Canada: Staff Report for the 2003 Article IV Consultation
Author: International Monetary Fund
Publication Date:
25 Feb 2003
eISBN:
9781451806892
Language:
English
Keywords:
ISCR; CR; headline CPI inflation; inflation expectation; report update; core inflation; hike; contingency reserve; debt service; labor market; output gap; structural unemployment; Global
Download PDF (2.1 MB)

This 2003 Article IV Consultation highlights that Canada’s strong policy framework has brought impressive economic results, and the Canadian economy has proven exceptionally resilient in the face of the recent global downturn. Economic activity slowed relatively modestly in 2001, with only one quarter of output decline recorded, and growth recovered strongly thereafter, averaging 4 percent over the subsequent four quarters. Household consumption and residential investment have remained robust. Household and business demand was supported by sustained productivity growth, rapid growth of employment and labor incomes, and gains in real estate prices.

Abstract

This 2003 Article IV Consultation highlights that Canada’s strong policy framework has brought impressive economic results, and the Canadian economy has proven exceptionally resilient in the face of the recent global downturn. Economic activity slowed relatively modestly in 2001, with only one quarter of output decline recorded, and growth recovered strongly thereafter, averaging 4 percent over the subsequent four quarters. Household consumption and residential investment have remained robust. Household and business demand was supported by sustained productivity growth, rapid growth of employment and labor incomes, and gains in real estate prices.

I. Introduction

1. Canada’s strong policy framework has brought impressive results. Beginning in the early 1990s, provincial and federal governments undertook major fiscal reforms that moved the general government balance from a deficit of 9 percent of GDP to a surplus of 3 percent of GDP in 2000. During the same period, in order to cement the authorities’ commitment to price stability and policy transparency, inflation targets were established, providing an effective framework for responding to cyclical developments. A broad range of structural reforms was also introduced aimed at boosting productivity growth and ensuring financial stability, including: reforms of the public pension system; trade liberalization in the context of the North American Free Trade Agreement; tax reforms; an overhaul of the unemployment insurance system; and financial sector liberalization. The strength of policy implementation has been recognized by the Fund in the context of Article IV consultations since the mid-1990s (Appendix I), and has helped yield the fastest growth among the major industrial countries over the past five years.

2. Indeed, the Canadian economy has proven exceptionally resilient in the face of the recent global slowdown. Real GDP growth in 2001 slowed only modestly, and the subsequent recovery has been more robust than in the United States and other G7 countries. Notwithstanding weaker activity domestically and abroad, the combined federal and provincial governments will still register a sizable surplus in 2002, and the external current account surplus remained large. Looking forward, the prospects are for continued favorable macroeconomic performance.

3. Nonetheless, a number of policy challenges remain, which were the main focus for the consultation discussions. These included:

  • Uncertainties surrounding the near-term outlook—Monetary policy will need to continue to carefully balance the downside risks to recovery against signs that economic slack is being taken up.

  • Longer-term demographic pressures—It will be important to sustain public debt reduction and to reform health care systems, in order to prepare for the fiscal consequences of population aging.

  • Structural and other reforms—Measures to improve labor market flexibility, to further liberalize trade, and to strengthen capital markets would help boost the economy’s long-term potential and meet the challenge of an aging population.

II. Recent Economic Developments

4. The Canadian economy slowed relatively modestly in 2001 in the face of the recent global slowdown, and has recovered strongly in 2002 (Box 1). Real GDP declined in only one quarter—falling by ½ percent (annual rate) in 2001Q3—and growth averaged 4 percent over the subsequent four quarters (Figure 1, Tables 1 and 2). The economy’s strength compared with the United States—Canada’s major trading partner—has reflected a number of factors: a relatively modest investment boom prior to the downturn and the smaller size of the information and communication technology (ICT) sector; robust consumer spending in response to sustained growth in labor income and employment; a depreciated Canadian dollar, which boosted competitiveness and spurred net exports; and timely monetary and fiscal stimulus.

Figure 1.
Figure 1.

Real Output and Domestic Demand

(Annualized quarterly growth, in percent)

Citation: IMF Staff Country Reports 2003, 033; 10.5089/9781451806892.002.A001

Table 1.

