Canada: Staff Report for the 2007 Article IV Consultation
Author:
International Monetary Fund
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Publication Date:
13 Feb 2007
eISBN:
9781451807028
Language:
English
Keywords:
ISCR; CR; rate; default rate; fiscal policy; commodity; financial market; world commodity boom; net debt; headline inflation; treasury bill; Global
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This 2007Article IV Consultation highlights that after surging in the first quarter of 2006, real GDP growth in Canada slowed subsequently, in part reflecting a cooling in the United States. Domestic demand remained the main driver of the economy, with private consumption expanding a robust 3¾ percent and business investment growing 8 percent. Financial sector performance remained strong in 2006, largely reflecting continuing benign global market conditions. Long-term interest rates remained low despite monetary tightening, as did spreads on private instruments, reflecting default rates that continue to be low.

Abstract

This 2007Article IV Consultation highlights that after surging in the first quarter of 2006, real GDP growth in Canada slowed subsequently, in part reflecting a cooling in the United States. Domestic demand remained the main driver of the economy, with private consumption expanding a robust 3¾ percent and business investment growing 8 percent. Financial sector performance remained strong in 2006, largely reflecting continuing benign global market conditions. Long-term interest rates remained low despite monetary tightening, as did spreads on private instruments, reflecting default rates that continue to be low.

I. Introduction

1. Over the last year, the Canadian economy has remained close to potential and inflation has been contained despite significant external shocks (Table 1 and 2). The boost to activity from rising commodity prices has been largely offset by the headwinds from a roughly 35 percent nominal effective appreciation of the exchange rate over the last few years. Headline inflation, which was earlier boosted by higher energy prices, has fallen below the 2 percent mid-point of the target range recently, while the core rate has remained close to target. More recently, however, the economy has slowed, partly owing to weaker U.S. activity.

Table 1.

Canada: Indicators of Economic Performance

article image
Sources: Fund staff estimates; and IMF, World Economic Outlook.
Table 2.

Canada: Selected Economic Indicators

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

article image
Table 2.

Canada: Selected Economic Indicators (concluded)

(In percent change, unless otherwise indicated)

article image
Sources: Haver Analytics; and Fund staff estimates.

Contribution to growth.

Not seasonally adjusted.

Includes local governments and hospitals.

2. In view of Canada’s strong macroeconomic and policy performance, this year’s consultation discussions were streamlined. Past Fund advice and the authorities’ views are summarized in the table on the next page, and discussions this year focused on:

  • Vulnerabilities. Given close economic ties, Canada’s growth, financial market conditions, and fiscal prospects are especially vulnerable to U.S. spillovers.

  • The fiscal framework. The new government has refined its debt reduction goals and is committed to overhauling the system of federal “equalization” payments to provinces.

  • The business environment and productivity. In November, the government issued Advantage Canada (available at http://www.fin.gc.ca/ec2006/plan/pltoce.html) outlining an ambitious structural agenda.

II. Macroeconomic and Financial Risks

3. Macroeconomic prospects remain broadly favorable. Staff projects growth recovering to around potential of 2¾ percent by mid-2007 and inflation close to target (after adjusting for the recent GST cut). The slowing of domestic demand as a result of earlier interest rate hikes would be offset by a diminished drag from net exports as the effects of the earlier exchange rate appreciation and slower U.S. activity wane. With the output gap around zero, inflation would remain close to the mid-point of the 1-3 percent band.

4. Staff viewed spillovers from the United States as tilting growth risks to the downside, while inflation risks were smaller and more balanced (Figure 1). Various estimates suggested that a percentage point fall in U.S. growth reduced Canadian activity by 0.3-0.7 percentage points (see following Table). The effect was likely to be in the upper part of this range given that the lower estimates come from macroeconomic models, which might not capture well financial spillovers, and key linkages to the vulnerable U.S. auto sector.

Figure 1.
Figure 1.

