Canada
Staff Report for the 2011 Article IV Consultation

The Canadian monetary and fiscal policies have remained accommodative, reflecting in large measure the effective response to the crisis. Canada is expected to set the appropriate policy mix in the future, at a time of high uncertainty and significant external headwinds. Given the advanced stage of the recovery, a still-large budget deficit, and the need to address long-term fiscal challenges, fiscal policy has moved toward a tightening stance. Resilient household credit has helped sustain private consumption and the construction sector during the crisis.

Abstract

The Canadian monetary and fiscal policies have remained accommodative, reflecting in large measure the effective response to the crisis. Canada is expected to set the appropriate policy mix in the future, at a time of high uncertainty and significant external headwinds. Given the advanced stage of the recovery, a still-large budget deficit, and the need to address long-term fiscal challenges, fiscal policy has moved toward a tightening stance. Resilient household credit has helped sustain private consumption and the construction sector during the crisis.

RECENT DEVELOPMENTS AND OUTLOOK

A. Context: The Economic Recovery is Well Advanced

1. The Canadian economy recovered strongly in 2010, thanks to a decisive policy response, a resilient financial sector, and high commodity prices. The economy expanded well above its potential rate in 2010, and GDP returned to pre-crisis levels in Q3 2010 (Figure 1). Unemployment has declined from its 2009 peak, reflecting rising public and private employment, but is still above 2008 levels. Both monetary and fiscal policies have remained accommodative, reflecting in large measure the effective response to the crisis.

Figure 1.
Figure 1.

The State of Canada’s Recovery

Citation: IMF Staff Country Reports 2011, 364; 10.5089/9781463929220.002.A001

Sources: Haver Analytics and Fund staff calculations.1/ Peak is defined as the highest quarterly GDP level between 2005 and 2008. Trough is the lowest quarterly GDP level 2008–2010. Current is 2011Q1 except UK and US which is 2011Q2.2/ Excluding Canada, simple average.3/Commodity exporters are Australia, New Zealand, and Norway, simple average.

2. A key challenge facing Canada will be to set the appropriate policy mix going forward, at a time of high uncertainty and significant external headwinds. Given the advanced stage of the recovery, a still-large budget deficit, and the need to address long-term fiscal challenges, fiscal policy has moved toward a tightening stance. At the same time, faced with an uncertain external environment and extraordinarily low levels of U.S. interest rates likely for a prolonged time, monetary policy is expected to remain accommodative. A key challenge is how to calibrate the policy response should external conditions deteriorate further, taking a toll on the outlook for Canada. At the same time, the policy toolkit may need to include macro-prudential measures, since further sustained increases in household debt and house prices would increase risks to macroeconomic stability.

B. The Current Conjuncture

3. Economic growth is cooling off in 2011, reflecting an adverse external environment and more subdued domestic demand. After a strong first quarter, the expansion stalled in Q2 2011, partly due to transient factors (Japan’s earthquake and other factors hampering energy exports) and a weaker external environment. Domestic demand remained the driver of growth, but at a more moderate pace given a slowdown in government spending and private consumption. Business investment, on the other hand, continued to boom, reflecting low funding costs, cheaper imports of capital goods, and elevated commodity prices.

4. After surging in 2010, growth in private consumption and residential construction has moderated, reflecting slower growth in household incomes and consumer credit as well as tighter mortgage rules. Resilient household credit helped sustain private consumption and the construction sector during the crisis. However, it also led to an increase in household debt to record levels—now standing at close to 150 percent of disposable income, higher than in the U. S.1 Private consumption growth decelerated markedly in the first half of 2011, reflecting both weaker growth in real disposable income and a sharp deceleration in consumer credit. In addition, since 2008, the government has implemented macro-prudential policies to tighten mortgage lending standards by adjusting the rules for government-backed insured mortgages. These measures have helped tame mortgage growth from very high rates in 2007–08 to a still robust pace of 6.7 percent (s.a.a.r.) in August of 2011 (Figure 2). Residential investment also decelerated sharply in the second quarter of 2011 after a strong increase in the previous quarter, as the latest mortgage measures took effect.

Figure 2.
Figure 2.

Canada’s Housing Boom

Citation: IMF Staff Country Reports 2011, 364; 10.5089/9781463929220.002.A001

Sources: Canadian Real Estate Association, Haver Analytics, Teranet, and Fund staff calculations.
uA01fig02

Household Debt

(Percent of disposable income)

Citation: IMF Staff Country Reports 2011, 364; 10.5089/9781463929220.002.A001

Sources: Haver Analytics and Fund staff calculations.

5. Unemployment has been falling steadily, but weaknesses in some segments of the economy are impeding a more robust expansion of private sector employment and wages. Driven by growth in the public sector and private services, total employment has expanded by about 1½ percent relative to 2008, helping to sustain the economic recovery. The unemployment rate, which fell from a high of 8¾ percent in August 2009 to 7.3 percent in October 2011, still remains above pre-crisis levels and estimates for the long-run NAIRU (around 6 percent). The recovery in private sector employment has been hampered by large job losses in manufacturing (where employment remains 10 percent below 2008 levels), and to a lesser degree, agriculture, and forestry (Figure 3). The lackluster performance of these sectors is also linked to their heavy exposure to the U.S. markets that suffered the most during the crisis (e.g., housing and auto). Wage growth has been modest, with no real gains in the first half of 2011 relative to same period in 2010.

Figure 3.
Figure 3.

The Labor Market is Gradually Recovering

Citation: IMF Staff Country Reports 2011, 364; 10.5089/9781463929220.002.A001

Sources: Haver Analytics, Statistics Canada, and Fund staff calculations.

