Canada: Staff Report for the 2016 Article IV Consultation

After several years of solid growth, real GDP growth decelerated to 1.2 percent in 2015, as energy companies slashed investment spending in response to the decline in oil prices. Growth is expected to rebound in 2016, supported by exchange rate depreciation and accommodative monetary and fiscal policies, but uncertainty about oil prices, challenges in sustaining the global recovery, and elevated domestic vulnerabilities suggest risks to the outlook are tilted to the downside. A new government, led by Prime Minister Trudeau, took office in late 2015.


After several years of solid growth, real GDP growth decelerated to 1.2 percent in 2015, as energy companies slashed investment spending in response to the decline in oil prices. Growth is expected to rebound in 2016, supported by exchange rate depreciation and accommodative monetary and fiscal policies, but uncertainty about oil prices, challenges in sustaining the global recovery, and elevated domestic vulnerabilities suggest risks to the outlook are tilted to the downside. A new government, led by Prime Minister Trudeau, took office in late 2015.

A Sobering Year

A. The Macroeconomic and Political Context

1. After almost two years, the effects of the oil price shock continue to reverberate through the Canadian economy (Figures 12). Oil prices have fallen by 60 percent since 2014, with the spot WTI touching a low of US$27 in January 2016. At these prices, the oil sands industry is struggling to break even. With oil and gas accounting for a large share of economic and financial activity, the effects of the oil price decline have spread through the economy, transmitted through macro-financial linkages (Box 1). The economy slipped into recession in the first half of 2015, as oil companies slashed investment spending, and the stock market fell by 17 percent. In a pro-active move to insure against falling prices and slowing growth, the Bank of Canada (BOC) cut the policy rate twice in 2015. The economy recovered in the second half of 2015 and is likely to gain strength in 2016, but the complex adjustment to lower oil prices continue to weigh on the near-term outlook.

Figure 1.
Figure 1.

Lower Oil Prices Hit The Canadian Economy Hard

Citation: IMF Staff Country Reports 2016, 146; 10.5089/9781475530872.002.A001

Sources: Statistics Canada; Haver Analytics; Bank of Canada; and IMF staff estimates.1/ Natural gas, refined petroleum products, electricity and other energy products.
Figure 2.
Figure 2.

Complex Macro-Financial Channels… Still Unfolding

Citation: IMF Staff Country Reports 2016, 146; 10.5089/9781475530872.002.A001

Sources: Moody’s Credit Edge, Statistics Canada, Haver Analytics and IMF staff estimates.1/ Non-resource provinces are Quebec, Ontario and British Columbia; resource provinces are Saskatchewan, Alberta and Newfoundland, but data reflects only Alberta and Saskatchewan.2/ Values in reverse order.3/ One year EDF 25 percentile (total sample, 253 energy companies).

Canada: Oil and Gas Sector Snapshot

article image
Sources: Statistics Canada, Bloomberg and IMF staff estimates.

Includes support activities for mining and oil.

Includes forestry, fishing, mining, oil and gas sectors.

2. A new government, led by Prime Minister Trudeau, took office in late 2015. It announced its first Budget in March 2016, emphasizing infrastructure investment and strengthening the middle class as central to growing the economy.

B. Adjusting to Lower Oil Prices

3. Growth has decelerated but inflation expectations remain well anchored. Real GDP growth decelerated to 1.2 percent in 2015, down from 2.5 percent in 2014 (Table 1). Headline and core inflation were within the BOC’s target range (1–3 percent). Two opposing factors were at play with respect to consumer prices: pass-through from a weaker Canadian dollar was adding to inflationary pressures, while lower energy prices and slack in the economy were placing downward pressures. Notwithstanding the magnitude of the oil shock, a terms-of-trade decline of 8 percent in one year, the labor market has held up relatively well, with the unemployment rate rising slightly above 7 percent (Figure 3).

Table 1.

Canada: Selected Economic Indicators, 2012–17

(Percentage change, unless otherwise indicated)

article image
Sources: Haver Analytics and Fund staff calculations.

Percent of GDP.

In percent.

Figure 3.
Figure 3.

Canada’s Labor Market Has Fared Relatively Well

Citation: IMF Staff Country Reports 2016, 146; 10.5089/9781475530872.002.A001

Sources: Statistics Canada; Haver Analytics; and IMF staff estimates.

