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.


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.


Canada successfully weathered the earlier global downturn, growing substantially faster than other G7 countries, but the economy softened beginning in late 2002 and growth slowed to only 1 percent during the four quarters to 2003Q3. Industrial production has been especially sluggish, with manufacturing output in November 2003 below its level a year ago. Low productivity growth, in part related to the cyclical downturn, caused unit labor costs to accelerate even in the face of modest wage increases.

Several adverse factors contributed to the slowdown: the SARS outbreak dampened domestic demand and tourism receipts in the second quarter, 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, as the inventory/sales ratio rose above trend, significant de-stocking was triggered in 2003, especially in the automotive sector, which subtracted about 3 percentage points on average from annual growth in the second and third quarters.

In addition, the sharp and rapid appreciation of the Canadian dollar also weighed on demand. From late 2002 to end 2003, the domestic currency appreciated by over 20 percent against the U.S. dollar, and by close to 15 percent in real effective terms. This helped cause net exports to contract sharply, subtracting about 2% percentage points from annual GDP growth during the four quarters to 2003Q3.

Nonetheless, domestic demand was supported by low interest rates and remained robust over 2003. Personal consumption rose by 4¼ percent in 2003Q3 from the same period in 2002, underpinned by a resilient labor market. Job creation was robust, especially in the service sector, and the unemployment rate edged down to 7.4 percent by end-2003, despite record high levels of labor participation. While strong consumption took the personal saving rate down to an unusual low of 1¼ percent, most household balance sheet indicators remain comfortable.

Low interest rates and pent-up demand also helped spur high levels of residential investment. In addition, following two years of decline, business fixed investment began to recover and purchases of machinery and equipment rose by over 5½ percent in real terms during the four quarters ending in 2003Q3, in response to the strength of corporate profits, low interest rates, and rising equity prices.

The opening of an output gap helped return inflation to the Bank of Canada’s 1-3 percent target range. Staff estimates suggest that the economy moved from a position close to potential around the end of 2002 to roughly 1½ percent below potential by 2003Q3. The core CPI inflation rate had surged to just over 3 percent (12-month rate) in late 2002/early 2003, partly reflecting special factors including a spike in insurance premiums. However, as these special factors dissipated and excess capacity emerged, core inflation fell rapidly to 1½ percent in August, before edging up toward 2½ percent by end 2003.

The weaker economy and lower inflation have led to a shift in the stance of monetary policy. During 2002, the Bank of Canada had begun withdrawing stimulus, reflecting concern that capacity constraints and demand pressures would push inflation above the target range. While geopolitical risks helped persuade the Bank to hold off from further interest rate hikes during late 2002 and early 2003, as these risks moderated, the Bank tightened further in March and April 2003, taking overnight rates to 3¼ percent. More recently, however, the Bank has responded to the slowdown in demand, the sharp appreciation of the exchange rate, and the drop in inflation, easing in July and September 2003, and then again in January 2004, to return overnight rates to 2½ percent.

The room for fiscal maneuver has narrowed over the last year. At the federal level, after achieving a federal surplus of C$7 billion (½ percent of GDP) in 2002/03, the economic slowdown and last year’s budget initiatives—including a commitment to transfer additional funds to the provinces and territories for health care—appear likely to cause the surplus to decline appreciably in 2003/04. Nonetheless, the public debt-to-GDP ratio is expected to fall further and the federal authorities have indicated their continued commitment to rebuilding normal budgetary reserves and maintaining the debt ratio on a steady downward track. In support of this long-standing commitment, and to be able to advance on the initiatives announced in the recent Speech from the Throne, the government launched a major review of all expenditure programs, with the results of this exercise to be announced in the fall of 2004.

At the provincial level, despite the balanced budget commitments in many provinces, a sizable deficit has emerged 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 legislations, provinces have responded by delaying previously scheduled tax cuts and announcing spending cuts.

Executive Board Assessment

Executive Directors agreed with the thrust of the staff appraisal. In particular, they commended Canada’s strong monetary and fiscal policy framework which, together with the structural reforms introduced since the early 1990s, has enabled the Canadian economy to respond flexibly to negative shocks in 2003 and provided a solid foundation for recovery.

Directors agreed that the near-term macroeconomic outlook appeared broadly favorable, with growth likely to rebound next year, underpinned by household spending and a quick pick up in business investment. Nonetheless, the recent softening of the economy underlined the downside risks, especially given the Canadian dollar’s strength and the possibility that this could weigh heavily on net exports and domestic profitability.

Against this background, Directors agreed that macroeconomic policies should remain supportive. Given the limited room for fiscal maneuver under the existing medium-term budgetary framework, Directors observed that the principal responsibility for fostering a cyclical recovery lay with monetary policy.

In this regard, Directors welcomed the Bank of Canada’s recent decision to lower interest rates. They acknowledged that special factors had clouded the signals provided by inflation data, and that considerable uncertainty was associated with estimates of the output gap. Nonetheless, with the apparent widening of the output gap, the appreciation of the Canadian dollar weighing on activity, and core inflation expected to remain low, Directors noted that there was room to cut interest rates further, if needed to support the ongoing recovery, especially in view of the credibility of the authorities’ inflation target. They commended the transparency of the authorities’ inflation targeting framework, while a few Directors saw merit in providing more detail regarding the Bank of Canada’s macroeconomic forecasts.

