2009 Article IV Consultation: Staff Report; Staff Statement; and Public Information Notice on the Executive Board Discussion

The staff report on Canada’s 2009 Article IV Consultation examines economic developments and policies. Canadian banks have weathered the crisis better than major-country peers, but the credit cycle will be challenging, particularly given high household debt. Financial instability is a tail risk, but heightened vigilance is warranted. The Bank of Canada has appropriately loosened monetary policy, bringing the policy rate target to a record-low ½ percent. Macroeconomic policies have adopted an expansionary tilt, and authorities have taken steps to safeguard financial stability.


The staff report on Canada’s 2009 Article IV Consultation examines economic developments and policies. Canadian banks have weathered the crisis better than major-country peers, but the credit cycle will be challenging, particularly given high household debt. Financial instability is a tail risk, but heightened vigilance is warranted. The Bank of Canada has appropriately loosened monetary policy, bringing the policy rate target to a record-low ½ percent. Macroeconomic policies have adopted an expansionary tilt, and authorities have taken steps to safeguard financial stability.

I. Macroeconomic and Financial Prospects and Risks

Despite Canada’s close real and financial linkages to the United States, it has so far avoided the virulent spillovers seen elsewhere, as it entered the crisis on a strong footing. This reflects sound financial regulation and conservative banking practices, fiscal prudence, and a credible and effective monetary policy framework, including a freely-floating currency. Nevertheless, strains are evident, and the authorities are appropriately responding with stimulus and steps to support financial stability. With the global outlook marked by unusually high uncertainty, the main task for policymakers is to maintain continued vigilance and readiness to respond if tail risks are realized.

A. Entering the Global Crisis from a Position of Strength

1. Canada entered the global financial turmoil on a solid footing (Figure 1). Through 2007, sound macroeconomic and financial policies along with a commodity boom delivered strong growth, price stability, fiscal and current account surpluses (Figure 2), historically low unemployment, and financial stability. Corporate and bank leverage were low, although high household debt and regional real-estate bubbles presented vulnerabilities.

Figure 1.
Figure 1.

Canada: Entering Crisis on a Strong Footing

Citation: IMF Staff Country Reports 2009, 162; 10.5089/9781451807080.002.A001

Sources: Haver Analytics; Organization for Economic Cooperation and Development; International Monetary Fund, World Economic Outlook; World Economic Forum, Global Competitiveness Report 2008-09, and IMF staff estimates.1/ Average. Excludes Canada, U.K., and the U.S.2/ Based on quarterly instead of monthly data.3/ Score between 1 and 7.
Figure 2.
Figure 2.

Canada: External Developments

Citation: IMF Staff Country Reports 2009, 162; 10.5089/9781451807080.002.A001

Sources: Haver Analytics; International Monetary Fund, Direction of Trade; and IMF staff estimates.

2. Nevertheless, the crisis has impacted growth and financial conditions. Canada is an open economy with strong real and financial linkages with the global economy, especially the United States, which accounts for about three-quarters of Canada’s exports and around a quarter of funding for Canadian businesses. These links have affected Canada in several ways:

  • Economic slowdown. Contracting external demand has depressed real exports; the wealth effects of falling equity, commodity, and house prices, along with financial tightening, have dampened domestic demand (Figure 3). Real GDP contracted by 3.4 percent (saar) in the fourth quarter of 2008 after a weak performance earlier in the year, and indicators point to a much deeper contraction in early 2009. Headline inflation has fallen sharply, due in part to collapsing oil prices.

  • Financial market volatility. The global financial crisis sparked volatility and pushed credit and money-market spreads to unprecedented highs (Figure 4), although spreads are below foreign levels. Similarly, bank risk indicators have risen but are below comparable levels abroad (Figure 5).1 Meanwhile, pensions and insurers have been hit by U.S. mortgage-related writedowns and the equity crash (Figure 6).

  • Plunging commodity prices. Commodity prices have retreated steeply from all-time highs, postponing energy investments, fostering the first current account deficit in a decade, undercutting growth in resource-rich western provinces, and deflating Western housing markets. Reflecting the gyrations in commodity prices, the Canadian dollar fell from above parity with the U.S. dollar in early 2008 to around four-year lows of 0.82 by end-2008.

Figure 3.
Figure 3.

Canada: Impact of the Crisis on Economic Growth

Citation: IMF Staff Country Reports 2009, 162; 10.5089/9781451807080.002.A001

Sources: Haver Analytics; Canadian Federation of Independent Business, Finance Canada; Royal-Lepage; Bank of Canada; Bloomberg; World Economic Outlook, IMF; and staff estimates.
Figure 4.
Figure 4.

Canada: Strains in the Financial Market

Citation: IMF Staff Country Reports 2009, 162; 10.5089/9781451807080.002.A001

Sources: Bloomberg; Haver Analytics; DataStream Advanced; Markit; and staff estimates.
Figure 5.
Figure 5.

Canada: Resilience of the Banking Sector So Far

Citation: IMF Staff Country Reports 2009, 162; 10.5089/9781451807080.002.A001

Sources: Bank of Canada; Office of Superintendent of Financial Institutions Canada; Insurance companies quarterly reports; Bloomberg; Haver Analytics; The Investment Funds Institute of Canada; and Fund staff estimates.1/ Average of Metlife and Prudential.2/ The MSCI U.S. insurance index is a market cap weighted index which measures price appreciation of stocks in this industry group.

