Canada: 2006 Article IV Consultation—Staff Report; Staff Supplement; and Public Information Notice on the Executive Board Discussion

Canada’s macroeconomic and policy performance has continued to outshine most other industrial countries, and its outlook remains favorable. The new government has pledged to maintain the strong social consensus in favor of fiscal surpluses, while aiming at enhancing incentives. The new budget should ensure that a prudent fiscal framework is maintained. The favorable domestic and external environment will boost the economy’s long-term growth potential. While the financial system appears well placed to support growth, there is still room to furthering its efficiency and resilience.

Abstract

Canada’s macroeconomic and policy performance has continued to outshine most other industrial countries, and its outlook remains favorable. The new government has pledged to maintain the strong social consensus in favor of fiscal surpluses, while aiming at enhancing incentives. The new budget should ensure that a prudent fiscal framework is maintained. The favorable domestic and external environment will boost the economy’s long-term growth potential. While the financial system appears well placed to support growth, there is still room to furthering its efficiency and resilience.

I. Introduction

1. Canada’s macroeconomic performance remained favorable over the last year despite the challenge posed by the rapid appreciation of its currency (Table 1). With core inflation contained, output still below potential, and net exports weakening, the Bank of Canada maintained a stimulative monetary policy stance through September 2005. Subsequently, rising capacity utilization and strong employment growth have prompted a resumption of rate hikes. Benefiting from a surge in personal and corporate incomes, the strong fiscal framework again delivered a federal budget surplus.

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Strong institutions and structural reforms have helped spur growth over the last decade.

Real GDP growth, average annual percent change, 1996–2005

Citation: IMF Staff Country Reports 2006, 230; 10.5089/9781451807011.002.A001

Source: World Economic Outlook.
Table 1.

Canada: Indicators of Economic Performance

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Sources: Fund staff estimates; and IMF, World Economic Outlook.

2. The boom in global commodity prices has significantly improved Canada’s economic prospects but also complicates macroeconomic management. High world oil prices have improved the financial viability of Canada’s enormous oil sands, boosting the country’s role as a major energy exporter (Box 1 and Annex I). However, the attendant significant appreciation of the real exchange rate required a shift of resources toward the oil and gas sector in the western provinces, creating economic frictions and widening gaps in fiscal capacity between resource-rich and resource-poor provinces.

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Surging energy prices and rising non-oil commodity prices are supporting the exchange rate.

Indices, 2000 = 100

Citation: IMF Staff Country Reports 2006, 230; 10.5089/9781451807011.002.A001

Source: Haver Analytics; and IMF Information Notice System.

3. The Conservative Party formed a minority government following the January 23 general election. The new government has promised to focus on “five priorities,” including raising accountability in government, reducing crime, lowering consumption taxes, providing choice and support for child care, and reducing wait times for medical procedures. It also pledged to reduce the role of government and work toward reducing federal-provincial “fiscal imbalances.” However, its minority status in parliament may limit the room for policy maneuver.

Canada as an Energy Exporter1

Canada’s oil sands—located almost exclusively in Alberta—contain one of the world’s largest known hydrocarbon deposits. The cost of extracting much of the oil had been prohibitively expensive, but improved technology and higher oil prices have made them economical. Recoverable oil is estimated at about one sixth of global reserves.

Capital spending on oil sands projects is projected to continue to increase sharply, but there are obstacles to exploiting oil sands deposits:

  • Limited infrastructure and difficulties in attracting skilled labor have boosted costs.

  • Canada’s natural gas output is expected to peak in about 10 years’ time. With natural gas a key input for oil sands production, this could pose a serious long-term cost problem.

  • Greenhouse gas emissions created by oil sands production are likely to conflict with Canada’s Kyoto Accord commitments.

Most forecasters assume that projects will come on stream gradually. Production projections tend to imply a tripling of oil sands production volume to 2½–3 million barrels per day (mb/d) over 10 years. With conventional oil output already past its peak, Canada’s total oil production would increase from 2.5 mb/d in 2003 to about 4 mb/d by 2015.

