Vladimir Klyuev, Martin Mühleisen, and Tamim Bayoumi
Published Date:
October 2007
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Vladimir Klyuev

Over the last decade, Canada has enjoyed robust GDP growth, declining unemployment, low and stable inflation, and a string of fiscal and current account surpluses. These outcomes are largely the result of sound macroeconomic policies and a favorable external environment. This book analyzes Canada’s recent economic success, drawing together analyses conducted by IMF staff members. The book outlines the effects of recent fiscal, monetary, and financial policies and examines the economy’s salient features, including its close trade integration with the United States, its large commodity sector, and its decentralization and regional diversity.

Part I of this paper assesses Canada’s macroeconomic environment, including factors underlying the business cycle, the macroeconomic implications of Canada’s energy sector, and the interrelationships between Canada and the United States. Part II takes a closer look at Canada’s fiscal policies, including a comparison of Canadian budget forecasts with those of other industrial countries, an examination of the results of pension reform, and the opportunities for tax reduction afforded by Canada’s fiscal surpluses. Part III explores Canada’s monetary and financial policy environment by outlining the positive results of Canada’s long experience with inflation targeting (IT), reviewing the evolution of the monetary policy transmission mechanism since the 1990s, and examining Canada’s banking system and the implications for competition and financial stability. It is based largely on background work conducted by IMF staff in the context of annual bilateral consultations with Canada. While some of the frameworks (for example, fiscal) have evolved, and some analysis may not be based on the most recent data, the underlying messages remain relevant.

Macroeconomic Environment

Canada is an open economy whose trade is dominated by the United States. Kose (2004) finds that Canadian-U.S. free trade agreements have substantially increased trade and financial flows while increasing business-cycle synchronicity. In Section I of this paper, Alejandro Justiniano uses factor analysis to demonstrate that the U.S. business cycle explains about half the variation in Canada’s real GDP and industrial production.

Canada’s impressive GDP growth over the last decade despite somewhat lackluster productivity performance is explained by a substantial rise in labor force participation, particularly among women. Tsounta (2006) finds that reforms in the Canadian tax and benefit system in the mid-1990s account for at least a third of the observed increase in female participation during 1995–2001.

Since the early 1980s, Canada, like the United States, has experienced a secular decline in the household saving rate. Faulkner-MacDonagh (2004) estimates a long-run relationship between the saving rate and household net worth, inflation, interest rates, and government spending and finds this decline reflects improvement in the fiscal balance, success in fighting inflation, and increases in households’ net worth. Klyuev and Mills (2006), using an error-correction framework on saving behavior in four Anglo-Saxon economies, find that, in contrast to the experience in the United States, the decline in the Canadian household saving rate in recent years has not coincided with a rise in home-equity withdrawal.

Canada’s large commodity sector makes the country susceptible to terms of trade shocks that spill over into the Canadian dollar—its “commodity currency”— which has appreciated strongly in recent years as oil and other commodity prices have soared. Lee and Mühleisen (2004) argue that this appreciation has largely been in line with the fundamentals. In Section II of this paper, Tamim Bayoumi and Martin Mühleisen reinforce this assessment and, in particular, argue that the relationship between the Canadian dollar and energy prices has tightened over time, reflecting the growing importance of net energy exports.

Section III explores the deep interrelationships between the Canadian and U.S. economies. One of Canada’s challenges is its regionally specialized economy, with manufacturing concentrated in the central provinces and raw materials production elsewhere. In the first segment of this section, Vladimir Klyuev and Rodolfo Luzio find that, despite some convergence over the last decade, Canadian regions are still significantly more diverse than their U.S. counterparts in terms of industrial structure and their responses to macroeconomic shocks.

