Canada: Staff Report for the 2002 Article IV Consultation
Author: International Monetary Fund
Publication Date:
12 Mar 2002
eISBN:
9781451806885
ISBN:
9781451806885
Language:
English
Keywords:
ISCR; CR; Core CPI inflation; Canada; report update; authority; core CPI; anti-bribery legislation; statistics Canada; core inflation; Canadian dollar; inflation targeting; Inflation; Global
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This 2002 Article IV Consultation highlights that the Canadian economy has slowed substantially since late 2000. The slowdown in large part has reflected the slowing in the United States economy, which has reduced growth in Canada’s exports and contributed to weakening private investment. In addition, consumption growth has moderated, owing to a slowing in real income growth, a softening in the employment situation, and an associated fall in consumer confidence. The slowing in economic activity in recent quarters has also led to a decline in resource utilization.

Abstract

This 2002 Article IV Consultation highlights that the Canadian economy has slowed substantially since late 2000. The slowdown in large part has reflected the slowing in the United States economy, which has reduced growth in Canada’s exports and contributed to weakening private investment. In addition, consumption growth has moderated, owing to a slowing in real income growth, a softening in the employment situation, and an associated fall in consumer confidence. The slowing in economic activity in recent quarters has also led to a decline in resource utilization.

I. Introduction1

1. At the time of the last Article IV consultation in March 2001, Executive Directors commended the authorities for maintaining sound macroeconomic and structural policies over most of the past decade, which had provided a solid foundation for sustained economic expansion and put the economy in a good position to cope with major economic shocks.2 Monetary policy had successfully maintained low inflation, helping to establish the credibility of the inflation targeting framework. Fiscal consolidation by all levels of government had brought budgets into surplus and led to a sharp reduction in government debt as a share of GDP in recent years. Important structural reforms, including improvements in the employment insurance system and financial regulatory framework, had helped enhance economic efficiency and further strengthen the financial system. Looking ahead, Directors judged that the major uncertainty facing Canadian policymakers was the depth and duration of the U.S. economic slowdown and its impact on Canada. They agreed that monetary policy should be the main instrument used in attempting to sustain the economic expansion. The automatic fiscal stabilizers also should be allowed to work.

2. The global economic outlook has darkened since the Article IV consultation last March, and especially since the September 11 terrorist attacks in the United States. Against this background, the 2002 Article IV consultation discussions focused on the main short-term policy challenges of how to provide sufficient support to the economy in the face of what is essentially a large external shock, while sustaining a macroeconomic framework consistent with medium-term growth objectives.3

II. Economic Developments and Outlook

A. Recent Economic Developments

3. Economic activity has slowed substantially since late 2000, in large part reflecting the U.S. downturn. After growing at an average annual rate of 4½ percent during the year through the third quarter of 2000, real GDP growth slowed thereafter, falling to an annualized rate of ½ percent in the second quarter of 2001, and GDP declined by ¾ percent in the third quarter (Table 1, Figure 1, and Box 1). The slowdown has been sharper than originally anticipated. Slower U.S. demand growth sapped net exports, with exports of machinery and equipment (led by telecommunications) declining during the first three quarters of 2001. Reduced U.S. demand also contributed to a contraction in private investment in late 2000 and early 2001, and the underlying momentum of this investment has remained weak subsequently, reflecting a draw down in inventories and lower investment in machinery and equipment in response to increasing excess capacity, particularly in the telecommunications sector. The decline in information technology investment since the third quarter of 2000 has reduced the annual rate of GDP growth by ¾ percentage point. Moreover, public investment has weakened and consumption growth has moderated, owing to a slowing in real income growth, a softening in the employment situation, and an associated fall in consumer confidence.

Table 1.

Canada: Selected Economic Indicators

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Sources: Statistics Canada; and Fund staff estimates.

Data for the 1960s-1970s are based on the old (unrevised) national accounts statistics.

Contribution to growth.

Constructed using 1989-91 trade weights.

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

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.

Figure 1.
Figure 1.

