirable combination of moderate export growth and low volatility, relative to other export markets.

All in all, over the past decade, Canadian exports to the United States have been less volatile on average than have exports to most other regions. Where they have been more volatile, they have been accompanied by significant trade growth. Shifting exports away from the United States in the past decade would likely have increased volatility and decreased trade growth, making Canada worse off, assuming all else was equal.

The analysis shows that a policy of reducing Canada's trade with the United States relative to other trading partners - if effective - would not necessarily make Canada better off and might instead significantly increase volatility without proportionate trade growth.

Questionable efficacy
Finally, the efficacy of government efforts to change trade patterns is questionable. Individuals, rather than governments, determine economy-wide trade patterns. This, combined with the fact that geographic proximity drives most trade and that much of what Canada makes is not easily traded outside its immediate neighborhood, is why past efforts to change trade patterns have failed. As risks and opportunities rise over time in non-U.S. markets, businesses will adjust and take advantage of those opportunities.

Although Canadian businesses overwhelmingly trade and invest in the U.S. market, Canadian trade and investment are less concentrated in the United States than is commonly cited. Official statistics overstate the concentration, and the share of U.S. exports in overall Canadian production is much lower than their share of Canadian trade.

Further, Canada-U.S. trade as a share of Canada's total trade is declining, as trade with other countries rises faster than trade with the United States. For example, 79 percent of Canada's exports of goods and services now go to the United States, down from 81 percent in 1999, and 67 percent of Canada's imports of goods and services now come from the United States, down from 75 percent in 1999.

Instead of trying to change trading and investment decisions made by Canadian businesses and individuals, Ottawa should turn its attention to providing market information not easily accessible to businesses, and addressing barriers to trade and investment where Canadian firms are already significantly engaged and payoffs are likely to be greatest. Then businesses can expand opportunities, both in the United States and in other regions.   VTR_US

Danielle Goldfarb is a senior policy analyst with the C.D. Howe Institute, Toronto. This is excerpted from a paper that can be read at www.cdhowe.org or www.cdhowe.org/pdf/commentary_236.pdf.