Canada’s economy has been humming in recent years, but there are plenty of problems lurking down the road. In the short run, rising energy prices are posing challenges for the country, and economists say a shortage of workers will be a problem in the longer term as the population ages.

Everything looks great at the moment. One sign of economic health is the Canadian dollar, which is trading around US87¢ and is up by about 40% since the beginning of 2003. Exports are at record highs and trade surpluses are soaring. And the good news is reflected in the stock markets, in which the S&P/TSX composite index recently surpassed the 12,000-point level and is in record territory.

Strong energy prices are helping to power the markets and the economy to such impressive levels. Statistics Canada notes the 3.9% rise in exports to record levels in December was almost entirely because of a double-digit increase in energy exports. Trading in energy stocks is also causing much of the action on the Toronto Stock Exchange.

Prevailing forecasts are pretty rosy. The Bank of Canada is calling for gross domestic product growth of 3.1% this year and 2.9% in 2007. The outlook for the energy engine is also good. Standard & Poor’s Corp. ’s investment policy committee recently reiterated its confidence in energy stocks and commodity prices. “We believe oil prices will find strong support in the US$55-US$57 [a barrel] zone, and are setting up for another run at record highs,” its chief technical strategist, Mark Arbeter, writes in a recent report.

But the salad days won’t last forever. For one thing, the strength of the energy sector is a double-edged sword, exposing other underlying structural weaknesses in the Canadian economy and intensifying the equity markets’ dependence upon a single sector.

There is nothing wrong with enjoying the commodity roller coaster for as long as it lasts, but its dominant effect on Canadian assets may hitch markets too tightly to the performance of oil prices. “From a market perspective, as long as global energy demand continues to rise, the dominance of the energy sector over the Canadian equity market will grow and remaining diversification will be further reduced,” Montreal-based BCA Research cautions in a recent research note. It predicts that the C$ will continue to become “an oil play.”

Although asset prices can rise and fall without doing lasting damage to the Canadian economy, the more pernicious effect of our growing energy dependence may be the spotlight it shines on more fundamental problems. “While the Canadian trade surplus is still huge, it has been entirely supported by commodities,” the BCA report notes. “When resources exports are stripped out, the deterioration in the competitiveness within non- resources export markets is evident. On this basis, Canada has a trade deficit of about $25 billion, and it is growing rapidly.”

The faltering competitiveness in export industries, such as manufacturing, is no small thing. Politicians and assorted commentators have expressed concern about the growing regional disparity within Canada. Alberta and other resources-rich regions are booming, thanks to high oil prices, at the expense of the central Canadian manufacturing base.

In a recent report, Bank of Nova Scotia’s economics department predicts Alberta will be the top provincial economy through 2007, with annual growth averaging around 4.5%, closely followed by British Columbia. “In contrast, annual growth in Ontario will do well to exceed 2% in both years,” it notes.

What may be more important than regional tensions is whether governments have the will to allow the kind of economic adjustments that may be required to reflect the new reality. When sectors become globally uncompetitive, adjustments ultimately mean lost jobs, plant closures and accompanying disruptions that are often politically unpalatable.

Scotiabank suggests a stronger C$ will “reinforce this momentum, and keep pressure on export-sensitive firms to improve their bottom-line performance through strategic, productivity-enhancing investments, mergers and acquisitions, and plant rationalization, as well as labour and benefit cost savings.”

Putting aside the question of whether the effects of currently high oil prices will intensify the structural changes, the economy may have to face them in the future anyway. U.S.-based research firm Global Insight Inc. says the Canadian economy is poised for a notable slowdown in its long-term growth potential, one that will probably demand many of the same fundamental economic adjustments.

@page_break@The culprit is demographics. In its report, the firm says a slowdown in population growth will undermine economic growth. It notes that our economy has grown at an average annual pace of 3% in the past three decades, with employment growth at about 1.9% and productivity growth at 1.1%. Its population projections, however, translate into employment growth falling to 0.4% in the next 25 years.

The slowdown could be moderated but not prevented by increased immigration, says the Global Insight report’s author, economist Wojciech Szadurski. “It would take unprecedented immigration flows to prevent the slowdown in employment growth,” he says.

Productivity improvements will probably not do the trick, either. Global Insight assumes productivity will advance by 1.7% annually over the long term, but, Szadurski says, the number may prove optimistic, given historical trends and the probability that an aging workforce will also be a less dynamic one. Canadians in their 20s may be willing to move across the country for a job, but those in their 50s are probably less eager to do so.

“Our hope is the dearth of workers will force companies to focus on productivity more than in the past,” Szadurski says.

The Global Insight report nevertheless warns that the inevitable slowing of population growth “suggests Canada’s potential GDP growth will cool toward 2% over the next two decades, even with an optimistic assumption about productivity growth.”

Moreover, it notes that much of corporate Canada may not be prepared for such a downshift. “Although the case for a significant slowdown in economic growth is solid, many in the business community appear to be expecting the 3% pace to be sustained over the long haul,” the report cautions. “Unless it wakes up to the demographic reality, Global Insight thinks the Canadian business community will be in for a big disappointment.”

Workers as well may be in for a shock. Scotiabank worries that many appear to be saving too little, given the plethora of downside risks on the horizon. “While this aging process is more of a gradual flow than a seismic shift, the immutable forces of Nature — remember, retirement is just around the corner — suggest Canadians ought to begin saving more and spending less,” it notes.

Companies, workers and governments must also be aware of the probable economic fallout of such a shift. “For companies serving the domestic Canadian market, the implication is much slower sales growth over the long term,” Global Insight says. It highlights the industries that will be affected, including retailers, arts, entertainment and recreation, residential construction, real estate and education.

Businesses that cater to the elderly, such as health-care industries, will surely benefit from the demographic shift, but there will probably be other effects, Global Insight predicts. Exporters that struggle to meet robust foreign demand with a minimally growing workforce, for example, may come under increased pressure to send some operations offshore or seek cheaper foreign input to make up for the impact of the domestic labour shortage. Meanwhile, firms that are in industries that can’t be sent offshore, such as natural resources extraction, will probably have to increase their efforts to import skilled foreign labour. The same pressures that energy costs are applying today will probably come from labour costs in the future.

The problem with such long-term demographically dependent predictions is that while population trends may be forecast fairly easily, it is harder to anticipate the adjustments that may have to take place to ameliorate some of the more dire problems. As long as the economy is fairly flexible, companies and, ultimately, workers will gravitate to wherever the demand takes them.

Szadurski says that even though “policy changes can ease the extent of the slowdown,” they probably won’t “be able to prevent it.”

Nevertheless, governments must play their part in ensuring that the economy is equipped to accommodate such changes. Labour and immigration laws must be flexible, and capital needs to be fairly unconstrained. People have to be able to work longer and retrain more easily.

To boost productivity, governments should be cutting the marginal effective tax on capital and ensuring personal income taxes for high earners are internationally competitive, Szadurski says. “And increase the quality of university education, especially at the graduate level, as this kind of human capital drives innovation,” he adds.

Sky-high energy prices are already encouraging significant adjustments to the makeup of Canada’s economy. Whatever their effect, the economy may ultimately be forced to make changes as the population ages and the workforce dwindles. IE