3. In response, macroeconomic policies have adopted an expansionary tilt and authorities have taken steps to safeguard financial stability. Since December 2007, the Bank of Canada has cut its policy rate by 400 basis points to ½ percent, a historic low, and expanded liquidity through enhanced facilities. In January 2009, the authorities tabled the 2009 federal budget with a fiscal stimulus of 2.8 percent of GDP. The authorities have also launched facilities to offer guarantees on wholesale borrowing for banks and insurance companies, purchased mortgage-backed securities to ease liquidity pressures, and introduced additional tools to preserve financial stability if needed (Table 1).

Table 1.

Initiatives to Stabilize the Financial System

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Source: Bank of Canada; Finance Canada; and staff estimates.

4. Looking ahead, policies should focus on managing the downside risks to growth and financial stability. Given the rapidly deteriorating global environment, domestic economic activity will likely decline further in the near term, before picking up on the back of the policy stimulus already in train. To dampen the downturn and hedge deflation risks, the current accommodative monetary stance should be maintained until economic recovery is firmly underway. Fiscal room exists for further stimulus, if downside risks materialize. Given the worrisome market indicators and macro-financial feedbacks, the contingency policies to deal with worsened financial stress are appropriate, and authorities should stand ready to act further, if needed. (A table in the Informational Annex summarizes past and current Fund policy advice in areas that are not the focus of this report).

B. Financial Stability Amid the Turbulence

5. Canada’s banking system has so far displayed remarkable stability amid the global turbulence, thanks in good part to strong supervision and regulation. The financial system has avoided systemic pressures: no financial institution has failed or required public capital injections (banks have raised capital in markets, albeit at elevated cost owing to higher global risk aversion). Key factors behind this relatively strong performance were (Selected Issues, Chapter I):


Bank Writedowns

(In percent of 2008 GDP)

Citation: IMF Staff Country Reports 2009, 162; 10.5089/9781451807080.002.A001

Source: Bloomberg.1/ In percent of 2008 Euro Area GDP.
  • Sound supervision and regulation: The 2008 FSSA Update found that the regulatory and supervisory framework meets best practice in many dimensions, including with regard to the revised Basel Core Principles for banking supervision.

  • Stringent capital requirements: Solvency standards apply to banks’ consolidated commercial and securities operations. Tier 1 capital generally significantly exceeds the required 7 percent target (which in turn exceeds the Basel Accord minimum of 4 percent). The leverage ratio is limited to 5 percent of total capital (Box 1).

  • Low risk tolerance and conservative balance sheet structures: Banks have a profitable and stable domestic retail market, and (like their customers) exhibit low risk tolerance. Banks had smaller exposures to “toxic” structured assets and relied less on volatile wholesale funding than many international peers.

  • Conservative residential mortgage markets: Only 5 percent of mortgages are non-prime and only 25 percent are securitized (compared with 25 percent and 60 percent, respectively, in the United States). Almost half of residential loans are guaranteed, while the remaining have a loan-to-value ratio (LTV) below 80 percent—mortgages with LTV above this threshold must be insured for the full loan amount (rather than the portion above 80 percent LTV, as in the United States). Also mortgage interest is nondeductible, encouraging borrowers to repay quickly (Selected Issues, Chapter II).

  • Regulation reviews: To keep pace with financial innovation, federal authorities review financial sector legislation every five years (Ontario has a similar process for securities market legislation).

  • Effective coordination between supervisory agencies: Officials meet regularly in the context of the Financial Institutions Supervisory Committee (FISC) and other fora to discuss issues and exchange information on financial stability matters.2

  • Proactive response to financial strains: The authorities have expanded liquidity facilities, provided liability guarantees, and purchased mortgage-backed securities. In addition, several provinces now provide unlimited deposit insurance for provincially-regulated credit unions. The 2009 Budget further expands support to credit markets, while providing authority for public capital injections and other transactions to support financial stability.

Canadian Bank Regulatory Capital Requirements: Are They Tougher?

Among the G7, only Canadian and U.S. bank regulators impose leverage caps. Elsewhere, two large Swiss banks, UBS and Credit Suisse, will be subject to leverage caps in 2013 (Table 1).1 The Canadian leverage cap is calculated on total (Tier 1 and 2) capital, and the U.S. cap on Tier 1 capital. OSFI includes some off-balance sheet exposures in its definition of assets, whereas the U.S. leverage calculation does not. (These off-balance sheet exposures include credit derivatives, financial standby letters of credit, guarantees, and surety arrangements.)

Table 1:

Regulatory Leverage Ratio Limits

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Canadian specified off-balance sheet exposures include direct credit substitutes (see above), trade- and transaction-related contingencies, and repurchase agreements.

The Swiss minimum leverage ratio (excluding domestic lending) will be 3 percent (at group level) and 4 percent (for the individual institutions). The leverage ratio will be tighter in good times (most likely 4-5 percent). The determination of this cyclical adjustment is not linked to macroeconomic conditions but the supervisory assessment once leverage increases above 20.

U.S. banks that meet certain criteria of strength and sophistication are subject to a 33 1/3 percent maximum leverage ratio. All others are limited to 25 percent.

Canada’s minimum capital requirements are tougher than called for by Basel II, and all other G7 bank regulators (Table 2). Canadian banks have to hold Tier 1 capital of at least 7 percent (versus 6 percent in the United States) of risk-weighted (RWA) assets, and 10 percent (versus 8 percent in most other G7 countries) of RWA as total capital.2

Table 2:

Tier 1 and 2 Capital Requirements as a Percent of Risk-Weighed Assets

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The higher (lower) requirements apply to internationally active (domestically oriented) Japanese banks.

