Canada: Staff Report for the 2001 Article IV Consultation
Author: International Monetary Fund
Publication Date:
23 Apr 2001
eISBN:
9781451806878
ISBN:
9781451806878
Language:
English
Keywords:
ISCR; CR; monetary policy announcement date; core consumer price inflation; Canada; Canadian dollar; interest rate cut; statistics Canada; Canada capacity utilization ratio; price deflator; forward-looking inflation targeting framework; Inflation; Global; price-earnings ratio
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The Canadian economy ended the 1990s with a very strong performance, underpinned by the sound macroeconomic policies put in place during the decade. The Bank of Canada raised interest rates markedly in 2000 as estimates of slack in the economy were narrowing rapidly. Executive Directors agreed with the authorities' view that monetary policy should be set to reflect economic conditions in Canada and should aim to allow the economy to seek its productive potential without compromising the official inflation target.

Abstract

The Canadian economy ended the 1990s with a very strong performance, underpinned by the sound macroeconomic policies put in place during the decade. The Bank of Canada raised interest rates markedly in 2000 as estimates of slack in the economy were narrowing rapidly. Executive Directors agreed with the authorities' view that monetary policy should be set to reflect economic conditions in Canada and should aim to allow the economy to seek its productive potential without compromising the official inflation target.

I. Introduction1

1. At the time of the 2000 Article IV consultation, Executive Directors commended the authorities for maintaining sound macroeconomic and structural policies over most of the past decade, which had underpinned the strong performance of the Canadian economy.2 They noted that the Bank of Canada’s successful inflation targeting policy has helped to maintain inflation at a level among the lowest of major industrial countries. While supporting the Government’s intention to use prospective fiscal surpluses to continue bringing down the ratio of public debt to GDP, to reform the income tax system, and to increase spending moderately in priority areas, Directors recommended that debt reduction and income tax reform should be top priorities. Reducing the high burden of personal and corporate income taxes was seen as offering potentially large efficiency gains. Directors also welcomed Canada’s participation in the pilot Financial System Stability Assessment Program.

II. Economic Developments and Outlook

A. Recent Economic Developments

2. The Canadian economy ended the 1990s with a very strong performance, underpinned by the sound macroeconomic policies put in place during the decade. Inflation has been maintained at a low level under the inflation targeting policy introduced in 1991. All levels of government have achieved substantial improvements in their fiscal positions, helping to bring down public indebtedness. Policy efforts in such key areas as the employment insurance system and the financing of the public old-age support system have improved economic efficiency, lowered unemployment, and enhanced the economy’s growth prospects.

3. Following a slowdown in growth in late 1997 and 1998 largely associated with the fallout from the Asian crisis, the pace of economic growth has been vigorous and broadly based. Real GDP has grown at an average annual rate of about 4¾ percent between the fourth quarter of 1998 and the third quarter of 2000, broadly in line with growth in the United States (Figure 1 and Table 1). During this period, the rapid expansion of demand has been supported by strong private consumption, buoyant private and public fixed investment, and by net exports. Consumption has risen at an average annual rate of 4¾ percent, reflecting strong employment gains and reduced taxes. Investment in machinery and equipment has also grown briskly, at an annual average rate of about 20 percent, owing to the strength of domestic demand and a stepped-up pace of adoption of new information technology equipment. While the ratio of public investment to GDP remains low, growth in such investment has also been significant. In the fourth quarter of 2000 real GDP growth slowed to 2½ percent, reflecting the effects of a slowdown in U.S. growth during the second half of the year.

Figure 1.
Figure 1.

Canada. Output and Demand

(Annualized quarterly growth, in percent)

Citation: IMF Staff Country Reports 2001, 062; 10.5089/9781451806878.002.A001

Table 1.

Canada: Selected Economic Indicators

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Sources: Statistics Canada; and Fund staff estimates.

Contribution to growth.

Constructed using 1989-91 trade weights.

Defined in terms of relative normalized unit labor costs in manufacturing, as estimated by the IMF’s Competitiveness Indicators System, using 1989-91 trade weights.

Based on NIA data.

Includes local governments and hospitals.

Gross national saving does not equal the sum of gross domestic investment and net foreign investment because of statistical discrepancy.

4. Strong U.S. demand growth, together with some recovery in commodity prices, helped to shift the external current account from a deficit of ½ percent of GDP in 1999 to a surplus of 1¾ percent of GDP in 2000 (Table 2). A sharply improving trade surplus has been mainly propelled by buoyant export growth to the United States. The deficit in net investment income has also declined, partly reflecting the cumulative effects of lower interest rates and a more recent rebound in foreign earnings of Canadian corporations. As for the capital account, portfolio outflows rose markedly, as the strong demand for foreign stocks by Canadian residents continued. U.S. investors increased sharply their purchases of Canadian stocks, particularly in technology-related sectors. In addition, direct investment inflows and outflows both rose markedly, especially with the United States and Europe.

Table 2.

Canada: Balance of Payments

(In billions of Canadian dollars)

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Source: Statistics Canada.

Includes bank, nonbank, and nonofficial reserves transactions.

