By all measures, the trade and investment ties that bind the U.S. and Canada are the world’s largest between any two sovereign states. In 2010, the two countries exchanged $481.5 billion worth of commodities, with an average of $1.3 billion in goods crossing the border each day. The same year, Canada was also the largest single destination for U.S. foreign direct investment (FDI) in manufacturing, holding an estimated $296 billion in cumulative FDI from the U.S.

Given its longstanding peaceful relationship with the U.S., Canada rarely attracts attention south of its border — and when it does, the attention is often positive. In recent years, the country’s image has been bolstered by its superior performance during the global economic meltdown, largely because of the more prudent strategies pursued by Canadian banks. Despite the relatively modest size of its GDP ($1.4 trillion, compared with $15.29 trillion in the U.S.), several Canadian financial institutions qualified for Bloomberg Markets‘ most recent list of the world’s “strongest” banks. Canada’s leading banks “are well-regulated and have a long history of avoiding financial crises,” says Wharton finance professor Franklin Allen . “They provide [the country] with financial stability.”

The world’s tenth-largest economy, Canada’s unemployment rate of 7.1% in September 2012 was its lowest since December 2008. Moreover, the country’s system of universal healthcare is envied by many Americans as a model of sensible, moderate reform.

Nevertheless, analysts say, Canada has fundamental shortcomings that it must address in order to continue attracting foreign direct investment and compete effectively in an innovative global market. According to a recent report by the Canadian Chamber of Commerce, the country’s weaknesses include declining labor productivity growth; insufficient investment in infrastructure; a lack of innovative, global brands; and a shortage of highly skilled labor that, in some sectors, is “becoming desperate, threatening our ability to keep up in a global, knowledge-based economy,” the report notes.

‘Hewer of Wood, Drawer of Water’

Some economists worry that Canada will ultimately suffer from a full-blown case of so-called “Dutch Disease” — that is, when a country’s overdependence on exports of primary products pushes up the value of its currency, leading to a downward spiral in its manufacturing productivity and competitiveness. As recently as 2002, the Canadian dollar was traded at its all-time low of 61.7 U.S. cents, but it has since risen to near parity with the U.S. dollar as a result of soaring global prices for the commodities that Canada exports, especially oil.

Not coincidentally, over the past decade, manufacturing output and employment in Canada have both declined sharply. Some 600,000 Canadian manufacturing jobs have been lost since 2000, notes Jim Stanford, chief economist for the Canadian Auto Workers Union. In 2010, natural resources (energy, forest products and mining) generated a combined 11.5%, or $142.5 billion, of Canada’s GDP, and directly employed close to 763,000 people, according to Natural Resources Canada, a government agency. That same year, the natural resources sectors contributed $86.1 billion to the Canadian trade balance, while Canada’s major manufacturing sectors suffered a combined negative trade deficit of $64.4 billion.

For decades, Canada strived to escape its traditional status as a supplier of natural resources and commodities — or “a hewer of wood [and] a drawer of water,” notes George S. Day , a Wharton marketing professor who was born and raised in Canada. Yet by July 2011, unprocessed and semi-processed resource exports accounted for two-thirds of Canada’s total exports, the highest figure in decades, according to Stanford. The growth in natural resource exports has not been sufficient to offset the decline in other exports, such as manufacturing and services, Stanford adds. “This surge in resource exports, even with high global commodity prices, still isn’t enough to pay our bills in world trade. Trying to pay for sophisticated high-tech imports by digging more resources out of the ground ever faster is a losing battle.”

Rather than compete against global manufacturers, a great deal of business activity in Canada these days has been moving into “non-tradable sectors” of the economy — locally focused businesses and services, such as construction. Despite the fact that the country has signed numerous free-trade agreements in recent years (NAFTA with the U.S. and Mexico, and bilateral pacts with Chile, Colombia, Costa Rica, Israel and Peru), exports as a percentage of Canada’s GDP have declined from about 45% in 2000 to only about 30% today. This trend means that “Canada’s economy is actually de-globalizing,” according to Stanford.

