(FORTUNE Magazine) – THAT chill breeze you feel blasting down from the Arctic just may be the wheeze of Canada's ice-cold economy. Like that of the U.S., it seemed to be easing out of recession last spring -- but since then has been unable to mount a robust recovery. To make matters worse, structural flaws have appeared that won't easily be cured. The country also faces arguably the most serious threat yet of secession by French separatists. Canada's multiplying troubles are also bad news for Americans. In no other country does U.S. business have a bigger stake. Some $200 billion in goods and services flow between Canada and the U.S. -- the biggest trading relationship ever between any two nations. Canada takes 20% of American exports (almost as < much as the 12-country European Community) and supplies the U.S. with vital energy and natural resources. Many American companies, including General Electric and IBM, use their Canadian operations as major global suppliers of some of their products. Americans have more invested in Canada ($68.4 billion) than in any other foreign land. A longstanding common market for autos enables U.S. companies to gain greater economies of scale in North America. And the U.S.-Canada free trade arrangement, which began phasing in nearly three years ago, is creating a continental market for most other products. U.S. investors also hold much of Canada's $230 billion foreign debt. Canadian bonds and notes have yielded very handsome spreads with little apparent exchange risk. That may well change, though, as separatist sentiment grows in the province of Quebec, which has a quarter of Canada's 25 million people. As Lloyd C. Atkinson, executive vice president of the Bank of Montreal, says, ''The inevitable question in the mind of the foreign investor would be: 'Do I really want to play in the traffic while Canadians sort out these matters?' '' Canada's internal political turmoil could also jeopardize the creation of a North American free-trade area -- including Mexico -- with a population of 360 million. Such an alliance partly aims to deter the European Community from erecting trade barriers against North America. No wonder Canadian Prime Minister Brian Mulroney pleads with his countrymen to ''get our act together'' so that Canada can survive intense global competition. Assuming Canada does hold together, it still faces formidable economic difficulties. Its gross domestic product has been on a roller coaster this year. In the first quarter, the economy shrank at an annual rate of 4.7%, partly because Canadian consumers were in shock over the new 7% national sales tax that took effect January 1. Growth ballooned to a 5.7% rate in the second quarter, a cheering result that proved artificial because the first three months had been so depressed. In the third quarter, Canada expanded at just a 0.9% rate. The country has the lowest productivity growth (0.4% per year over the past decade) among major industrial nations -- and fast-rising labor costs. Small wonder that unemployment is 10.3%, compared with 6.8% in the U.S. The pity is that through most of the 1980s, Canada had real growth second only to that of Japan. But a new study of Canada's prospects by Michael Porter of the Harvard business school warns that ''the core of its economic prosperity is at risk.'' Squeezed by high prices and taxes at home, Canadians pour across the border to U.S. shopping centers, spending an estimated $4.5 billion this year. Many companies also have fled south to the U.S. in search of a more stable business environment. Those departures, plus the outright failure of other companies, have taken away some 300,000 jobs (out of a total of 12.5 million) in the past few years. Says Frank Stronach, chairman of Magna International, a Toronto producer of auto parts: ''Less and less is made in Canada. We're eroding as an industrial nation.'' ECONOMIC PRESSURES are forcing Canada to resolve 30 years of constitutional wrangling. Quebec plans a referendum next October on either accepting new federal arrangements or dropping out of Canada. The issue that has dominated Canadian politics for so long is simple enough: Quebec, originally settled by France in the 16th century, wants guarantees from the central government that its French language and distinctive laws will be protected. English-speaking Canadians are weary of the tedious debate and of the often tortuous gestures to placate Quebec. Toronto, for example, has French-language television and radio stations despite its tiny French-speaking population. Says W. W. Stinson, chief executive of Canadian Pacific, the giant transportation conglomerate: ''While we're dealing with unity issues, the realities of becoming uncompetitive are pressing hard against us.'' The countdown to the referendum could amount to a ticking debt bomb. So far, bond-rating agencies give Canada top marks for managing its debt. But some officials worry that even nothing more than a verbal civil war could turn international investors against Canadian bonds and securities. The $370 billion Canadian federal debt -- including the $230 billion of foreign debt -- represents nearly 44% of gross domestic product, vs. 32.9% for the U.S. If you toss in borrowing by Canadian provinces, the country's total government debt comes to over 70% of annual output -- a higher proportion than any major industrial country except Italy. Partly because of the political squabbling, Canada has had to pay a premium to finance that debt. Atkinson estimates the premium to be one percentage point on long-term government bonds and two percentage points on short-term bonds. Meanwhile, Canada's central bank keeps interest rates high to dampen | inflation, attract foreign currency, and bolster the Canadian dollar. The results are punishing for business. For all its pride, an independent Quebec would be hard pressed to service its own loans, let alone its share of Canada's national debt. The province has borrowed just over $15 billion in foreign currencies