By making asymmetric shocks more likely, regional diversity underscores the need for flexible markets. Bayoumi, Sutton, and Swiston (2006) find that Canada’s labor markets are flexible by international standards, with migration playing a significant role in adjustment. Flexibility is particularly notable from the province of Ontario westward, while adjustment is more sluggish in Quebec and the Atlantic provinces. This may reflect the finding by Kaufman, Swagel, and Dunaway (2003) that the Employment Insurance (EI) system discourages migration and impedes convergence in per capita output. Moving beyond the labor market, Bayoumi and Cardarelli (2005) find that the Canadian economy is characterized by a relatively high degree of flexibility, as demonstrated by substantial changes in the industrial structure over time, high rates both of firm entry and exit and of job creation and destruction, and speedy adjustment to macroeconomic disturbances.

Despite the close integration between the Canadian and U.S. economies, however, the labor productivity gap between the two countries has widened over the last two decades. In the second segment of Section III, Roberto Cardarelli explores the factors that have led to the Canadian–U.S. productivity gap using a sectoral growth-accounting approach. This lack of productivity convergence is also analyzed in Cardarelli and Kose (2004), who find that it is explained by Canada’s industrial structure rather than increased trade integration with the United States. In this section, Cardarelli concludes that the United States has been much more successful in shifting resources toward high-productivity industries and that differences in industrial structure explain the majority of the productivity growth gap over the second half of the 1990s.

In the final part of Section III, Iryna Ivaschenko and Andrew Swiston explore the impact of U.S. shocks on the Canadian economy, using a two-country model. They find that spillovers from U.S. activity are significant but can be mitigated by a speedy monetary policy response, while U.S. monetary policy has relatively modest effects on Canada.

Fiscal Policies

Canada has had an enviable fiscal record in recent years, moving from chronic deficits and rising public debt to nine consecutive federal budget surpluses. In Section IV, Martin Mühleisen and others emphasize that macroeconomic uncertainty makes necessary a considerable cushion to ensure that Canada’s asymmetric “balanced budget or better” objective (in place until 2006) can be met. They compare Canada’s budget forecasts against those of other industrial countries and find that the authorities have a tendency to build that cushion partly by using conservative macroeconomic and fiscal assumptions. They suggest that the transparency of the budget process could be improved.

Cardarelli (2003) finds the country’s long-term fiscal prospects to be relatively favorable even in the face of demographic pressures. In Section V, Mühleisen reviews the current status of the pension system and points out that, despite the success of the 1998 reform, there is scope for simplifying and better targeting public pension benefits. At the same time, cost pressures within the health care system remain a challenge (De Masi and Towe, 2003).

Section VI reviews the opportunities for tax reduction that have been opened by Canada’s fiscal prudence. Using the IMF’s Global Fiscal Model (GFM), Bayoumi and Dennis Botman demonstrate significant macroeconomic benefits of debt reduction, and Botman then uses the model to compare the efficiency gains from different tax cuts and concludes that the efficiency gains from cutting the Goods and Services Tax (GST, Canada’s value-added tax) would be relatively low.

Monetary and Financial Policies

Canada was among the pioneers of inflation targeting. In Section VII, Jorge E. Roldos tracks changes in the monetary transmission mechanism in Canada since 1990 and shows that these changes are partly the result of a shift from indirect (bank-based) to direct (market-based) financing, which increased the responsiveness of aggregate demand to the real interest rate. In Section VIII, Bayoumi and Klyuev examine the contribution of the IT regime to reducing Canada’s macroeconomic volatility since 1991. They attribute the enhanced stability during this period primarily to the high credibility of the new regime, which made inflation expectations more forward looking, rather than to changes in the monetary reaction function or tamer shocks. The final two sections in this part address the relationship between financial stability and efficiency. A key policy issue in Canada is whether to allow further mergers in a banking system dominated by six large banking groups. In Section IX, Ivaschenko finds that the Canadian banking system is relatively competitive and efficient despite this concentration. In Section X, Gianni De Nicolò, Alexander Tieman, and Robert Corker calculate market-based soundness indicators for the six large banks and find that the low correlation of risk profiles across these banks enhances the resilience of Canada’s financial system.

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