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The Globe and Mail

When commodities boom ends, will Canada be going Dutch?

Canadians have grown accustomed to basking in praise for the way this country has weathered the Great Financial Crisis, for the stability of its banking system, its lack of U.S.- or European-style fiscal woes and for its good fortune to be sitting atop vast quantities of some of the world's most sought-after resources. For years now, astute global investors have been raking in handsome profits from forays into our equities, bonds, commodities and the dollar.

But it turns out that this heartwarming story is not destined to have a fairy-tale ending. Once the current commodity boom ends the loonie will plunge, the economy will stumble badly, wages will fall and complacent policy makers will find out what happens when there isn't enough growth to compensate for a lack of fiscal prudence.

This rather bleak view of life a few years down the road does not emanate from the better-known members of the gloom-and-doom fraternity. Heck, even David Rosenberg, Gluskin Sheff's estimable resident bear, likes much of what he sees of Canada's prospects. It comes instead from MRB Partners, a Montreal-based investment research outfit run by a handful of top-notch global strategists who spend much of their time analyzing the rest of the world.

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In turning their attention to the home front, they pull no punches, starting with the title of their report, Oh Canada or Uh-Oh Canada, which should cause quite a stir in investment circles.

'Substantial and Rapidly Growing Imbalances'

"We are constructive about the prospects for the economy and maintain a positive cyclical outlook on Canadian risk assets," the report says.

Well, that doesn't sound like something that would frighten off foreign investors. But the author, Phillip Colmar, a partner of global strategy, is just getting warmed up. "Nonetheless, the euphoria needs to be kept in check. Oil and rocks have masked substantial and rapidly growing imbalances that will prove devastating if not corrected before the next global economic recession." Investors, he adds, "should be careful not to dismiss these risks."

It will not take a marked slowdown in China to end the Canadian story, Mr. Colmar says. "Ultimately, the Canadian economy will fall of its own weight."

Simply put, he has concluded that Canada is suffering from an advanced case of "Dutch disease," an affliction for which the prognosis is never good and the outcome rarely pretty. The economy-shredding syndrome was first used to describe what befell the Netherlands after a major natural gas find in the North Sea in the 1960s and its subsequent exploitation. The resulting resource boom was too much for the small Dutch economy to handle. In those pre-euro days, the guilder shot up far too quickly for the government or industry to adjust. Manufacturers suddenly found themselves uncompetitive, exports withered and the business sector shrank.

'Hollowed Out'

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In Canada, exporters of manufactured goods were already uncompetitive before the commodity boom and had relied on a cheap dollar to keep their heads above water. Business was in no shape to cope with the additional competitive strains introduced by currency appreciation.

"It really hollowed out chunks of the Canadian business sector," which, in turn, made the economy even more heavily reliant on resources, Mr. Colmar tells me. Energy and agriculture now account for 34 per cent of exports, up from 13 per cent in the late 1990s. Shipments of consumer goods have plummeted by nearly half, to 17 per cent.

This shift is also reflected in the markets, where energy and materials account for 57 per cent of equity capitalization. As recently as 2000, the resource share stood at 15 per cent - a figure driven artificially low by the overhyping of the tech sector and Nortel Networks Corp.

The report is highly critical of the Conservative government for pumping more stimulus into the economy than necessary during the recession and of the Bank of Canada for similarly maintaining loose monetary policy for much too long. "It's not just investors globally who seem to be buying this story that Canada is in the sweet spot," Mr. Colmar says dryly. "That worries me."

MRB is not advising clients to sell Canada just yet, even though it regards Canadian bonds, stocks and other assets as overvalued. It does warn that a passive, long-term buy-and-hold strategy is a bad idea. "In fact, investors should progressively lighten their holdings as the commodity boom rolls on, especially once global leading economic indicators weaken materially."

So where should people be putting their money? MRB strategists prefer stocks over bonds and still like certain emerging markets, including South Korea, Mexico and South Africa. German and other northern European equities are also on their radar. "We're still growth-oriented," Mr. Colmar says. "We're not looking for recessions here."

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