1 As part of their financial stabilization measures adopted in fall 2008, the Swiss financial market supervisor (FINMA) introduced a minimum leverage ratio that adjusts to downturns—while acknowledging the need to avoid enhancing the current downturn by tightening capital and other rules too early.2 These comparisons do not account for potential differences in Tier 1 and 2 capital definitions from country to country, although these are believed to be immaterial. Also, supervisors may impose undocumented higher capital requirements on some banks (e.g., systemically important and/or large complex institutions).

6. Nevertheless, the global turbulence has had noticeable effects on Canada’s financial markets. In mid-2007, Canada’s non-bank asset-backed commercial paper (ABCP) market froze (a restructuring agreement was brokered in January 2009).3 During 2008, the nonperforming assets of the “big six” banks doubled to C$10.2 billion and charge-offs increased by a third to C$5 billion (yet representing just 0.3 and 0.2 percent of total assets, respectively). Bank profits remained positive (C$3 billion total for the “big six” in the first quarter of 2009), albeit 20 percent down from a year ago.4 Strains were most evident among non-banks, including life insurers, pension funds, and mutual funds (Figure 6). Major financial institutions maintain fairly strong ratings, some with negative outlooks.

Figure 6.
Figure 6.

Canada: Impact of the Crisis on Non-Bank Financial Sector

Citation: IMF Staff Country Reports 2009, 162; 10.5089/9781451807080.002.A001

Sources: Bank of Canada; Office of Superintendent of Financial Institutions Canada; Insurance companies quarterly reports; Bloomberg; Haver Analytics; The Investment Funds Institute of Canada; and Fund staff estimates.1/ Average of Metlife and Prudential.2/ The MSCI U.S. insurance index is a market cap weighted index which measures price appreciation of stocks in this industry group.

C. Macrofinancial Linkages

7. Credit flows held up well through the turn of the year but have ebbed more recently (Figure 7). Credit has been supported as banks have moved to fill gaps left by retrenching securities markets and finance companies. However, lending standards have tightened, with the net percentage of respondents reporting tightening in lending standards at a record high in the fourth quarter of 2008 (since data collection began in 1999), and new credit growth has slowed recently. Banks have asked for new financial instruments to be counted as regulatory capital, suggesting that capital could constrain lending. These factors point to a continued deceleration of lending, with knock-on effects to growth (staff analysis shows that lending standards affect economic activity with a lag; Selected Issues Chapter III).

Figure 7.
Figure 7.

Credit Flows to Households and Corporations

Citation: IMF Staff Country Reports 2009, 162; 10.5089/9781451807080.002.A001

Source: Eurostat; European Central Bank; Federal Reserve Bank; Haver Analytics; Statistics Canada; and staff calculations.

Banks’ Non-price Lending Conditions 1/

Citation: IMF Staff Country Reports 2009, 162; 10.5089/9781451807080.002.A001

Sources: Haver Analytics;1/ Includes small business, commercial and corporate sector.

8. In addition, the credit cycle could entail adverse macro-financial feedback:

  • Weakening commodity, home, and equity prices, along with rising unemployment, are squeezing highly-indebted households, restraining consumption and credit demand. Household debt—mostly mortgages—is at record highs relative to disposable income (Figure 8). Consumer bankruptcies have swelled and are set to rise more, particularly as housing prices fall further, in turn pressuring credit quality (Figure 9).

  • While corporate balance sheets are stronger than households’, debt and commercial paper issuance have fallen (Figure 10).

  • Ongoing falls in house prices, particularly in the West (which experienced a housing-price bubble; Selected Issues Chapter IV), will continue to crimp residential investment and dampen demand for business credit.

Figure 8.
Figure 8.

Canada: Risks to Households from Declining Income Growth

Citation: IMF Staff Country Reports 2009, 162; 10.5089/9781451807080.002.A001

Source: Haver Analytics; Finance Canada; and staff estimates.1/ Includes Alberta and British Columbia.2/ Includes Quebec and Ontario.3/ Household debt includes liabilities of households, nonprofit organizations, and nonfarm noncorporate business sector.
Figure 9.
Figure 9.

Canada: Risk to Households from a Softening Housing Market

Citation: IMF Staff Country Reports 2009, 162; 10.5089/9781451807080.002.A001

Sources: Bank of Canada; Canada Mortgage and Housing Corporation; Canadian Real Estate Association; Haver Analytics; Finance Canada; OECD; and IMF staff calculations.
Figure 10.
Figure 10.

Canada: The Impact of the Crisis on the Corporate Sector

Citation: IMF Staff Country Reports 2009, 162; 10.5089/9781451807080.002.A001

Sources: Haver Analytics; Thomson One Analytics; Canadian Federation of Independent Business; and IMF staff calculations.1/ The balance of opinion is calculated as the weighted percentage of surveyed financial institutions reporting tightened credit conditions minus the weighted percentage reporting eased credit conditions. The sample includes lending to small business, commercial, and corporate sector.

Contribution to Growth of Household Debt

(quarter over quarter)

Citation: IMF Staff Country Reports 2009, 162; 10.5089/9781451807080.002.A001

Sources: Haver Analytics; and Fund staff estimates.

D. Outlook and Risks

9. Sharply declining aggregate demand is expected to significantly lower growth and dampen price pressures. The staff’s baseline forecast is for a sharp contraction in real GDP in 2009—the worst since 1981 when GDP plunged by 2.9 percent—followed by a return to positive growth in 2010. Output would shrink through the first half of 2009, rebounding with fiscal stimulus. Staff models find that the U.S. downturn will be the largest drag on growth, followed by tighter financial conditions. House-price deflation will pose headwinds, although overheating has been regional rather than national (Selected Issues Chapter IV).5 Weak commodity prices would prolong the recession, consistent with the experience in other commodity exporters (Selected Issues Chapter V).


