Canada: Staff Report for the 2004 Article IV Consultation
Author: International Monetary Fund
Publication Date:
10 Mar 2004
eISBN:
9781451806960
Language:
English
Keywords:
ISCR; CR; core measure; headline CPI; overnight rate; labor market indicator; fiscal policy framework; U.S. dollar; exchange rate; personal income; labor market; dairy export practice; Inflation
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The government’s strong monetary and fiscal policy framework, as well as the structural reforms introduced, have enabled the Canadian economy to respond flexibly to recent shocks and laid a solid foundation for recovery. Macroeconomic policies should remain supportive, with fiscal policy continuing to focus on sustained debt reduction and structural reforms geared toward boosting productivity. Canada’s commitment to exchange rate flexibility has been helpful in facilitating the adjustment of global macroeconomic imbalances. Ensuring that regulatory and other policies support productivity, growth remains a key long-term challenge.

Abstract

The government’s strong monetary and fiscal policy framework, as well as the structural reforms introduced, have enabled the Canadian economy to respond flexibly to recent shocks and laid a solid foundation for recovery. Macroeconomic policies should remain supportive, with fiscal policy continuing to focus on sustained debt reduction and structural reforms geared toward boosting productivity. Canada’s commitment to exchange rate flexibility has been helpful in facilitating the adjustment of global macroeconomic imbalances. Ensuring that regulatory and other policies support productivity, growth remains a key long-term challenge.

I. Introduction

1. At the time of last year’s consultation, Canada’s macroeconomic performance was highly favorable and policies were broadly consistent with past Fund advice (Appendix I). The economy had weathered the global downturn and geopolitical uncertainties, and growth had outstripped that in other G-7 countries by substantial margins. The central bank had begun to raise interest rates in the face of signs that the output gap was closing, while fiscal policy remained geared toward sustaining surpluses and debt reduction, notwithstanding significant new spending initiatives and tax cuts.

2. However, the macroeconomic and policy environment during the past year has been more difficult than anticipated. A series of negative shocks caused the economy to slow sharply in the second half of 2002 and into 2003. These shocks, as well as increased outlays in support of the public health care system, have eroded federal fiscal surpluses. With the economy weakening, the Canadian dollar appreciating sharply, and inflation falling back to well within the 1-3 percent target range, the Bank of Canada has recently reversed course and lowered interest rates.

3. Although the outlook is broadly favorable, challenges remain. While leading indicators suggest growth will regain momentum, considerable uncertainty remains regarding the extent to which the sharp appreciation of the Canadian dollar will weigh on net exports and the economy’s return to full employment. Broader questions exist, too, regarding the extent to which Canada’s favorable growth performance in the face of the global IT and stock market bust of recent years reflected a durable increase in productivity growth or more transient factors such as an undervalued exchange rate, the strength of U.S. household demand, and Canada’s relatively modest IT and investment boom.

4. Against this background, the discussions focused on the policies needed to foster the recovery while supporting fiscal sustainability and productivity growth. In the near term, with inflation low and limited scope for countercyclical fiscal policies given the commitment to balanced budgets, monetary policy will need to remain accommodative. The priority for fiscal policy remains to sustain debt reduction and prepare for impending demographic pressures on retirement and health care systems. At the same time, continued financial sector, labor, trade, and other structural policy reforms are needed to strengthen Canada’s growth potential and to take full advantage of the increased integration of North American markets.

II. Recent Developments

5. After slowing only modestly during the global downturn, Canada’s macroeconomic situation weakened during the past year. During 2000-2002, Canada’s real GDP growth averaged 3½ percent—almost twice the G-7 average—reflecting the effects of a depreciated exchange rate and low interest rates on net external and domestic demand (Table 1 and Table 2). However, the economy’s momentum began to slacken late in 2002. Activity contracted by ¾ percent (annual rate) in the second quarter of 2003, and only achieved 1 percent growth in the third quarter. Labor market conditions also deteriorated, with significant job losses registered in the manufacturing sector, labor incomes slowing in real terms, and the unemployment rate moving up to 8 percent, before dropping to 7½ percent by end-2003.

Table 1.

Canada: Indicators of Economic Performance

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Source: Fund staff estimates; IMF, World Economic Outlook.
Table 2.

Canada: Selected Economic Indicators

(Percent change at annual rates, unless othewise indicated)

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Sources: Statistics Canada; and Fund staff estimates.

Contribution to growth.

Includes local governments and hospitals.

A01Ufig01

Canada: Real GDP and Domestic Demand

Citation: IMF Staff Country Reports 2004, 061; 10.5089/9781451806960.002.A001

A01Ufig02

Canada: Real Effective Exchange Rate

Citation: IMF Staff Country Reports 2004, 061; 10.5089/9781451806960.002.A001

A01Ufig03

Canada: External Indicators

Citation: IMF Staff Country Reports 2004, 061; 10.5089/9781451806960.002.A001

6. Several factors have weighed on activity. The SARS outbreak dampened domestic demand and tourism receipts in 2003Q2, the discovery of one case of BSE in Alberta resulted in restrictions on beef exports, and electrical power blackouts caused a significant drop in production in August. Moreover, the inventory/sales ratio rose above trend, triggering significant de-stocking, especially in the automotive sector, lowering growth by 3 percentage points (annual rate) on average in Q2 and Q3. Finally, the Canadian dollar appreciated sharply against the U.S. dollar during 2003, rising over 10 percent in real effective terms, reflecting both the broader weakness of the U.S. dollar as well as increases in world commodity prices and widening Canada-U.S. interest differentials.