Overview

Citation: IMF Staff Country Reports 2007, 051; 10.5089/9781451807028.002.A001

Sources: Haver Analytics; International Monetary Fund, World Economic Outlook; and Fund staff estimates.

Canada: Fund Policy Advice

article image

Economic Outlook

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

article image
Sources: Haver Analytics; and Fund staff estimates.

An export-weighted average of growth in trade partners.

Bank officials also suggested that spillovers from slower U.S. residential investment might be particularly large, while Finance Canada and most private sector analysts saw the spillovers from housing as similar to other types of U.S. demand. Officials remained concerned that a disorderly unwinding of global imbalances involving a U.S. dollar depreciation, weaker U.S. activity, and lower commodity prices, would weigh especially heavily on Canada (as discussed in the 2006 Staff Report).

Various Estimates of Contemporaneous Spillovers from a One Percentage Point Fall in U.S. Growth

(percentage point fall in Canadian growth)

article image
Source: Fund staff calculations.

5. Staff and officials agreed that the floating exchange rate had acted as a useful shock absorber in recent years (Figure 2 and Table 3). While the desk exchange rate equation and some staff multilateral analysis suggested that the Canadian dollar could be modestly (0-10 percent) above equilibrium (possibly reflecting investment inflows associated with oil sands), it was agreed that the rapid appreciation of the Canadian currency since 2002 mainly reflected the world commodity boom. This was consistent with experience and macroeconomic models, which suggested that the short-term impact on domestic investment from changes in commodity prices tended to be offset by the effect on external demand of the exchange rate response. That said, given capacity constraints in Alberta (where oil sands are concentrated), the impact of further oil price increases could be modestly negative.

Figure 2.
Figure 2.

External Developments

Citation: IMF Staff Country Reports 2007, 051; 10.5089/9781451807028.002.A001

Sources: Haver Analytics; International Monetary Fund, World Economic Outlook; and Fund staff estimates.
Table 3.

Canada: Balance of Payments

(In billions of Canadian dollars, unless otherwise indicated)

article image
Sources: Haver Analytics; and Fund staff calculations.

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

6. It was agreed that there was a risk that the recent revival of labor productivity growth could be transitory. The staff forecast assumed that higher investment and greater competitive pressures in industries exposed to external competition would support productivity. However, in light of weak productivity performance earlier in the decade, less optimistic scenarios could be envisaged.

7. Prospects for domestic demand and balance sheets were seen as strong:

  • Households (Figure 3). Robust real income growth and rising household wealth ratios had supported consumption, even with near-zero household saving. Indeed, given that house prices were less inflated than in other cyclically-advanced countries, and that a near-prime mortgage market was beginning to develop, residential investment and consumption could be more buoyant than anticipated.

Figure 3.
Figure 3.

Household Activity and Balance Sheets

Citation: IMF Staff Country Reports 2007, 051; 10.5089/9781451807028.002.A001

Sources: Annual Reports of the 6 largest Canadian Banks; Canada Real Estate Association; Haver Analytics; Fund staff calculations; Klyuev, V., Mills, P. S. “Is Housing Wealth an ‘ATM’? The Relationship Between Household Wealth, Home Equity Withdrawal, and Saving Rates”, IMF Working Paper No. 06/162, National Bank Financial, Weekly Economic Letter, September 22, 2006.

  • Corporates (Figure 4). As in some other advanced countries, profit margins had risen and financing conditions were comfortable, suggesting a favorable outlook for business investment, particularly as exchange rate strength had lowered prices of imported equipment.

Figure 4.
Figure 4.

Corporate Sector Indicators

Citation: IMF Staff Country Reports 2007, 051; 10.5089/9781451807028.002.A001

Sources: Haver Analytics; Thomson One Analytics; Consensus Forecasts; and Fund staff calculations.

8. It was agreed that the financial sector was sound (Figure 5). Bank profitability and capital were high by historical (and, for the latter, international) standards, and risks from the housing market relatively limited. The financial sector appeared well positioned to cope with weaker U.S. activity—even though U.S. exposures had traditionally been a major source of volatility in earnings (one of the issues that will be pursued in the upcoming FSAP update) (Figure 6).

