Canada
2008 Article IV Consultation-Staff Report; Staff Statement; and Public Information Notice on the Executive Board Discussion

Canada has enjoyed high growth while adjusting smoothly to commodity price gains, currency appreciation, and, more recently, slowing U.S. demand. Monetary policy has appropriately shifted to guarding against increasing near-term downside risks. A sound fiscal framework policy has produced an enviably strong fiscal position that makes eliminating general government net debt feasible. The budgetary overperformance provides room for tax relief while maintaining small budget surpluses. To foster efficiency, the fiscal room should be used to reduce high marginal effective tax rates on capital, saving, and labor.

Abstract

Canada has enjoyed high growth while adjusting smoothly to commodity price gains, currency appreciation, and, more recently, slowing U.S. demand. Monetary policy has appropriately shifted to guarding against increasing near-term downside risks. A sound fiscal framework policy has produced an enviably strong fiscal position that makes eliminating general government net debt feasible. The budgetary overperformance provides room for tax relief while maintaining small budget surpluses. To foster efficiency, the fiscal room should be used to reduce high marginal effective tax rates on capital, saving, and labor.

I. Macroeconomic and Financial Prospects and Risks

A. Overview

1. Canada has enjoyed high growth while adjusting smoothly to commodity price gains, currency appreciation, and, more recently, slowing U.S. demand. Over the past five years, the commodity boom has strengthened the external position and boosted domestic demand (Tables 2 and 3). There has been some offset from real net exports, as the real exchange rate has appreciated sharply in response to rising terms of trade and the resulting pressures on resources (Figure A). Reflecting strong domestic demand, the unemployment rate remains close to its recent 33-year low and staff and most analysts view the economy as currently operating above potential. Having been in the upper half of the Bank of Canada’s 1–3 percent target range since the fall of 2006, however, core CPI inflation recently dropped below the midpoint on stronger-than-expected exchange rate passthrough.

Figure A.
Figure A.

Overview

Citation: IMF Staff Country Reports 2008, 069; 10.5089/9781451807059.002.A001

Sources: Haver Analytics; International Monetary Fund, World Economic Outlook; and IMF staff estimates.
Table 1.

Canada: Fund Policy Advice

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Table 2.

Canada: Indicators of Economic Performance

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Sources: IMF staff estimates; and IMF, World Economic Outlook.
Table 3.

Canada: Selected Economic Indicators

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

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Table 3.

Canada: Selected Economic Indicators

(In percent change, 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.

Economic Outlook1/

(Annualized percent change from previous period unless otherwise indicated)

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

As of January 15, 2008.

An export-weighted average of growth in trade partners.

Simple average of prices of UK Brent, Dubai, and west Texas intermediate crude oil.

2. Looking forward, however, officials and private analysts agreed with the staff that near-term prospects are less favorable. With the U.S. downturn now expected to be more severe than earlier assumed and last year’s strong upward momentum in the Canadian dollar, the drag from real net exports will intensify. At the same time, domestic demand growth is forecast to moderate from its recent rapid pace, as the boost to real income growth from rising commodity prices dissipates and tighter financial conditions limit credit availability.

3. It was also generally agreed that external factors tilted the risks to the near-term outlook to the downside. In particular, there is a clear risk that the slowdown in the United States could be deeper than currently anticipated. A further tightening of financial conditions is also very possible given unsettled global financial markets. That said, domestic demand growth could slow by less than expected, particularly given recent buoyancy in some commodity prices.

4. Risks from extremely unfavorable external conditions are illustrated in the alternative scenario used for stress tests reported in the accompanying FSSA Update. While highly unlikely, a “perfect storm” involving a combination of a significant U.S. recession, associated U.S. dollar depreciation, and falling commodity prices could put the Canadian financial sector and economy under greater strain than the sharp recession of the early 1990s, when real GDP fell by 2 percent in 1991.

Stress test scenario

(year-on-year percent change, deviations from baseline)

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B. How Much Will Domestic Demand Growth Slow?

5. Consumption has been buoyant since 2002, driven by commodity-related terms of trade improvements. This boost to real income and net worth (Figure 1) has been reinforced by rising employment and accommodative credit conditions. Going forward, staff and most analysts project that consumption growth will decelerate moderately from recent exceptionally high rates, reflecting tighter financial conditions and a moderation in household real income growth as external demand slows and the terms of trade stabilize.

Figure 1.
Figure 1.

Household Activity and Balance Sheets

Citation: IMF Staff Country Reports 2008, 069; 10.5089/9781451807059.002.A001

Sources: Annual Reports of the 6 largest Canadian Banks; Canada Real Estate Association; Haver Analytics; IMF 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.

6. Strong housing demand is expected to moderate somewhat. House prices have recently started to decelerate. While overall residential investment remains buoyant, private sector analysts observed that there were signs of slowing in the exceptionally strong Alberta market where most of Canada’s oil field development is occurring. Going forward, Bank of Canada and Finance Canada officials agreed with staff that residential investment growth is expected to decelerate as income growth moderates and affordability decreases.