Canada: Output and Demand

(Annualized quarterly growth, in percent)

Citation: IMF Staff Country Reports 2002, 050; 10.5089/9781451806885.002.A001

4. Given its proximity and close integration with the United States, Canada has been heavily affected in the aftermath of the terrorist attacks. The immediate impact included the significant disruption of commercial traffic in the Canada-U.S. border area, a sharp decline in business confidence, and interruptions in activities such as air travel, tourism, and financial market trading.4 Moreover, the attacks have intensified the slowdown in U.S. activity that was already underway and added to the level of uncertainty regarding economic prospects. While the economic effects are hard to measure, the Bank of Canada estimates that the attacks may have reduced Canadian GDP growth by about 1 percentage point (at an annual rate) in both the third and fourth quarters of 2001, mainly reflecting production disruptions and confidence effects.5

Revisions to the National Income and Expenditure Accounts

In May 2001, the official Canadian national accounts statistics were revised to incorporate three key changes in methodology:

First, the former series for real GDP based on a fixed-weighted Laspeyres index was replaced by one based on a chain-weighted Fisher index. A Fisher index, which is a geometric average of Laspeyres and Paasche indices, is free of the biases inherent in fixed-weight series—especially the substitution bias—and is considered to provide more accurate measures of growth. Moreover, the use of fixed weights tends to overstate the level and growth of GDP when fast-growing sectors of the economy are experiencing sharp declines in relative prices. In Canada, like in the United States, the relative price of information technology has fallen since the mid-1980s, so that a shift to chain weights lowers GDP on this account.

Second, the national accounts were revised to include all software spending by organizations as investment; previously part of such software spending was treated as an intermediate good.

Third, while the previous real GDP series was expressed in 1992 prices, the revised series is re-based with 1997 as the reference year. This change contributes to raising measured GDP.

The overall impact of the revisions was to raise the level of measured real GDP significantly (e.g., by 9 percent in 2000). The change reflected mainly the re-basing from 1992 to 1997, which added to a small positive impact from the inclusion of software and more than offset a small negative impact from the shift to chain weights. Measured real GDP growth was reduced in 2000, when software price declines steepened, but was relatively unaffected in earlier years (see tabulation).

Canada: Real GDP Growth 1990-2000

(Annual percentage change)

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Chain weights. Software included.

Fixed weights. Software not included.

5. The current account surplus has continued to rise. In 2000, strong U.S. demand growth, together with some recovery in commodity prices, helped to raise the current account surplus to 2½ percent of GDP (Table 2). In 2001, a contraction in imports contributed to an increase in the trade surplus during the early part of the year. Subsequently, the current account surplus has declined somewhat as weaker U.S. demand growth and a moderation in commodity prices have dampened exports, but it still amounted to 3½ percent of GDP in the first three quarters of 2001. In the capital account, net direct investment inflows declined markedly (and turned negative) during the first three quarters of 2001. At the same time, there were sizable net portfolio outflows as net purchases of foreign stocks rose.

Table 2.

Canada: Balance of Payments

(In billions of Canadian dollars)

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Source: Statistics Canada.

First three quarters of the year at annual rates, current account flows have been seasonally adjusted.

Includes bank, nonbank, and official transactions other than reserve transactions.

6. Labor shortages have diminished appreciably since the beginning of the year. After falling to 6½ percent in June 2000 (its lowest level since the mid-1970s), the unemployment rate rose to about 7¼ percent in September 2000. It remained around that level before increasing to 7 percent in the period August-October 2001 and 7½ percent in November (Figure 2). The increases in unemployment have been broadly based across the country. Employment has been flat since May 2001, as losses in part-time jobs have broadly offset a small increase in full-time employment.

Figure 2.
Figure 2.

Canada: Unemployment

(In percent of labor force)

Citation: IMF Staff Country Reports 2002, 050; 10.5089/9781451806885.002.A001

1/ Staff estimate.

7. Other indicators also suggest that the slowing in economic activity in recent quarters has led to an easing of potential resource constraints. The actual level of GDP is estimated to have fallen from near potential during the latter half of 2000 to around 1½ percent below by the third quarter of 2001 (Figure 3).6 The index of capacity utilization for the nonfarm goods-producing sector shows a similar pattern of declining resource utilization (Figure 4). Although rising very rapidly between mid-1999 and mid-2000, capacity utilization fell sharply over the five quarters to the third quarter of 2001, largely reflecting a downturn in the manufacturing sector.

Figure 3.
Figure 3.

Canada: Employment and Output Gaps

(In percent, staff estimates)

Citation: IMF Staff Country Reports 2002, 050; 10.5089/9781451806885.002.A001

Figure 4.
Figure 4.