Canada: Contributions to GDP Growth

(Percent change from previous semester, seasonally adjusted)

Citation: IMF Staff Country Reports 2016, 146; 10.5089/9781475530872.002.A001

Source: Statistics Canada, Haver Analytics, and IMF staff calculations.

Canada: Macro-Financial Linkages from Oil Shock


First Round Effects on the Economy and Banking System

Citation: IMF Staff Country Reports 2016, 146; 10.5089/9781475530872.002.A001

Slowing growth in 2015 reflected:

  • Substantially weaker business investment, as oil companies cut investment spending by 40 percent in the face of declining profits. Canadian oil sands producers have high “all-in break-even” costs and their long-term viability is at stake. Those companies involved in upstream activities, in particular, face higher solvency risk and difficulties in raising new financing. The market for high yield debt has been frozen since early 2015 and banks have become more cautious in extending credit. Corporate bond spreads rose by 40 basis points (bp).

  • A slowdown in private consumption, owing to the impact of the oil shock on employment and house prices in resource-rich provinces. For the country as a whole, growth in real disposable income declined and in early 2016 consumer sentiment with respect to making big-ticket purchases, like a home or a car, fell to its worst level since the 2008–09 recession.

  • An uninspiring performance of non-energy exports, which grew well below what would have been expected given the more competitive Canadian dollar and recovery in the U.S. This reflects the erosion of manufacturing capacity during the oil boom years (2002–12), when the real effective exchange rate appreciated by 57 percent, and Canada lost market share in the U.S. (75 percent of Canada’s exports go to the United States) to Mexico and China. Weak external demand, beyond the nascent U.S. recovery, was also a factor.


Crude Oil Production Costs

(US$ per Barrel)

Citation: IMF Staff Country Reports 2016, 146; 10.5089/9781475530872.002.A001

Source: IEA, and IMF staff estimates.

4. With the slowdown in growth, the output gap has re-opened. The output gap narrowed from over 3½ percent of GDP in 2009 to almost zero in 2014. However, with rising slack in the economy, the output gap widened to 1 percent of GDP at the end of 2015. The latest Business Outlook Survey indicates the incidence of labor shortages remains low and the share of involuntary part-time workers remains elevated at 4.5 percent of the labor force. There are no signs of wage pressures.


Canada: Output Gap

(Percent of potential GDP)

Citation: IMF Staff Country Reports 2016, 146; 10.5089/9781475530872.002.A001

Sources: Bank of Canada and IMF staff estimates.

5. So far in 2016, economic performance has been mixed. While better than expected housing expenditure and exports at the beginning of the year has boosted first quarter growth, they have since slowed suggesting that the growth momentum is unlikely to be sustained in the second quarter. The Fort McMurray fires could also dampen second quarter growth although the overall impact for the year is likely to be limited.1

6. The banking system remains sound but exposure to the oil and gas sector will require higher provisions against expected losses (Figure 4 and Table 6). Canada’s banking system is dominated by six banks accounting for 93 percent of bank assets.2 These banks are among the most profitable in the world, averaging 16 percent return on equity. They have stepped up the pace of business lending in recent years, but household credit which grew by double digits in 2010–11 has slowed to 5 percent today. The expansion in business credit and increase in non-interest income have offset declining interest income margins. As a result, the big six banks have continued to build up capital, with their common equity Tier 1 ratios rising above 10 percent, while non-performing loans (NPLs) remain below ½ percent. The banks’ mortgage book is also secured by government guarantees on high risk mortgage loans (those with loan-to-value (LTV) ratios above 80 percent) some of which are pooled to raise financing in the securitization market. Insured mortgage loans account for 50 percent of banks’ mortgage loan portfolio. In terms of these banks’ exposure to the oil and gas sector:

Figure 4.
Figure 4.
Figure 4.

Financial Sector Remains Resilient But Challenges Are Emerging

Citation: IMF Staff Country Reports 2016, 146; 10.5089/9781475530872.002.A001

Sources: Bank of Canada; SNL, Database; Haver Analytics; Banks’ Annual Reports; Barclays; and IMF staff estimates.Source: OSFI and IMF staff estimates.
Table 2.

Canada: Balance of Payments, 2014–21

(Percent of GDP)

article image
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.

Percentage change.

Table 3.

Canada: External Debt 2007–15 1/

(End period)

article image
Source: Haver Analytics and IMF Staff estimates.