7. Most analysts were cautious regarding prospects for business investment. Reflecting strong dependence of some capital expenditure on U.S. cyclical developments, investment growth has been moving in tandem with U.S. real GDP growth (Figure 2). Thus, the impending slowdown in the U.S. economy and tightening financial conditions temper investment prospects despite high profitability, healthy corporate balance sheets, and lower prices of capital goods (that are mainly imported).

Figure 2.
Figure 2.

Corporate Sector Indicators

Citation: IMF Staff Country Reports 2008, 069; 10.5089/9781451807059.002.A001

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

8. Looking forward, it was generally agreed that domestic demand is likely to slow, although there are upside risks given its unexpected strength over the past two years. Private consumption and residential investment in particular could continue their current momentum, reflecting robust income growth, wealth increases, and favorable consumer confidence, as well as the recent increases in some commodity prices and tax cuts announced in the October 2007 Economic Statement. The boost to real incomes from recent greater-than-anticipated exchange rate passthrough into prices could also stimulate demand.

9. Staff and officials also agreed that the risk of a rapid downturn in the housing market of the type seen in the United States and feared elsewhere is small. This view was echoed by market professionals, who pointed out that while there might be some localized signs of speculative behavior, the strength of the broad housing market reflects fundamentals. House price appreciation has lagged relative to many other industrial countries, inventories are still below average, and recent readings of housing starts and building permits suggest continued favorable housing market conditions.

C. How much of a Risk is a Weaker U.S. Economy?

10. There is widespread skepticism that Canada can decouple from a U.S. slowdown. Staff observed that trade and financial linkages between the United States and Canada are among the strongest in industrial countries, with the U.S. receiving ¾ of Canada’s exports and financing about ¼ of the capital raised by Canadian corporations. Consistent with previous analysis, Chapter 1 of the Selected Issues paper suggests that on average a one-percentage point shock to U.S. GDP changes Canada’s growth by between ½ to ¾ of a percentage point, operating through trade, financial, and commodity price channels. Most interlocutors saw this as a reasonable estimate of U.S. spillovers to Canada.

11. Staff and officials agreed that the impact of the U.S. slowdown on Canada is likely to rise as the U.S. slowdown moves beyond the housing sector. With U.S. weakness through the third quarter primarily reflecting a housing downturn, spillovers have continued to be limited. The direct impact has been confined largely to building material-related industries, especially lumber. As the U.S. slowdown broadens to consumption, it is likely to generate more general trade effects. Officials stressed the importance of U.S. demand for automobiles, whose production is highly integrated (autos and parts represent one-third of Canadian goods exports). In addition, the tightening in U.S. financial conditions is also likely to slow the Canadian economy significantly as discussed in Section ESelected Issues Chapter 2 analyzes these financial linkages in more detail.

D. Is the Strong Canadian Dollar Consistent with External Stability?

12. Responding to higher commodity prices, the freely floating Canadian dollar has appreciated by almost half in real effective terms between early 2002 and end-2007. As Canada is susceptible to external shocks in general, commodity price hikes (falls) have traditionally led to exchange rate appreciation (depreciation) against the United States and other trading partners (Figure B). Indeed, the Canadian dollar is widely considered a commodity currency. By offsetting pressures on domestic demand, currency fluctuations generally support macroeconomic stability by acting as shock absorbers.

Figure B.
Figure B.

External Competitiveness

Citation: IMF Staff Country Reports 2008, 069; 10.5089/9781451807059.002.A001

1/ Weighted average relative prices.2/ Based on Balakrishnan and Tulin, “U.S. Dollar Risk Premiums and Capital Flows.” (2006)Sources: Haver Analytics; International Monetary Fund,World Economic Outlook; and IMF staff estimates.

13. Strong appreciation during 2007, however, has intensified earlier concerns about the economic cost of rapid currency movements. Even after plunging some 10 percent from November’s record high of US$1.10—partly reflecting changing expectations about the course of monetary policy—the Canadian dollar appreciated about 20 percent against its U.S. counterpart in 2007, more than other major U.S. trading partners. Given the dominance of the United States in Canada’s trade, this reinforced officials’ earlier concerns that Canada has borne a disproportionate share of U.S. dollar adjustment with associated pressures on exposed sectors. Staff estimate that roughly one-half of last year’s appreciation against the U.S. dollar reflects higher oil prices (non-energy commodity price changes have been modest), and that recent ups and downs have also reflected momentum trading.

14. Background work using exchange rate models suggests that much of the appreciation since 2002 has reflected the global commodity boom. At near parity against the U.S. dollar and with oil prices of $90-100 a barrel, the currency currently appears broadly in line with fundamentals, although some measures suggest modest overvaluation. More specifically, the team’s analysis using several exchange rate models suggests there could be a small overvaluation by the end of 2007, as does the Consultative Group on Exchange Rate Issues (CGER) equilibrium exchange rate approach. However, CGER analysis based on external balances suggest that the currency is fully consistent with fundamentals. This diversity corresponded to the views of most analysts, who pegged the equilibrium value against the greenback at between 90 cents and parity. In early January, Governor Dodge said that a value in the “low to mid 90s” was justified by historical relationships.