Directors welcomed Canada’s commitment to exchange rate flexibility, which had been helpful in facilitating the adjustment to global macroeconomic imbalances. Although the speed and extent of the appreciation of the Canadian dollar had raised concern, they did not view the exchange rate as significantly out of line with underlying fundamentals, especially considering Canada’s current account surplus and improved net foreign liability position, and supportive world commodity prices.

Directors commended the authorities’ overall fiscal framework, which had been remarkably successful in achieving substantial debt reduction over the past decade and has left Canada relatively well-positioned to cope with the fiscal burdens stemming from population aging. However, with pressures on pension and health care systems likely to grow in coming decades, they agreed that federal and provincial fiscal authorities would need to sustain debt reduction. Several Directors believed that the existing two-year budgetary planning framework could usefully be complemented by a clearer longer-term anchor, and expanded to allow for more flexibility over the cycle, though others thought the existing framework was adequate to sustain Canada’s strong fiscal performance.

Directors noted that challenges had emerged in the context of the short-term fiscal outlook, especially in light of the economic slowdown and the spending initiatives introduced with the 2003 Budget, particularly on health-care related transfers to the provinces. They suggested, therefore, that the forthcoming budget demonstrate a firm commitment to rebuilding normal budgetary reserves. Directors also welcomed the authorities’ recent commitment to introducing a comprehensive expenditure review and shifting fiscal priorities toward expenditure control. Although they did not see a need for broad-based tax cuts, they observed that there was still scope to improve incentives in the tax system to facilitate labor and capital market efficiency and maintain competitiveness vis-à-vis the United States. They also encouraged efforts to ensure that the withdrawal of social benefits at the low end of the income scale did not result in excessive marginal effective tax rates.

Directors cautioned that difficult spending issues at both the federal and provincial levels still need to be tackled. They supported the recent federal-provincial Health Accord as a means to provide greater certainty regarding the funding for provincial health programs, but saw scope for strengthening incentives to contain health care costs and usage. Directors highlighted the importance of ensuring that amendments to the system of federal-provincial equalization payments reduce its complexity, and contain the burden on the federal budget.

Although the public pension system and other age-related programs appear sound, Directors agreed that further reforms may still be warranted. For example, they considered that improving the actuarial fairness of the adjustment to Canada Pension Plan (CPP) benefits for those who retire before or after the statutory retirement age, or gradually rising the retirement age to take into account increases in longevity, could help encourage labor market participation and possibly enable an eventual reduction in the CPP premium rate.

Directors noted the resilience of the Canadian financial system in the face of recent shocks, and commended the authorities’ sound regulatory framework and proactive efforts to strengthen corporate accounting and governance standards. In their view, the need to ensure the soundness, efficiency, and global competitiveness of the Canadian financial sector argued in favor of harmonizing securities market regulation and legislation—including in the context of the establishment of a single regulator. Similarly, the recent weaknesses of some defined-benefit pension plans illustrated the potential benefits of strengthening disclosure requirements and rules governing contribution holidays, and of further harmonizing federal-provincial regulation and supervision. With respect to bank merger proposals, Directors also welcomed efforts to increase the transparency of the process and criteria governing them in order to facilitate the Canadian financial system’s response to increasing global competition.

Directors observed that the use of the employment insurance system to fund broader social policy objectives has resulted in cross-subsidization across industries and regions. They suggested, therefore, that the pending review of the system be used as an opportunity to consider experience-rated premiums and alternative funding options.

Some Directors observed that the gap in productivity between the United States and Canada has widened slightly in recent years, and they encouraged continued efforts toward reforms that would enhance the efficiency of the Canadian economy, including with regard to barriers to foreign direct investment and inter-provincial trade.

Directors remarked favorably on the openness and transparency of Canada’s external trade system, and noted that easing import barriers further—especially in the area of agriculture—would encourage greater competitive efficiencies and complement Canada’s overseas development objectives. They encouraged the authorities to play a leadership role in efforts to bridge differences among the participants of the Doha Round. They also welcomed Canada’s commitment to achieve its goal of increasing overseas development assistance.

Public Information Notices (PINs) are issued, (i) at the request of a member country, following the conclusion of the Article IV consultation for countries seeking to make known the views of the IMF to the public. This action is intended to strengthen IMF surveillance over the economic policies of member countries by increasing the transparency of the IMF’s assessment of these policies; and (ii) following policy discussions in the Executive Board at the decision of the Board. The Staff Report for the 2004 Article IV Consultation with Canada is also available.

Table 1.

Canada: Selected Economic Indicators 1/

(Annual change in percent, unless otherwise noted)

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Sources: Statistics Canada; and IMF staff estimates.

Data as available at the time of the Executive Board Discussion on February 18, 2004.

Contribution to growth.

Includes local governments and hospitals.


Under Article IV of the IMF’s Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country’s economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country’s authorities.

Canada: Staff Report for the 2004 Article IV Consultation
Author: International Monetary Fund