Rising oil production will affect the domestic economy in a number of important ways:

  • Domestic demand. Extraction of oil sands uses large amounts of capital and labor, which should push up demand and income outside the energy sector as well as outside Alberta.

  • Government revenues. While royalties and resource taxes accrue primarily to Alberta, the federal government and other provinces would benefit from higher sales tax and corporate income tax revenue.

  • Balance of Payments. At current energy prices, Canada’s current account balance could improve by about ½ percent of GDP by 2015.

Staff analysis suggests, however, that the impact on Canada’s real effective exchange rate would be small. The staff’s model also indicates that most of the recent appreciation of the Canadian dollar against the U.S. dollar has been driven by fundamentals.

Although oil output will rise in coming years, Canada’s future as an energy-exporting country will depend on finding technological solutions to overcome production obstacles. Gas exports are expected to fall sharply after 2015 as reserves are exhausted. Therefore, oil sands production would need to increase rapidly to maintain Canada’s energy trade balance. This will require significant investments in public and private infrastructure, improvements in extraction techniques, curbing the use of natural gas in oil sands production, and limiting greenhouse gas emissions.

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Canada: Projected Energy Production.

Citation: IMF Staff Country Reports 2006, 230; 10.5089/9781451807011.002.A001

Sources: National Energy Board; Canadian Association of Petroleum Producers; and Fund staff projections.
1 Written by M. Mühleisen. See also Annex I.

4. Against this background, the mission focused on the challenges of maintaining a balanced expansion and supporting economic flexibility and long-term growth in the face of population aging:1

  • Following a series of interest rate increases since the fall, the monetary stance has become less accommodative, and while further modest increases in the overnight rate will be required, the Bank of Canada will need to weigh carefully signs that slack has eroded against the drag from currency appreciation and risks from global imbalances.

  • The new government will need to demonstrate its commitment to budget discipline as it delivers on promised tax relief. In addition, reform of the health care system remains key to long-term fiscal sustainability.

  • On the structural front, the challenge will be to boost productivity as labor-intensive growth from rising participation over the last decade slows. While the Canadian economy remains highly flexible, there seems scope to streamline FDI, trade, and labor market regulations with a view to encourage foreign investment and boost domestic competition.

II. Recent Developments

5. The economy has maintained momentum even in the face of last year’s rapid currency appreciation (Table 2). Real GDP growth was close to 3 percent during 2005 (Q4/Q4 basis), reflecting a strong expansion in construction, services, and resource industries. Final domestic demand rose a robust 4½ percent, which more than offset a drop in inventory investment and net exports:

  • Private consumption expanded by 3¾ percent. Strong employment growth has bolstered household incomes, while solid gains in equity and housing prices (where there is little evidence of a bubble) have kept household wealth as a ratio to income close to historical highs despite a record-low saving rate.

  • Private fixed investment rose by 7½ percent. Residential construction growth has moderated but purchases of machinery and equipment accelerated through the year, supported by rising corporate profits, low long-term interest rates, and a booming energy sector in the west.

  • The growth of government consumption and investment was more moderate, reflecting discipline in final spending at both the federal and provincial level.

A01ufig04

Final domestic demand remains robust, while the drag from net exports has declined …

Contribution to growth, quarterly, saar

Citation: IMF Staff Country Reports 2006, 230; 10.5089/9781451807011.002.A001

Source: Haver Analytics.
A01ufig05

…solid gains in housing and equity wealth have boosted household spending …

4-quarter percent change, left scale; ratio to disposable income, right scale

Citation: IMF Staff Country Reports 2006, 230; 10.5089/9781451807011.002.A001

Source: Haver Analytics.
A01ufig06

…and business investment has picked up, supported by healthy corporate profits.

4-quarter percent change, left scale; percent of GDP, right scale

Citation: IMF Staff Country Reports 2006, 230; 10.5089/9781451807011.002.A001

Source: Haver Analytics.
Table 2.

Canada: Selected Economic Indicators

(In percent change at annual rates and seasonally adjusted, unless otherwise indicated)

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Sources: Haver Analytics; and Fund staff estimates.

Contribution to growth.

Not seasonally adjusted.

Includes local governments and hospitals.