7. As a result, net exports have contracted sharply while final domestic demand remained robust:

  • Net exports subtracted about 2½ percentage points from growth during the four quarters to 2003Q3. This reflected both a sharp drop in export volumes and buoyant imports of consumer goods. Nonetheless, the current account surplus has remained over 2 percent of GDP, owing to the positive effect of higher world commodity prices on the terms of trade (Table 2 and Table 3).

  • Household demand remained strong. Personal consumption rose by 4¼ percent in 2003Q3 from the same period in 2002, taking the personal saving rate down to an extraordinarily low 1¼ percent. Low interest rates and pent up demand helped spurred exceptional levels of residential investment. While most household balance

  • sheet indicators—including the debt service/income ratio—remain comfortable, the debt/income ratio has reached around 115 percent.

  • Business fixed investment has begun to recover. Purchases of machinery and equipment began to pick up in early 2003 and grew by about 5¾ percent during the four quarters ending in 2003Q3, supported by an improvement in corporate profits and low interest rates (Table 4). Nonresidential structures investment also bottomed out at the end of 2002.

Table 3.

Canada: Balance of Payments

(In billions of Canadian dollars, unless otherwise indicated)

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Source: Statistics Canada.

Quarterly flows are annualized.

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

Table 4.

Canada: Selected Vulnerability Indicators

(In percent of GDP unless otherwise indicated)

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Sources: Bank of Canada; Canadian Bankers Association; Statistics Canada; Bloomberg; Moody’s; and Fund staff estimates.

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, which account for over 90 percent of the total market share.

All chartered banks.

Persons and unincorporated business.

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

A01Ufig04

International Comparison: Stock Prices

Citation: IMF Staff Country Reports 2004, 061; 10.5089/9781451806960.002.A001

A01Ufig05

Canada: Interest Rate Spreads

Citation: IMF Staff Country Reports 2004, 061; 10.5089/9781451806960.002.A001

A01Ufig06

Canada: CPI Inflation

Citation: IMF Staff Country Reports 2004, 061; 10.5089/9781451806960.002.A001

8. The supply side of the economy has disappointed. Since mid-2002, productivity has been stagnant, causing unit labor costs to accelerate even while labor income growth has slowed. Although labor productivity growth had accelerated to 2 percent during 1996–2002, this was well below the U.S. rate and the per capita income gap remains wide.

9. Nonetheless, financial markets have generally strengthened in 2003. Stock prices have risen nearly 20 percent since late 2002, broadly in line with global equity markets but still roughly 30 percent below their 2000 peak. With interest rate differentials favoring Canadian instruments, net portfolio inflows increased in the first half of 2003, but eased sharply in the third quarter as the dollar’s appreciation reduced investor appetite.

10. Economic slack has helped return inflation to the Bank of Canada’s 1-3 percent target range. Staff estimates suggest that the economy was operating close to potential around the end of 2002, but that an output gap of around 1½ percent had emerged by 2003Q3. The core CPI inflation rate had surged to just over 3 percent (12-month rate) in late 2002/early 2003, partly reflecting the effects of large increases in insurance premiums. 1 However, core inflation has since fallen to 1¾ percent as these special factors dissipated and excess capacity emerged.

A01Ufig07

Canada: Employment and Output Gaps

Citation: IMF Staff Country Reports 2004, 061; 10.5089/9781451806960.002.A001

A01Ufig08

Canada: Labor Market Indicators

Citation: IMF Staff Country Reports 2004, 061; 10.5089/9781451806960.002.A001

11. A weaker economy and declining inflation led the Bank of Canada to reverse course and ease its policy stance. In early 2002, with the economy operating close to potential and demand pressures threatening to push inflation above the target range, the Bank raised overnight interest rates by a cumulative 75 basis points to 2¾ percent. Although inflation breached the target range by late 2002, the Bank held off further rate increases as geopolitical risks weighed on the global outlook. As these risks moderated, the Bank tightened further in March and April 2003, taking rates to 3¼ percent. However, with demand slowing, the exchange rate tightening overall monetary conditions, and inflation falling, the Bank moved in July and September to return overnight rates to 2¾ percent.

12. The room for fiscal maneuver has narrowed appreciably in the last year. Given the weaker economic outlook, additional transfers to the provinces, and scheduled tax cuts, the federal surplus is likely to be virtually erased in 2003/04 (Table 5). 2 At the provincial level, notwithstanding balanced budget commitments in many provinces and increased federal transfers, a sizable deficit is projected for this year, reflecting pressures on the public health care system as well as costs related to the SARS/BSE outbreaks. Partly driven by balanced budget legislation, provinces have responded by delaying previously scheduled tax cuts and announcing spending cuts.

Table 5.

Canada: Key Fiscal Indicators

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Source: Department of Finance Canada Economic and Fiscal Update (November 3, 2003); and Fund staff estimates

On a fiscal year basis, which starts on April 1

In percent of potential GDP.

Includes federal, provincial, territorial, and local governments; and Canada and Quebec pension plans.