Innovation is at the heart of productivity growth, which is what makes the difference between ordinary existence and rising prosperity. Furthermore, international trade is the key facilitator of economic growth – in both theory and practice.

Foreign trade is a strategic part of Canada’s economy. Exports represent 43 per cent of Canadian GDP. After taking account of imported inputs used in exporting, about 30 cents of every dollar earned by Canadians and one out of every five jobs comes from the exporting of goods and services. Canadian jobs and prosperity are thus more dependent on trade than those of any other G-7 nation.

In the broader context of the current innovation debate, trade and investment are vital links in the circular progression from innovation to prosperity. However, these links have not yet received the prominence they deserve. Furthermore, they have not garnered attention in regional debates organized in the Innovation consultation process.  
      
Trade, innovation and productivity – a virtuous circle

What is innovation? It is essentially a new way of doing things, implying constant and creative change. Innovation applies to how companies are managed as well as to new methods of manufacturing goods or delivering services. Innovation is not just confined to high-tech industries – resource-based sectors and services also benefit from innovation.

Empirical studies in Canada suggest that innovation and productivity are higher among export-oriented firms. Indeed, firms with greater international exposure typically pay higher wages due to their relatively higher productivity levels. A study by Statistics Canada shows that export-oriented companies pursue research and development (R&D) and innovation strategies more actively than companies focused on just the domestic market1. The same study further reveals that Canadian-owned firms that are export-oriented are just as innovative as their foreign counterparts operating in Canada. Thus, It is primarily the international orientation of a firm rather than its nationality, which dictates the degree of innovation and R&D.

In addition to promoting international investment, trade agreements such as the FTA and NAFTA have pushed more Canadian companies into the global marketplace. The end result is more research and development and innovation taking place in Canada – an important contributor to productivity, and ultimately, a better standard of living for Canadians. To be sure, Canadian productivity is higher now than it ever was prior to trade liberalization. The increased productivity resulting from trade and innovation further reinforces Canada’s ability to compete in international markets.

International trade and investment enables companies to take advantage of the scale economies generally not available from producing only for Canada’s relatively small domestic market. The evidence suggests that large firms tend to be more innovative than smaller companies for several reasons. Large firms benefit from economies of scale and scope; enjoy greater access to financing; and have the ability to take on riskier projects and do more R&D. Expanding into international markets can therefore provide the means for Canadian companies to grow from small to large, and be in a position to adopt more innovative strategies.  
      
Role of international investment flows

Past trade liberalisation is permitting international rationalisation of production. This means breaking up each production process into its component parts, and the optimal geographic positioning of each of those sub-processes.

The visible manifestations of this trend are a much higher level of foreign direct investment (FDI) relative to GDP. Building a global supply chain where all the parts fit logically together is causing companies to invest in foreign economies in record amounts.

During the 1990s, global FDI grew at a rate nearly three times that of world GDP. In turn, international trade grew at nearly twice the rate of world GDP. The result of this process of building global supply chains is a much higher level of trade relative to GDP since companies must get all the components in one place for final assembly and sale. Accordingly, trade and FDI are now integrated, instead of being substitutes as in the past.

This global transformation comes together under the rubric of "globalisation." The consequence is more income for all countries that participate in the globalisation process. Trade liberalization is promoting increasing specialization of production through more widespread and aggressive foreign sourcing of inputs. The products we buy today are often produced in several countries, with only the location of the final assembly explicitly indicated on the package.

For an individual company, this trend means focusing only on the parts of the supply chain to which the company is best suited. This specialization is the product of innovation. A company may not be able to invent a better or cheaper cellphone, but it may be able to perfect the process that creates the titanium board that is embedded in the cellphone – in other words, it may be able to innovate on one of the more valuable parts of the supply chain. It can do so because the benefits of success for innovation are now calculated in global terms. Globalisation therefore narrows the focus of product innovation, but expands the potential benefits.

The implication of this shift towards worldwide rationalization is that benefits to Canada are generated from FDI, regardless its direction. Inbound FDI boosts investment in Canada, creates jobs, and generates more trade with the rest of the world, the benefits of which cumulate long into the future. This is the traditional orientation, and why most countries seek to attract FDI. The benefits to Canada of outbound FDI are less understood, but potentially even greater. Outbound FDI from Canada generates investment and jobs in the foreign economy; profits for the Canadian company; and, most importantly, increased trade flows – including higher levels of exports from Canada – long into the future.  
      
Innovation and the demand and supply of risk management services

Annual growth of around 7per cent is forecast for Canadian trade during the next decade. This is somewhat slower than in the 1990s, and the result of increased international risks in the wake of the terrorist attacks on September 11, 2001. Yet these higher risk factors, plus the greater role being played by FDI in facilitating trade development, also mean that demand for international trade facilitation and risk management services will continue to grow. In terms of the supply of financial intermediation, the ongoing market trends of consolidation and specialization in the global financial sector are expected to continue. Meanwhile, Canadian financial institutions appear to be reducing their commercial lending and moving away from international risk management and facilitation. The result may be a widening gap between demand and supply of international trade and investment.  
      
Conclusion

Trade and innovation are integrally related. Take away international trade, and the incentive to innovate is vastly reduced, especially in a small economy like Canada. Therefore, facilitating trade and international investment is perhaps the most important thing we can do to foster innovation in Canada.

The risks associated with international trade have increased significantly post-September 11, 2001, with a potentially long-term impact on the world economy. As Canadian companies endeavour to improve their efficiency, productivity and innovation by engaging in international trade, they will also have a significant stake in managing their trade risk. In order to engage more successfully in international trade, they will also face an increasing need for financial intermediation. At the same time, to be more successful in the commercialization of innovation, Canadian firms will also require more financial capacity than has been available in the past.

Strengthening the innovation environment via improvements to the tax system, or through changes in regulatory regimes, is a very important element in the current debate. Establishing priorities for a better learning system that produces a more inclusive and higher-skilled workforce is equally important. Strengthening communities, so they can continue to be magnets for investment and opportunity, is also vital for the country’s future.

But the current debate should also place trade and investment at the heart of the innovation agenda. Greater prosperity, which is the ultimate goal of innovation, cannot be achieved without these essential elements. This means continuing efforts aimed at further liberalization of international trade. It also means continuing to work towards freer flows of investment. Finally, it means ensuring that sufficient financial capacity exists to facilitate international trade opportunities on behalf of Canadian companies.