Canada: Capacity Utilization Ratio

Citation: IMF Staff Country Reports 2002, 050; 10.5089/9781451806885.002.A001

8. Labor productivity declined in the fourth quarter of 2000 and first quarter of 2001, before rising by 2 percent at an annual rate during the second and third quarters. During the period 1997-2000, labor productivity in the business sector in Canada rose by 2.2 percent annually, 0.4 percentage point below its U.S. growth rate but stronger than in other G-7 countries such as France, Italy, and Japan.7 The differential with the United States has largely reflected slower productivity growth in Canadian manufacturing, in part because of the smaller size (relative to the United States) of the information technology sector, where productivity gains have been especially strong (Figure 5).8

Figure 5.
Figure 5.

International Comparison: Labor Productivity Growth in Business and Manufacturing Sectors

(Annual average, in percent, 1997-2000)

Citation: IMF Staff Country Reports 2002, 050; 10.5089/9781451806885.002.A001

9. Inflationary pressures have subsided with the slowing in economic activity and easing of capacity constraints. During the latter half of 2000, when the economy seemed to be operating near full capacity, core inflation moved up toward the mid-point of the Bank of Canada’s 1-3 percent target range (Figure 6).9 By the second quarter of 2001, with growth slowing and capacity use slackening, core inflation stabilized at slightly above the 2 percent mid-point and remained at that level in subsequent months before falling to 1 percent in November. Headline inflation, which had moved above the target range during the second quarter due to rising energy prices, fell to ¾ percent in November. Labor compensation per person hour and unit labor costs picked up moderately, rising at annual rates of 4 percent and 2¾ percent, respectively, during the first three quarters of 2001, compared to increases of 3½ percent and 2¼ percent in 2000.

Figure 6.
Figure 6.

Canada: CPI Inflation

(Percentage change, same month previous year)

Citation: IMF Staff Country Reports 2002, 050; 10.5089/9781451806885.002.A001

10. In response to the sharper-than-expected slowing in the economy, the Bank of Canada has lowered its target for the overnight rate by 350 basis points since the beginning of 2001 to 2¼ percent at present. It was initially expected that Canada would experience a moderate slowdown, with the downturn in Canadian growth being milder than in the United States, owing in part to the reduction in Canadian income tax rates at the beginning of the year and a smaller negative impact from the shakeout in the technology sector. In August 2001, against the background of lackluster growth in the second quarter and signs of further weakening in the United States and other parts of the world, the Bank of Canada stepped up the pace of interest rate reductions. In September, in an unscheduled move following the terrorist attacks in the United States, the Bank of Canada lowered its target overnight rate by 50 basis points, in tandem with the Federal Reserve, amid heightened concerns about consumer and business confidence. Then, at its scheduled monetary policy announcement dates on October 23 and November 27, the Bank of Canada further lowered its target rate by 75 basis points and 50 basis points, respectively. The spread between Canadian and U.S. short- and long-term interest rates has returned to positive levels, in part reflecting the differences in the timing and magnitude of the interest rate cuts in the two countries (Figure 7).

Figure 7.
Figure 7.

Canada: Interest Rate Differentials

(In percentage points, Canada minus the United States)

Citation: IMF Staff Country Reports 2002, 050; 10.5089/9781451806885.002.A001

11. The Canadian dollar weakened through late 2001. After peaking at 67 U.S. cents at the beginning of 2001, the Canadian dollar moved erratically until mid-2001. Since that time, the currency has depreciated, trading at an all-time low below 63 cents in early November. The real effective value of the Canadian dollar has experienced a trend decline, falling at an average annual rate of 3 percent between its previous peak in June 1991 and December 2000, and it depreciated by a further 1½ percent through November 2001 (Figure 8). The real effective depreciation of the Canadian dollar has primarily reflected the trend decline in non-oil commodity prices, but it also appears to have been influenced in recent years by relatively faster labor productivity growth in the United States than in Canada.10

Figure 8.
Figure 8.

