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Strong Fundamentals and Commodity Boom help Sustain Canada’s Vigorous Performance

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
July 2006
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The Canadian economy delivered another strong performance in 2005 and maintained its growth momentum during the early part of 2006. In addition to its excellent macroeconomic policy framework, the country has benefited from booming oil and gas exports and rising investment. A flexible labor market has also helped the economy adapt to an appreciating Canadian dollar, which has climbed to heights not seen for the past quarter century. With global competition intensifying, though, there is still more that Canada can do to increase labor market flexibility and bolster the economy’s adaptability to meet the challenges ahead.

GDP growth remained close to 3 percent in 2005 as high commodity prices provided a particular stimulus to Canada’s resource-rich western provinces (see chart, this page). Much of the rest of the country did well, too. As in recent years, increases in domestic demand provided the primary impetus for growth. Household spending was boosted by a rise in personal wealth, including some acceleration in house prices. In the corporate sector, strong earnings, low interest rates, and falling prices for imported capital goods facilitated business investment. Stepped-up development of Canada’s natural gas and oil resources—in response to rising energy prices—added significantly to investment demand.

Adapting to challenges

On the external side, the Canadian dollar has strengthened, particularly against the U.S. dollar, reaching levels not seen since the late 1970s. The appreciating exchange rate—which reflects, in part, a sharp improvement in the terms of trade in recent years—has dampened net exports, which continued to be a drag on economic activity in 2005. Nevertheless, rising revenues from commodity exports—notably oil and gas—have helped maintain Canada’s nominal current account surplus at 2¼ percent of GDP.

Canada’s economic performance has benefited from a highly flexible labor market that has permitted it to reallocate productive resources in response to shifts in the terms of trade and the exchange rate appreciation. With labor demand shifting from manufacturing toward the natural resource sector and services, as well as from the eastern to the western part of the country, employment expanded by almost 1½ percent in the first five months of 2006, and the unemployment rate has fallen to a 31-year low of 6.1 percent. Productivity growth has also accelerated since mid-2005, following several years of lackluster performance.

The west is booming

Strong demand for oil and gas exports has boosted growth rates in Canada’s western provinces.

Citation: 35, 13; 10.5089/9781451968361.023.A009

(growth rate; percent)

Data: Haver Analytics.

Prudent macroeconomic policies

Despite higher energy prices and robust growth, inflation has remained subdued. Headline inflation stayed well within the Bank of Canada’s 1 to 3 percent target band, except in September 2005, when a spike in energy prices in the aftermath of Hurricane Katrina caused it to overshoot temporarily. Core inflation (which excludes particularly volatile components, such as energy and food prices) has not exceeded 2 percent since early 2004, with the strong currency and global competition keeping prices of imported goods low, and well-anchored inflation expectations helping to contain the spillover of energy price shocks to other prices.

The change in government following the January general election has not affected Canada’s commitment to budget discipline. The FY2006/07 budget has centered on the new government’s objective to reduce the federal debt by C$3 billion a year. The government also took advantage of the FY2005/06 surplus (the ninth consecutive federal budget surplus; see chart, facing page) to advance the target of lowering the ratio of federal debt to GDP to 25 percent by one year to FY2013/14. The budget also aimed to contain expenditure growth and lower the tax burden, including through a 1 percentage point reduction in the goods and services tax and other measures designed to boost incentives to work, save, and invest.

Looking ahead

The IMF’s Executive Board agreed with the staff’s assessment that Canada’s near-term macroeconomic outlook appears broadly favorable. Growth is expected to remain around 3 percent through 2007—close to most estimates of Canada’s potential growth rate. The estimates reflect the continued support that high commodity prices are likely to provide to incomes and domestic demand.

This outlook is subject to risks, however, including the potential for a rapid adjustment of global imbalances—which could lead to, among other things, further exchange rate appreciation—and the low household saving rate. Against this background, and in light of increased global competition and intensifying demographic pressures, it will be important for Canada to maintain prudent fiscal and monetary policies and further improve the economy’s flexibility.

On the monetary side, the Bank of Canada has appropriately withdrawn monetary stimulus in recent months. With the economy operating near its potential, further policy decisions will need to balance the support that favorable terms of trade are providing to economic activity against the drag from an appreciated exchange rate, whose strength has continued to largely reflect fundamentals. Canada’s inflation targeting framework has kept inflation and inflation expectations low, and the Bank of Canada has established a commendable record of transparency.

The Executive Board welcomed the new government’s commitment to lowering the tax burden, maintaining fiscal surpluses, and continuing debt reduction. It also viewed the authorities’ emphasis on limiting the growth of spending, the planned reductions in corporate rates, and the early elimination of the federal capital tax (given the relatively high level of Canada’s marginal effective corporate tax rates) as appropriate. The Board said, however, that in its view, Canada could have provided greater incentives to save and invest by reducing marginal personal income tax rates and promoting tax-deferred saving rather than by cutting the goods and services tax rate.

In the black

Canada’s federal budget remained in surplus for fiscal year 2005/06-the ninth consecutive year it has done so.

Citation: 35, 13; 10.5089/9781451968361.023.A009

(percent of GDP)

1May change once final accounts are published.

Data: Haver Analytics, Finance Canada, and IMF staff calculations.

The Directors supported the new government’s prudent fiscal framework, which has benefited from steps to strengthen fiscal transparency. Both the medium-term debt anchor and the planned establishment of a Parliamentary Budget Office could help support the social consensus for prudent fiscal policies. Going forward, the Board cautioned that the authorities would have to be alert to the fiscal challenges presented to all levels of government by the rapid increase in provincial and territorial expenditures on health care. They will also need to ensure that the boom in oil and gas prices does not exacerbate regional disparities in fiscal capacity.

Canada’s financial sector has enjoyed strong profitability in recent years, and strong balance sheets and low default rates suggest that the sector is well placed to support continued economic growth. There is still room, however, to further strengthen the system’s efficiency and resilience, particularly with global competition intensifying in the financial services market.

Finally, although Canada has been among the fastest-growing industrial countries in recent years, there is still scope to boost productivity through labor and product market reform. In particular, continuing to reduce welfare walls—that is, spikes in the marginal tax rate at income levels where targeted tax preferences and social benefits are cut off—could increase labor participation among low-income groups.

On other fronts, amending the immigration process could help address skills shortages, and simplifying the recognition of occupational qualifications across provinces would also increase labor market flexibility. Consideration could also be given to funding the employment insurance system’s social benefits through general revenues rather than through the payroll tax. This would further reduce price distortions in the labor market.

Ravi Balakrishnan, Vladimir Klyuev, and Evridiki Tsounta

IMF Western Hemisphere Department

This article is based on IMF Country Report No. 06/230, Canada: 2006 Article IV Consultation. Copies are available for $15.00 each from IMF Publication Services. Please see page 208 for ordering details. The full text is also available on the IMF’s website (www.imf.org).

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