Canada has experienced drastic changes in its economy during the global financial crisis. This Selected Issues paper discusses the evolution of equilibrium real home prices in key Canadian provinces in the post-crisis period, Canadian dollar movement during and after the global financial turmoil in line with other world currencies, assessment of impacts on Canada’s potential growth, development of Canadian automotive sector—namely, NAFTA partners during the crisis, and the role of Canada Mortgage and Housing Corporation (CMHC) in Canada’s housing market.

Abstract

Canada has experienced drastic changes in its economy during the global financial crisis. This Selected Issues paper discusses the evolution of equilibrium real home prices in key Canadian provinces in the post-crisis period, Canadian dollar movement during and after the global financial turmoil in line with other world currencies, assessment of impacts on Canada’s potential growth, development of Canadian automotive sector—namely, NAFTA partners during the crisis, and the role of Canada Mortgage and Housing Corporation (CMHC) in Canada’s housing market.

III. Canada’s Potential Growth: A Post-Crisis Assessment1

A. Introduction

1. This paper revises IMF staff’s earlier assessment of the impact of the recent financial crisis on Canada’s potential growth. Such assessment is warranted now that economic recovery is underway and the immediate impact of the crisis has been observed; notably private investment during the financial crisis and thus capital accumulation have been impacted, while unemployment rate peaked at 8.7 percent in August, which could possibly affect equilibrium rates of unemployment—both lowering potential growth. While the impact of the financial crisis on total factor productivity (TFP) is not known a priori, it is unlikely that strong growth in TFP would lift Canada’s potential growth over the medium-term, given past experience.

B. Main Findings

2. We find that the potential GDP growth rate in Canada has declined significantly in 2009 and 2010 (by around ½ percentage point compared to 2008 and one full percentage point compared to the period 2004–08). The potential GDP level is also estimated to suffer a permanent decline of about 2 percent vis-à-vis a no-crisis scenario by 2015; a modest loss compared to previous financial crises in industrialized countries (Cerra and Saxena, 2008, and IMF, 2009).2 Staff estimates suggest that the loss could be eliminated if investment grows at close to twice the growth rates assumed in the latest WEO projection over the medium term.

3. The crisis has impacted mostly capital accumulation and to a lesser extent labor input with positive contributions to total factor productivity.

  • Capital accumulation. Canada has experienced a large drop in investment since mid-2008, with investment dropping by 18.5 percent during the crisis and so far only recovering by 6¾ percent since the trough, implying that it will take 4–5 years for the capital-GDP ratio to return to its historical average (as assumed in WEO projections).

  • Labor input. Due to the crisis, the unemployment rate rose from a 30-year low of 5.9 percent in early 2008 to a high of 8.7 percent in mid-2009, now standing at around 8 percent. Similar abrupt adjustments were also observed in the participation rate, which fell from a historic high of 78.6 percent in early 2008 to a trough of 77.6, now hovering at around 78.3 percent. Similarly, hours worked experienced a peak-to-trough drop of over 4 percent, though they have since recovered by over 3 percent.

  • TFP impact. So far the crisis had surprisingly a positive impact on TFP, which is estimated to have risen by over 2 percent in 2009, after a lukewarm performance in the previous years, possibly reflecting sectoral shocks and the accompanying reallocation of resources.3,4 This result is rather surprising since recent research points to negative implications from financial shocks on TFP. The explanation probably lies on several cyclical and composition effects, common during severe recessions—for instance, less skilled workers tend to be fired first and less productive firms tend to be weeded out during recessions; both effects raising observed TFP growth. To avoid this large cyclicality, estimates of potential growth use smoothed TFP growth rates.

  • Output gap. We find that the output gap reached its widest point in 2009 at 4¼ percent in mid-2009, and is expected to be halved by the end of 2010.