Short-term instruments include: money market, loans, deposits, trade credits, and other debt liabilities. Long term includes: bonds and notes, loans, and other debt liabilities.

Table 4.

Canada: Medium-Term Scenario 2013–21

(Percentage change, unless otherwise indicated)

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

Contribution to growth.

Percent of GDP.


Percent of potential GDP.

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

Percent of disposable income.

Table 5.

Canada: General Government Fiscal Indicators, 2013–21 1/

(Percent of GDP, unless otherwise indicated)

article image
Sources: Statistics Canada; Department of Finance Canada; provincial budget reports; Haver Analytics; and IMF staff estimates.

National Accounts basis.

Percent of potential GDP.

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

Table 6.

Canada: Financial Soundness Indicators 2010–15

(Percent, unless otherwise indicated)

article image
Sources: IMF FSI database; and IMF staff calculations.

Billions of Canadian dollars.


G-SIBS and Canada D-SIBs: Return on Equity

(As of February 2016, in percent)

Citation: IMF Staff Country Reports 2016, 146; 10.5089/9781475530872.002.A001

Sources: Bloomberg and IMF staff estimates.
  • Direct lending is limited to 2 percent of total loans on average, with another 2 percent in undrawn credit lines, but the indirect exposure through household and business lending in resource-rich provinces is a more substantial 13–15 percent.

  • Credit quality has deteriorated since 2014. Oil companies’ stock prices have fallen by 35 percent, their operating margin has declined by almost 15 percentage points, and their median probability of default has increased sharply (Box 2).

  • Loan delinquencies are gradually rising, albeit from low levels. Liquidity constrained companies are struggling to find buyers for their assets, as a result of a substantial decline in mergers and acquisitions activity. Banks are reviewing covenant breaches as part of their “borrowing base re-determination” and may be forced to take provisions for higher credit losses.3 Overall, the estimated increase in provisions is likely to be substantial, but it is from a low base, and will thus hit banks’ earnings rather than capital.4

  • The gradual increase in the overall NPL ratio probably reflects the cushion provided by severance packages, which could last more than a year, and the extension of unemployment benefits provided in the 2016 Budget. So far, the number of insolvencies filed by consumers in Alberta has increased by almost 40 percent from a year ago (Figure 5).

Figure 5.
Figure 5.

Housing Sector Vulnerabilities Have Increased

Citation: IMF Staff Country Reports 2016, 146; 10.5089/9781475530872.002.A001

Sources: CREA; CMHC; Haver Analytics; Statistics Canada; and IMF staff estimates.1/ Consumer loans and residential mortgage loans.

7. More broadly, vulnerabilities in the financial system are rising in the context of the oil shock and elevated household debt. With an economy weakened by the oil shock and historically high household debt (165 percent of disposable income), vulnerabilities in the housing market have increased (Figure 5). Low interest rates keep debt servicing costs manageable but there are important reasons for heightened vigilance:


Canada: House Prices Deviation from Fundamentals

(In percent)

Citation: IMF Staff Country Reports 2016, 146; 10.5089/9781475530872.002.A001

Sources: CREA, Haver Analytics and IMF staff estimates.

Canada: Business Cycle and Housing Cycle

Citation: IMF Staff Country Reports 2016, 146; 10.5089/9781475530872.002.A001

Source: IMF staff estimates1/ Measured as average of house price growth, residential mortgage credit growth, real investment growth (all standardized z-score) and a deviation in the residential mortgage credit to GDP ratio from its historical trend.
  • Although house prices in Alberta and other resource provinces are declining, they are rapidly rising in British Columbia and Ontario (Box 3 and Table 7). Staff estimates national house prices to be about 10–30 percent above their fundamental values.

  • The proportion of debt held by highly indebted households (those with debt to income of 350 percent or more) has risen from 13 percent to 21 percent. The bulk of this debt is mortgages held by younger and low- to middle-income households, who have fewer savings to cushion an employment shock in an economic downturn.

  • The business and housing cycles are beginning to diverge, and while the gap is smaller than during 2008–09, it is occurring in the context of much higher household debt. The BOC estimates that higher debt, under a stress scenario, leads to 27 percent greater mortgage loan arrears after three years.5

Table 7.