5. The strong pace of economic growth has pushed the economy to levels of resource utilization not seen during the past 25 years. The unemployment rate fell by about 1½ percentage points since end-1998, reaching 6½ percent in June, its lowest level since the mid-1970s (Figure 2), It has risen somewhat since then and stood at 6.9 percent in January 2001, partly reflecting an increase in the participation rate.3 Employment rose by 2¾ percent on average in 1999 and in 2000; a significant part of these gains was in full-time jobs. The staff estimates that the output gap has moved from 2¾ percent below potential in the fourth quarter of 1998 to ½ percent above potential in the fourth quarter of 2000 (Figure 3). However, estimates of the level and growth rate of potential output are uncertain given the recent rapid rate of growth in equipment investment and the lack of indications of price pressures. Recent data suggest some moderate pickup in the growth rate of potential output from 2½ percent to 2¾ percent.4 The index of capacity utilization for the nonfarm goods producing sector trended upward at a very rapid pace from mid-1999, before easing slightly in the third quarter of 2000 (Figure 4). Capacity utilization is particularly high in manufacturing, which in the third quarter of 2000 stood at a level not experienced since early 1974. As noted in the February 2001 Monetary Policy Report Update, the economy continued to operate close to capacity in the fourth quarter of 2000 and early 2001 as suggested by very low vacancy rates in the residential and commercial real estate sectors and by continuing reports of skilled labor shortages in several sectors.

Figure 2.
Figure 2.

Canada: Unemployment

(In percent of labor force)

Citation: IMF Staff Country Reports 2001, 062; 10.5089/9781451806878.002.A001

1/ staff estimate
Figure 3.
Figure 3.

Canada: Employment and Output Gaps

(In percent, staff estimates)

Citation: IMF Staff Country Reports 2001, 062; 10.5089/9781451806878.002.A001

Figure 4.
Figure 4.

Canada Capacity Utilization Ratio

Citation: IMF Staff Country Reports 2001, 062; 10.5089/9781451806878.002.A001

6. Despite indications of higher levels of resource utilization, inflationary pressures remain quiescent Core inflation hovered within a narrow range around 1 ½ percent between mid-1998 and November 2000 (Figure 5), and rose to the mid-point of the authorities’ 1-3 percent target range in January 2001. Overall inflation has risen more rapidly, largely reflecting the impact of energy prices. CP1 inflation was 1¾ percent in 1999 and 2¾ percent in 2000. Wage pressures also remained well contained, as labor compensation per person hour rose by about 2½ percent in 1999 and by 3¾ percent in 2000. Unit labor costs, which remained virtually unchanged in 1999, rose at an annual rate of almost 1 percent in the first three quarters of 2000. Surveys indicate that inflationary expectations continue to be around the mid-point of the official target range, suggesting continued high credibility in the authorities’ inflation target. In addition, the yield differential between fixed-rate and inflation-indexed government bonds has remained around 200 basis points since late 1999.

Figure 5.
Figure 5.

Canada; Core CPI Inflation

(Percentage change, same month previous year)

Citation: IMF Staff Country Reports 2001, 062; 10.5089/9781451806878.002.A001

7. Canada has not yet experienced the same sharp upturn in labor productivity growth observed in the United States. Since end-1995, labor productivity for the business sector in Canada has risen by about 1 percent annually, 1½ percentage points below that for the United States.5 This differential has largely reflected lagging productivity growth in Canadian manufacturing (Figure 6), in part because of the smaller size of the information technology sector, which has experienced especially strong productivity gains. According to OECD data, labor productivity growth for the total economy also has been somewhat smaller in Canada than that observed in some European economies (notably Germany and France), partly owing to less substitution of capital for labor in Canada (Figure 7). However, the share of information technology spending in GDP in Canada has been high relative to European countries and very similar to the shares observed in Japan and the United States over the past few years (Figure 8). Moreover, there are expectations that Canada may be set to experience an acceleration in productivity following the massive restructuring of firms undertaken in the 1990s and as a result of the large investment in equipment embodying new technology since 1996.6 Recent data show a strong pickup in labor productivity growth in the business sector, which rose at an annual rate of 2¼ percent in the year through the third quarter of 2000.

Figure 6.
Figure 6.

International Comparison: Labor Productivity Growth in Business and Manufacturing Sectors

(Annual average, in percent, 1996-99)

Citation: IMF Staff Country Reports 2001, 062; 10.5089/9781451806878.002.A001

Figure 7.
Figure 7.

International Comparison: Labor Productivity in the Total Economy

(Real GDP per hour: index=1995)

Citation: IMF Staff Country Reports 2001, 062; 10.5089/9781451806878.002.A001

1/ Staff estimate
Figure 8.
Figure 8.

International Comparison: IT Expenditures

(In percent of GDP)

Citation: IMF Staff Country Reports 2001, 062; 10.5089/9781451806878.002.A001

8. The Bank of Canada raised interest rates markedly in 2000 as estimates of slack in the economy were narrowing rapidly and owing to concerns about potential inflationary spillovers from faster-than-expected U.S. growth. However, following the sharp turnaround in the U.S. outlook, the Bank of Canada lowered interest rates in January 2001. Between November 1999 and May 2000, the Bank of Canada raised the bank rate by 125 basis points. This tightening of monetary policy was reflected in a flattening of the yield curve through most of this period and a rise in the yield spread between long-term corporate and government bonds. At its scheduled monetary policy announcement date on January 23, 2001, the Bank of Canada lowered the bank rate by 25 basis points owing to concerns regarding near-term Canadian economic prospects stemming from indications that the U.S. slowdown would be more abrupt than expected. Canadian short-term interest rates have been below U.S. rates since May 1999, but the differential narrowed in late 2000 and in early 2001 (Figure 9), As for long-term yields, the small negative differential that prevailed throughout most of the past two years shifted to positive in December 2000, and has fluctuated around a positive 25 basis points so far in 2001.