Canada: Selected Economic Indicators

(Unless otherwise indicated in percent change at annual rates)

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Sources: Statistics Canada; and Fund staff estimates.

Contribution to growth.

For quarterly data, year-on-year percent change.

For quarterly data, quarter-on-quarter percent change.

Includes local governments and hospitals.

Table 2.

Canada: Indicators of Economic Performance

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Source: Fund staff estimates. Projections for G-7 countries except Canada are from the World Economic Outlook (September 2002).

Comparing the Canadian and U.S. Business Cycles

Canadian and U.S. GDP growth rates have been closely correlated in recent years, reflecting the close integration of the U.S. and Canadian economies. Around 85 percent of Canada’s merchandise trade is with the United States. However, the Canadian economy performed surprisingly better than the United States in the most recent downturn, experiencing a shallower downturn and a stronger recovery. Several factors help explain these developments:

uA01fig01

Real GDP Growth, Canada and United States

(year-on-year percentage changes)

Citation: IMF Staff Country Reports 2003, 033; 10.5089/9781451806892.002.A001

  • Canada exhibited a more modest hi-tech investment boom and bust. With the lower share of the ICT sector in its economy, Canada has suffered less from the problem of excess capacity in ICT sectors than the United States.

  • The Canadian economy did not reach the same level of excess demand. Although the Canadian economy exceeded its estimated potential in 2000, the output gap was smaller and shorter-lived than in the United States.

  • Net foreign demand provided support in the downturn. Net exports from Canada continued to provide a positive contribution to GDP growth throughout the downturn, reflecting the effects of the weaker Canadian dollar, recoveries in Asia, and strong household demand from the United States. By contrast, net exports represented a drag on U.S. growth, partly in response to the strong U.S. dollar.

To what extent can Canada continue to outpace the United States, given the historical strength of trade and financial ties? The tabulation at the right illustrates the close correlation between both the real and financial sectors of the two economies. Not only does U.S. GDP growth tend to lead Canadian GDP growth, but the U.S. stock market, yield curve, and credit spread also tend to lead similar financial variables in Canada. Given the importance of these financial variables as indicators for Canadian GDP growth, the recent deterioration of U.S. financial markets suggests a risk for the Canadian economy going forward.

Canada-U.S. Cross Correlation 1/

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Correlations are for quarterly data covering the period 1981:Q1–2002;Q3. The first column includes the correlation between real GDP growth in the United States and Canada, the second column contains correlations between Canada-U.S. stock market returns, etc. Real GDP change and real equity returns are in quarter-on-quarter percent. The yield curve and corporate bond spreads are in basis points.

5. As in many other countries, business investment and inventory adjustments led the slowdown and subsequent recovery. Business investment, which had picked up in the latter half of the 1990s, especially in computer and related equipment, slowed sharply in early 2000 and subsequently declined through to end-2001. The inventory-sales ratio had also risen above trend by mid-2000, and destocking acted as a considerable drag on activity in the latter half of 2000 and in 2001 as a whole (Figure 2). In the first three quarters of 2002, however, inventory adjustments had been largely completed and business fixed investment rebounded strongly in response to lower interest rates, improved profits, and relatively comfortable corporate balance sheets (Table 3).1

Figure 2.
Figure 2.

Inventory-to-Sales Ratio

(In percent)

Citation: IMF Staff Country Reports 2003, 033; 10.5089/9781451806892.002.A001

Table 3.

Canada: Vulnerability Indicators

(In percent of GDP, unless otherwise indicated)

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Sources: Bank of Canada; BankScope; Canadian Bankers Association; Department of Finance Canada; Statistics Canada; and Fund staff estimates.

Unless otherwise indicated data are as of third quarter of 2002. Balance of payments data have been seasonally adjusted at annual rates. Personal sector indicators are staff estimates based on quarterly flows.

Defined as Government of Canada securities held by nonresidents.

Income payments on foreign-owned assets (other private payments plus Canada government payments).

Unless otherwise indicated, based on data reported by the six largest chartered Canadian banks.

Data are for all chartered Canadian banks as of second quarter of 2002.