Canada: Bilateral and Real Effective Exchange Rates

(Index 1990-100)

Citation: IMF Staff Country Reports 2002, 050; 10.5089/9781451806885.002.A001

12. The authorities’ commitment to promoting fiscal discipline has been reflected in a substantial turnaround in the budget balance since 1993. The federal fiscal position shifted from a deficit of 5¾ percent of GDP in 1993/94 to a surplus of more than 1½ percent in 2000/01 (public accounts basis; Table 3 and Figure 9).11 Cuts in program spending accounted for over two-thirds of this improvement. In its February 2000 Budget, the Government presented a plan for reducing personal and corporate income taxes over a five-year period, as well as modest new spending initiatives in health, education, public infrastructure, and the environment. Subsequently, the Government in its October 2000 Economic Statement and Budget Update expanded these tax reductions and advanced their timing, and it introduced some additional spending initiatives.12 The strong fiscal performance has translated into a substantial reduction in net federal government debt, which fell from a peak of over 70 percent of GDP in 1995/96 to 52 percent in 2000/01 (Figure 10).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 starts on April 1.

Figure 9.
Figure 9.

Canada: Federal Fiscal Policy Indicators

(In percent of GDP)

Citation: IMF Staff Country Reports 2002, 050; 10.5089/9781451806885.002.A001

Figure 10.
Figure 10.

Canada: Federal Government Net Public Debt

(Public accounts basis; in percent of GDP)

Citation: IMF Staff Country Reports 2002, 050; 10.5089/9781451806885.002.A001

13. Provincial governments also have strengthened their finances in recent years, contributing to an improvement in the general government balance from a deficit of 6 percent of GDP in 1994 to a surplus of 3 percent of GDP in 2000 (national accounts basis). Buoyant tax revenue and spending restraint have contributed to the improvement in the aggregate fiscal position of the provinces, which, after 30 years of continuous deficits, moved into slight surplus in 1999 and to a surplus of 1 percent of GDP in 2000.14 In 2000, rising energy prices benefited Alberta, which accounted for nearly half of the aggregate provincial surplus. In their budgets for 2001/02, many provinces indicated a continued commitment to tax reduction and modest spending initiatives, while further reducing provincial debt. With the slowdown in economic activity, however, the “balanced budget” legislation that eight out of ten provinces have in place limits the scope for tax reduction and spending initiatives in the near term. The improvement in federal and provincial fiscal positions has reduced the ratio of general government net debt to GDP from 87 percent in 1994 to 66 percent in 2000 (Figure 11 and Table 4). However, the ratio of net debt to GDP in Canada remains above the average for G-7 countries (Table 5).

Figure 11.
Figure 11.

Canada: General Government Net Debt

(National accounts basis; in percent of GDP)

Citation: IMF Staff Country Reports 2002, 050; 10.5089/9781451806885.002.A001

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.

Canada 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.

Table 5.

Canada: Indicators of Economic Performance

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Source: Fund staff estimates. Projections for 0-7 countries except for Canada and the United Slates are from the World Economic Outlook (December 2001).

Germanys net debt starts in 1986.

14. Fiscal consolidation since the early 1990s has helped raise the ratio of gross national saving to GDP, substantially reducing reliance on foreign saving. The rise in the government saving rate, together with a rise in corporate saving, has offset a decline in personal saving. The ratio of gross domestic investment to GDP in nominal terms has risen since the mid-1990s but remains below its average during previous decades. In real terms, however, gross private investment is substantially higher than its historic average reflecting the fall in the price of capital equipment, which has declined to lower levels in Canada than in other G-7 countries (except the United States) in recent years (Figure 12).

Figure 12.
Figure 12.

International Comparison: Relative Cost of Capital

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

Citation: IMF Staff Country Reports 2002, 050; 10.5089/9781451806885.002.A001

15. Personal and corporate sector balance sheets have remained generally sound thus far despite the weakening in economic activity and a drop in the stock market. A continued sell-off in the telecommunications sector has contributed to a 30 percent decline in the Toronto Stock Exchange (TSE) 300 Index since its peak in 2000, contributing to a decline in personal sector net worth as a percent of disposable income. Personal sector debt remained at over 110 percent of disposable income in 2000, reflecting high mortgage borrowing as interest rates remained low, and the debt ratio rose further in the first half of 2001 (Table 6 and Figure 13). However, the ratio of personal debt service to disposable income has not increased appreciably as interest rates have declined. In the corporate sector, business bankruptcies have increased moderately relative to a year ago, chiefly concentrated in the automobile, telecommunications, and utilities sectors.15 In the period since May 2001, the deterioration in the economic outlook and the increase in uncertainty, particularly after the September terrorist attacks, have contributed to a tightening in credit conditions for businesses, reflected in an increase in the yield spreads on corporate over government debt. The growth of business credit has, nonetheless, picked up in recent months, in part reflecting firms’ increased demand for additional liquidity during a period of heightened economic uncertainty. This, along with slower growth in corporate profits, has arrested the decline in the debt of nonfinancial corporations as a ratio to GDP and in the debt-to-equity ratio (Figure 14).