Figure 5.
Figure 5.

Financial Market Trends

Citation: IMF Staff Country Reports 2007, 051; 10.5089/9781451807028.002.A001

Sources: Annual Reports of 6 largest Canadian banks; Bankscope; Haver Analytics; Moody’s; RBC; and Fund staff estimates.1/ For a discussion of distance-to-default measures, see Chapter 6 of Canada: Selected Issues (IMF Country Report 05/116).
Figure 6.
Figure 6.

Linkages to U.S. Financial Markets

Citation: IMF Staff Country Reports 2007, 051; 10.5089/9781451807028.002.A001

Sources: Annual Reports of 6 largest Canadian banks; Bank for International Settlements; Haver Analytics; International Monetary Fund, World Economic Outlook; Statistics Canada; U.S. Federal Reserve Board, Flow of Funds; and Fund staff estimates.1/ For a discussion of distance-to-default measures, see Chapter 6 of Canada: Selected Issues (IMF Country Report 05/116).

III. Macroeconomic Policies

9. Monetary policy should remain the first line of defense in response to macroeconomic shocks. The inflation targeting framework has provided more than adequate scope for the Bank of Canada to provide countercyclical support. Fiscal policy has appropriately focused on achieving steady debt reduction, and, while the fiscal framework does not preclude deficits in the face of significant shocks, officials stressed the strong social consensus for avoiding such an outcome.

10. After a period of gradual monetary tightening, the Bank has appropriately left rates at 4¼ percent since May (Figure 7). While much will depend on incoming data, staff observed that it appeared apposite at present to maintain the current stance (in line with market expectations) given symmetric inflation risks, real short-term interest rates around neutral, well-anchored inflation expectations, and moderate labor cost increases. Officials broadly agreed and noted that the Bank was especially alert to the possibility that the continuing shift of resources from the manufacturing-based center to the commodity-rich west had lowered productivity temporarily (Figure 8). Partly in recognition of the risk this posed to inflation, the Bank had lowered its estimate of potential output growth.

Figure 7.
Figure 7.

Monetary Policy Indicators

Citation: IMF Staff Country Reports 2007, 051; 10.5089/9781451807028.002.A001

Sources: Bloomberg L.P.; Haver Analytics; and Fund staff calculations.
Figure 8.
Figure 8.

The Regional Divide

Citation: IMF Staff Country Reports 2007, 051; 10.5089/9781451807028.002.A001

Sources: Haver Analytics; Expert Panel on Equalization and Territorial Formula Financing; and Fund staff calculations.

11. The team welcomed the renewal of the inflation targeting framework for a further five years, given its success in keeping inflation expectations well anchored. Bank officials explained, however, that they now had greater flexibility to announce adjustments to the 6-8 quarter time frame for returning inflation to the target. This would allow adjustments for the apparent decline in inflation persistence, which might suggest a faster response, or for the possibility that some shocks—for example to asset prices—could be more persistent. Staff welcomed the Bank’s intention to continue to analyze the benefits and costs of a lower inflation target and price level targeting (PLT) in time for the next renewal (Box).

Price Level Targeting—Evolution Rather than Revolution?

In price level targeting (PLT), the central bank targets a path for the price level (which will generally rise to ensure nominal flexibility). In contrast to inflation targeting (IT), high inflation now implies lower inflation at some point in the future. Analysts have come to mixed conclusions about the relative performance of IT and PLT, with a “hybrid” strategy containing elements of both generally working best.