15. Staff and officials agreed that real net exports are likely to be a major drag on activity through at least the first half of 2008 (Figure C and Table 4). Past currency appreciation and weakening U.S. activity are projected to lead to a significant deterioration in exports of manufactures and services, which remain the bulk of Canadian exports. This weakness has been exacerbated by the recent spike in cross-border shopping as the currency surged to parity against the U.S. dollar, which made price comparison easier.

Figure C.
Figure C.

External Developments

Citation: IMF Staff Country Reports 2008, 069; 10.5089/9781451807059.002.A001

Sources: Haver Analytics; International Monetary Fund,World Economic Outlook ; and IMF staff estimates.
Table 4.

Canada: Balance of Payments

(In billions of Canadian dollars, unless otherwise indicated)

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Sources: Haver Analytics; and Fund staff calculations.

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

16. Staff noted that, at a constant real exchange rate, the current account surplus is expected to continue to narrow despite high projected commodity prices. Officials agreed that the favorable effects of elevated commodity prices, further modest increases in fuel export volumes, and declining net income payments would only partly offset weaker exports of manufactures and services.

17. Reflecting flexible labor markets, the domestic adjustment to currency appreciation and rising commodity prices has been remarkably smooth. Unemployment rates have steadily declined, including in the more manufacturing-oriented central provinces, as employment gains in services, construction, and mining as well as interprovincial migration have more than offset manufacturing job losses (Figure 3).

Figure 3.
Figure 3.

Adjustment to Commodity Price Gains and Real Appreciation

Citation: IMF Staff Country Reports 2008, 069; 10.5089/9781451807059.002.A001

1/ Excludes public administration2/ Includes forestry and fishing.3/ Finance, insurance, and real estate.Source: Haver Analytics and IMF staff calculations.

18. Rising labor demand in the resource-rich provinces has been partly met through net migration from elsewhere in Canada, as local wages have been bid up. At current exchange rates, staff suggested that this relatively smooth adjustment is likely to continue. Senior officials broadly agreed, while noting that activity in parts of manufacturing and forestry may well lead to local difficulties.

E. Will Financial Strains Feed Through to the Real Economy?

19. Bank balance sheets have deteriorated in response to global financial problems, although strains appear smaller than in other major markets. While the size of current financial vulnerabilities is inevitably subject to much uncertainty and varies from bank to bank, estimated exposures to asset-backed securities and related products appear more limited than in the United States or Europe. As a result, while synthetic credit default insurance spreads have risen significantly since the late summer, they remain lower than in the United States. This is consistent with stress tests conducted for the accompanying FSSA Update that suggest that the major banks have sufficient capital to withstand large shocks.

20. As elsewhere, interbank money markets remain under strain. Interbank spreads for major Canadian banks have risen and remained elevated, albeit generally at lower levels than in the United States and Europe (Figure D). Indeed, Canadian interbank rates have been particularly highly correlated with U.S. rates since financial strains emerged in August, reflecting their close integration with U.S. wholesale financial markets. This illustrates one channel through which global financial turmoil is affecting the financial sector.

Figure D.
Figure D.

Financial Market Trends

Citation: IMF Staff Country Reports 2008, 069; 10.5089/9781451807059.002.A001

Sources: Bankscope; Bloomberg, L.P.; Haver Analytics; Merrill Lynch; Moody’s; and IMF staff estimates.1/ For a discussion of distance-to-default measures, see Chapter 6 of Canada: Selected Issues (IMF Country Report 05/116).

21. Staff and Bank officials agreed that overall financial conditions had tightened noticeably since the summer. The October Monetary Policy Report had estimated that the average cost of borrowing for households and businesses had risen by some 25 basis points, while the availability and terms of credit had also tightened modestly. It was agreed that financial conditions had continued to deteriorate subsequently and that strains were likely to persist, with staff suggesting that in early December the increase in the cost of borrowing might well be double that estimated in October.

22. Staff observed that in the face of balance sheet strains, recent strong growth in credit is likely to decelerate, slowing future activity:

  • Officials responded that the increase in domestic credit risk will likely remain limited, given relatively low household debt ratios and high commodity prices that support incomes (see Table 5). This view was largely mirrored by private sector analysts.

  • Officials suggested that writedowns to date have fairly accurately reflected the likely scale of losses and that comfortable risk-adjusted capital ratios allow banks to absorb these developments.

  • Officials agreed with staff that uncertainties related to banks’ foreign exposures were greater and less predictable, following an historical pattern. A further deterioration in U.S. market conditions is a particular concern, given significant U.S. operations and exposures of some Canadian banks (Figure E).

Figure E.
Figure E.

Linkages to U.S. Financial Markets

Citation: IMF Staff Country Reports 2008, 069; 10.5089/9781451807059.002.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; and IMF staff estimates.1/ For a discussion of distance-to-default measures, see Chapter 6 of Canada: Selected Issues (IMF Country Report 05/116).
Table 5.

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 for the six largest chartered Canadian banks, which account for over 90 percent of the total market.

All chartered banks.

Persons and unincorporated business.

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

2007 calculations until July 2007