Canada: Headline and Core Inflation

Citation: IMF Staff Country Reports 2009, 162; 10.5089/9781451807080.002.A001

Sources: Haver Analytics; and staff estimates.

10. The recession and weak commodity prices will depress inflation. Upward price pressures from exchange rate depreciation should be more than offset by downward pressures from a large output gap. Given the sharp drop in oil prices since mid 2008, compounded by a growing economic slack, headline inflation will be about zero on average in 2009, remaining well below the Bank of Canada’s inflation target range of 1–3 percent before rising gradually to 2 percent by early 2012. That said, medium-term inflation expectations remain well anchored at around 2 percent.


Near and Medium Term Inflation expectations

Citation: IMF Staff Country Reports 2009, 162; 10.5089/9781451807080.002.A001

Source: Bank of Canada (Consensus Forecasts).

11. At the time of the mission, the authorities’ projections were less pessimistic than staff’s. January forecasts published by the Bank of Canada and Finance (the latter based on private forecasts adjusted for risk) have higher growth in 2010 than staff’s projections. The differences mainly reflect negative data (for both Canada and globally) released since January, and staff’s below-consensus outlook for U.S. growth.

12. Downside risks prevail. Larger negative spillovers would occur if U.S. real and financial conditions are worse than staff’s current forecast, entailing risks of weaker growth, as well as more prolonged low inflation or deflation (a tail risk under the baseline). Financial instability in Canada is another tail risk, which would erode household and business confidence and credit flows, undercutting consumption and investment spending, with repercussions abroad (Box 2). House prices could also decline by more than expected. A larger than expected recovery in commodity prices would improve domestic demand via wealth effects, and act as an upside risk to both growth and prices.

International Spillovers

The slowdown is likely to result in significant aftershocks in many countries that rely on Canadian remittances. With Canada being among the main recipients of immigrants in the world—accounting for almost a fifth of its population—the current slowdown could have important implications on remittances and, thus, income in many countries, including some economies already under severe stress.

The downturn and currency depreciation would also affect tourism-dependent economies, especially in the Caribbean. Canadian residents represent 10 percent of Caribbean tourism flows—a share that has grown rapidly in recent years (annual growth of 10 percent, compared to 2.8 percent and 4.3 percent for U.S. and European tourists). Thus, the Canadian downturn, along with the falling currency, would affect the region’s growth and FDI outlook.


Estimated Remittances from Canada, 2005

Citation: IMF Staff Country Reports 2009, 162; 10.5089/9781451807080.002.A001

Sources: World Bank, and WEO.

Tourism Arrivals in Select Caribbean Destinations, 2008

(annual percentage change)

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Source: Caribbean Tourism Organization

The share of each destination’s total tourism originating from Canada in 2008.

Canadian financial strains could also have repercussions abroad. Several Canadian banks have expanded U.S. operations, while some institutions (such as Scotia, RBC, and CIBC) have large retail presences in the Caribbean, holding about half of retail deposits in the Eastern Caribbean. A few banks also operate in Latin America. The major insurers are among the world’s largest; Manulife, for example, is the largest insurance company in North America by market capitalization and the fourth largest globally.

Canadian Banks’ Position in North America April 1 2009

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Source: Bloomberg.

End-September 2008 foreign bank’s claims on Canada by nationality of reporting banks

Citation: IMF Staff Country Reports 2009, 162; 10.5089/9781451807080.002.A001

Sources: BIS; and Fund staff calculations.


Discussions focused on policies to deal with risks and vulnerabilities to the economic and financial stability outlook. Monetary and fiscal stimulus in train will support economic activity and minimize tail risks of significant deflationary pressures, and monetary policy should remain accommodative until recovery is firmly underway. Systemic financial instability is a tail risk. Nevertheless, heightened vigilance and readiness to deploy newly-formulated tools to support financial stability are warranted, to forestall worsening adverse macro-financial feedback.

A. Monetary Policy: Warding Off Deflation Risks

13. Staff welcomed the monetary easing undertaken so far, and agreed with the authorities that maintaining an accommodative stance would be appropriate. Continued communication about the price stability outlook and the downside risks to inflation would signal a commitment to maintain an easy stance as long as needed to avoid an undershooting of inflation and inflation expectations. Indeed, recent measures from the Bank of Canada have gone beyond traditional open market and discount window operations, which along with the government’s mortgage-backed securities purchase program, have entailed elements of unconventional easing. Bank officials noted that they are working on refining the monetary policy framework (in time for the BoC’s April Monetary Policy Report) with a view to using quantitative easing measures, if needed.6 However, the authorities emphasized that monetary policy in Canada is highly effective: medium-term inflation expectations are well-anchored and the monetary transmission mechanism functions smoothly because banks are stable. Bank officials also stressed that they will continue to monitor carefully economic and financial developments to evaluate the measures required to meet the 2-percent inflation target over the medium term. That said, they saw deflationary risks as quite low.7


10 Year Treasury Bond Yields and Quantitative Easing Measures

Citation: IMF Staff Country Reports 2009, 162; 10.5089/9781451807080.002.A001

Source: Bloomberg.