Some practitioners have suggested that differences between IT and PLT are overstated. Governor King of the Bank of England has observed that IT is in many ways equivalent to PLT if an average inflation target is adopted. Inflation has averaged 2 percent since the adoption of a 2 percent IT target in December 1995, although Governor Dodge has emphasized this need not transpire in the future. This suggests that a “hybrid” regime could be introduced in a relatively evolutionary manner by adding a criterion that inflation should average the target rate over the medium term in the policy agreement between the Bank and the government.

uA01bx01fig01

Price level since December 1994

(adjusted for indirect taxes)

Citation: IMF Staff Country Reports 2007, 051; 10.5089/9781451807028.002.A001

Source: Haver Analytics.
uA01bx01fig02

Average inflation since December 1994

(adjusted for indirect taxes)

Citation: IMF Staff Country Reports 2007, 051; 10.5089/9781451807028.002.A001

12. The November Fiscal Update underscored the strong fiscal position. FY2005-6 saw another larger-than-anticipated federal surplus—1 percent of GDP and 0.4 percentage points higher than projected in the May Budget—as program expenses fell in nominal terms for the first time since FY1996-97. The Update also projected somewhat higher future surpluses than projected in the Budget. Provincial fiscal positions have also improved, in some cases due to resource revenues.

Federal Budget: Staff Projections 1/

(In percent of GDP)

article image
Sources: Finance Canada; Haver Analytics; and Fund staff estimates.

The projections are based on the baseline provided by the authorities’ 2006 Economic and Fiscal Update adjusted for staff macro assumptions. It includes a GST cut of 1 percentage point in 2010/11.

Planning surplus = budget balance minus debt reduction.

Assuming future planned debt reduction is achieved.

13. The team welcomed the Update’s focus on fiscal prudence (Figure 9). This included continued targeting of debt reduction of C$3 billion, the advancement of the commitment for lowering the federal debt ratio to 25 percent by a year to FY 2012-13, and allocating unanticipated surpluses to further lowering debt. Given spending pressures from population aging, fiscal sustainability required a steady and significant decline in debt in coming decades, as well as further steps to contain public health spending growth. The Update’s goal to eliminate general government net debt by 2021 appropriately highlighted the role of asset accumulation by public pension plans and balanced budgets by provincial-territorial governments (which deliver health services). This could be further buttressed by a regular assessment of long-term sustainability, a point that officials acknowledged.

Figure 9.
Figure 9.

Fiscal Policy Indicators

Citation: IMF Staff Country Reports 2007, 051; 10.5089/9781451807028.002.A001

Sources: Haver Analytics; International Monetary Fund, World Economic Outlook; OECD Economic Outlook; and Fund staff estimates.1/ The OECD measure of general government net financial liabilities.2/ The difference with the OECD measure mainly reflects the inclusion of government employee unfunded pension liabilities in Statistics Canada definition of general government National Balance Sheet Accounts. Net debt is not adjusted for Financial assets of Social Security Funds. The “Baseline” path reports projected government debt ratios assuming for the first ten years that the federal government achieves its ten-year debt reduction target, provinces run balanced budgets, and public health care inflation equals the growth in all prices through 2046. The “No-debt ratio reduction” path assumes that federal and provincial debt ratios remain unchanged over the next ten years. The “Debt reduction and high health inflation” path illustrates the impact of public medical costs rising 2 percent per year faster than all prices, with the additional costs offset only though 2016. In all cases, the fiscal system is assumed unchanged after 2016. More details on the model are provided in “Assessing the Long-Term Fiscal Position of Canada” in IMF Country Report No. 03/34.

14. Officials emphasized the government’s intention to reduce the tax burden, supported by steady reductions in spending as a ratio to GDP. To bolster the social consensus for debt reduction, the Update had committed to use savings from debt service to lower personal income taxes. Staff welcomed these plans, but suggested that reducing Canada’s high marginal effective income tax rates (particularly on investment) would provide greater efficiency benefits than the proposed further cut to the Goods and Services Tax (GST). Indeed, with population aging steadily eroding the ratio of workers in the population, there was a case for bolstering consumption taxes. Promised further GST cuts could provide fiscal room for remaining provinces to harmonize their sales taxes with the GST. Harmonization to a VAT would eliminate provincial taxes on business inputs, lowering marginal effective rates on investment, and a GST cut could help cushion the effect of higher sales taxes on consumption needed to offset revenue losses.