Figure 9.
Figure 9.

Canada: Interest Rate Differentials

(In percentage points, Canada minus the United States)

Citation: IMF Staff Country Reports 2001, 062; 10.5089/9781451806878.002.A001

9. After peaking at 69 U.S. cents in December 1999, the Canadian dollar depreciated to about 65½ U.S. cents by late February 2001. The weakness in the bilateral exchange rate through end-2000 mirrored developments in the bilateral rates of other major industrial countries vis-à-vis the U.S. dollar (Figure 10). In real effective terms, the Canadian dollar depreciated slightly during 2000 (Figure 11).

Figure 10.
Figure 10.

International Comparison: Exchange Rales

(US$ per national currency)

Citation: IMF Staff Country Reports 2001, 062; 10.5089/9781451806878.002.A001

Figure 11.
Figure 11.

Canada. Bilateral and Real Effective Exchange Rates

(Index 1990=100)

Citation: IMF Staff Country Reports 2001, 062; 10.5089/9781451806878.002.A001

10. The authorities’ commitment to promoting lasting fiscal discipline has been reflected in an impressive turnaround in the federal fiscal position, which shifted from a deficit of 5¾ percent of GDP in 1993/94 to a surplus of 1¼ percent in 1999/00 (Table 3 and Figure 12). Over two-thirds of this improvement is the result of significant cuts in program spending. Staff estimates suggest that, over this period, the structural balance shifted from a deficit of 4¾ percent of GDP to a surplus of 1½ percent. In The Budget Plan 2000, the Government presented a five-year tax-reduction plan for personal and corporate income taxes, while also allowing for modest new spending initiatives on health, education, public infrastructure, and environment, which build upon measures introduced in previous budgets. The budget recorded a larger-than-expected surplus of $12.3 billion in 1999/00, owing to strong growth in tax revenues, which suggested that prospective fiscal surpluses could be greater over the medium term than envisaged in The Budget Plan 2000. Given these developments, the Government in its October 2000 Economic Statement and Budget Update presented a mini-budget, where it expanded the tax reductions presented in The Budget Plan 2000 and introduced some modest additional spending initiatives (Box 1). It also announced that a minimum of $10 billion in debt would be repaid in 2000/01, implying that the federal budget surplus would reach 1 percent of GDP. The budgetary improvements and economic growth achieved over the past few years have allowed the federal government net debt (on a public accounts basis) to be reduced from over 70 percent of GDP in 1994/95 to an estimated 52 percent in 2000/01 (Figure 13).

Table 3.

Canada: Federal Government Budget, Public Accounts 1/

(In billions of Canadian dollars; unless otherwise indicated)

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Sources: Department of Finance; and Fund staff estimates.

On a fiscal year basis, which ends on March 31.

Figure 12.
Figure 12.

Canada: Federal Fiscal Policy Indicators

(In percent of GDP)

Citation: IMF Staff Country Reports 2001, 062; 10.5089/9781451806878.002.A001

Figure 13.
Figure 13.

Canada: Federal Government Net Public Debt

(Public accounts basis; in percent of GDP)

Citation: IMF Staff Country Reports 2001, 062; 10.5089/9781451806878.002.A001

11. With strong fiscal consolidation at the federal and provincial levels, the general government balance improved from a deficit of 6¾ percent of GDP in 1994 to a surplus of 3½ percent of GDP in 2000 (national accounts basis). The provinces have been able to improve their fiscal position through a combination of buoyant tax revenues and spending restraint. In 1999, Ontario achieved a surplus exceeding expectations and was envisaged to post another surplus in 2000. Quebec posted a modest budget surplus in 1999 for the second consecutive year, while Alberta is poised to eliminate its net public debt in the current fiscal year. In their 2000/01 budgets, many provinces have confirmed their intention to proceed with tax cuts and to increase health and education spending, but the provinces as a group are expected to continue to run an aggregate surplus. The improvement in federal and provincial fiscal positions has significantly reduced the ratio of general government net debt to GDP over the past few years to an estimated 67 percent of GDP in 2000 (Table 4 and Figure 14). Nevertheless, the ratio of net debt to GDP in Canada remains above the G-7 average (Table 5).7

Table 4.

Canada: Net Government Debt

(In percent of GDP)

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Sources: Statistics Canada, National Balance Sheet Accounts (13-214) and Canada’s International Investment Position (67-202); Department of Finance, Canada; and Fund staff estimates.

Calendar year.

Also includes local government and hospital sectors.

Canadian Pension Plan and Quebec Pension Plan.

Fiscal year, beginning April 1. The public accounts measure of net debt includes government indebtedness to the public service pension plans, the CPP, and the QPP as a government liability. Note that data on intergovernmental holdings of net debt are not available on a public accounts basis so that the totals may be biased upward.

As a percent of total marketable debt.

Figure 14.
Figure 14.

Canada: General Government Net Debt

(National accounts basis; in percent of GDP)

Citation: IMF Staff Country Reports 2001, 062; 10.5089/9781451806878.002.A001

Table 5.

Canada: Indicators of Economic Performance

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Source: Fund staff estimates. Projections for G-7 countries except for Canada and the United States are from the World Economic Outlook (October 2000).