6. The external current account balance deteriorated sharply in recent years, reflecting the effects of the crisis (particularly in the U.S.) and a gradual loss of external competitiveness over the last decade. After a decade of surpluses, the current account balance shifted to a deficit of 3 percent of GDP in 2009–10, mostly reflecting much weaker export volumes after the crisis (Figure 4). Exports of autos, machinery, and lumber were particularly affected by the collapse in U.S. demand, the strength of the Canadian dollar, and competition from emerging markets. The deterioration in the external accounts also reflects a structural loss of external competitiveness over the last decade that was exacerbated by the crisis—export volumes in 2010 remain below 2000 levels (Box 1). Foreign purchases of government and corporate debt securities have been the main source of large net capital inflows.

Figure 4.
Figure 4.

External Developments

Citation: IMF Staff Country Reports 2011, 364; 10.5089/9781463929220.002.A001

Sources: Haver Analytics, IMF International Financial Statistics, IMF World Economic Outlook, Joint External Debt Hub (most recent data), and Fund staff calculations.
uA01fig03

Current Account and Capital Flows

(Billions of USD, left; percent of GDP, right)

Citation: IMF Staff Country Reports 2011, 364; 10.5089/9781463929220.002.A001

Sources: IMF International Financial Statistics, Haver Analytics and Fund staff calculations.

7. Core inflation remains contained and inflationary expectations are well anchored around the target. Twelve-month headline inflation has been hovering around 3 percent, the upper limit of the Bank of Canada control range of 1–3 percent, mainly reflecting higher fuel prices and, to a lesser degree, food prices. Core inflation, the main guide for monetary policy, remains close to the 2 percent target. The policy rate has been kept constant at 1 percent since September 2010, in a context of well-behaved inflationary expectations, existing economic slack, and an uncertain global outlook (Figure 5).

Figure 5.
Figure 5.

Monetary Policy Remains Accommodative

Citation: IMF Staff Country Reports 2011, 364; 10.5089/9781463929220.002.A001

Sources: Bloomberg L.P., Haver Analytics, Statistics Canada, and Fund staff calculations.

8. The corporate and financial sectors have weathered well the recent volatility in international financial markets. As of late November, the stock market is some 10 percent lower relative to end-2010, as fears of a European crisis and uncertainty about the U.S. have mounted. Despite some recent tightening, credit conditions remain highly favorable, with firms taking advantage of funding costs well below historical averages. Lending to households has slowed, but credit growth to businesses rebounded to 6 percent y/y in the third quarter of 2011, with the Senior Loan Officer Survey pointing to still-easy lending conditions (Figure 6). The 3-month CAD Libor-OIS spread has remained low and banks have been accessing funding at historically low rates.

Figure 6.
Figure 6.

Financial Markets Continued to Face Bouts of Volatility, but Credit Conditions Remain Favorable

Citation: IMF Staff Country Reports 2011, 364; 10.5089/9781463929220.002.A001

Sources: Bank of Canada, Bloomberg LLC., Canadian Office of the Superintendent of Financial Institutions, Haver Analytics, and Fund staff calculations.

9. The Canadian banking sector is in a solid position. Profits have returned to pre-Lehman levels, in line with sound asset quality and an adequate level of capital and provisions. Average returns on equity have remained at high levels since 2010, above 15 percent. Despite the rapid expansion in credit, with residential mortgage loans as the main driver, nonperforming loans (NPLs) have remained below 1.2 percent of total loans. Provisioning ratios average 73 percent of NPLs for the main financial institutions. Tier 1 capital levels are above 13 percent under Basel II definitions, while common equity ratios adjusted for Basel III deductions are above 7 percent. Liquidity levels are adequate, with banks funded for the remaining of 2011 and most of 2012. The market for covered bonds is developing rapidly, with total issuance by Canadian financial institutions reaching C$40 billion by 2011.

C. Outlook and Risks

10. The economy is expected to grow at a moderate pace over the next quarters, with easy financial conditions and still-high commodity prices supporting domestic demand. Recent indicators point to a rebound in the second half of this year, as some of the transitory factors that led to a contraction in Q2 dissipate. However, the outlook remains uncertain. Consumer confidence is at the lowest levels in two years and business sentiment is less positive than earlier in 2011. Staff projects growth to decelerate to around 2 percent on average in 2011 and 2012, constrained by weak external demand and ongoing fiscal adjustment. Private demand will remain the driving force behind growth, with investment expected to play a key role. Several large projects in the energy and mining sector are in the pipeline and firms are expected to take advantage of very favorable funding conditions and cheaper imports of capital goods (due to a strong Canadian dollar).

11. With weaker terms of trade, the current account deficit is projected to deteriorate to 3¾ percent of GDP in 2012. With foreign demand remaining lackluster in the near term and weaker oil prices and terms of trade, the current account deficit is projected to remain around 3½ percent of GDP over the 2011–13 period. The recovery in the U.S. economy is expected to lead to a stronger trade balance over time, but rebalancing would be eased by a weaker Canadian dollar, which staff assesses to be on the strong side of medium-term fundamentals (Box 2). This would help offset slower growth of domestic demand needed to raise domestic savings, as the envisioned fiscal consolidation is implemented.

12. While the baseline medium-term scenario is broadly positive, risks are tilted to the downside. The main risks are external, associated with negative spillovers from Europe and the U.S., as well as lower commodity prices.

  • External headwinds from a weaker U.S. economy and distress in European debt markets. A worsening of U.S. growth prospects or financial conditions would likely have a substantial negative impact on Canada given the close trade and financial links, although arguably lower than typical, given already-depressed U.S. demand for autos and housing.2 Further financial turmoil in Europe is considered by the Canadian authorities as the main source of risk for Canada. Spillovers could be transmitted via trade, financial, and confidence channels. While direct trade and financial linkages are relatively modest, indirect spillovers could be significant, operating through a decline in equity prices, falling consumer and business confidence, and higher funding costs and lower liquidity for banks leading to tighter financial conditions.

  • Lower commodity prices. These could result from weaker activity in Europe and/or the United States, but also from a slowdown in emerging markets, especially in China. A large deterioration in the terms of trade in a context of weak global demand would imply a widening in the current account deficit3 and would affect Western provinces—where house prices, investment in commodity projects, and fiscal revenue linked to commodities are particularly high—most severely. However, the impact of a decline in commodity prices on the economy and the external accounts would likely be cushioned by a depreciating currency, as the Canadian dollar has historically been strongly correlated with commodity prices.