14. Staff supported the Bank’s floating exchange rate policy, noting that the currency has served as an effective “shock absorber.” The authorities reiterated their policy of letting markets determine the exchange rate. They observed that currency interventions were generally ineffective in developed-country markets, and for Canada would be reserved for countering disorderly market conditions. They pointed to the adjustment in the Canadian dollar in recent years as evidence of its flexibility, noting that around two-thirds of the recent depreciation was explained by the plunge in commodity prices. Staff’s CGER exercise puts the Canadian dollar at near equilibrium (Box 3).8

Exchange Rate Assessment

The Canadian dollar has depreciated considerably following the plunge in commodity prices. The loonie is close to a 4-year low against the U.S. dollar while it is close to a 7-year low against the Japanese yen—Canada’s third largest trading partner after the United States and the European Union. Depreciation pressures started to emerge in early 2008, driven partly by broad-based U.S. dollar strength amid decreasing risk appetite. In effective terms, the nominal and real exchange rates have fallen by around 17 percent since early 2008, with most of the depreciation occurring in the midst of the financial market turmoil.


Canada: Nominal and Real Effective Exchange Rate

(monthly percentage change)

Citation: IMF Staff Country Reports 2009, 162; 10.5089/9781451807080.002.A001

Source: International Financial Statistics, IMF.

The last time the Bank of Canada intervened in foreign exchange markets to affect movements in the Canadian dollar was in September 1998. Prior to September 1998, Canada’s policy was to intervene systematically in the foreign exchange market to resist, in an automatic fashion, significant upward or downward pressure on the Canadian dollar. Since September 1998, however, the policy has changed and Canada intervenes in foreign exchange markets on a discretionary basis.

Three approaches have been applied to assess the level of the Canadian dollar relative to its medium-term equilibrium level, based on the estimates by the IMF’s Consultative Group on Exchange Rate Issues (CGER) which provides exchange rate assessments for a number of advanced and emerging economies from a multilateral perspective. The complementary approaches are (i) the “macroeconomic balance” approach (MB) based on the gap between the projected medium-term current account and a “CA norm” which takes into account the impact of the oil trade balance, (ii) the reduced-form “equilibrium real exchange rate” approach (ERER)—where the equilibrium RER is estimated as a function of the country’s medium-term fundamentals (such as the net foreign asset (NFA) position, the relative productivity differential between the tradable and nontradable sectors, and the terms of trade), and (iii) the “external sustainability” approach (ES)—which calculates the difference between the actual current account balance and the balance that would stabilize the NFA position of the country at some benchmark level.1 The ERER approach is probably best suited to assessing Canada’s currency, as it explicitly accounts for commodity price fluctuations.

According to these approaches, the Canadian dollar is estimated to be close to equilibrium, based on exchange rates as of February 2009:

  • According to the macroeconomic balance approach, the Canadian dollar is above fundamentals by about 4 percent. This assessment hinges on an estimated current account norm of around 0.9 percent of GDP; estimates of the norm are derived from a panel of 55 advanced and emerging economies over 1973–2006.

  • The external sustainability approach implies that the currency is about 6 percent below fundamentals.

  • The equilibrium exchange rate approach—staff’s preferred approach for Canada—suggests that the currency is at equilibrium, with the terms of trade, the productivity differential, and net foreign assets as the main determinants.


Option-Implied Volatility for Canadian Dollar- U.S. Dollar Exchange Rate at Various Maturities

Citation: IMF Staff Country Reports 2009, 162; 10.5089/9781451807080.002.A001

Source: Bloomberg.

Forward interest rates

Citation: IMF Staff Country Reports 2009, 162; 10.5089/9781451807080.002.A001

Source: Bloomberg1/ 3x6 FRA = 3-month maturity forward rate agreement, beginning in 3 months.

Nevertheless, derivative prices imply increasing risk of large near-term currency moves.

  • Implied volatility—a measure of market uncertainty—on loonie/dollar option contracts is significantly above past peaks at short maturities.2

  • That said, the term structure of implied volatilities slopes downward, suggesting less uncertainty about exchange rate moves over longer horizons.

  • Forward CAD interest rates have moved in line with the U.S. dollar, and “risk reversals” put no premium on Canadian dollar appreciation versus the U.S. dollar.

1 For further details of these methodologies, see IMF (2008), “Exchange Rate Assessments: CGER Methodologies,” Occasional Paper No. 261.2 Implied volatility is an estimate of market uncertainty about future asset-price moves extracted from option prices. If investors were risk neutral, implied volatility would be equal to the market estimate of the standard deviation of asset price changes.

B. Safeguarding Financial Stability to Underpin Growth

15. Staff welcomed the authorities’ proactive response to financial strains. The authorities have responded to market-specific stresses and enhanced their toolkit for dealing with financial instability, notably in Budget 2009. Authorities noted that many of the measures are precautionary, while some—particularly guarantees on bank liabilities—have been adopted in part to level the international playing field.

16. Measures include:

  • Provision of liquidity through enhanced Term Purchase-and-Resale Agreements by the Bank of Canada, including at longer terms, for a wider set of counterparties, and with a broader range of accepted collateral;

  • Facilities to guarantee bank and insurance liabilities under the Canadian Lenders Assurance Facility (CLAF) and Canadian Life Insurance Assurance Facility (CLIAF) (none yet drawn);

  • Purchases of insured mortgages to boost bank liquidity and support housing finance;

  • Purchases of securities backed by automobile loans and equipment leases through the Canadian Secured Credit Facility to bolster financing for businesses and consumers (to become operational shortly);

  • Greater resources for Export Development Canada and the Business Development Bank of Canada to raise financing for corporations;

  • Increased collaboration between financial Crown corporations and private sector lenders and insurers under the new Business Credit Availability Program to ease credit constraints for creditworthy businesses;

  • Additional tools for the Canadian Deposit Insurance Corporation (CDIC), including ability to establish a bridge bank and own shares in member financial institutions; and a boost in its borrowing limit from C$6 billion to C$15 billion;

  • Broader authority for the Minister of Finance to maintain financial stability via various financial operations (including capital injections).