Germany’s net debt starts in 1986.

Main Elements of the Federal Tax Reform

In The Budget Plan 2000 and the October 2000 Update, the Government introduced and implemented a comprehensive reform to the personal and corporate income tax regime in Canada. The main elements of this reform were:

    Personal Income Tax

  • Full indexation of income taxes to inflation was restored and income thresholds at which marginal rates apply were raised.

  • The marginal tax rate on middle income taxpayers was reduced from 26 percent to 24 percent effective July 2000 and to 22 percent as of January 2001.

  • Tax rates for low-income bracket groups ($0 to $30,754) and for a new upper middle-income bracket ($61,509 to $100,000) were reduced from 17 percent to 16 percent and from 29 percent to 26 percent, respectively.

  • The 5 percent surcharge on high-income taxpayers was eliminated as of January 2001.

  • The taxation of gams on qualifying stock options was shifted to when the shares are sold from when the options are exercised or enriched.

After these changes, and effective January 1, 2001, the marginal tax rates that apply to taxable income brackets are: 16 percent for income less than $30,754; 22 percent for income between $30,754 and $61,509; 26 percent for income between $61,509 and $100,000; and 29 percent for income exceeding $100,000.

  • The income inclusion rate for capital gains was reduced from three-quarters to two-thirds in February 2000 and to one-half in October 2000.

    Corporate Income Taxes

  • A plan was introduced to lower the highest tax rate from 28 percent to 21 percent by 2004 on corporate income not eligible for special tax treatment, comprising industries other than manufacturing and processing operations, which already benefited from the 21 percent rate or the resource sector which benefits from special tax preferences. Effective January 1, 2001, the corporate income tax rate was reduced by 1 percentage point, and the rate is to be cut by 2 percentage points in each of the following three years.

  • Small businesses with income between $200,000 and $300,000 also had their tax rates reduced to 21 percent effective January 2001.

12. While the ambitious fiscal consolidation has contributed to raise the share of gross national savings to GDP to its average during the 1980s, the falling cost of capital equipment has helped Canada achieve levels of real private investment that are significantly higher than those in the previous three decades. Gross national savings rose to 22¼ percent of GDP in 2000, as higher government and corporate savings more than offset a decline in personal savings.8 Gross private investment, measured in nominal terms, has hovered around 18 percent of GDP since 1997, below its average for the 1970s and 1980s. However, in real terms, gross private investment is now well above its average since the 1960s. In comparison with other G-7 countries, the relative price of capital equipment in Canada generally has declined faster, falling at an annual rate of about 1½ percent since 1994 (Figure 15 and Box 2).9

Figure 15.
Figure 15.

International Comparison: Relative Cost of Capital

(1990=100 Price index of fixed private investment relative to CPI)

Citation: IMF Staff Country Reports 2001, 062; 10.5089/9781451806878.002.A001

Saving and Investment in Canada: An International Perspective

Overall trends in national saving and gross domestic investment (as a percent of GDP) during the 1990s were broadly similar in Canada and the United States (see figure). In both countries, national saving rose from the early 1990s through the end of the decade, as a strong increase in government saving offset a continued decline in private saving. Gross domestic investment also rose during the period, as roughly unchanged government investment was accompanied by a sharp rise in private investment. In both Canada and the United States, investment in machinery and equipment contributed significantly to the rise in private investment.

There were important differences between Canada and the United States during their economic expansions in the 1990s. In Canada, the increase in national saving started earlier and was larger than in the United States, while the recovery in investment started later and was smaller. Although both countries experienced a decline in net private saving (private saving less private investment), Canada’s external balance strengthened, as the decline in net private saving was more than offset by a rise in net government saving, in contrast to the sharp deterioration in the U.S. external balance. These developments suggest that trends in the private saving-investment balance are not necessarily a good indicator of overall macroeconomic risks.

Other G-7 countries (except Germany and Japan) shared the North American trend of a rise in national saving and investment starting in the early 1990s. They also generally shared the pattern of a decline in private saving—especially in the household sector—that was more than offset by a rise in government saving, and a rise in private investment that more than offset a fall in government investment. Common factors contributed to the decline in household saving, including fiscal consolidation, reductions in inflationary expectations, wealth effects (arising from equity or real estate gains), and an easing of households’ borrowing constraints.

13. Household and corporate balance sheets strengthened further during 1999, led by rising equity prices and a sharp improvement in corporate profits, before slipping modestly in the second half of 2000. Personal sector net worth rose by 5 percent in 1999 to reach a high of almost 510 percent of disposable income in 1999, spurred by increases in fixed assets such as land and residential property, as well as financial assets (Figure 16). The rise in personal sector net worth has been broadly in line with its average for the decade. More recent data suggest that the ratio of net worth to disposable income declined to 509 percent by the end of 2000, owing to a decline in equity prices. At the same time, household debt increased to 98 percent of disposable income, the highest level in the past 30 years; like in the United States, mortgage debt is the most important household liability, accounting for about two-thirds of the total. A rise in corporate profits of 23 percent in both 1999 and 2000 reduced the need for borrowing and helped bring down the ratio of nonfinancial corporate debt to GDP to 58 percent in 2000 (Figure 17). The rebound in corporate profits, together with the upward trend in equity prices (Box 3), has kept the debt-to-equity ratio on a downward trend since 1992, declining from 90 percent to 72 percent in 2000. Since 1995, Canadian corporations have raised an average of $13½ billion per year in net new bond issues in U.S. markets. During 2000, net bond financing declined markedly to about $½ billion, but this decline was more than offset by increased net new issues in Canada, partly reflecting a tightening of credit conditions in U.S. markets.