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.

6. Household consumption and residential investment have remained relatively robust. Consumption growth eased to average 2¾ percent in 2000 and 2001, and continued at a solid pace during the first three quarters of 2002, despite decelerating in the third quarter. Residential construction—which had been stagnant during the mid-1990s—began to strengthen in 2000 in response to lower interest rates and pent-up demand, and accelerated further in late 2001 and into 2002. Gains in real estate prices helped mitigate the impact of stock market declines on household net worth—which remained high at 484 percent of disposable income (Table 3).

7. Favorable labor market conditions and productivity growth have helped to support household and business demand (Figure 3). Employment rose by 2¼ percent during the first 11 months of 2002, after remaining broadly unchanged during 2001, and average weekly earnings also registered strong gains. However, the unemployment rate—which had fallen to a three-decade low of 6¾ percent in mid-2000—rose to 8 percent by December 2001 and remained at 7½ percent in November 2002, as a sharp increase in the participation rate helped offset the rapid employment growth. With labor productivity growth outstripping increases in labor compensation, unit labor costs fell during the four quarters ending in 2002 Q3 and profits have rebounded strongly.

Figure 3.
Figure 3.

Labor Market Indicators

Citation: IMF Staff Country Reports 2003, 033; 10.5089/9781451806892.002.A001

1 Staff estimate.

8. Net external demand also remained supportive in 2001, but less so in 2002 (Figure 4). Although export volumes fell sharply in 2001, the reduction was more than offset by the decline in imports, particularly for industrial goods and machinery. Exports began to recover in early 2002, but the increase was again more than matched by a rebound in imports, in this case reflecting imports of both consumer and investment goods. Thus, the current account surplus fell to under 2 percent in the first three quarters of 2002, from 2¾ percent of GDP in 2001, despite an improvement in the terms of trade as world commodity prices firmed (Table 3). Nonetheless, continued surpluses have brought Canada’s net foreign liability position to just under 19 percent of GDP by end-2001, half the level of the mid-1990s.

Figure 4.
Figure 4.

External Indicators

Citation: IMF Staff Country Reports 2003, 033; 10.5089/9781451806892.002.A001

9. Fiscal policy cushioned the effects of the slowdown, through the working of the automatic stabilizers, as well as some discretionary measures (Figure 5 and Table 5). The federal fiscal surplus (public accounts basis) fell from 1¾ percent of GDP in FY 2000/01 to over ¾ percent of GDP in FY 2001/02 (the budget year begins April 1). A large component of the decline was attributable to cyclical effects, but discretionary measures included cuts in personal and corporate income tax rates announced in October 2000 and spending increases (totaling ¼ percent of GDP) introduced in the December 2001 budget.2 The provinces’ fiscal position also shifted from a surplus of 1 percent of GDP in 2000 to an estimated deficit of ¼ percent of GDP in 2002, reflecting the impact of the economic slowdown. As a result, the general government surplus declined to an estimated ¾ percent of GDP (national accounts basis) in 2002, from over 3 percent in 2000.

Table 4.

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.

Table 5.

Canada: Federal Government Budget, Public Accounts 1/

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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.

Unless otherwise indicated on a fiscal year basis, which starts on April 1.

The public accounts measure of net debt includes government debt held by the public service pension plans, the CPP and QPP.

Excluding the unfunded liabilities of the public employee pension plan.

Also includes local government and hospital sectors.

Canada Pension Plan and Quebec Pension Plan.

As a percent of unmatured debt.

Figure 5.
Figure 5.

Federal Fiscal Balance

(Public Accounts basis, in percent of GDP)

Citation: IMF Staff Country Reports 2003, 033; 10.5089/9781451806892.002.A001

10. The rebound in activity is bringing the economy back toward potential (Figures 6 and 7). Staff estimates—which are consistent with those of the Bank of Canada—suggest that the excess supply gap narrowed from around 1½ percent of potential output at the end of 2001 to about ½ percent in mid-2002. However, considerable uncertainty surrounds such estimates. While the capacity utilization rate has also increased significantly, it remains well below the levels of late 1999, when output was considered at potential, and the unemployment rate remains above most estimates of the natural rate (Box 2).