Table 6.

Canada: Personal and Corporate Financial Indicators

(In percent unless otherwise indicated)

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Sources: Statistics Canada; and Fund staff estimates.

Data for 2001 are constructed using quarterly flows through the third quarter.

Persons and unincorporated business.

Comprises interest payments on mortgage and other types of consumer credit/bank loans. The five-year average residential mortgage rate and bank rate on consumer loans were used to calculate interest payments on mortgage and other consumer credit/bank loans, respectively.

Based on total debt less trade payables, corporate claims, and other liabilities.

The prime business loan rate is used to compute business credit interest payments.

For 2001, the 12-month percent change for July is reported.

Figure 13.
Figure 13.

Canada: Personal Sector Net Worth and Debt

(In percent of disposable income) 1/

Citation: IMF Staff Country Reports 2002, 050; 10.5089/9781451806885.002.A001

1/ Data for 2001 are constructed using quarterly flows for the first three quarters.
Figure 14.
Figure 14.

Canada: Debt of Nonfinancial Corporations 1/

(In percent of GDP unless otherwise indicated)

Citation: IMF Staff Country Reports 2002, 050; 10.5089/9781451806885.002.A001

1/ Data for 2001 are constructed using quarterly flows for the first three quarters.

16. Canadian financial institutions have been affected by the slowing in economic activity, but their overall capitalization and profitability remain high.16 Major loan problems have not emerged, despite difficulties in some sectors, mainly because banks have been well diversified and provisioned. Banks’ impaired loans rose from 1 percent of gross loans in 2000 to 1½ percent in the third quarter of 2001, reflecting developments in some domestic industrial sectors as well as in the U.S. economy.17 Banks have responded by increasing loan-loss provisions; provisions for the first three quarters of 2001 were about 50 percent higher than in the same period of 2000. Banks personal and commercial business lines have continued to provide a stable source of earnings growth, allowing the major banks return on total equity to remain relatively robust at 15¼ percent (annual rate) through the third quarter of 2001 (Figure 15). The banks total capital adequacy ratio rose to 12½ percent in the third quarter of 2001, well above the Office of the Superintendent of Financial Institutions (OSFI) benchmark of 10 percent. Earnings growth has also declined among insurance companies and other nonbank financial institutions, but these institutions too remain well capitalized and have not encountered major difficulties.

Figure 15.
Figure 15.

Canada: Chartered Banks: Return on Total Shareholders Equity

(In percent) 1/

Citation: IMF Staff Country Reports 2002, 050; 10.5089/9781451806885.002.A001

1/ Based on data reported by sin largest Canadian banks representing about 90 percent of all chartered banks assets in Canada as of third quarter of 2001.

B. The Outlook

17. Economic activity in both Canada and the United States is expected to turn around starting in the first half of 2002 and gather pace during the year. Losses of output in the financial, transport, and tourism sectors, combined with the effects of declining consumer and business confidence on domestic demand are likely to contribute to a further decline in Canadian GDP during the fourth quarter of 2001. However, the substantial easing of monetary conditions in Canada, support from the tax cuts enacted in 2000 and from the working of the automatic fiscal stabilizers, and a recovery in U.S. growth are expected to contribute to a turnaround in the Canadian economy in early 2002 and a strengthening expansion during the remainder of the year and into 2003. On this basis, the staff’s near-term outlook foresees GDP growth of 1½ percent in 2001, ¾ percent in 2002, and 3½ percent in 2003 (Table 7). Core inflation would fall to the lower end of the 1-3 percent target range in the near term, reflecting increased slack in the economy, and it would move back toward the middle of the range as the economy recovers.

Table 7.

Canada: Staff Projections

(In percent change from previous period; unless otherwise indicated)

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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, aimed at reducing taxes and introducing new spending initiatives, are implemented such that the federal government would maintain budget surpluses equivalent to the contingency reserve in the budget. The consolidated fiscal projection for the provinces is assumed to be consistent with their stated medium-term targets.