Figure 16.
Figure 16.

16 Canada Personal Sector Ket Worth and Household Debt

(In percent of disposable income)

Citation: IMF Staff Country Reports 2001, 062; 10.5089/9781451806878.002.A001

Figure 17.
Figure 17.

Canada: Debt of Nonfinancial Corporations 1/

(In percent of GDP)

Citation: IMF Staff Country Reports 2001, 062; 10.5089/9781451806878.002.A001

Asset Prices in Canada and the United States

The sharp rise in asset prices in the United States over the past five years has raised considerable debate about the underlying factors driving U.S. equity prices, particularly the role played by the development and application of information technology. Given the high degree of financial and trade integration between the Canadian and U.S. economies, the recent large gains in Canadian equity prices have raised similar concerns about market valuations.

While current equity market valuations in Canada appear to be high relative to historical values, and difficult to reconcile with what they suggest in terms of expected growth in corporate profits and risk premia, several analyses suggest that current valuations in Canada and the United States are primarily a “high-tech phenomenon”. Once the technology sector is excluded, current valuations would appear to be more reasonable and consistent with a combination of somewhat higher growth in corporate profits and lower risk premia than suggested by historical averages.1 A sharp rise in the price-earnings ratio for the TSE300 since mid-1998 reflected a marked rise in the price index for the industrial subsector, especially in technology (hardware and software) stocks (see top figure). In recent months, the price-earnings ratio for the TSE 300 has declined sharply, from 38 in August 2000 to 23 in December, reflecting a marked decline in technology stock prices that outpaced a fall in earnings. In the fourth quarter of 2000, the high technology subsectors experienced significant negative earnings.

The rise in asset prices in Canada appears to be primarily confined to equity. Following a sharp decline in real estate prices in the early 1990s, prices for new houses and for nonresidential structures have remained largely unchanged in real terms, in contrast to the moderate pickup in new housing prices in real terms that has taken place in the United States since mid-1998.

Household equity wealth has risen rapidly in Canada since 1993, but its pace has not been as buoyant as in the United States. As of end-1999, the ratio of household equity wealth to personal disposable income was 1¼ significantly lower than the 2.3 for the United States. With estimates for the marginal propensity to consume out of equity wealth in Canada ranging from 2 to 4 cents per dollar, somewhat below those of the United States, the staff estimates that a 35 percent drop in Canadian equity prices would reduce equity wealth by roughly $250 billion from its-end-1999 level and consumption by $5-10 billion (½ to 1 percent of GDP) over the long-term.

uA01fig02

TSE 300 Price-Earnings Ratio (December)

Citation: IMF Staff Country Reports 2001, 062; 10.5089/9781451806878.002.A001

uA01fig03

Real Estate Prices in Canada and the United States (deflated by CPI)

Citation: IMF Staff Country Reports 2001, 062; 10.5089/9781451806878.002.A001

uA01fig04

Household Equity Wealth (ratio to personal disposable income)

Citation: IMF Staff Country Reports 2001, 062; 10.5089/9781451806878.002.A001

1 See Cerisola and Ramirez (2000), “U.S. Equity Prices and the Technology Boom” in united states: selected issues, IMF Staff Country Report No. 00/112, and Hannah (2000), “Approaches to Current Stock Market Valuations,” in bank of canada review, Summer 2000.

14. Over the past few years, the profitability and asset quality of financial institutions in Canada have remained high, enabling them to further strengthen their overall capitalization levels. In the past three years, the Big Six Canadian chartered banks had a return on total equity (ROE) of about 15 percent on average (Figure 18), as buoyant growth in fee-based income has helped to more than offset declining net interest earnings. Nonperforming loans net of provisions have declined steadily, from a peak of 2½ percent of average loans in 1993 to less than ½ percent in the fourth quarter of 2000 The total capital ratio for banks has also risen steadily, reaching almost 11 percent in the third quarter of 2000, comfortably above the Office of the Superintendent of Financial Institutions’ benchmark of 10 percent. Other financial institutions, such as life insurance companies and credit unions, have also experienced above-historic average ROE, and also remain well capitalized.

Figure 18.
Figure 18.

Canada: Chartered Banks: Return on Total Shareholders’ Equity

(In percent) 1/

Citation: IMF Staff Country Reports 2001, 062; 10.5089/9781451806878.002.A001

B. The Outlook

15. The staff envisages a “V-shaped” pattern for real GDP growth in 2001 primarily reflecting a temporary negative trade shock from the United States (Table 6). Growth is expected to slow to 1½ percent (annual average) in the first half of 2001, owing largely to the U.S. slowdown. The recently enacted tax reductions, the cut in short-term interest rates, and high levels of employment are expected to help sustain momentum in economic activity in Canada, and the staff expects economic growth to accelerate in the second half of 2001 to 3 percent (annual rate) along with a rebound in U.S. growth. Monetary conditions in Canada also are envisaged to ease further in the first half of 2001. For the year as a whole, GDP is projected to increase by 2½ percent. Subsequently, the economy is expected to grow at 2¾ percent, its estimated potential growth rate. Core inflation is expected to remain close to the 2 percent mid-point of the official target range through 2006.

Table 6.