Figure 6.
Figure 6.

Employment and Output Gaps

(In percent, staff estimates)

Citation: IMF Staff Country Reports 2003, 033; 10.5089/9781451806892.002.A001

Figure 7.
Figure 7.

Capacity Utilization

Citation: IMF Staff Country Reports 2003, 033; 10.5089/9781451806892.002.A001

11. Inflation has picked up over the past year (Figure 8). Headline inflation breached the Bank of Canada’s 1–3 percent target range, reaching 4¼ percent on a 12-month basis in November. The Bank of Canada’s measure of core CPI inflation has also increased, rising to just over 3 percent in November from an average of 2 percent in 2001. The pickup has reflected a number of special factors, including the base effect of discounting in the wake of the September 11th attacks, the effect of deregulation of electricity prices, automobile insurance price hikes, and tobacco price increases. Inflation expectations, nevertheless, appear to remain well anchored—the spread between nominal and inflation-indexed bonds has narrowed to close to 2 percentage points and private sector consensus forecasts are for inflation to return to 2 percent by 2004.

Figure 8.
Figure 8.

CPI Inflation

(12-month rate)

Citation: IMF Staff Country Reports 2003, 033; 10.5089/9781451806892.002.A001

Labor Productivity and the Structural Unemployment Rate

Considerable uncertainty surrounds assessments of recent and prospective Canadian productivity growth and measures of the structural rate of unemployment. These uncertainties—which have important implications for longer- and shorter-term macroeconomic and structural policies—have been heightened by the marked differences between the recent performance of the U.S. and Canadian economies.

In particular, although Canadian labor productivity accelerated in the late 1990s, the Canada-U.S. productivity gap widened, largely owing to differences in the rate of capital accumulation.

uA01fig03

Productivity Growth

Citation: IMF Staff Country Reports 2003, 033; 10.5089/9781451806892.002.A001

  • During the 1988–1995 period, annual labor productivity growth in Canada was roughly ¼ percentage point below that in the United States. More rapid rates of capital investment and improvements in the quality of labor inputs were more than offset by substantially weaker growth of multi-factor productivity (MFP), which proxies for technological and other efficiency gains.

  • Since the mid-1990s, Canadian productivity growth accelerated, but lagged that in the United States by an even greater margin. However, in this latter period the difference mostly reflected stronger rates of U.S. capital accumulation, and MFP growth in Canada surged to close to the U.S. rate.

  • Perhaps more significantly, sectoral data suggest that MFP growth in Canada has been broad-based, while recent studies have shown that most of the MFP growth in the United States occurred in ICT industries.

The difference between the U.S. and Canadian structural rates of unemployment has also remained significant. Although most estimates suggest that the structural rate in Canada declined markedly during the 1990s, reaching a level of around 6½ percent in 2001, it remained over 1 percentage point above the U.S. rate.1 Possible explanations for the gap include:

  • Despite the reforms since the mid-1990s, the Canadian employment insurance system remains relatively more generous than in me United States.

  • The decline in the U.S. structural unemployment rate has been argued to reflect the lagged response of wage demands to the surge in productivity growth. The Canada/U.S. productivity gap, therefore, may have also contributed to a structural unemployment rate gap.

  • Other structural factors may also have played a role, including the higher participation rate in Canada of demographic groups that tend to have higher unemployment rates—e.g., younger and female workers—and the greater role of temporary help agencies in the United States.

These developments leave estimates of Canada’s potential growth rate and the output gap highly uncertain. There would seem considerable room for productivity growth and structural unemployment rates in Canada to converge to U.S. rates and, if so, the challenge would be to ensure that structural and other policies are supportive of this process. However, to the extent that this process is protracted, or that recent U.S. developments cannot be sustained, a more cautious macroeconomic policy stance may be required.

uA01fig04

NAIRU Estimates

Citation: IMF Staff Country Reports 2003, 033; 10.5089/9781451806892.002.A001

1 A. Sharpe and T. Sargent, 2000, “Structural Aspects of Unemployment in Canada,” Canadian Public Policy.

12. The Bank of Canada began to withdraw monetary stimulus in early 2002 but has paused since July. During April-July, the Bank raised its target overnight rate by a cumulative 75 basis points, to 2¾ percent, citing the need to act preemptively given the narrowing of the output gap. However, at its three meetings since July, the Bank’s Governing Council left the target rate unchanged, stating that, while further reductions in monetary stimulus would eventually be required, weaker near-term prospects for the U.S. and global economy and the unsettled circumstances in global financial markets argued for a pause.