  • On the upside, a successful resolution of Europe’s sovereign debt crisis and quicker resumption of solid growth in the U.S. would likely lead to a rebound in Canadian exports and boost consumer and business confidence.

13. On the domestic front, a key vulnerability comes from high and rising household debt and housing prices. Following a further tightening of mortgage standards in January 2011, the rate of growth of mortgage credit has slowed. Nevertheless, the high level of household indebtedness (Figure 7) and elevated housing prices are a source of vulnerability. Adverse macroeconomic shocks, such as a faltering global environment and declining commodity prices, could result in significant job losses, tighter lending standards, and declines in house prices, triggering a protracted period of weak private consumption as households reduce their debt. The effects on economic growth could be exacerbated by weaker external demand and slowing construction activity. For example, a staff downside scenario featuring an external shock4 triggering a decline in house prices by 15 percent accompanied by a severe downturn of construction activity could result in a GDP decline of some 2½ percent over a period of two years relative to the baseline.

Figure 7.
Figure 7.

High Household Indebtedness is a Key Domestic Vulnerability

Citation: IMF Staff Country Reports 2011, 364; 10.5089/9781463929220.002.A001

Sources: Bank of Canada, Canadian Office of the Superintendent of Financial Institutions, Haver Analytics, and Fund staff calculations.

POLICY DISCUSSIONS

Discussions centered on the challenges to manage the transition to a neutral macroeconomic policy stance in an unsettled external environment, while pressing ahead with the reforms needed to address long-term fiscal challenges; the potential risks posed by elevated household debt in the context of buoyant house prices and an uncertain economic outlook; and how to move forward with the domestic and international reform agenda for financial regulation and supervision.

A. Monetary Policy Remains Accommodative

14. The monetary policy stance remains highly supportive of economic activity given the negative output gap and challenging global environment. Well-behaved inflationary expectations, together with the ongoing fiscal tightening, give further policy flexibility to the Bank of Canada. The Bank has kept the policy rate at 1 percent since late 2010 and has recently indicated that this level, near historical lows, leaves considerable monetary stimulus in place. The authorities also noted that in an environment of heightened external headwinds, the policy rate does not necessarily have to return to neutral at the same time as the output gap closes. Staff agrees that it is appropriate to keep the policy rate exceptionally low for some time, provided core inflation and inflation expectations remain quiescent.5 On the other hand, should the recovery be accompanied by further sustained increases in mortgage debt as a share of disposable income spurred by low interest rates, a tightening of macro-prudential policies by the government may be needed (see below).

15. The authorities stand ready to quickly respond to a deterioration in the economic outlook and/or to spillovers from increased turbulence in global markets. Staff argued that interest rate cuts could provide some support in response to a worsening outlook (a 75 bps rate cut could raise growth by about 0.3 percentage point). The authorities agreed and noted that, in the event of a severe external shock, the Bank of Canada could deploy additional measures, as it did during the 2008–09 financial crisis. They also noted that, while banks have high levels of liquidity, the Bank of Canada could quickly activate instruments to provide liquidity if pressures were to arise due to further stress in international financial markets.6

16. The authorities noted that the inflation targeting regime has served the Canadian economy well, with the crisis highlighting the need to react flexibly in the face of risks to economic and financial stability. The Government and the Bank of Canada have just agreed to renew the inflation targeting framework (“Inflation-Control Target”) for a further five-year period. In the discussions, the authorities stressed the importance of a credible and flexible approach, noting that monetary policy may in exceptional circumstances be used to support financial stability, including by varying the horizon over which inflation is expected to return to the target. Staff welcomed the renewal of the inflation-control target and agreed with the authorities’ emphasis on a flexible approach that takes into account the evolution of risks to the outlook and financial stability.

B. Fiscal Policy: Path to a Balanced Budget over the Medium Term

17. Fiscal consolidation in now under way, as the policy stimulus is being gradually removed. The federal government, which recently updated its adjustment plans to reflect a worsening of the outlook, is leading the initial fiscal effort with a federal budget deficit reduction of some 1 percent of GDP in structural terms between 2010 and 2012, including by unwinding the stimulus measures.7 For provincial and local governments, staff expects a broadly stable deficit in 2011, on the basis of the outturn in the first half of the year and the extension of some stimulus measures, and some deficit reduction in 2012. Overall, staff projects a reduction in the general government structural deficit of around 0.3 percent of GDP in 2011 and 0.8 percent of GDP in 2012. The latter would imply a drag on economic growth of almost ½ percentage point, broadly appropriate under our baseline scenario, in light of relatively high gross debt levels, the still-large external current account deficit, and resilient private domestic demand.

18. In an uncertain global economic environment, the authorities noted that they will be flexible and pragmatic, and adjust policy as needed. Staff concurred that macroeconomic policies should respond to significant changes in the economic outlook. Specifically, in the event that the economic expansion would falter, the full operation of automatic fiscal stabilizers and a reduction in the monetary policy rate should be the first line of response—particularly in the case of lower external demand (the recent update of federal fiscal plans goes in this direction). In a scenario where domestic demand would weaken significantly, there is some space to further loosen the fiscal stance, and temporary stimulus would be appropriate in a major downside scenario. The authorities and staff agreed that any temporary stimulus program, if needed, should not derail efforts to identify the fiscal savings required to achieve the medium-term fiscal consolidation goals.