Effectiveness and Role of Fund Surveillance

  • Past Fund advice. Staff have been highly supportive of Canada’s strong institutional framework and continuing structural reforms. Although the authorities have resisted suggestions to reform the Employment Insurance system, policies in general—and the adoption of a medium-term debt target in the FY 2004–05 budget and recent increases in monetary policy transparency, in particular—have been in line with staff recommendations.

  • A recent academic study—based on interviews with Department of Finance officials—came to mixed conclusions on the effectiveness of Fund surveillance.1 The study found that Fund staff came with “sophisticated expertise and technical advice,” “demonstrated intellect and insight about the Canadian economy,” and had the “big picture.” However, Fund reports were generally found to be less valuable than those by the OECD because they were less “user-friendly,” contained more limited use of cross-country comparisons, and were less focused on issues of immediate interest to policy makers.

  • Targeted advice. Staff have recently provided focused analyses in response to specific requests by Canadian authorities:

    • Fiscal forecasting. At the authorities’ request, last year the staff prepared an international comparison of fiscal forecasting procedures and outcomes, utilized by an independent report on the same topic, which in turn was cited in the November 2005 Budget Update.

    • Review of Bank of Canada research and analysis. At the authorities’ request, staff has provided the Board of Governors of the Bank of Canada with bi-annual assessments of the Bank’s research and communications strategy. This year, the presentation was also given to Governor Dodge and Senior Deputy Governor Jenkins. In addition, the Bank of Canada has been actively involved in both using and developing the Fund’s Global Economic Model.

  • The Role of the Fund. Senior Canadian policymakers have recently offered a number of suggestions for strengthening Fund surveillance. Bank of Canada Governor Dodge and Finance Minister Flaherty both called on the Fund to focus more on multilateral surveillance, better integrate financial sector analysis into country reviews, put more emphasis on exchange rates, and define the roles of the Board, management, and staff more concretely.2 They suggested that the Fund’s primary role should be to promote a market-based international monetary order, acting as a forum for developing the “rules of the game” and as an “umpire” making impartial calls as to whether the rules were being followed.

1 Momani, B., 2005, “Assessing the Utility of and Measuring Learning from Canada’s IMF Article IV Consultations,” Department of Political Science and History, University of Waterloo.2 See, for example, Dodge, D., 2006, “The Evolving International Monetary Order and the Need for Evolving IMF,” Lecture to the Woodrow Wilson School of Public Affairs, Princeton University.

6. Net exports continued to be a drag on activity (Table 3). Real exports, supported by strong external demand, expanded almost 5 percent over the course of 2005, but this was more than offset by a 6½ percent increase in real imports, which were spurred by a strong currency. Nonetheless, soaring energy prices buoyed the nominal trade balance and the current account.

Table 3.

Canada: Balance of Payments

(In billions of Canadian dollars, unless otherwise indicated)

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Source: Haver Analytics.

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

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Commodity prices move the nominal trade balance …

Merchandise trade balances, in percent of GDP

Citation: IMF Staff Country Reports 2006, 230; 10.5089/9781451807011.002.A001

Source: Haver Analytics.
A01ufig08

…while trade volumes depend more on manufactures.

Real merchandise trade balances, in percent of GDP

Citation: IMF Staff Country Reports 2006, 230; 10.5089/9781451807011.002.A001

Source: Haver Analytics.

7. After a modest retreat in the early months of 2005, the Canadian dollar has resumed its appreciation. The dollar has gained some 30 percent in real effective terms since early 2003 and has risen to highs not seen since the early 1990s, partly reflecting market responses to growing actual and expected energy export revenues and foreign investment in Canada’s oil and gas sector. Assessing Canada’s competitiveness is complicated by movements in the terms of trade as well as growing penetration of low cost producers in the U.S. and domestic markets. However, while the currency’s strength has crimped manufacturing employment, the exchange rate appears largely in line with underlying fundamentals, with much of the recent appreciation reflecting the boom in energy and other commodity prices (staff analysis is summarized in Annex I).2 Multilateral analysis conducted by the IMF’s Research Department suggests that the exchange rate is up to 15 percent undervalued when compared with equilibrium saving-investment balances. However, the gap is smaller using the methodology that calculates purchasing power parities and takes the improvement in the terms of trade into account.

