Source: The Canadian Press

Canada’s economy is largely missing out on a strong U.S. recovery because businesses are not competitive enough and the dollar is too strong, the Bank of Canada says.

The central bank’s latest global and domestic economic review contains a huge upgrade in American growth for this year — to 3.3% from the previously estimated 2.3% — but it also includes an admonition to Canadian businesses.

Firms need to do better in investing to keep up with their global rivals, the bank says, especially since the steep appreciation of the dollar has made their competitive disadvantage worse.

As a result, Canada sees only a 0.2% pickup in output this year from the strong U.S. surge, leaving economic growth moderate at 2.4% in 2011, and 2.8% in 2012.

The new forecasts are based on the assumption the loonie will remain at about par with the U.S. dollar.

The loonie closed Wednesday at 100.45 cents US, down 0.27 of a cent.

“Over the past several years, Canada’s competitiveness has declined with the sharp rise in the labour cost of producing a unit of output in Canada compared with other countries,” the bank explained in the report.

“The divergence in productivity growth between Canada and the United States has become even more pronounced in recent years.”

At a news conference, bank governor Mark Carney would not quantify the potential foreign sales Canadian firms are leaving on the table, but said it was “significant.”

“We have lost competitiveness over a number of years. That’s the product of the level of the currency, it’s the product of poor relative productivity performance,” he said.

The competitive deficit means Canada is not only losing out to American firms, but also firms from other nations shipping into the U.S. Canada’s current account deficit in relation to the rest of the world reached a 20-year record last summer, he noted, while Canada’s market share of U.S. imports have fallen.

The report details why this has happened. Labour costs per unit of output in Canada increased by 31% relative to the U.S. since 2005, with two-thirds of that gap due to the appreciation of the loonie and one-third to poor productivity. Annual productivity growth in Canada has average only 0.5% in the past five years, compared to 2.1% in the U.S.

Even compared to a sampling of 42 countries tracked by the Organization for Economic Co-operation and Development, Canada does not do well, with relative manufacturing labour costs having increased by 17% in the past five years.

“It’s absolutely essential to start to rebuild this competitive position in what is a tougher external environment,” Carney said.

He pointed out that governments had done much to encourage business investment, including cutting corporate taxes, an area of political controversy in Ottawa.

In a television interview with CBC aired Tuesday night, Prime Minister Stephen Harper defended the approach, saying higher taxes for firms would “make this a less competitive country, a less good place to invest.”

Carney welcomed that businesses have begun to start spending in new machinery and equipment, which should improve productivity, but said they have a long way to go to even return to pre-recession levels.

Analysts generally agreed with Carney’s message, although some suggested Carney may be too gloomy about Canada’s economy this year and next if the U.S. does indeed bounce back as strongly as predicted.

“In the past seven years, the annual growth rate in Canada has not diverged by more than half a point — but the bank is assuming a gap of almost a full percentage point between the U.S. and Canada this year,” noted Doug Porter of BMO Capital Markets. “That’s not impossible, but I don’t believe it’s likely.”

BMO believes the Canadian economy will expand by 2.7% this year.

But given Carney’s pessimistic view, more analysts said it was now likely interest rates will remain at the current super-low levels until the summer or fall.

The central bank’s newest forecast show growth increasing in both the U.S. and Europe. Overall, global growth will expand by 4% in 2011, it predicts.

For Canada, the recovery will proceed more slowly. It will take two full years before the economy returns to full capacity, it says.

While Canada is now growing slower than the U.S., and possibly some other nations in the Group of Seven, that does not mean the economy is weaker.

The bank notes that Canada has recouped all the jobs lost during the recession, whereas the U.S. has only recovered about one-seventh of the over eight million jobs that vanished in the slump.

Canada is also the only country in the G7 that has returned to pre-slump levels in terms of economic output.

Canada recovered from the recession strongly, largely because consumers kept buying everything from clothes, appliances, cars and houses and federal and provincial governments stepped up spending.

That cycle is coming to an end, the bank says. Households are now tapped out and governments are phasing out extraordinary spending programs.

In their place, the economy will need to depend on business investment and exports improving, particularly in commodities, despite the high dollar.

The bank stresses that risks to the global economy remain elevated, particularly stemming from the ongoing European debt crisis, weak financial institutions, and tensions over currency exchange rates.