and pays even higher interest than does the federal government. Says Robert Blohm, an American investment banker in Montreal who helps bring Japanese capital to Canada: ''Quebec cannot do what it wants unless the international financial community provides support.'' Quebec politicians blithely talk about seceding while maintaining monetary links with the rest of Canada. Warns Prime Minister Mulroney: ''Separation means separation. Period.'' Mulroney hopes to hold his country together by focusing on economic challenges. At the same time, he wants to increase the free flow of goods and services within Canada. For example, provinces often impede the sale of beer that is not brewed locally. As a result, the country has 67 breweries, far more than required for an efficient industry. Because electric and telephone utilities in various provinces give preference to local suppliers, there are 31 wire and cable plants. Such practices, designed to create jobs, cost the economy an estimated $5.3 billion a year, just under 1% of the GDP. Despite Mulroney's efforts, the notion that government can spend an economy to prosperity is clearly growing in Canada. In little more than a year, three provinces -- Ontario, British Columbia, and Saskatchewan, which together have more than half the population -- have elected moderately socialist governments. Ontario already is planning to help bail out de Havilland, a commuter aircraft manufacturer that has been losing money over the past five years. Boeing, which bought the company in 1986, has been unable to turn it around and now wants to sell. Never mind that de Havilland earlier limped along under state ownership for more than a decade. The swing to the left is reflected in the approval ratings -- 12%, the lowest ever -- of Mulroney's conservative government, which came to power in 1984. Canada's smokestack industries are just beginning to cope with the restructuring that U.S. companies have been going through for as much as a decade. While American manufacturers closed obsolete facilities and modernized others, Canada coasted on cheap currency. Says Frederick Telmer, CEO of Stelco, Canada's second-largest integrated steel producer: ''We were competitive without having to change, and now we have to face reality.'' THAT REALITY is grim: The Canadian dollar has appreciated over 25% in the past five years, mainly because the Bank of Canada's strong monetary policy has kept inflation down. In the same period, Canadian unit labor costs rose more than 46% (in U.S. dollar terms), vs. a decline of 0.3% in American manufacturing. After a 100-day strike last year, Stelco found that many of its customers had folded or moved to the U.S. To survive, the company raised more than $220 million by floating new stock and is restructuring operations to raise productivity. Says Telmer: ''Adversity tends to focus the mind on the need to accept change.'' New labor contracts peg compensation partly to the performance of the plant in which an employee works. Stelco has also teamed with Mitsubishi to make zinc-coated steel for Japanese auto plants in North America. Michael Porter's $1 million study, underwritten by the government and by Canada's equivalent of the Business Roundtable, warned that Canada is ''in many respects ill equipped to respond to a rapidly changing competitive environment.'' Exports represent over 25% of Canada's GDP, more than those of any major industrial country except Germany. Mostly Canada exports relatively unprocessed natural resources, which are vulnerable to low-cost Latin American rivals. Canada has seriously shortchanged investment in research, worker training, and new machinery. As Porter put it to the Canadians, ''You need a new mode of competing.'' A few smart Canadian companies that have long followed Porter's prescription are thriving in global markets. Inco (with $3.1 billion in sales last year) supplies one-third of the world's nickel. By investing heavily over the past decade in new mining techniques -- $1 billion in the past two years alone -- Inco has cut its Canadian work force in half, to some 9,500. At one experimental operation, miners operate giant hauling vehicles a mile below ground from a control center on the surface. Says Inco Chief Executive Donald Phillips: ''We cannot control prices, but we can control costs.'' Labor contracts peg pay partly to the price of nickel and the cost of living. And the company adds significant value to ores by producing nickel alloys, turbine blades, and mining equipment largely for foreign customers. Another promising Canadian company, SHL Systemhouse, sells computer services to such American clients as Motorola, the California Department of Motor Vehicles, and Los Angeles International Airport. On the strength of its work with the Canadian post office, Systemhouse has been awarded a $270 million contract to build a system to track U.S. Express Mail at 16,000 locations. An 800 phone number will allow customers to check the delivery time of any item. CAE, a world leader in flight simulation and training devices, spends 16% of its nearly $1 billion annual sales on research and development. Says President David Race: ''We've succeeded by finding niches.'' Several years ago CAE abandoned a successful foray into auto parts to focus on what it does best. To win U.S. government contracts, it acquired Link, the American pioneer of ground-based pilot-training devices, from Singer. Digesting Link has been troublesome, but the company now provides training devices for U.S. manned spaceflights. During the war with Iraq, American pilots rehearsed for precision bombing missions on CAE simulators using satellite photos taken just hours before. Clearly, many Canadians can compete. As Race puts it, ''It's almost a cultural problem. We have traded on our resources for so long, and now we've got to get down to work.'' So do Canadian government leaders. The last thing the U.S. needs is the creation of one or more new (and insolvent) nations on its border.