4. Moving forward, we expect Canada’s potential growth to rise to 2 percent over the medium term, with capital accumulation being the main driving force. Using a perpetual inventory method, including by accounting for a historical rate of depreciation of around 8 percent a year, we obtain the path for the growth in the capital stock shown in Figure 1 and Table 1, which returns to the pre-crisis recent historical average, bringing the capital-output ratio to its long-term average.5 Changes in the participation rate and hours worked due to the crisis are not expected to negatively impact potential growth over the medium term (given the flexibility of the Canadian labor market). 6 Beyond the crisis, demographic forces will contribute negatively to potential growth, with average hours of work and NAIRU expected to continue their downward trend; the latter has temporarily halted during the crisis.7 We also expect that the recent uptick in total factor productivity is mostly a one-off, cyclical effect with minimal implications over the medium term; overall, trend TFP grew by around 0.4 percent a year in the last decade, after falling in the 1990s.8

Figure 1.
Figure 1.

Canada: Potential Output Growth

Citation: IMF Staff Country Reports 2010, 378; 10.5089/9781455213559.002.A003

Sources: Haver Analytics, WEO, OECD, and author’s calculations.
Table 1.

Path for Potential Output Growth Components 1/

article image
Sources: Haver Analytics, WEO, OECD, and staff estimates.

Output-labor elasticity assumed to be 0.6 and output-capital elasticity assumed to be 0.4, see Sharpe, Arsenault and Harrison (2008).

Trend capacity utilization is calculated using data from Stats Canada (detrended by HP-filter).

Non-accelerating inflation rate of unemployment. HP filter of civilian unemployment rate, 15-64 years (seasonally adjusted).

Trend labor force participation rate calculated by applying the HP filter of the ratio between labor force and working age population.

Trend changes in annual hours work per employee is calculated by applying the HP filter of annual hours worked per employee in the total economy.

Working-age population refers to Canadian population 16-65 years of age . Projections as published by Stats Canada.

C. Conclusions and Policy Implications

5. What do our estimates imply for policymakers? Data suggest that Canada’s output gap is still considerably large, implying that the current accommodating stance for monetary and fiscal policies should stay in place. Moving forward, the crisis would have a permanent impact on Canada’s potential GDP level, implying that policies to raise potential growth would be worth considering. These could include enabling private R&D investment (which is low in Canada in international comparisons), facilitating internal trade, enabling foreign direct investment and enhancing product market competition, removing obstacles that hinder elderly labor force participation, and ensuring that incentives do not hinder firms from growing larger.9,10 Indeed, the authorities are considering or are already implementing many of the recommendations noted above as highlighted in Advantage Canada (2006)—the authorities’ economic plan to increase Canada’s competitiveness, including lowering corporate income taxation (at the provincial and federal level) and eliminating capital taxes, while in the latest Budget they committed to move forward with the recommendations of the Competition Policy Review Panel (2008) to enhance competition and productivity.

References

  • Balakrishnan, R. (2008), “Canadian Firm and Job Dynamics,” IMF Working Paper No. 08/31, International Monetary Fund.

  • Bishop, G. and D. Burleton (2009), “A New Normal: Canada’s Potential Growth During Recovery and Beyond,” TD Economics Special Report, November.

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  • Cerra, V. and S. Saxena (2008), “Growth Dynamics: The Myth of Economic Recovery,” American Economic Review, Vol. 98(1), pp. 439457.

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  • Competition Policy Review Panel (2008), Compete to Win, June, Government of Canada.

  • Cross, P., “Year-end review of 2009,” Canadian Economic Observer, Ottawa: Statistics Canada.

  • Department of Finance Canada (2006), Advantage Canada: Building a Strong Economy for Canadians.

  • Estevão, M. and T. Severo (2010), “Financial Shocks and TFP Growth,” IMF Working Paper No. 10/23, International Monetary Fund.

  • Estevão, M. and E. Tsounta (2010), “Canada’s Potential Growth: Another Victim of the Crisis?,” IMF Working Paper No. 10/13, International Monetary Fund.