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The exchange rate has been appreciating …

Indices 2000=100. An increase signifies appreciation.

Citation: IMF Staff Country Reports 2006, 230; 10.5089/9781451807011.002.A001

Sources: IFS; and IMF Information Notice System.
A01ufig10

…imposing adjustment on the manufacturing sector.

Index, December 2002 = 100

Citation: IMF Staff Country Reports 2006, 230; 10.5089/9781451807011.002.A001

Source: Haver Analytics.

8. Most indicators suggest that the economy is operating at around potential. The unemployment rate has fallen to 6¼ percent—a 31-year low—reflecting employment growth in the commodity-producing western provinces but also in the central provinces, where losses in export industries have been offset by gains in construction and services. Both the staff and the Bank of Canada estimate a negligible output gap.

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The unemployment rate has fallen, while labor force participation has remained high.

In percent, participation rate of 15 to 64 year olds

Citation: IMF Staff Country Reports 2006, 230; 10.5089/9781451807011.002.A001

Source: Haver Analytics.

9. Nonetheless, inflation remains tame.3 As the upward pressure from higher energy prices has dissipated, headline inflation has fallen back to 2.2 percent, close to the center of the Bank of Canada’s 1–3 percent target range, while the core measure has stayed below 2 percent since January 2004. However, wage increases accelerated during 2005 and, despite a pickup in productivity, unit labor costs rose by 3½ percent driven largely by the service sector.

10. After pausing for almost a year, the Bank of Canada resumed withdrawing monetary stimulus in the fall of 2005. Reflecting the assessment that the economy was operating near capacity, the Bank has raised its target for the overnight interest rate to 3¾ percent in five consecutive ¼ percentage point steps starting in September. In its March 2006 statement, the Bank indicated that “modest” further tightening may be needed, which was interpreted by financial markets as suggesting that rates would rise by only a further 25–50 basis points through end-2006. As in the rest of the world, yields on long-term government bonds remain close to historic lows in real and nominal terms, even after modest recent rises.

A01ufig12

Although unit labor costs have risen recently, core inflation has been stable in the bottom half of the Bank of Canada’s target range.

Yearly percent change

Citation: IMF Staff Country Reports 2006, 230; 10.5089/9781451807011.002.A001

Source: Haver Analytics.
A01ufig13

Monetary tightening resumed in September after being interrupted by exchange rate appreciation …

overnight rate, percent

Citation: IMF Staff Country Reports 2006, 230; 10.5089/9781451807011.002.A001

Source: Haver Analytics.
A01ufig14

… while inflation expectations remain contained and nominal bond yields have fallen.

Percent

Citation: IMF Staff Country Reports 2006, 230; 10.5089/9781451807011.002.A001

Sources: Bloomberg; and Haver Analytics.1/ Inflation expectations use bonds maturing in 2021.

11. The fiscal outlook remains very favorable. Buoyant personal income tax collections and large corporate income tax payments are expected to lead to a surplus in FY2005/06 (ending in March). The disposition of projected budget surpluses was a key focus of the pre-election debate. The new government has pledged a range of tax cuts and spending restraint that—if fully implemented—would be consistent with their commitment to pay down federal debt by at least C$3 billion (about ¼ percent of GDP a year).

12. Financial and corporate sectors remain sound (Table 4). In the financial sector, high profitability, robust balance sheets, a benign provisioning environment, and strong distance-to-default indices—which combine measures of financial performance and market uncertainty—do not suggest systemic risks. In addition, staff analysis (summarized in Annex I) finds the gradual trend to greater direct financing has strengthened the monetary transmission mechanism. The corporate sector also enjoys strong balance sheets and profitability, although the funding situation of many of Canada’s defined benefit (DB) pension plans has deteriorated as declines in long-term interest rates and increases in life expectancy have boosted the present value of liabilities.

Table 4.

Canada: Selected Vulnerability Indicators

(In percent of GDP, unless otherwise indicated)

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Sources: Bloomberg; Canadian Bankers’ Association; Haver Analytics; and Office of the Superintendent of Financial Institutions.

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.