Meanwhile, Canada’s labor productivity growth rate has continued to be poor. From 1962 to 1984, the country’s labor productivity grew by an annual average of 2.8% before slowing to an annual average growth rate of 1.2% between 1984 and 2010. Low productivity growth represents “an enormous challenge” for Canada’s future prosperity and competitiveness, says the Conference Board of Canada, an independent research firm, in a recent report. According to Andrew Sharpe, executive director of the non-profit Center for the Study of Living Standards in Ottawa, over the past decade, “the manufacturing sector has suffered the worst decline” — with growth rates dropping from 4% to 0.1%.

Despite those statistics, Wharton’s Day rejects the comparison between Canada’s challenges and the Dutch Disease. “I don’t see this [situation] as acute enough to qualify as Dutch Disease,” he says. He points out that in the classic case of the economic malady, the Dutch government spent its revenues from a natural gas discovery on lavish projects. On the contrary, rather than throw caution to the wind, Canadian officials “have been pretty prudent about spending.” For example, the government of Alberta still has billions of dollars in its reserve fund.

Day agrees that the high value of the Canadian dollar represents “a huge challenge” for Canada because “it puts any [Canadian] manufacturing item at a disadvantage. I worry a lot about the auto sector. Are we going to be able to keep the auto sector in Canada?” For his part, Stanford notes that Canadian exporters have already suffered “a huge loss of competitiveness compared to the U.S. and countries like China, which more or less peg their currencies to the U.S. dollar.” However, Wharton’s Allen points out that the strength of Canada’s currency “cuts both ways. Although manufacturing has problems, it also means you can buy [imported] things cheaply.”

Lagging R&D

Meanwhile, research and development expenditures by Canadian firms have declined by almost one-third since 2001, measured as a share of the Canadian GDP, and the figures are getting worse. Currently, business R&D stands at just 0.9% of Canada’s GDP — a small fraction of the investments being made by businesses in such countries as South Korea, Sweden, Finland, the U.S. and even China, notes Stanford. Canada has the most generous tax subsidies for R&D among the member nations of the Paris-based Organisation for Economic Co-operation and Development (OECD). “Yet there is a growing consensus among innovation experts that across-the-board tax cuts have very little impact on business investment in capital and technology,” Stanford says.

Day cautions that the mere fact that Canada’s aggregate R&D expenditures compute to a lower percentage of the country’s GDP is not necessarily significant, given the surge in the volume of Canada’s output of natural resources. More fundamentally, countries that are major producers of natural resources do not normally spend as much on R&D as do other kinds of economies. And while R&D may be a good proxy in such sectors as information technology or pharmaceuticals, in a lot of other areas — such as the finance sector — innovation is not primarily about pouring lots of money into research and development. So Canada’s comparatively low level of R&D spending “does not show an incipient decline” in innovation for the country as a whole, he states.

Provincial Challenges

Glen Hodgson, senior vice-president and chief economist at the Conference Board of Canada, argues that a major factor behind Canada’s flagging labor productivity growth has been the country’s failure to address its antiquated regulatory restrictions, including those involving inter-provincial commerce. “The free-trade agreement with the U.S. in 1990 was critical, but we didn’t follow it up” by doing away with a lot of regulations that hamper business activity, says Hodgson. It wasn’t until 2010 that British Columbia and Alberta signed their inter-provincial Trade, Investment and Labour Mobility Agreement. Meanwhile, Canada’s two largest provinces — Quebec with seven million people and Ontario with 10 million — “are still talking about [creating] an understanding about free trade between them,” he notes.

According to Hodgson, provinces like Quebec and Alberta focus too much attention on their own unique challenges, and they “want to regulate their own affairs” rather than have the federal government do so. The attitude of provincial authorities is that “we reserve the right to be a little different in our regulations,” even if doing so raises the costs of doing business — and lowers labor productivity. “Part of the challenge in Canada is figuring out who the regulator is,” Hodgson says.