15. It was agreed that reforms to federal equalization transfers that reduce differences in provincial fiscal capacities should make them more rules-based and predictable. 1 Differences in provincial fiscal capacity had been widened by elevated commodity prices, prompting ad hoc bilateral arrangements. Staff supported the O’Brien panel’s recommendations to partially include resource revenues from all provinces in the standard for equalization transfers and to cap transfers so no receiving province would have a higher fiscal capacity than a nonreceiving one. Federal officials observed that the panel’s proposals provided a useful starting point for negotiations and there seemed to be general, although by no means unanimous or enthusiastic, acceptance of its main recommendations by provinces.

IV. Structural Agenda

16. Sustained productivity growth is essential to raise living standards in the face of an aging population (Figure 10). Indeed, the theme of Advantage Canada is particularly timely against a background of modest business investment ratios for machinery and equipment and R&D, as well as a widening productivity gap with the United States.

Figure 10.
Figure 10.

Structural Indicators

Citation: IMF Staff Country Reports 2007, 051; 10.5089/9781451807028.002.A001

Sources: OECD; Koyama and Golub, 2006; Conway and Nicoletti, 2006; Haver Analytics; C.D. Howe Institute; World Economic Forum, Global Competitiveness Report, 2006/07.

17. Reflecting previous staff analysis, the team emphasized the importance of measures to enhance the business environment: 2

  • The tax system could be made friendlier for saving and investment. Canada’s effective marginal tax rates on investment are among the highest in the world, partly reflecting provincial sales and capital taxes. While the team welcomed the decision to end the tax advantage for income trusts, other aspects of the tax system, including the differential between rates applying to large and small firms, could distort capital allocations. There was also scope to support personal saving through lowering taxes on dividends and capital gains, and by raising contribution limits on tax-advantaged retirement plans.

  • While Canada’s federal regulatory system was generally given high marks internationally, specific reforms could encourage product market efficiency. In particular, regulations on foreign direct investment—especially for network industries such as airlines, communications, and the media—as well as public ownership in the electricity sector appeared outmoded. Interprovincial barriers to trade remained high despite the welcome Alberta-British Columbia Trade, Investment, and Labour Mobility Agreement.

  • Lowering regulatory impediments to bank entry and consolidation could increase the efficiency and dynamism of the financial sector (Figure 11). Against a backdrop of a rapidly changing global environment, greater clarity on the basis for ministerial approval of bank mergers and liberalizing bank ownership rules would lower uncertainty, increase contestability in the banking system, and help stimulate innovation.

Figure 11.
Figure 11.

Canadian Banking Indicators in Global Context 1/

Citation: IMF Staff Country Reports 2007, 051; 10.5089/9781451807028.002.A001

Sources: Bankscope; and Fund staff estimates.1/ Frequency distributions on vertical axes; indicator values in percent on horizontal axes. Canada: 6 largest banks. United States: 20 largest bank holding companies. World: 100 largest banks. All data for end-2005.

  • Employers’ access to skilled workers could be improved. The difficulty in adapting the immigration system to skill shortages created by Alberta’s boom underlined the potential for attuning the system more to the needs of employers. Limited recognition of professional qualifications across provinces also remained an important constraint. Recent research comparing outcomes between New Brunswick and Maine also highlighted the continuing costs of the Employment Insurance system for labor market participation.

18. Officials noted that Advantage Canada was a comprehensive plan covering all levels of government, to raise prosperity, and included many of the staff’s priorities. They stressed the importance of provinces harmonizing sales taxes and eliminating capital taxes for achieving the objective of attaining the lowest marginal effective tax rate on investment in the G-7. Advantage Canada had also committed to reducing the regulatory burden on firms and to creating a dynamic and globally competitive financial system (separately, Bank officials observed that realizing scale economies could increase efficiency in the banking system). In addition, incentives to work and save would be enhanced through lower personal income taxes, including a Working Income Tax Benefit for the working poor. The need to reform the immigration system, improve post-secondary education, and encourage greater interprovincial labor mobility were also stressed.

