The Canada-U.S. connection

What's the world's largest bilateral trade relationship? You might be surprised to learn that it does not involve China. The biggest bilateral economic trade occurs in the Western Hemisphere, between the United States and Canada. These two neighbors exchanged goods and services valued at more than US $700 billion in 2009.

The strength of U.S.-Canada trade is not simply a matter of proximity, although that certainly plays a role. The relationship also revolves around cultural, geographic, economic, sociological, and political similarities and disparities (asymmetry).

Article Figures

[Figure 1] U.S. sales volatility Enlarge this image

[Figure 2] Canadian sales volatility Enlarge this image

In terms of per-capita economic growth, the United States and Canada are similar, with the Americans slightly ahead of their northern neighbor in most economic categories. Canada's percapita income, at purchasing power parity (PPP), is approximately 80 percent of the U.S. level, due primarily to the United States' greater competitiveness and productivity. PPP is the rate of currency conversion that eliminates the price differences between countries.

The asymmetry between the two countries can mainly be found in their comparative economic size, which has important implications for the economy of the smaller economic partner. Thus, the combined trends in the health of the U.S. economy and in developments affecting supply chains have a disproportionate impact on Canada.

Cross-border integration Canada's proximity to the United States offers insights into the level of integration between the two countries' economies and supply chain activities. Approximately 90 percent of Canadians live within 100 miles of the U.S. border, while 85 percent of Canada's 20 largest cities are located within 110 miles of the border. Many Canadian production and distribution centers are situated closer to major U.S. markets than their American counterparts are.

Cross-border integration
Canada's proximity to the United States offers insights into the level of integration between the two countries' economies and supply chain activities. Approximately 90 percent of Canadians live within 100 miles of the U.S. border, while 85 percent of Canada's 20 largest cities are located within 110 miles of the border. Many Canadian production and distribution centers are situated closer to major U.S. markets than their American counterparts are.

There are more than 15,000 Canadian-owned companies in the United States, and many of them depend on integrated, cross-border supply chains that handle high-value-added goods and services. Trade liberalization has been an important factor in this development. The first substantial trade liberalization agreement between the two nations was the Automotive Agreement of 1965, which eliminated tariffs on automobiles and parts. The Canada-U.S. Free Trade Agreement of 1989, which eventually morphed into the North American Free Trade Agreement (NAFTA), eliminated most nonagricultural tariffs.

The level of economic similarity, geographic proximity, and bilateral trade liberalization between the two countries has also increased economic trade flows in similar manufactured goods. Approximately 50 percent of all merchandise trade consists of intermediate production inputs, and more than 33 percent of cross-border shipments are intracompany transfers. This is one reason why supply chain connectivity in certain sectors more closely resembles a web than a chain. Automotive parts, for example, frequently cross the border six or more times before entering the final assembly stage.

The flow of some commodities and finished goods, however, is unidirectional—mostly southbound trade destined for the U.S. market. One example is energy, which is a huge component of U.S.-Canada trade. Approximately 25 percent of U.S. petroleum imports are from Canada, and over 90 percent of Canada's energy exports are destined for U.S. consumers and businesses. The southbound energy flows from Canada to the United States are highly integrated, and the energy infrastructure serving the two countries is wellconnected and efficient. In addition, the neighbors' strong economic and political relationship and peaceful border allow significant crossdependence relative to energy inventories, thus helping to reduce the United States' dependence on volatile energy markets. In this sense, unidirectional trade has benefited both countries.

Retailers look northward
One of the significant asymmetries between the United States and Canada is the role trade (exports plus imports) plays in each economy. In 2009, trade as a percentage of gross domestic product (GDP) was approximately 18 percent for the United States; for Canada it was 48 percent. Exports to the United States alone represent 18 percent of Canada's GDP. This exposure to the U.S. economy, and therefore to the U.S. consumer—remember that consumer spending represents 70 percent of U.S. GDP—places Canada in a very vulnerable position and exposes the country's economy to U.S. economic cycles. This was easily observed during the recent recession. As the housing and financial crisis was working its way through the U.S. economy, retail sales plummeted, thereby constricting both Canadian and U.S. manufacturing. However, Canadian consumption expenditures did not experience the same downturn that was seen in the United States. (See Figures 1 and 2.)

A major reason for the smaller slump in Canada's consumer spending was the country's regulatory control over the way Canadian financial institutions manage mortgages. That policy shielded Canada from some of the massive dips in the economy seen in the United States. Because consumers were less affected by the downturn than their U.S. counterparts, they were able to take advantage of falling interest rates and increased their spending. This ultimately helped drive Canada's economy out of recession, but it has led to record levels of debt among Canadian households.

The Canadian consumer's resilience has many U.S. retailers eyeing a possible expansion across the border. U.S.-based companies that have already entered the Canadian retail space include American Apparel, Bath and Body Works, and Aldo. Recently, Target, Express, and Zumiez have confirmed plans to expand into this market.

Over the last few years, U.S. retailers entering the Canadian market have tweaked their domestic supply chain networks to handle northbound goods. Because most Canadian businesses and major cities are clustered near the border, U.S. retailers that expand into Canada are well-positioned to efficiently serve their new customers. Another advantage to expanding within North America: U.S.-based distribution operations can keep costs lower because they will have shorter distances to cover than they would if they expanded overseas. As the automotive industry's experience shows, there are also opportunities to keep costs low through the exchange of manufactured goods across the border.

In light of the demand shock U.S. retailers suffered during the past two years, moving into Canadian markets seems like a natural and logical diversification of risk. Moreover, the reduction of the Canadian corporate tax rate from 18 percent to 16.5 percent on January 1, 2011, and the further reduction to 15 percent scheduled for January 1, 2012, make Canada even more attractive to U.S. companies. Still, with Canadians becoming more cautious about spending, American companies expanding northward will have to make keeping costs low one of their top priorities.