13. Despite a favorable macroeconomic performance, capital outflows and the strength of the U.S. currency have contributed to continued weakness of the Canadian dollar (Figures 9 and 10). Large current account surpluses were mirrored by net portfolio outflows, reflecting the effects of an easing of restrictions on investment by retirement funds in non-Canadian assets, as well as the world-wide appetite for U.S. equities. The dollar reached historical lows against the U.S. currency in January 2002, and has stayed close to these levels despite the recent widening of interest rate differentials. In real effective terms, the Canadian dollar remains roughly 5 percent below its average of the mid-1990s, and undervalued relative to levels suggested by medium-term fundamentals.3

Figure 9.
Figure 9.

Interest Rate Differentials

(In basis points, Canada minus the U.S.)

Citation: IMF Staff Country Reports 2003, 033; 10.5089/9781451806892.002.A001

Figure 10.
Figure 10.

Exchange Rates

(Index 1990=100)

Citation: IMF Staff Country Reports 2003, 033; 10.5089/9781451806892.002.A001

14. Canadian stock prices also fell sharply from their peak in late-2000, but real estate prices have been buoyant (Figure 11). Following the collapse of the U.S. equity price bubble, Canadian stock prices fell by over 30 percent between September 2000 to end-2001. The broad TSX composite index fell a further 25 percent during the first nine months of 2002, before recovering somewhat in October and November. Recent stock market declines seemed to have stemmed in large part from spillovers from the weakening of investor sentiment in the United States following Enron’s collapse and subsequent corporate scandals, and the weaker outlook for the telecom sector. Despite the absence of major accounting scandals in Canada, the market valuation of a number of prominent hi-tech companies was particularly hard hit. However, residential real estate prices have firmed—the national average of new home prices rose by nearly 5 percent in September from a year ago, but still remained below its 1990 peak.

Figure 11.
Figure 11.

Stock Market Indices

(1990=100;Canada=S&P/TSX, US=S&P5Q0)

Citation: IMF Staff Country Reports 2003, 033; 10.5089/9781451806892.002.A001

15. Bank balance sheets have weakened somewhat with the recent slowdown. In the face of a deterioration in asset quality, mainly reflecting banks’ exposures to the telecom and U.S. corporate sectors, loan-loss provisions have been boosted significantly—by 80 percent in 2002 Q3 (four-quarter rate). Higher provisions, as well as the poor performance of investment banking and asset management business lines, have lowered bank profits (Figure 12 and Table 3).4 However, lower funding costs and the solid performance of banks’ retail business have kept profits still well above the previous cyclical low. Moreover, despite an increase in the loan-loss rate, this ratio remains low and the system’s capital adequacy ratio rose further to 12½ percent by mid-2002, well above the regulatory benchmark of 10 percent.

Figure 12.
Figure 12.

Banking Indicators

(In percent)

Citation: IMF Staff Country Reports 2003, 033; 10.5089/9781451806892.002.A001

III. Outlook

16. The staff projects real GDP growth to moderate from 3¼ percent in 2002 to 3 percent in 2003 (Table 6). Household spending and a continued recovery of business fixed investment are expected to support final domestic demand, but the completion of inventory adjustments and softer net external demand are projected to weigh on overall GDP growth through to mid-2003. With external demand expected to recover and an anticipated acceleration of business investment, GDP growth would then begin to pick up, closing the excess supply gap by early 2004. As one-off factors dissipate, inflation would settle back to around 2 percent by 2004. Modest gains in world commodity prices and gradual recoveries abroad are expected to leave the current account surplus around 3 percent of GDP. Fiscal surpluses would be maintained, reflecting existing policy commitments.

Table 6.

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 2001/02, 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.