In billions of Canadian dollars.

For fiscal years, which start on April 1.

Includes local governments and hospitals.

18. During the rest of the medium-term forecast period through 2006, the staff envisages that GDP would grow faster than potential, with the output gap being closed by the end of the period. Unemployment would rise to a peak of 8 percent in 2002, before declining over the medium term to 6½ percent. The current account surplus as a percent of GDP would decline gradually as domestic activity picks up.

19. The main risk to the short-term outlook arises from developments in the United States (Box 2). In a worse-case scenario, a prolonged dip in U.S. consumer and business confidence would contribute to a substantial loss in private domestic demand in the United States, with knock-on effects on labor markets and second-round effects on investment and consumption that would be only partially offset by increased expenditure for reconstruction, government assistance, and defense. In this scenario, U.S. GDP would decline by ½ percent in 2002 before recovering in 2003. The effects on Canada would be felt mainly through the trade channel, and would be roughly similar to the decline in growth in the United States, assuming that the bilateral exchange rate is largely unchanged. In these circumstances, Canadian GDP growth would fall to around zero in 2002 before rising to 2¼ percent in 2003. The effects on GDP in Canada, however, could be cushioned to some extent by a depreciation in the Canadian dollar that would accompany a softening in commodity prices that might be associated with a further significant U.S. downturn.

Canada-U.S. Economic Integration

During the 1980s and 1990s, the Canadian economy dramatically increased its exposure to the U.S. economy, primarily through greater trade integration (see tabulation). In 2000, 80 percent of Canadian merchandise trade was with the United States, up from 61 percent in 1980.1 Even within the European Union and the euro-zone economies, trade is less integrated, despite economic and monetary union. Asian integration is even less pronounced, since a much larger share of Asian trade is with the United States.

Direct financial flows between the United States and Canada are more limited. In the balance of payments data, financial flows to and from the United States account for 54 percent of total Canadian financial flows. This statistic, however, may understate the financial linkages between the two countries. Canadian financial institutions have a sizable presence in the United States through their affiliates, and U.S. financial institutions likewise through their affiliates have a significant presence in Canada. More generally, direct investment is an important channel that ties the two economies together. The U.S. share in Canada’s direct investment abroad is over 40 percent, equivalent to 12 percent of Canadian GDP, and U.S. direct investment in Canada accounts for approximately two-thirds of total foreign investment in Canada and is equivalent to 18 percent of Canadian GDP.

Close trade and financial integration have implied a strong correlation between economic developments in the two countries, with the correlation coefficients for Canada-U.S. equity price changes and real GDP growth during 1982-2000 being 0.71 and 0.88, respectively (see figures).

Trade and Financial Linkages, 2000

(in percent)

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Source: IMF DOTS and IFS, U.S. Bureau of Economic Analysis, Statistics Canada, and staff calculations. Trade data refer to merchandise trade.

Includes Greece.

Regional Asian trade includes Japan, Australia, New Zealand, and emerging Asian economies.

uA01fig01

Canadian and U.S. Equity Market Performance

(y/y percent change)

Citation: IMF Staff Country Reports 2002, 050; 10.5089/9781451806885.002.A001

uA01fig02

Canadian and U.S. Real GDP Growth

(y/y percent change)

Citation: IMF Staff Country Reports 2002, 050; 10.5089/9781451806885.002.A001

1U.S. trade shares in earlier years from V. Arora and A. Vamvakidis, “The Impact of U.S. Economic Growth on the Rest of the World: How Much Does It Matter?” IMF WP 01/119, 2001.

20. The Canadian authorities and private sector analysts shared the staff’s view that the Canadian and U.S. economies were likely to recover from their present weakness in the course of 2002, while acknowledging the unusually large degree of uncertainty in the economic outlook. They were generally more optimistic about the pace of the recovery than the staff, but expressed particular concerns about security-related problems that have adversely affected movements of goods across the U.S.-Canadian border.18 Resolution of these problems was seen as vital for ensuring the near-term recovery of the Canadian economy and its long-term health, owing to the negative implications border traffic disruptions could have on future investment in Canadian plants to produce for the North American market.

III. Policy Discussions

21. In the context of the current economic slowdown and global uncertainty, the discussions focused on near-term economic prospects and policies.