19. The authorities are strongly committed to return to a stronger fiscal position over the medium term. This is important to reverse the increase in gross and net debt that took place during the crisis (Figure 8). General government gross debt expanded by almost 19 percentage points of GDP between 2007 and 2010, to 85 percent of GDP at end-2010, reflecting both the stimulus measures and government loans to Crown corporations (Box 3 and Selected Issues paper, Chapter III), while net debt rose to 30 percent of GDP. Reversing the increase in public debt would also help deal with long-term spending pressures from population ageing and the rise in health-care costs. It will also contribute to preserve Canada’s strong fiscal reputation and help provide a buffer from stress in international sovereign debt markets. The consolidation plans of the federal government aim at a budgetary balance by 2015/16, relying on the expiration of stimulus measures, bringing spending levels as share of GDP down to pre-crisis years, and higher revenues as the output gap closes. The authorities stressed their commitment to fiscal consolidation, noting that savings expected from the Deficit Reduction Action Plan will support a return to budget balance. The exceptional funding provided to the Canada Mortgage Housing Corporation (CMHC) to purchase insured mortgages during the financial crisis will also be entirely repaid by 2014–15.

Figure 8.
Figure 8.

Fiscal Policy:The Plan to Balance

Citation: IMF Staff Country Reports 2011, 364; 10.5089/9781463929220.002.A001

Sources: Finance Canada Update of Economic and Fiscal Projections 2011, Canadian Provincial Budgets, IMF World Economic Outlook, Haver Analytics, OECD, 2010 Parliamentary Budget Officer Study, Statistics Canada, TD Economics, and Fund staff calculations.

20. Provincial governments have also announced their intention to reach balanced budgets over the next several years. The size and length of the adjustment plans vary, reflecting the heterogeneity of the fiscal situation across provinces, with those with the largest deficits (such as Ontario) taking longer to reach a balanced budget. Following recent elections in several provinces, provincial administrations will need to define how they intend to achieve their medium-term targets. As most provinces do not intend to raise taxes, restraining operational spending growth will be critical to reducing public debt while allowing space to implement infrastructure projects. Further specificity on the measures to underpin their ambitious consolidation goals would help enhance the credibility of their plans.

21. Addressing the longer-term fiscal challenges posed by rising health costs and the impact of ageing will require a joint effort by all levels of government. Sub-national governments have the main responsibility for health spending, with the federal government providing funding support via transfers. However, given the size of the challenges posed by rising health costs and the impact of ageing population, it will be critical to step up coordinated efforts between the federal and regional governments. Staff noted that the review of federal government transfers to the provinces, which must be completed by 2014/15, would provide an opportunity to make progress on this front, and that regular and comprehensive fiscal sustainability reporting covering all levels of government would help build consensus around the need for reforms. In this respect, staff welcomed the recent fiscal sustainability studies prepared by the Parliamentary Budget Office (PBO), alerting to the significant fiscal challenges that Canada would face over the longer term (Box 4).

C. Household Debt and Housing Prices: Managing the Risks

22. The authorities have adopted macro-prudential measures to rein in the build-up of household debt. While households’ net worth has been boosted by rising house prices, their debt is at a historical high relative to disposable income, mainly due to rising mortgages. In addition, several housing price indicators are significantly above historical averages and high by international comparisons. Specifically, the price-to-rent and price-to-income ratios are 29 percent and 20 percent above their averages for the last decade, respectively. While there are structural factors that can explain increases in such ratios, their elevated level and other empirical evidence suggest that house prices may be higher than justified by underlying fundamentals, at least in some provinces—staff estimates indicate an average price overvaluation of around 10 percent, with significant regional differences (Selected Issues paper, Chapter I).8 To ensure the long-term stability of housing markets, authorities have increased public awareness of the risks and, as noted, tightened mortgage insurance standards several times since 2008 (Table 1).

Table 1.

Tightening of Minimum Standards for Government-Backed Insured Mortgages Since 2008

article image
Source: Finance Canada.
uA01fig04

House Price to Income

(Index:Average 2000-2010=100)

Citation: IMF Staff Country Reports 2011, 364; 10.5089/9781463929220.002.A001

Sources: OECD and Fund staff calculations.
uA01fig05

House Price to Rent

(Index:Average 2000-2010=100)

Citation: IMF Staff Country Reports 2011, 364; 10.5089/9781463929220.002.A001

Sources: OECD and Fund staff calculations.

Those measures, together with rising uncertainty because of global financial market turmoil, have led to some reduction in the pace of mortgage credit growth.

23. The authorities and staff discussed the scope for further macro-prudential measures should household debt and house prices continue to rise much more rapidly than disposable income. While structural features of the Canadian market (high household equity in housing, recourse loans, prudent lending practices, tight financial supervision) make a U.S.-style bust unlikely, a correction in the housing market would weigh on consumption and construction activity. Staff estimates suggest that a 15 percent decline in house prices would reduce the ratio of household net worth to disposable income by 45 percentage points, and could trigger a decline in private consumption by over 1½ percent (Selected Issues paper, Chapter I). The authorities noted that there was no evidence of large mismatches between supply and demand in the residential sector. Nevertheless, they stressed that, should the slowdown in the growth of mortgage debt prove temporary, they would be ready to consider additional measures. Staff and the authorities agreed that the introduction of such measures, if required, would need to be well timed and appropriately balanced to avoid pro-cyclical effects. Staff suggested that, to minimize these risks, such measures could include larger down-payment requirements for new mortgages and requiring lower debt service-to-income ratios. Staff also inquired whether measures could target housing markets in specific provinces where prices have increased most rapidly. The authorities noted that they were not considering regulations differentiated across provinces. Continued tight supervision of financial institutions would also ensure conservative underwriting standards and strict adherence to the existing regulations.

24. In light of the Canada Mortgage and Housing Corporation’s central role in the growing housing sector, the authorities and staff agreed it will be important to continue to ensure that it has an appropriate governance structure and supervision framework. CMHC is the largest provider of mortgage insurance in Canada, accounting for more than two-thirds of the market. As a Crown corporation, it benefits from explicit government backing (Selected Issues paper, Chapter II). Stress tests conducted by CMHC suggest that its insurance business is well positioned to weather severe economic scenarios, with the most significant risks stemming from protracted episodes of high unemployment. Staff estimates also suggest that in a downside scenario with housing market distress such as the one sketched in ¶13 losses to government net worth arising from higher CMHC insurance outlays would be relatively modest, with the deterioration in fiscal accounts arising primarily from the worsened macroeconomic situation in that scenario. However, since CMHC is now one of the largest financial institutions in Canada and the key backstop to the housing market it would be useful to undertake a review aimed at ensuring that CMHC has a modern and effective governance structure and supervision, and assessing the scope for further strengthening its risk management.