17. The mission noted that the ongoing Canadian credit cycle and risks to international financial stability pointed to a need for continued vigilance (Box 4). Staff advised close supervisory attention to bank exposures to U.S. assets. Authorities clarified that most U.S. operations are in the retail sector; while these exposures would be affected by the U.S. downturn, banks have already provisioned or taken write-downs against specific concentrated exposures. They also noted that an intensification in the turmoil in the auto industry would mostly affect banks via declining economic activity, given their limited direct exposure. The mission further advised vigilance on exposures to commodity-affected sectors, non-banks (especially insurers and pension plans), and households, with a particular focus on cross-institution spillovers and macroprudential risks related to high household debt. The mission saw close cooperation among supervisors as especially useful, given that Canada’s financial system is dominated by a few large and highly interconnected players. Cooperation between federal and provincial supervisors would be important as well, as certain institutions (like credit unions) were regulated at the provincial level.

Canadian Bank Losses: Implications from FSSA Stress Tests

Adapting the macroeconomic stress test from the 2008 Financial System Stability Assessment of Canada to the current outlook, staff estimates possible bank capital losses of 1 to 2 percentage points in the next two years. Compared to the outlook, the stress test envisaged a contraction of U.S. and Canadian GDP twice as large but with a faster rebound, broadly similar unemployment, and pronounced U.S. deflation. The stress test anticipated bank losses of 2.5−3.5 percentage points of capital. Extrapolating (by assuming that changes in the original stress test have a linear impact on bank capital), the current macroeconomic outlook can result in losses of about 1 to 2 percentage points of capital.

Corrections in housing prices could also cut bank capital by ½ to 1 percentage point in two years. The FSSA presented a separate test (not additive to the results above) assuming declines in real estate prices of 30 percent in Western Canada and 15 percent in Eastern Canada, projecting bank losses of about 4 percentage points of capital. Staff currently estimates that residential real estate in Canada is overvalued by about 7 percent in Western Canada, but in line with fundamentals in Eastern Canada. Using the FSSA parameters, a housing correction would lead to bank losses of about ½ to 1 percentage point of capital, taking into account a possibility of modest price overshooting on the downside.

Under a stress scenario, banks could approach or breach national capital thresholds and need to raise additional capital. As of February 2009, the six largest Canadian banks had tier 1 capital ratios above 9 percent (compared to the Basel Accord minimum of 4 percent and a national target of 7 percent) and total capital ratios above 11 percent (compared to the Basel Accord minimum of 8 percent and a national target of 10 percent). Although banks are likely to remain comfortably above the Basel minima, some may approach or even breach national targets without new capital. Since the beginning of the turmoil Canadian banks raised over C$16 billion of tier 1 capital in markets, which has more than offset the effects of provisions and writedowns on capital ratios. With the outlook for markets uncertain, the facility for public capital injections could be tapped if needed.

FSSA Stress Test Assumptions Versus IMF Forecast

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Sources: Canada FSSA 2008 and Fund staff estimates

Capitalization of Canadian banks

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March 2009. Source: Bloomberg

18. Officials expressed cautious confidence in financial stability, underpinned by a conservative financial system structure, effective supervision, and relatively strong underlying fundamentals. That said, they saw no room for complacency, and would remain watchful for signs of instability. They saw the existing system of regulation and resolution as effective (including for non-banks), with the federal authorities supervising all systemically important financial institutions, and capable of dealing with contingencies (also noting that stress tests undertaken under the FSSA had proven useful in thinking through risks). In addition, banks maintain capital ratios well above Basel standards. They agreed that cooperation between federal and provincial supervisors was essential, noting that communication lines are open, and saw provincial regulators as rigorous as federal ones.

19. Staff supported authorities’ plans to move toward centralized securities supervision, in line with recommendations of an Expert Panel on Securities Regulation and longstanding Fund advice. Budget 2009 noted the authorities’ intentions to follow the Expert Panel’s recommendations, and table a national securities act this year to lay the groundwork for a national regulator, which could become operational by Fall 2011.9 Staff noted that the current passport system of 13 provincial and territorial securities supervisors risks regulatory arbitrage and creates gaps in oversight, given that securities markets are effectively national in scope. A federal regulator could coordinate more readily with other regulators in monitoring risks and responding quickly to a crisis, and could also have an enhanced focus on the issues that securities markets may pose for national financial stability.

20. Staff discussed measures to provide relief to life insurance companies and pension funds that have been hit by the stock market downturn. These included easing capital requirements for life insurers’ segregated funds, which have suffered large writedowns in recent months, and increasing from five to ten years the amount of time companies are allotted to make up funding shortfalls in their defined-benefit pension plans.10 Staff and authorities agreed that these measures, while helpful, give only temporary relief, and the authorities plan to enact pension reforms (including on solvency funding rules) by end-2009. Looking beyond the current cycle, it seems likely that guaranteed insurance products and defined benefit plans will play smaller roles than in the past due to their substantial exposure to market risk, which questions the sustainability of these arrangements in volatile periods.


Nominal and Real Pension Fund Returns in Selected OECD Countries, (January-October 2008)

Citation: IMF Staff Country Reports 2009, 162; 10.5089/9781451807080.002.A001

Source: OECD.1/ Official data up to June 2008 then complemented by OECD estimate up to October.2/ 2008 data refer to 30 September 2008.3/ Data refer to statutory earnings-related pension plans.4/ Data refer to the mandatory and voluntary pension systems.5/ Data refer to new pension funds (contractual and open) instituted after 1993 legislation.