  • The need for additional monetary actions. With inflationary pressures likely to remain subdued, the authorities and the staff agreed that monetary policy should be the main instrument used in attempting to limit the impact of the present downturn and that there remains scope for further easing to support economic activity should economic weakness persist.

  • The fiscal policy actions that should be taken in response to the slowdown. With fiscal stimulus already being provided through the automatic stabilizers, the key issue was whether to provide additional discretionary stimulus in the budget that was to be released on December 10. The authorities felt that, beyond spending initiatives to meet national security needs, further discretionary action could undermine the hard-won credibility of the Government’s medium-term commitment to continue lowering public debt.

22. The discussions also covered a number of issues affecting the medium-term evolution of the Canadian economy, including:

  • Fiscal consequences for the federal and provincial governments stemming from the aging of the population, with particular attention being paid to health care costs.

  • The need to further improve the flexibility and efficiency of the labor market in Canada, particularly through additional reforms to the Employment Insurance (EI) system.

  • Further steps to liberalize international trade, particularly the removal of barriers to trade in agricultural, textile, clothing, and footwear products.

A. Monetary Policy and the Exchange Rate

23. The authorities and the staff agreed that monetary policy should be the main instrument used in attempting to limit the impact of the downturn and to speed the recovery of the economy. Although lags in the effects of policy changes on economic activity are potentially long and variable, monetary policy was seen as being able to respond more quickly and flexibly to developments in the economic situation. At this point, the authorities expected resource utilization to continue to slacken until the economy picked up strength in the latter part of 2002. Accordingly, both core and overall inflation are expected to remain below the mid-point of the 1-3 percent official target range throughout 2002 and into 2003. These circumstances afford considerable scope for monetary policy to provide support for economic activity, in the context of Canada’s forward-looking inflation-targeting framework. The authorities noted that they had acted aggressively to cut rates rapidly after September 11, and with the high level of uncertainty prevailing, they emphasized that they remained ready to ease policy further should prospects remain weak. The Bank of Canada moved at its regular November 27 announcement date, after the mission, to reduce its target for the overnight rate by an additional 50 basis points.

24. The Governor of the Bank of Canada and the Finance Minister announced in May 2001 that the 1-3 percent inflation target range would be extended beyond its scheduled expiration in 2001 to the end of 2006. At the same time, several refinements to the inflation-targeting framework were introduced to strengthen its implementation and effectiveness (Box 3).19 The staff welcomed these changes, which will enhance the conduct of monetary policy by further improving transparency, accountability, and communications with the public. The staff also noted the apparent success of the Bank of Canada’s shift to a schedule of regular monetary policy announcements, introduced in late 2000. The authorities said that the announcement dates have made it easier for the Bank to operate monetary policy to reflect economic conditions in Canada and more independently of policy actions in the United States. Only on one occasion (following the September 11 terrorist attacks) did the Bank take a policy action between announcement dates, and this was clearly seen as involving extraordinary circumstances. Financial market participants told the staff that the fixed schedule of monetary policy announcement dates had helped reduce market uncertainty and volatility; they were generally supportive of the new regime.

Inflation Targeting and Monetary Policy Announcements

Inflation targeting has been the cornerstone of monetary policy in Canada over the last decade. The Bank of Canada seeks to maintain inflation around the mid-point of its target range. Using the overnight rate as its instrument, the Bank targets inflation over a 6 to 8 quarter horizon. Inflation targeting has made monetary policy actions more readily understandable to financial markets and the public, and provided a clear benchmark for evaluating the effectiveness of monetary policy.

Since the inception of inflation targeting in 1991, three reviews have been conducted by the Minister of Finance, on behalf of the Government, and the Governor of the Bank of Canada. At the last review (May 2001), the 1-3 percent inflation target range was renewed through the end of 2006, and several refinements were introduced to increase transparency and accountability. It was reaffirmed that monetary policy will continue to aim at keeping inflation near the 2 percent mid-point of the target range. The Bank, however, is not indifferent between inflation rates within the target range and would react with increasing force if inflation were expected to depart from the mid-point. To increase transparency and accountability, the Bank announced that its Monetary Policy Reports and Updates will pay special attention to explaining the sources of any deviations of actual inflation from the 2 percent target mid-point, the policy actions to bring inflation back in line, and the time horizon over which inflation would return to the mid-point.