D. Financial Stability: Managing External Risks and Moving Ahead With the Regulatory Reforms

25. The Canadian banking system was able to withstand the international crisis well, and the authorities have continued to monitor risks closely. They stressed that banks are well capitalized and have prudent management; nevertheless they remain vigilant, given the high external and domestic risks.

  • The authorities noted that while direct exposures of Canadian banks to Europe are estimated to be limited, further financial turmoil in the region could affect the Canadian financial system through higher funding costs, a re-pricing of assets, and lower liquidity. In this context, the authorities and staff agreed on the importance of banks having appropriate liquidity buffers, which have increased recently. Liquidity shortages could be alleviated by prompt and coordinated policy action, including central bank assistance, as during 2008–09.

  • Stress-testing scenarios developed by the authorities indicate the financial system would face manageable losses under adverse scenarios, including a significant deterioration in households’ ability to service debt—in part reflecting the large share of mortgages insured by CMHC and private insurers. Stress tests also suggest that only a protracted period of high unemployment (around 10 percent or higher) would lead to significant losses in the financial sector. At the same time, the authorities recognized that elevated household indebtedness does carry new policy challenges, as households are more vulnerable to an adverse shock.

  • When assessing resilience, the authorities also noted that, while corporate credit has accelerated in recent quarters, firms have relatively low leverage and banks are not heavily exposed to the sectors that were hit the hardest by the crisis (e.g., auto).

uA01fig06

Bank Regulatory Capital

(As a % of Risk-Weighted Assets)

Citation: IMF Staff Country Reports 2011, 364; 10.5089/9781463929220.002.A001

Sources: IMF Financial Soundness Indicators (FSIs) and Fund staff calculations.
uA01fig07

Non-Financial Corporations

(Percent)

Citation: IMF Staff Country Reports 2011, 364; 10.5089/9781463929220.002.A001

Sources: Haver Analytics and Fund staff calculations.

26. A prolonged period of low interest rates would also pose challenges to financial institutions and supervision. There is a risk, in particular, that such a scenario could encourage excessive borrowing by economic agents and risk-taking by banks. In addition, the authorities recognized that institutions with a large fixed-income portfolio, such as insurance companies and pension funds, would be negatively affected, and could be forced to change their business structure. They indicated that they were working closely with these institutions to assess the best policy response to such a scenario.

  • Insurance firms, while well capitalized and hedged, have reacted by reallocating part of their portfolio to non-fixed income securities, as well as changing pricing strategies and product menus, and expanding abroad. Pension funds with defined benefits have fewer options and may need to increase contributions or reassess benefits over time.

  • With high levels of capital and profitability, banks are better prepared to withstand lower interest rates. However, persistently low rates could put pressure on banks’ margins, leading to changes in their business model. The expansion abroad of some Canadian banks in recent years (Selected Issues paper, Chapter IV) poses new challenges for supervision. The authorities noted that banks had expanded abroad cautiously and that geographical diversification should help keep risks manageable. However, the authorities are in close contact with supervisors in destination countries to jointly assess and monitor risks.

Consolidated Foreign Claims of Canadian Banks

(Ultimate risk basis, billions of USD)

article image
Sources: Bank of International Settlements and Fund staff calculations.

27. Canada is moving forward steadily with the international financial reform agenda. The authorities are moving ahead with the action plan to adopt the Basel III capital and liquidity requirements, including with the publication of regulatory guidance relating to non-viability contingent capital and transitioning for non-qualifying instruments. The combination of sound capital management and international guidance on prudent earnings retention should result in Canadian banks meeting the 2019 Basel III capital requirements early in the transition period which starts on January 1, 2013. The authorities consider the current Assets to Capital Multiple (ACM) rule to have served Canada well and will be considering whether changes to the ACM are appropriate in the future to simplify dual reporting of leverage and to adapt the ACM to elements of the Basel III leverage ratio. Adoption of the liquidity standards under Basel III may prove to be more challenging, although these standards have not yet been fully defined. The authorities have endorsed both the liquidity coverage ratio (LCR) and the net stable funding ratio (NSFR), but considered it prudent to await the completion of an observation period for subsequent revisions of existing domestic regulations. Their expectation is that Canadian banks should be able to gradually satisfy the rules over the internationally agreed transition period, even though the implementation of the NSFR will likely require them to gradually increase their base of retail deposits funding. The authorities have indicated their agreement in principle for an FSAP-Update, which has been penciled in for 2013. In addition, the authorities also indicated that they are continuing to strengthen compliance with AML/CFT international standards in areas such as customer due diligence.

28. The authorities are committed to keeping the adoption of a national securities regulator on track, as well as to the development of CCPs for repo and OTC derivatives. A draft proposal for a national securities regulator was referred to the Supreme Court for review and a decision is still pending. The eventual adoption of the draft will require substantial coordination across provinces and the federal authorities, and a transitional office is currently in charge of harmonizing provincial rules. The authorities expect to launch the national regulator in 2012, with most provinces expected to join. Progress toward the establishment of a central counterparty (CCP) for repo markets is on track, which will help reduce counterparty risk and enhance transparency. For OTC derivatives, authorities are evaluating a shift towards global clearing houses. They noted that these may provide a lower-cost alternative compared to domestic CCPs, but could also present access challenges, particularly for mid-sized financial institutions and those not based in the CCP home jurisdiction, and may imply higher systemic risk.

29. There has also been substantial progress with the development of recovery and orderly resolution plans for Canada’s largest banks, a key component of the crisis resolution framework. A large Canadian bank was selected in 2009 to develop “living will” documents, outlining the steps the bank would follow in case of a failure. The remaining large banks were subsequently included in this exercise, and the resolution plan is now being modified on the basis of the findings of the exercise.