Broken Bridges

Another obstacle facing Canada is its aging infrastructure. The country’s infrastructure development has been dictated by an ambitious $33 billion “Building Canada Plan” administered by Infrastructure Canada, a government agency. While Canada’s federal and provincial governments may be spending more money on infrastructure projects these days, “Canada’s infrastructure is still in a very dire state,” says Saeed Mirza, professor emeritus of civil engineering and applied mechanics at McGill University. According to Mirza, “about 30% of the entire infrastructure in Canada is more than 85 years old. The life expectancy of a little over 80% of our infrastructure has been exhausted. This represents a very serious situation.”

While $33 billion may sound like a lot of money, the sum is “totally inadequate” in the world of global infrastructure, says Mirza. “Our politicians are forgetting that our infrastructure deficit is really $400 billion…. None of Canada’s political parties even mentions infrastructure.” Ultimately, that impacts business: Transportation and logistics costs are much higher than they should be as a result of crumbling bridges, crowded highways and congestion along rail corridors, he points out.

Absent Brands

Among other problems, Canada has failed to maintain its fair share of global corporate brands, analysts say. “Canadian firms are well-known in mining and petroleum, and a small number of other industries such as banking,” notes Stanford. “But in terms of being able to develop and sell high-value, innovative products to the world, Canadian firms are almost invisible. Why invest in innovation when you can get pretty easy money from the resource boom? Canadian companies have become lazy and coddled by international standards.”

Only a handful of Canadian companies compete on a global scale, and their numbers are dwindling. “Once, we used to point to Nortel [Networks] and [BlackBerry maker] Research in Motion [as examples], but now, with the exception of Canadian banks — which are global, but very protected — there are only a few companies, such as [aircraft manufacturer] Bombardier and [automotive supplier] Magna [International],” Stanford notes. Nortel, whose market capitalization peaked at $398 billion (Canadian dollars) in 2000, collapsed after the dot-com bubble burst, and it ultimately filed for bankruptcy in 2009. As for RIM, it rode out the recent global economic recession without suffering a decline in brand value, according to consulting firm Interbrand. But Interbrand’s latest report (released on October 2) estimates that the BlackBerry brand lost $3.9 billion in value — a 39% decline — in 2011 alone because of RIM’s failure to keep pace with such innovators as Apple, Google and Samsung. It remains to be seen if RIM will recover.

Reasons for Optimism

Such troubling reports overlook the success of some smaller firms that operate well under the radar, including numerous pharmaceutical firms in Quebec and high-tech firms in Ontario, notes Day. “Canada also has really good universities and an educated populace,” he adds.

Despite the challenges, Canada’s problems are self-correcting to some extent, Day suggests. “Canada has diversified from its extreme dependence on the U.S.” and is now pursuing trade with China and other markets. While that brings Canada an opportunity to open new markets for its manufactured exports, Day adds, it also leaves Canada more vulnerable to possible slowdowns in demand from China for Canadian raw materials such as wood pulp and paper, ores, wood products and mineral fuels. Already, China has become Canada’s second-largest merchandise trading partner (after the U.S.), with bilateral Canada-China merchandise trade reaching $64.5 billion in 2011, up from $57.4 billion in 2010.

The challenge facing companies in both the U.S. and Canada is how to make important strategic decisions about the country while there is continued uncertainty about the value of the Canadian dollar. The good news, notes Day, is that there is no issue about any upcoming “fiscal cliff” as there is in the United States. After all, Canada’s more expensive dollar results not just from higher world prices for Canadian exports, but from the fact that Canada is justifiably “viewed as stable, well-run and a safe haven,” says Day. Overall, adds Allen, “Canada has a good chance of overcoming its challenges. It certainly helps that they have strong natural resources and are not heavily indebted.”