V. Staff Appraisal

19. The strong recent performance of the Canadian economy is likely to continue, although risks are tilted to the downside. Staff projects that growth will rebound to potential, estimated at around 2¾ percent, by mid-2007 and inflation will stay around 2 percent. The main risk is the possibility of a larger-than-expected U.S. slowdown.

20. The Bank of Canada has adroitly balanced competing growth and inflation risks, including by keeping rates on hold since May. While much will depend on incoming data, with policy rates in the neutral range and inflation pressures contained, the current stance appears appropriate moving forward. The decision to leave the highly successful inflation targeting framework unchanged, coupled with continued analysis of possible future improvements, is also welcome.

21. The financial sector is well positioned to cope with a turning of the global credit cycle. The banks are profitable, well-capitalized, and risks from the housing market are more limited than in other cyclically-advanced countries. At the same time, there seems to be scope to improve financial sector efficiency and innovation by reducing regulatory impediments to bank entry and consolidation, as well as by moving toward establishing a national securities regulator.

22. Fiscal policy is appropriately focused on reducing debt, lowering taxes, and reforming the equalization system. While great strides have been made in lowering government indebtedness, long-term fiscal sustainability requires further debt reduction as well as steps to curb increases in public health spending. We welcome the government’s commitment to using interest savings from debt reduction to lower personal income taxes and to reducing effective marginal tax rates on investment, which would provide larger efficiency gains than further cuts to the GST. The reforms suggested by the O’Brien panel would appropriately make the equalization system more rules-based and predictable.

23. With sound frameworks delivering macroeconomic stability, we welcome Advantage Canada’s theme of enhancing prosperity. In addition to cutting tax rates on capital (including through promoting actions by provinces) and improving financial market competition, the business environment could be enhanced by phasing out restrictions to foreign direct investment, increasing the flexibility of the immigration system, and eliminating interprovincial barriers to trade in goods and labor mobility.

24. It is recommended that the next consultation occur on the usual 12-month cycle.

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Table 4.

Canada: Fiscal Indicators

article image
Sources: Department of Finance Canada The 2006 Econmic and Fiscal Update; Haver Analytics; and Fund staff estimates.

On a fiscal year basis, which starts on April 1.

The budgetary surplus on an accruals basis measures changes in net worth, while net lending provides a better picture of the impact of fiscal policy on domestic demand.

In percent of potential GDP.

Assuming future planned debt reduction is achieved.

NIA and calendar year basis. Includes federal, provincial, territorial, and local governments; and Canada and Quebec pension plans.

1

The system is described at http://www.fin.gc.ca/FEDPROV/eqpe.html.

2

See Box 5 of the 2006 Staff Report.

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Cover IMF Staff Country Reports
Canada: Staff Report for the 2007 Article IV Consultation
Author:
International Monetary Fund
Volume/Issue:
Volume 2007: Issue 051
Publisher:
International Monetary Fund
ISBN:
9781451807028
ISSN:
1934-7685
Pages:
34
DOI:
https://doi.org/10.5089/9781451807028.002
Figure 1.

Overview
Figure 2.

External Developments
Figure 3.

Household Activity and Balance Sheets
Figure 4.

Corporate Sector Indicators
Figure 5.

Financial Market Trends
Figure 6.

Linkages to U.S. Financial Markets
Figure 7.

Monetary Policy Indicators
Figure 8.

The Regional Divide

Price level since December 1994

(adjusted for indirect taxes)

Average inflation since December 1994

(adjusted for indirect taxes)
Figure 9.

Fiscal Policy Indicators
Figure 10.

Structural Indicators
Figure 11.

Canadian Banking Indicators in Global Context 1/