E. Improving External Competitiveness

30. A key structural challenge for Canada will be to strengthen its export performance after a weak decade. While the 2008 crisis has triggered a sharp deterioration in the external trade balance, Canada’s export growth had been weak for over a decade. The authorities pointed out that exchange rate appreciation had played a key role in constraining export growth, but lagging productivity growth and increased competition from emerging economies in the U.S. market also contributed (Box 1). They noted that the manufacturing sector had been undergoing an adjustment period, becoming better prepared to face the new competitive environment and stronger currency. Looking forward, they saw robust business investment as a key factor to strengthen labor productivity and competitiveness. The recovery in the U.S., particularly in sectors severely affected by the crisis such as autos and housing, should also provide a boost to exports over the next years. The Canadian government is engaged in reaching new bilateral trade agreements to help diversify Canadian exports, given slow progress in multilateral trade discussions. There is also an ongoing review of the government’s strategy toward improving business R&D, an area where Canada lags its main trade partners. Large investment projects in energy and mining also help improve export growth prospects, although some face legal and environmental challenges.

STAFF APPRAISAL

31. After a strong recovery from the crisis, growth in Canada is moderating. Thanks to a decisive policy response, a resilient financial sector, and high commodity prices, the economy expanded well above its potential growth rate in 2010. However, a substantially weaker and more uncertain external environment has taken its toll on short-run growth prospects, posing new policy challenges.

32. A key challenge will be to unwind the exceptional policy support at the right pace in a more adverse external environment. While the medium-term baseline scenario is broadly favorable, near-term uncertainty remains high. The domestic private sector is expected to drive growth as fiscal consolidation takes hold and foreign demand remains weak. Investment is expected to remain buoyant, but the outlook for private consumption is clouded by rising household indebtedness and fragile consumer confidence. Important downside risks remain, including external headwinds from financial market turmoil in Europe; a weaker U.S. economy; and lower commodity prices under a scenario of weaker global activity. The domestic impact of significant adverse external shocks could be amplified by elevated household debt and house prices.

33. With modest core inflation, well-anchored inflation expectations, and ongoing economic slack, an accommodative monetary policy stance will likely remain appropriate for some time. There is some space for further monetary easing if the economy were to weaken, and the Bank of Canada is prepared to quickly respond to liquidity strains in a scenario of heightened international financial turbulence by redeploying the tools it successfully used during the crisis. Staff also welcomes the renewal of the inflation-targeting framework, whose flexible implementation has served the Canadian economy well.

34. Fiscal policy is appropriately shifting toward consolidation in the aftermath of the effective stimulus program. The federal government is leading the initial fiscal effort, as spending is gradually being brought to pre-crisis levels as a share of GDP. It will also be important for provincial governments to move ahead with their own fiscal consolidation efforts, given their large share of public spending and fiscal deficit. Overall, the projected reduction in the general government structural deficit in 2012 is appropriate under our baseline scenario of resilient domestic demand and a somewhat higher external current account deficit.

35. Macroeconomic policies have room to adjust in response to significant changes in the economic outlook. Full operation of automatic fiscal stabilizers and a reduction in the monetary policy rate should be the first line of response if the recovery were to falter. In particular, should the outlook for domestic demand weaken materially, there is some space to loosen the fiscal stance relative to plans, and a temporary stimulus would be appropriate in a major downside scenario, while maintaining the medium-term consolidation plans.

36. Staff supports the authorities’ objective of returning to a stronger fiscal position in the medium term. This is necessary to put gross and net public debt on a declining path relative to GDP, thus placing public finances on a stronger footing to deal with the long-term spending pressures from population ageing and rising health-care costs. As the provinces’ consolidation plans rely heavily on expenditure restraint for broad programs, further specificity on the measures to underpin these ambitious goals would enhance the transparency and credibility of their plans.

37. The federal government and the provinces will also need to undertake a concerted effort to deal with the longer-term fiscal challenges posed by rising health costs in an ageing society. The review of transfers of the federal government to the provinces, which must be completed by 2014/15, would provide an opportunity in this regard. Regular and comprehensive fiscal sustainability reporting covering all levels of government would also help build consensus around the need for reforms. The recent long-term fiscal sustainability studies prepared by the PBO are an important first step forward.

38. The authorities have appropriately adopted macro-prudential measures to curb the build-up of mortgage debt. Household debt is at an historical high relative to disposable income, and various indicators suggest that house prices in some regions are above levels consistent with economic fundamentals. To ensure the long-term stability of housing markets, the authorities have increased public awareness of the risks and tightened mortgage insurance standards which, together with rising uncertainty because of global financial market turmoil, have slowed mortgage credit growth.

39. However, additional macro-prudential measures may be needed in the event of further sustained increases in household debt and house prices. In an environment of very low interest rates, there is a risk that household debt will continue to rise faster than personal disposable income. In such a scenario, further macro-prudential measures may be needed to prevent a more disruptive adjustment in the future, with due consideration to the overall cyclical position. It will also be important to continue with tight supervision of financial institutions to ensure conservative underwriting standards and strict adherence to regulations.

40. It would be useful to undertake a review of CMHC to assess the scope for modernizing its governance structure and supervision, given its key role as housing sector backstop. CMHC plays a key role in the residential mortgage sector by being the main provider of mortgage insurance and by implementing public policy in this area. CMHC is now one of the largest financial institutions in Canada and the largest federal Crown enterprise. Given elevated house prices and household debt and the potential fiscal risks associated with its balance sheet in a stress scenario, a review of CMHC’s governance structure and supervision would be very timely.

41. With the Canadian banking sector well supervised and in a solid position to manage risks, the authorities stand ready to quickly respond to spillovers from increased turbulence in international markets. Banks are well capitalized and the authorities maintain high prudential standards and tight supervision. The authorities’ stress tests also indicate banks are well prepared to manage most adverse scenarios, given their high level of capital. A sharp and prolonged increase in unemployment would represent the main risk to the financial system. In the event of increased international financial turbulence, one of the sources for potential stress to Canadian banks could be through reduced access to wholesale funding, underscoring the need for prudent liquidity buffers. Canada’s institutional arrangements are also supportive of an appropriately coordinated response from the authorities if necessary, as evidenced by their proactive approach during the crisis.