21. Staff also welcomed the measures to protect the long-term stability of Canada’s housing market. Along with increased funding to mortgage markets, the Canada Mortgage Bond (CMB) program was expanded to include a CMB with a 10-year maturity to attract new investors seeking assets beyond the current five-year term; two issues, the most recent on February 18, have provided an additional C$4.5 billion in liquidity to financial institutions. The government also moved to reduce the maximum loan amortization period from 40 to 35 years, and to require down payments of at least five percent for federally-insured mortgages.

C. Fiscal Actions Within a Strong Framework

22. The economic downturn coupled with fiscal stimulus will break an 11-year string of federal surpluses. Canada’s strong framework based on budgetary discipline and conservative forecasting has more than halved the net federal debt/GDP ratio in 10 years. Since 2006, the authorities have targeted an annual reduction of C$3 billion in federal government debt (0.2 percent of GDP), aiming to bring federal debt (now at around 29 percent of GDP) to 25 percent by 2011−12. However, fiscal stimulus and the recession will foster deficits and delay achieving the 25-percent-of-GDP debt target.

23. The mission supported the authorities’ proactive fiscal response to the crisis. Staff noted that the January 2009 fiscal package was appropriately large, timely, well diversified and structured for maximum effectiveness (with a large direct spending component and matching resources from the provinces on infrastructure), building on the permanent tax relief from the 2007 Fiscal and Economic Update. All told, and taking into account supplementary provincial actions announced following the federal budget, the measures total around 2 percent of GDP per year in 2009 and in 2010, making them among the largest across G-20 countries. Notably, the January stimulus relies mainly on infrastructure spending, and support to vulnerable sectors (including housing) and provinces. It boosts safety nets, thus protecting the most vulnerable; provides training to facilitate job reallocation; and allows automatic stabilizers to be given full play. It also provides permanent tax relief, particularly to low- and middle-income households. Finally, the budget cuts external tariffs, in line with Canada’s long-standing commitment to trade liberalization and openness. In this regard, the authorities noted their concern with “Buy American” provisions in the latest U.S. budget proposal, indicating that the NAFTA procurement provisions for free trade do not apply at the provincial/state level.

Discretionary Fiscal Measures in Select Countries, 2009-10

(in percent of GDP)

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Source: IMF staff estimates.

Fiscal year basis.

Excluding measures in 2007 Economic Statement.

No information is available for 2010.

Excludes financial system support measures estimated at US$797 billion (5.7 percent of 2009 GDP).


24. The near-term focus is on implementing the current stimulus package. The framework for quarterly monitoring of budget deployment (first review was completed in mid-March) will promote maximum effectiveness and provide opportunities to assess both implementation and impact. Authorities and staff agreed that the challenge would be to ensure the speedy and effective implementation of infrastructure projects, most of which will be undertaken at the subnational level. Authorities aim at having the bulk of the 2009 stimulus available for implementation as early as April, when they are legally allowed to use resources in Budget 2009. They also pointed to a “use it or lose it” clause aimed to ensure that all the spending is completed by end-FY2010.

25. The mission observed that fiscal room exists for further action, should it be needed if downside risks materialize. Staff saw the fiscal response as appropriate given Canada’s situation. However, because of Canada’s enviable fiscal position (the lowest debt to GDP ratio in the G-7 and among the lowest 10-year bond yields among industrial countries), and despite fiscal risks (Box 5), further stimulus would be feasible if needed. In particular, Canada would be well positioned to join in a further round of coordinated stimulus with other countries.

Fiscal Risks

There are increasing risks to the fiscal outlook, stemming from a more protracted recession and deflation, worsening financial conditions, declining asset and commodity prices, and sectoral problems.

  • Recession and deflation. Authorities’ calculations suggest that, if real GDP growth slows by 1 percentage point, then the federal deficit would rise by C$3.1 billion (around one-fifth of 1 percent of GDP). If GDP inflation is a percentage point lower, then Canada’s budget deficit would be 0.1 percent of GDP higher.

  • Public support to financial sector. The preemptive measures undertaken to support financial stability have had minimal fiscal impact thus far but represent contingent liabilities. While the need for public capital injections appears remote, as institutions remain solidly capitalized and have successfully raised private capital so far, this option cannot be ruled out.

  • Rollover/liquidity squeeze. While staff analysis suggests that Canada’s medium-term public net debt position will not exhibit stresses under various scenarios (e.g., lower growth outcome than envisioned or increasing contingency liabilities), there is the risk that markets may require higher interest rates if government bond supply increases sharply (although alternatively, Canadian government bonds may benefit from “safe haven” flows). With around half of net debt maturing within one year, near-term gross funding requirements are rising in importance for Canada, although debt roll-over risks remain minimal.

  • Worsening pension plans performance. With investments in equities and mutual funds of over 10 percent of GDP, large public and private pension funds are highly exposed to financial turmoil. While the Canadian pension plan (CPP) is expected to rely only on contributions until 2019 to pay benefits, the Quebec pension plan is under increasing pressure after incurring a record loss of around US$7 billion (a fourth of its net assets) in 2008 on asset sales and writedowns tied to insolvent issuers of Canadian commercial paper. The largest risk stems from a possible support for private pensions, given their rising unfunded liabilities.