Although overall CPI inflation is the objective of the target, the Bank uses core inflation as an operational guide. In the last review, the Bank redefined the core measure to better reflect trend inflationary pressures, excluding from the CPI the eight most volatile items and the direct effect of changes in indirect taxes.1 The Bank has indicated that if the core and overall measures of inflation were to depart from each other for a prolonged period, the Bank would adjust policies and practices to attempt to ensure that overall inflation was at the mid-point of the target range.

In an effort to reduce uncertainty in financial markets and increase the focus of public attention on domestic economic conditions as the key factor in making monetary policy decisions, the Bank of Canada in December 2000 established a fixed schedule for announcements on policy decisions. The Bank retains the option to change policy any time between the fixed dates, although this discretion is intended to 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.2

1The components of the CPI excluded from the new core measure are: fruit, vegetables, gasoline, fuel oil, natural gas, inter-city transportation, tobacco, and mortgage-interest costs. Previously, the core inflation measure excluded food and energy items and the effects of changes in indirect taxes.2When a change in policy was anticipated, the money market would tend to stop operating for a short period in the morning around 9 a.m., the time that the Bank would usually intervene if it intended to change interest rates.

25. Despite concerns in some quarters over the recent fall in the Canadian dollars value, the authorities and the staff agreed that Canada’s flexible exchange rate has continued to serve the country well. The recent depreciation of the currency primarily reflected cyclical conditions, particularly in commodity markets, and was helping to cushion Canada against the impact of the global downturn. The Bank of Canada’s success in maintaining inflation near the mid-point of the target range has helped to anchor inflation expectations, allowing it to take monetary policy actions without large repercussions on the currency. Following the change in intervention policy in September 1998, Canada has not intervened unilaterally in the foreign exchange market. Market intervention is restricted to exceptional cases when the exchange rate is considered to be significantly misaligned and the Government’s presence in the market is judged as being able to influence market perceptions about the currency’s fundamental value.20

26. Over the medium term, Canada’s strong macroeconomic fundamentals should support the value of the currency. Nevertheless, the exchange rate will continue to be influenced significantly by movements in non-energy commodity prices.21 A possible monetary union with the United States at some future stage remains an issue receiving some attention in the business and financial community, with proponents emphasizing the gains from a common currency and the political economy argument that a fixed exchange rate may foster greater harmonization of standards and regulations across the two countries, facilitating even closer economic integration. However, staff agreed with officials that the present flexible exchange rate regime has continued to provide a valuable degree of freedom for short-term macroeconomic management.22

B. Fiscal Policy

27. The Minister of Finance presented the 2001 Budget Plan on December 10.23 The Budget, which covers the remainder of 2001/02 and 2002/03-2003/04, seeks to support economic activity while preserving the authorities framework of medium-term fiscal discipline (Table 8). New initiatives amount to $7 billion during 2001/02-2003/04 (¼ percent of cumulative GDP), mainly to strengthen national security as well as raise spending in other priority areas, such as skills, infrastructure, and official development assistance (ODA). The budget is expected to be roughly in balance in 2001/02-2003/04, compared to a surplus of more than 1½ percent of GDP in 2000/01. Most of the reduction in the surplus in 2001/02 reflects the effects of tax and expenditure measures enacted prior to the 2001 Budget. Any surplus that materializes in 2001/02 would be dedicated to two new funds for financing infrastructure projects and for providing aid to promote sustainable development in Africa.24 The Government also strongly signaled its intention to continue with debt reduction in the medium term. The staff’s estimates of the budget balance are roughly consistent with the authorities estimates during 2001/02-2003/04 and suggest that there could be small planning surpluses after 2004/05 (Table 9).

Table 8.

Canada: Federal Government 2001 Budget

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Source: Department of Finance Canada The Budget Plan 2001.

Based on the assumption in the Budget that there is no incremental debt paydown during 2001/02-2003/04.

Table 9.

Canada: Medium-Term Federal Government Budget

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Sources: Department of Finance Canada The Budget Plan 2001; and Fund staff estimates.

The staff assumes that the contingency reserve and economic prudence are restored to their pre-2001-Budget levels after 2003/04.

Based on the staff’s assumption that, starting 2004/05, the contingency reserve is applied to debt reduction.

This consists of the contingency reserve and economic prudence factor plus the remaining balance.

In percent of potential GDP.

For calendar years, in percent.