Canada: Staff Projections

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Source: Fund staff estimates.

Contribution to growth.

Projections are based on the WEO assumption of unchanged fiscal policy. After FY 2000/01, it is assumed that new measures of Can$5-7 billion (around ½ percent of GDP) are introduced each year, aimed at reducing taxes and implementing new spending initiatives. This would imply that the federal government would maintain budget surpluses that would reach Can$3 billion annually. The consolidated fiscal projection for the provinces is assumed to be consistent with their stated medium-term targets.

In billions of Canadian dollars.

Fiscal year (April-March).

Includes local governments and hospitals.

16. Clearly, the uncertainty about the depth and duration of the U.S. slowdown and its potential impact on Canada is the main risk to the outlook. A sharper fall off in U.S. growth would result in a large negative trade shock for Canada (see tabulation below).10 In this alternative scenario, it is assumed that the sharper U.S. slowdown would entail a 20 percent drop in U.S. equity prices and a significant depreciation of the U.S. dollar against the euro and the yen (on the order of 20 percent and 10 percent, respectively). Canadian equity prices are assumed to decline by 10 percent and the Canadian dollar would appreciate modestly against the U.S. dollar. Given that more than 80 percent of Canadian exports go to the United States, the appreciation against the U.S. dollar and the slowdown in U S. growth would result in a marked decline in real net exports, the current account surplus, and real GDP growth during 2001-03. The Canadian authorities are expected to reduce short-term interest rates to cushion the impact of the sharper U.S. slowdown on the Canadian economy, reflecting the deflationary nature of the shock to Canada and the way in which the inflation targeting regime is implemented. Nevertheless, in this scenario, real GDP in Canada would remain below its baseline level over the five-year forecast horizon, owing to a weaker U. S. economy and some real effective appreciation of the Canadian dollar.

A Sharper Slowdown in the United States and its Implications for Canada

(Percent deviation from baseline levels, unless otherwise noted)

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17. The implications for the Canadian economy of this scenario are subject to considerable uncertainty, stemming primarily from the relative importance of trade and financial shocks, how these shocks unfold, and how they would affect the exchange value of the Canadian dollar. It is not clear whether increased financial uncertainty in the United States would lower or raise the international demand for Canadian financial assets and the value of the Canadian dollar. If instead of appreciating, the Canadian dollar depreciated in real effective terms, the impact of the U.S. shock on the Canadian economy would be reduced. At the same time, a potential squeeze in the U.S. corporate bond and loan markets, which are important sources of financing for many Canadian firms, would significantly affect investment in Canada. In addition, world growth would decelerate as a result of the slower growth in the United States, and this could precipitate a significant decline in commodity prices and consequently downward pressure on the Canadian dollar. The deterioration in the terms of trade would have additional negative effects on Canadian economic activity, which would be partially offset by the currency’s decline.

III. Policy Discussions

18. There was broad agreement between the authorities and the staff on the course of macroeconomic and structural policies in the period ahead. The discussions centered on the following issues, which are key for sustaining the economic expansion:

  • in the near term, how monetary policy should respond, in the context of the inflation targeting framework, to the potential risks of an excessive slowing in economic activity, related to shocks emanating from the United States.

  • the allocation of prospective fiscal surpluses to debt reduction, tax cuts, and higher spending in priority areas.

  • the need to maintain and further improve the flexibility and efficiency of the labor market in Canada, especially given recent and proposed changes to the Employment Insurance program.

A. Monetary Policy and the Exchange Rate

19. In assessing the economy’s near-term prospects, the authorities noted that activity in Canada has maintained considerable momentum through the second half of 2000 and into early 2001. Moreover, the tax cuts enacted during 2000, some of which became effective in January 2001, were expected to help sustain domestic demand growth in the first half of 2001. They felt that Canada was in a reasonably good position to weather the impact of the anticipated slowdown in U.S. economic growth. The authorities agreed with the staff that, although the timing of the tax cuts had turned out to be fortuitous, monetary policy was the preferred policy instrument to deal with an excessive slowing of economic growth in the near term. They stressed that monetary policy would be set to reflect economic conditions in Canada. While developments in the U.S. economy would certainly influence these conditions, they noted, and the staff agreed, that there was no need for monetary policy to respond to every shock stemming from events in the United States. However, the staff indicated that monetary policy would need to be eased in the event of a substantial U.S. slowdown. The authorities noted that by setting policy in the context of the inflation targeting framework they would, as a matter of course, respond appropriately to evolving conditions in a forward-looking manner, without attempting the sort of “fine tuning” that had been a major policy mistake in the late 1960s and 1970s. In light of a number of considerations bearing on the economic outlook and the expected trend of inflation in Canada, particularly the slowdown in the United States, the Bank of Canada lowered interest rates by a quarter of a percentage point in late January.

20. The Bank of Canada has recently established a fixed schedule for announcements on monetary policy decisions in an effort to reduce uncertainty in financial markets and to increase the focus of public attention on domestic economic conditions as the key factor in making these decisions. In October 2000, the Bank indicated the eight dates during 2001 on which it will make announcements regarding monetary policy. The Bank retains the option to change policy any time between these fixed dates, although this discretion would be used sparingly so as not to undermine the importance of the announcement dates. These dates were fixed primarily with reference to the release of important Canadian economic data. The move to regularly scheduled policy announcements also was prompted by the goal of avoiding the temporary market disruptions that had sometimes occurred under the previous arrangement where the Bank could potentially change interest rates on any business day.11 Bank of Canada officials explained that the introduction of fixed announcement dates was part of the Bank’s broader communication strategy that encompassed the semi-annual monetary policy reports and the two interim updates of these reports. They also noted that the timing of the move to fixed announcement dates had been fortuitous in that there had been no significant disruptions in domestic money markets after the U.S. interest rate cut on January 3, as market participants generally did not expect Canadian monetary policy to move before the January 23 fixed announcement date. Moreover, the public debate regarding the appropriate policy response had focused on economic conditions and prospects in Canada.