  • Asset and commodity price declines. Staff estimates for G-20 countries suggest that a 10 percent decline in equity prices decreases cyclically-adjusted revenues by 0.07 and 0.08 percent of GDP in the current and subsequent year, while a similar fall in real housing prices decreases revenues by 0.27 percent of GDP in the following year. Canada would also lose around ¾ percent of GDP in revenues due to the decline in commodity prices, with increasing risks on corporate income taxes given the weakening business outlook.

  • Collapse of the automobile sector. The authorities (including the Government of Ontario) have pledged about C$4 billion in loans to the automobile sector in 2009, representing a contingent liability to the fiscal accounts in view of the large risks faced by the sector.

26. The mission discussed the limits to potential additional stimulus, although these were not seen as presently binding. Infrastructure spending had been sharply increased and would at some point face implementation constraints; larger permanent tax cuts could put at risk the underlying fiscal position; and temporary tax cuts would have limited effectiveness. The mission and the authorities agreed that automatic stabilizers should be given full play, and also concurred that Canada could join in further internationally coordinated stimulus, if needed, observing that coordination would reduce leakages from a further domestic fiscal impulse.

27. The mission welcomed the authorities’ commitment to medium-term fiscal prudence and debt reduction. In this connection, Budget 2009 noted the aim to avoid longterm structural deficits. Officials stressed their commitment to spending discipline (notably, caps on the public wage bill as in Budget 2009), including by limiting program spending once economic recovery is underway. The mission observed that this commitment to prudence, along with a strong track record of budgetary responsibility, underpinned Canada’s fiscal credibility. Staff and the authorities agreed that the considerable uncertainty surrounding the outlook complicated setting numerical debt targets at present. Targets could be recalibrated when the outlook is clearer, further bolstering fiscal credibility.11 The mission also welcomed the creation of the Parliamentary Budget Office with a mandate to support the work of parliamentary committees.

Budget Impact of Stimulus Measures

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Sources: Finance Canada; Provincial Budgets; Fund staff estimates.

Effects of phased revenue measures.

III. Staff Appraisal

28. Canada is better positioned than many countries to weather the crisis. It entered the crisis from a position of strength, reflecting a track record of strong policy management that has supported underlying macroeconomic and financial stability. It has taken proactive steps to stimulate demand, ward off deflation, and enhance the toolkit for dealing with worsening financial strains if they emerge. Thanks to these factors, the strains evident in other countries, especially in the financial sector, are markedly less serious in Canada.

29. Nevertheless, Canada faces a challenging period ahead in light of the sharp deterioration in the global environment and its strong international linkages. Employment, income, and investment will come under substantial pressure, with output recovering only as the full effects of policy stimulus are felt. With economic slack widening, core inflation will ebb to low levels. Downside risks still predominate, including negative spillovers to Canada if the global environment worsens more than expected. Accordingly, the key policy priorities are continued vigilance and readiness to respond if tail risks are realized.

30. Monetary policy should remain accommodative until disinflationary pressures abate. The aggressive monetary easing and expanded BoC facilities are justified by the subpar economic outlook and liquidity pressures. Going forward, maintaining an easy stance will limit downside risks to inflation and inflation expectations. The latter can also be managed through continued clear communication of the commitment to price stability. Unconventional measures could help to reinforce this commitment, if downside risks materialize.

31. Fiscal policy has provided significant stimulus and authorities are rightly focused on implementation. The January stimulus package was appropriately sized, diversified, and structured, and included steps to facilitate labor reallocation and protect Canada’s most vulnerable. Provincial stimulus will add to the ameliorating effects of federal measures. Moreover, the new quarterly monitoring framework will maximize the effectiveness of fiscal actions by providing opportunities to assess both their implementation and the prevailing economic environment. In addition, the move to liberalize the trade regime by lowering tariffs is welcome.

32. Canada’s sound fiscal situation would allow for further expansionary measures if they became necessary. With debt low, Canada would be well positioned to participate in a globally coordinated round of further stimulus. Meanwhile, automatic stabilizers can be given full play. Further fiscal expansion would not put at risk debt sustainability, in view of the credible commitment to medium-term structural surpluses. Looking beyond the crisis, debt targets could be recalibrated once the outlook becomes clearer; in the meantime, fiscal credibility could be supported by continuing to signal the commitment to medium-term consolidation.

33. Canada’s financial stability amid the turbulence bears testimony to effective supervision and regulation. Rigorous limits on leverage and targeted capital ratios well above Basel standards have helped to avoid vulnerabilities. In addition, five-year reviews have ensured that federal regulatory legislation is modernized periodically, while regular interaction among officials has supported the smooth exchange of information needed to preserve financial stability.

34. Consolidating and enhancing securities regulation would further strengthen the already robust financial stability framework. Over time, bringing a greater financial stability focus to securities regulation, and achieving broader national integration, would provide a more holistic perspective to financial stability arrangements. The intention expressed in Budget 2009 to follow the recommendations of the Expert Panel on Securities Regulation is an important step in the right direction.

35. The challenging credit cycle ahead calls for vigilance to forestall an adverse macro-financial feedback loop. The sharp economic downturn will continue to pressure bank credit quality, with feedback onto tighter credit conditions, thus further dampening economic activity. But proactive steps to safeguard financial stability, including by augmenting the financial stability toolkit, will serve Canada well in containing this dynamic. In addition, continued close consultation among federal supervisors and regulators could focus on risks to individual institutions and cross-institution spillovers, and macro-prudential risks related to high household debt. In addition, continued close cooperation between federal and provincial supervisors would manage any potential spillovers between provincial and national markets.

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

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.

Table 3.

Canada: Indicators of Economic Performance 1/

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

Data generated from an interim WEO submission, as of early-April 2009.