42. At the same time, a scenario of low interest rates for a prolonged period also requires close monitoring of possible negative effects on financial institutions and excessive risk taking. Such a scenario could encourage excessive borrowing by economic agents and risk-taking by banks, underscoring the need for continued close supervision. The insurance sector and pension funds would also face significant challenges if such an environment where to persist for a prolonged period of time.

43. Canada is well placed to advance with the financial reform agenda. The Canadian authorities are committed to a swift adoption of the Basel III capital and liquidity requirements, and staff welcomes progress in developing recovery and orderly resolution plans for Canada’s largest banks, a key element of the crisis resolution framework. Progress towards the establishment of a central counterparty for repo markets is on track, as is progress in the area of OTC derivatives, which will help reduce counterparty risk and enhance transparency. Staff also welcomes the government’s intention to launch a national securities regulator in 2012, which would be another tool to further strengthen oversight and the existing strong institutional financial stability framework.

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

A Decade of Waning External Competitiveness

The external trade balance has been deteriorating gradually over the last decade, after reaching a record high surplus in 2000–01. In the 1990s, Canada faced a boom in external trade, benefiting from a large depreciation of the currency and bilateral trade agreements (CUSFTA/NAFTA), leading to a trade surplus close to 6 percent of GDP. After 2001, however, exports declined sharply as a share of GDP, even though Canada faced very favorable terms of trade in 2003–08. Since 2009, the trade balance has reverted to a deficit.

Although non-energy exports were hit the hardest during the recent crisis, weak export performance started well before 2007. Between 2000 and 2007, merchandise exports excluding energy grew at an average annual rate of 0.4 percent. Subsequently, exports collapsed with the crisis and have remained well below pre-2008 levels. Non-energy export volumes are more than 10 percent below 2000 levels, while total merchandise exports are about 6 percent lower than a decade ago.

Several factors seem to be at play in explaining the weak export performance:

  • A large appreciation of the currency since 2001.

  • Weak labor productivity growth vis-à-vis foreign peers such as the U.S., U.K., and Japan. There are several possible explanations for the productivity lag, including abundant labor supply (and low incentives to invest in human capital), low investment in business R&D, and excess capacity built in the 1990s in the manufacturing sector as firms expected to keep a solid presence abroad.

  • The weaker export performance in some key markets in the U.S. (the largest trade partner by far) also coincided with gains from emerging economies, especially China. Since 2000, Canada’s market share of U.S. imports has dropped by 40–50 percent in key sectors such as machinery, transportation, and manufacturing goods—suggesting that increased competition from low-cost countries also contributed to Canadian firms’ poor performance abroad.

uA01fig08

External Trade

(Percent of GDP, s.a.a.r.)

Citation: IMF Staff Country Reports 2011, 364; 10.5089/9781463929220.002.A001

Sources: Haver Analytics and Fund staff estimates.
uA01fig09

Terms of Trade and Real Effective Exchange Rate

(Index: 2000=100, rise in REER equals appreciation)

Citation: IMF Staff Country Reports 2011, 364; 10.5089/9781463929220.002.A001

Sources: Haver Analytics and Fund staff calculations.
uA01fig10

ExportVolumes

(Index: 1990Q1=100)

Citation: IMF Staff Country Reports 2011, 364; 10.5089/9781463929220.002.A001

Sources: Haver Analytics and Fund staff calculations.
uA01fig11

Labor Productivity

(Output per hour, Index: 1999Q1=100)

Citation: IMF Staff Country Reports 2011, 364; 10.5089/9781463929220.002.A001

Sources: Haver Analytics and Fund staff calculations.

Exchange Rate Assessment

Staff assesses the Canadian dollar—which is some 10 percent above its 1980–2011 average as of end-October—to be on the strong side of fundamentals. Export performance has been weak, Canada has been losing market shares, and the current account deficit exceeds 3 percent of GDP, despite strong terms of trade. These factors notwithstanding, staff sees no risk to Canada’s external stability: the current account deficit is projected to decline as the U.S. economy recovers, net external liabilities (some 12 percent of GDP as of 2011Q2) are modest, and gross external debt (67 percent of GDP as of 2011Q2) is low relative to other advanced economies and reflects mostly domestic-currency liabilities (particularly foreign holdings of government and corporate bonds).

uA01fig12

Net International Investment Position, 1990-2016

(Percent of GDP)

Citation: IMF Staff Country Reports 2011, 364; 10.5089/9781463929220.002.A001

Sources: Haver Analytics and Fund staff calculations.

The exchange rate assessment is consistent with the quantitative estimates provided in the CGER. The most recent CGER exercise found the Canadian dollar somewhat above equilibrium (9 percent above according to the Macroeconomic Balance approach, 8 percent above according to the Equilibrium Real Exchange Rate approach, and 4 percent above according to the External Sustainability approach, as of the WEO reference period of July–August 2011). Since that period, the real effective exchange rate has depreciated by some 3 percent, while commodity prices have weakened slightly—on balance, the assessment would remain broadly unchanged.

Gross External Debt, 2011Q2

(Percent of GDP)

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Sources: IMF International Financial Statistics, Joint External Debt Hub, and Fund staff calculations.

General Government Gross and Net Debt

Canada has the lowest general government (GG) net debt among G-7 economies, reflecting substantial holdings of financial assets. At end-2010, gross debt of the GG amounted to 85 percent of GDP, while net debt amounted to only 30 percent. Less than half of the debt is owed by the federal government and the remainder by the provinces and local governments. From 2007–10, gross debt of the GG rose by almost 20 percentage points and net debt by 7 percentage points, as government claims on Crown corporations (mainly loans and equity on SOEs, and foreign exchange reserves) rose significantly. At present, these claims account for 40 percent of total GG financial assets.