21. The Bank of Canada aims at keeping inflation around the mid-point of the 1-3 percent official target range over six to eight quarters The authorities explained that the band is regarded as a “range of uncertainty” and not a “range of indifference.” The band was established to reflect uncertainties in achieving a specific point inflation target owing to the difficulties in forecasting inflation and the effects of monetary policy changes. However, the Bank was not indifferent to all inflation outcomes within the band. As inflation moved away from the middle of the band, monetary policy would be expected to respond with increasing force to bring inflation back in line with the mid-point. With heightened uncertainty surrounding estimates of the economy’s productive capacity and the extent of remaining slack in resource utilization, the Bank of Canada has attributed less usefulness to estimates of the output gap and the NAIRU in predicting inflationary pressures and guiding monetary policy. The Bank has relied on a broad range of indicators (such as core and trend inflation, data on wage settlements, unit labor costs, and evidence of inflationary expectations embedded in financial assets) to assess the degree of pressure on capacity and inflation.

22. At the time of the last extension of the official inflation target in 1998, it was announced that before the end of 2001 the Finance Minister and the Governor of the Bank would jointly determine a new target range. The authorities have been engaged over the past year in extensive research on the merits of changing the inflation target and/or making other refinements to the inflation targeting regime to enhance its effectiveness.12 The staff agreed with the authorities that it was useful to continue assessing options for further refining the current inflation targeting framework. At the same time, the current 1-3 percent inflation target range had served Canada well, and the empirical literature suggested that the additional net benefits of moving from very low to even lower inflation were probably small, especially in comparison to the significant gains already achieved. Therefore, the staff held the view that, in making a decision this year, there was no reason for a major change, although some refinements were possible. It would be useful to consider steps to increase the accountability of the Bank of Canada with respect to its performance in meeting the inflation target—for example by requiring a report in the event of sustained cumulative deviations from the midpoint target—as a means of potentially anchoring longer-term price expectations more firmly.

23. The credibility established in the inflation targeting framework for setting monetary policy has contributed to enhancing the effectiveness of Canada’s floating exchange rate regime. In turn, the floating exchange rate provides Canada with the scope to pursue an independent monetary policy and buffers the effects of external shocks to the economy.13 The authorities and the staff agreed that the costs arising from a flexible exchange rate (mainly related to the effect of currency volatility on trade and investment) need to be weighed against the benefit of retaining monetary independence in the presence of asymmetric shocks, especially vis-à-vis the United States. The Bank of Canada’s success in maintaining inflation near the mid-point of the target range has helped to anchor inflation expectations and reduce the likelihood of a loss in confidence in the Canadian dollar. At the same time, Canada’s experience since the inception of free trade with the United States in 1989 demonstrates that exchange rate fluctuations have not significantly impeded economic integration between the two countries.

24. Following the change in intervention policy in September 1998, Canada has not intervened unilaterally in the foreign exchange market. At that time, it was decided that the practice of intervening in a symmetrical fashion to ensure that there was sufficient liquidity in the market would be discontinued. Instead, intervention would be conducted on a discretionary basis in exceptional cases when the exchange rate was considered to be significantly out of line with its fundamental value and a substantial government presence in the market could influence market perceptions about the currency’s value. In such cases, intervention would be announced. In September 2000, the Bank of Canada joined the European Central Bank and other central banks for a concerted intervention in the foreign exchange market to bolster the value of the euro. Over the past year, the value of the Canadian dollar has been affected by the weakness in non-energy commodity prices and by the relative cyclical positions of Canada and its trade partners, especially the United States. The Bank’s internal models show that the value of the Canadian dollar is well in line with its fondamental determinants. With continued strong macroeconomic fundamentals and a projected current account surplus, the currency is expected to appreciate somewhat over the medium term.14

B. Fiscal Policy

25. In the October 2000 Economic Statement and Budget Update, the Government presented a “mini-budget” which expanded the income tax reductions of The Budget Plan 2000, introduced some modest new spending initiatives in the areas of education, research, and the environment, and further refined the approach to debt reduction. The reductions in personal and corporate taxes presented in The Budget Plan 2000 were accelerated and a specific schedule was set for lowering the basic federal corporate income tax rate. The authorities saw these reforms as a major step to boost incentives to work and invest. In particular, the reductions in tax rates on nonmanufacturing and on nonprocessing, nonresource corporations will help to promote the spread of new technologies and entrepreneurship and to enhance the competitiveness of Canadian firms. When the tax cuts are fully implemented in 2004, the combined federal-provincial corporate and capital gains tax rates would be below current U.S. rates. Despite the significant reductions enacted, personal income taxes in Canada would remain higher than in the United States. To some extent, this was seen as inevitable, reflecting Canada’s choice to provide a higher level of public services. In 2001/02, the tax cuts are estimated to amount to nearly $13½ billion, equivalent to about 1¼ percent of GDP.15

26. With regard to debt reduction, the authorities explained that the current practice of establishing each year a $3 billion contingency reserve in the budget will be continued and these funds will be used, in the absence of adverse economic shocks, to repay debt. In addition, the Minister of Finance will announce in each October budget update whether an additional amount should be dedicated to paying down debt, depending on the projected outcome for the current fiscal year. In 2000/01, a minimum of $10 billion (1 percent of GDP) will be targeted for debt repayment.