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  • Haugh, D., P. Ollivaud, and D. Turner (2009), “The Macroeconomic Consequences of Banking Crises in OECD Countries,” OECD Working Paper No 683, Organization of Economic Co-operation and Development.

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  • International Monetary Fund (2009), World Economic Outlook, Crisis and Recovery, April.

  • OECD (2006), Canada: OECD Economic Surveys, June.

  • OECD (2004), Canada: OECD Economic Surveys, December.

  • Pilat, D. (2005), “Canada’s Productivity Performance in International Perspective,” International Productivity Monitor, No. 10, Spring.

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  • Statistics Canada (2007), “Depreciation Rates for the Productivity Accounts,” The Canadian Productivity Review, Research Paper No. 005.

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1

Prepared by Evridiki Tsounta. This paper is a revised and streamlined version of Estevão and Tsounta (2010).

2

According to Cross (2010), the current recession was milder than the ones in the 1980s and 1990s for Canada; GDP dropped by 3.3 percent over three quarters between the fall of 2008 and the summer of 2009, compared to a GDP decline of 4.9 percent over six quarters in the early 1980s, and a 3.4 percent GDP drop in the 1991–92 downturn over four quarters. Similarly, employment fell just 1.8 percent in the recent recession, compared with 3.2 percent in 1991–92 and 5 percent in 1981–82.

3

Estevão and Severo (2010) show that financial shocks affect TFP growth through their effect on factor allocation, which in turn depends on an industry’s degree of reliance on external funding and whether the financial shock affects firms differently within each industry. The model presented shows that TFP growth in an industry would decline if banks’ tightened lending standards cause higher heterogeneity in capital costs within an industry. That would force the market equilibrium further away from an optimal allocation of resources as done by, say, a social planner, thus reducing industry’s TFP growth. They show that for the period going from 1990 to 2007 and using data for 31 industries in the United States and Canada, financial shocks indeed tended to lower TFP growth.

4

In comparison, U.S. TFP has risen by 2.9 percent in 2009.

5

Statistics Canada (2007) indicates that Canada’s depreciation rate is greater than the rates observed in the United States due to higher depreciation in building and engineering construction. While both countries have similar depreciation rates for machinery and equipment asset classes (18 percent on average in the United States and 20 percent in Canada), there is a considerable difference between Canadian and U.S. depreciation rates for buildings and engineering construction (U.S. rate is 3 percent versus an 8 percent Canadian average).

6

Balakrishnan (2008) finds that Canada’s labor market is as efficient as the one in the United States, though the data used in the analysis are up to 2004, thus excluding the increasing strains on the Canadian labor market amid the commodity boom, intensified by internal barriers to trade (such as interprovincial mobility barriers). Labor market flexibility is reflected in the significant and immediate impact of the Canadian downturn on the unemployment rate, which increased from 6.2 percent in October 2008 to 8.7 percent in August 2009, now standing at around 8 percent.

7

Stats Canada’s baseline projections indicate that between 2006 and 2011, working-age population will rise by a cumulative 4.4 percent versus over 13 percent increase in the elderly population. This discrepancy increases over time; by 2031, the elderly population more than doubles (compared to 2006) while the size of the working-age population only increases by 8 percent.

8

For a discussion of trend TFP for industrial countries during financial crises, refer to Haugh et al. (2009).

9

Pilat (2005) finds that Canada lags many OECD countries in innovative performance and may have some scope for further catch-up. However, it notes that Canadian investment in R&D is unlikely to catch up with the R&D intensity recorded in some OECD countries, as it is limited by the structural composition of the economy—i.e., without a large high-tech industry—and by a relatively small average firm size.

10

For a more extensive discussion of possible structural reforms that could raise productivity in Canada, the reader is referred to OECD (2004 and 2006) and Bishop and Burleton (2009).

Canada: Selected Issues Paper
Author: International Monetary Fund