The increase in the gross debt of the federal government in recent years reflects both fiscal deficits and loans to Crown corporations. At the federal level, gross debt reached 41¼ percent of GDP in 2010, while net debt was 25½ percent of GDP. The difference is mainly explained by large loans to Crown corporations since the beginning of the crisis. Of these, government loans to the Canada Mortgage Housing Corporation (CMHC) now represent about 30 of its total financial assets. The CMHC loans provided support to the mortgage market through the purchase of mortgage pools (the so-called IMPP program), which are expected to be repaid by 2015. Other sizable financial assets at the federal level include accrued tax receipts not yet collected and loans to international institutions.

The provinces and local governments have relatively high financial assets. While their total gross debt amounted to 52 percent of GDP in 2010, their net debt was only 16 percent of GDP. The substantial financial assets of sub-national governments include: (i) investments in domestic and foreign bonds and shares (around half of total assets, in part reflecting Alberta’s oil fund); (ii) government claims for about 20 percent of total; and (iii) receivables (mainly accrued tax revenues to be distributed by the federal government), loans, and cash reserves.

uA01fig13

General Government Debt

(Percent of GDP)

Citation: IMF Staff Country Reports 2011, 364; 10.5089/9781463929220.002.A001

Sources: OECD, Statistics Canada, and Fund staff calculations.

Canada: GG Financial Assets and Liabilities, 2007-10

(Percent of GDP)

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Sources: Finance Canada, OECD, and Fund staff calculations.

Government claims on Crown Corporations, mainly loans and equity.

Includes accrued corporate income taxes less collection, deferred interests, among others.

uA01fig14

Government Loans to Crown Corporations

(Percent of GDP)

Citation: IMF Staff Country Reports 2011, 364; 10.5089/9781463929220.002.A001

Sources: Finance Canada and Fund staff calculations.

Rising Health Care Spending Pressures

The health care system in Canada is predominantly publicly-financed and decentralized to the provinces. Public health care expenditures, representing about 70 percent of total health expenditures, are estimated to have increased to around 8½ percent of GDP in 2009–10. Health expenditures have increased rapidly in the 2000s mainly reflecting high health care inflation (due in part to rising earnings of health care professionals), technological changes (which contributed to rising hospital and prescription drug costs), and to a lesser degree demographic factors (ageing).1 The cash component of the “Canada Health Transfer” from the federal government to the provinces and territories finances about 20 percent of provincial public health spending.

The rise in public health expenditures is the most important long-term fiscal challenge faced by Canada, as in other advanced economies. The share of health spending in provincial budgets has been steadily rising and accounts for close to 40 percent of total program spending. The Canadian Parliamentary Budget Office (PBO) projects that health and other ageing-related expenditures will rise substantially over the next decades as a consequence of health care inflation and as the effects of population ageing intensify. The annual contribution of ageing factors to public health spending growth would rise from 0.9 percentage points in 2010 to 1.2 percentage points by 2032, and decline gradually after that. Even abstracting from ageing, the PBO assumes that health spending would grow faster than nominal GDP (0.4 percent a year, in line with the 1976–2010 average). As a consequence, public health expenditures would reach 13 percent of GDP around 2050 and 15 percent of GDP by 2085. In addition, annual federal elderly benefits are projected to rise by 1 percent of GDP by 2035/36 under the PBO study. The pressures from health and other ageing-related spending would hence lead to a substantial increase in the deficit and public debt over the long term if no compensatory spending or revenue measures were taken.

Public Expenditure on Health Care, 1980–2009

(Percent of GDP)

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Sources: OECD Health Database and Fund staff calculations.

2009 data for Japan refers to 2008.

1 “Health Care Cost Drivers: The Facts,” Canadian Institute for Health Information (2011).
Table 2.

Canada: Selected Economic Indicators, 2008–11

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Sources: Haver Analytics and Fund staff calculations.

2011 credit numbers refer to the August Y/Y growth rate.

Table 3.

Canada: Medium-Term Scenario, 2010–16

(In percent change, unless otherwise indicated)

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Sources: Haver Analytics and Fund staff calculations.

Contribution to growth.

Table 4a.

Canada: Federal Government Fiscal Indicators, 2009/10–2016/17

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Sources: Department of Finance Canada Budget, Department of Finance Canada Fiscal Update, Haver Analytics, and Fund staff estimates.

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

Authorities’ definition includes unfunded pension liabilities.

Authorities’ definition is an accumulated deficit concept.

Table 4b.

Canada: General Government Fiscal Indicators, 2009–2016 1/

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Sources: Department of Finance Canada Budget, Department of Finance Canada Fiscal Update, Haver Analytics, OECD, and Fund staff estimates.

National Accounts basis.

In percent of potential GDP.

Includes federal, provincial, territorial, and local governments; and Canada and Quebec pension plans.

Table 4c.

Canada: General Government Operations (GFSM 2001 Format), 2006–2010

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Sources: IMF International Financial Statistics and Fund staff calculations.

Includes pension liabilities not included in gross debt.

Table 5.

Canada: Balance of Payments, 2008–16

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Sources: Haver Analytics and Fund staff calculations.

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

Based on market valuation of portfolio stocks and official international reserves. 2011 represents stocks at Q2 for all components of IIP.

2011 represents stock at Q2.

Percentage change. 2011 data refers to January-October average. A minus sign indicates a depreciation in the Canadian dollar.

Table 6.

Canada: Indicators of External and Financial Vulnerability

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Sources: IMF Financial Stability Indicators, IMF International Financial Statistics, Haver Analytics, Joint External Debt Hub, Office of the Superintendent of Financial Institutions, Public Works and Government Services Canada: Public Accounts of Canada, and Fund staff calculations.

Percent change.

Portfolio investment and official international reserves valued at market prices.

Government of Canada direct and guaranteed securities and loans.

Billions of Canadian dollars.

Reported in the prior fiscal year for the following year end.

Percent.

Deflated by CPI.