27. The authorities and the staff agreed that the federal government’s fiscal position remains sound over the medium term, even after full implementation of the measures enacted and proposed in the past year. Factoring in the impact of all measures legislated or proposed since The Budget Plan 2000, and after allowing for the $3 billion contingency reserve and an explicit factor for economic prudence to offset the effects of potentially less favorable economic conditions, the staff estimates that a surplus of about $2 billion would remain in 2000/01. Such “remaining surpluses” would range between $4–5 ½ billion (roughly ½ percent of GDP) over the medium term (Table 7).16 The staff commended the authorities for their pragmatic and sound fiscal policy framework and welcomed the new approach to debt reduction and the fiscal measures taken during 2000.17 The uncertainties in the near-term economic outlook underscored the wisdom of the authorities’ approach to budgeting and of their decision not to allocate all of the “planning surpluses” in prospect. In the event that economic developments are less favorable than envisaged, the staff believed that there was ample room to allow the automatic stabilizers to work to support the economy and latitude for discretionary action, if needed.

Table 7.

Canada: Medium-Term Projections for Federal Government Budget

(In billions of Canadian dollars)

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Source: Fund Staff estimates.

Projections for revenues in 2005/06 are staff estimates based on the average of private sector forecasts in the ESBU.

Based on the assumption that the contingency reserve is applied to debt reduction, except for 2000/01.

Annual, in percent.

28. The authorities and the staff also discussed what might he an appropriate longer-term objective for fiscal policy. The staff noted the difficulty in pinning down such an objective. In Canada’s context, with a relatively high government debt-to-GDP ratio, steady progress in reducing debt was appropriate, but economic theory did not offer concrete conclusions on how far or how fast the debt-to-GDP ratio should be brought down. The staff judged the authorities’ current fiscal policy framework as being a satisfactory and pragmatic approach. It allows for the debt-to-GDP ratio to steadily fall, while still providing sufficient flexibility for the automatic stabilizers to work to support the economy and some latitude for discretionary actions in difficult economic circumstances. Moreover, the Government in adopting its new debt reduction approach had decided to seize opportunities provided by favorable economic conditions to accelerate the pace of debt reduction. Consistent with this new approach, the staff recommended that, in the event that the medium-term fiscal outlook evolved as envisaged in the October 2000 Update, the bulk of any surplus funding realized each year be dedicated to reducing government debt.

29. Reforms to the Canada Pension Plan (CPP) introduced in late 1997put the plan on a sound financial footing, primarily through a phased increase in contributions (Box 4). The reforms also mandated the diversification of the CPP’s accumulated surplus into private assets in order to increase the plan’s rate of return. The CPP Investment Board is responsible for managing the plan’s new net cash flow, and started to invest these funds passively in equities (by replicating major market indexes) in early 1999. In February 2000, the Board was permitted to increase the share of foreign equities in its portfolio, and it was allowed to follow active investment strategies in domestic equities beginning in August 2000. The authorities did not foresee major risks to the CPP from a sharp correction in equity prices, as the exposure of CPP’s portfolio to stock market risk was still limited, accounting for only one-sixth of the total assets, and the CPP’s holdings were long term. The establishment of an independent CPP Investment Board was seen as sufficient to ensure that decisions on how to invest CPP assets were based on sound investment practices and not influenced by other considerations.

Reforms to the Canada Pension Plan

Canada is one of the few major industrial countries that has taken action to deal with the long-term financing problems of its public pension plan. By end-1996, the present value of unfunded liabilities of the Canada Pension Plan (CPP) were estimated to be $588 billion, equivalent to 70 percent of GDP. If the plan had continued on its basic pay-as-you-go basis, payroll taxes would have had to be increased even more substantially than the sizable increases that had been already been legislated to meet the plan’s obligations, as the rate would need to have increased from 5.6 percent in 1996 to 14¼ percent after 2015. To address the CPP long-term financing needs without such a sharp rise in payroll taxes, the Government decided in 1997 to partially prefund the plan’s future liabilities. This was in large part to be accomplished by accelerating payroll tax rate increases, with the rate rising to 9.9 percent by 2003 (instead of by 2015 under the previous legislation). As a result, the CPP is expected to build up assets equivalent to roughly one-fifth of its future liabilities by 2020, and these assets would be used subsequently to help meet benefit payments so that payroll tax rates will remain largely unchanged. In addition, a formal review of the financial condition of the CPP is required every three years.

Additional funding for the CPP was to be derived by investing a portion of the plan’s funds in private securities in order to raise its return on assets. The CPP Investment Board (CPPIB) was set up to manage the plan’s assets based solely on sound investment practices. Previously, CPP assets had been invested in federal and provincial government bonds at below market rates. Beginning in 1999, provinces were allowed a “one-time” roll over of their maturing borrowings from the CPP at market rates. In addition, the CPPIB started to invest the new net cash inflow in equities, following a passive investment strategy, whereby its holdings b