Canada: Heat Maps of Regional Housing Markets

article image
Notes:1. Colors are based on Z-scores, which are calculated on the annual growth rate of nominal house prices, real residential investment, real residential mortgage loans, on the trend of household debt-to-GDP ratio, and on the level of sales to new listing index. House prices and sales-to-new listing ratios are those for major cities in the sample provinces, while the other variables are those for provinces. The data are quarterly, and the sample period is from Q1 1995 to Q4 2015.2. Total index is calculated using the principal component methodology.

Canada: Bank Exposure to Solvency Risk of Oil and Gas Sector

The solvency risk of the Canadian corporate sector, and specifically of oil and gas companies, is estimated using a new corporate default database and a Bottom-up Default Analysis (BuDA) tool developed by Duan et al (2015). BuDA forecasts the median probability of default (PD) by incorporating economy-wide effects, firm-specific balance sheet information, and market-based factors. The model is estimated directly with default and other exit data for the U.S. and Canada. Staff prefers to use the BuDA model to assess corporate solvency risk since the default database and calibration methodology is made available and such hybrid models add predictive power to the pure contingent claims approach derived from the Merton (1973, 1974) model. With the projected PDs, the impact of higher credit risk on bank balance sheets can be assessed using the one-factor Vasicek (1991) model. Higher PDs require banks to raise new provisions to cushion against higher expected losses.

Baseline macroeconomic scenario

Under the baseline scenario for 108 oil and gas companies, projected PDs will increase and stay elevated through most of 2016, but subsequently subside owing to a rebound in external demand and a gradual recovery in oil prices. For a sample of 72 companies involved in oil exploration and production, the median PD is projected to peak at about 1.2 percent in the first half of 2016. This implies a credit rating deterioration of about four notches, from Ba1 to B2, compared to the second half of 2014. PDs of the overall nonfinancial corporate sector are, however, projected to rise to only 0.3 percent, indicating limited spillover from the oil to the non-oil sector.


Median Probability of Default


Citation: IMF Staff Country Reports 2016, 146; 10.5089/9781475530872.002.A001

Sources: IMF staff estimates based on BuDA and Moody’s rating grades.

BuDA versus Moody’s Expected Default Frequency (EDF)

Market analysts typically use Moody’s EDFs to assess risks in individual sectors of the economy. For roughly the same sample of 70 companies involved in oil exploration and production (as used in BuDA), Moody’s EDF suggests an increase in the median 12-month EDF to an average of 4.5 percent in the first half of 2016, which is larger than projected by BuDA. The difference in PDs and EDFs can be explained by two main factors. First, Moody’s EDFs are based on a mapping between the distance-to-default (DtD), which is derived from equity prices and not default data, and the observed default rate of firms with similar DtD “buckets”. In general, the EDF curve overestimates the default risk of low- and medium-risk firms. Second, Moody’s has on average higher frequency of default observations. Hence, for a given sample, EDFs are likely to be 2 to 4 times as large as BuDA PDs.


Contributions to Changes in Projected Corporate PDs /1

(basis points)

Citation: IMF Staff Country Reports 2016, 146; 10.5089/9781475530872.002.A001

1/ Changes compared to the scenario where the values of the macrovariables are fixed at their December 2015 levels.2/ Include domestic GDP and unemployment.3/ Include US growth, short-term and long-term interest rates.Sources: IMF staff estimates based on BuDA.

Impact on provisions

As an illustrative scenario, the projected increase in BuDA PDs suggests that banks may need to at least double provisions against energy loans compared to the average 2015 level. Given the level of provisions at end-2015, the potential impact on earnings could range between 1 to 3 percent of annual net income, therefore leaving capital unaffected.

Canada: A Spotlight on Regional Housing Markets

The oil shock has caused housing market trends to “trifurcate” (see heat maps in Table 7).1 So far, there has been no contagion risk between the diverging markets.

Resource provinces (Alberta and Saskatchewan, accounting for 23 percent of national GDP)

  • Alberta’s economy has contracted by an estimated 4 percent in 2015 and is projected to shrink by another 1.6 percent in 2016.

  • House prices in Calgary and Regina have fallen by 3–4 percent from their peak in 2014 and rental vacancies have quadrupled within the span of one year (October 2014–2015). The decline in house prices followed a massive housing market boom in the mid-2000s when house prices soared by 200 percent (2004–07). With little prospect for a quick recovery in oil prices in the near term, house prices in these regions are likely to continue to trend downward.

  • Alberta and Saskatchewan account for 21 percent of total household debt (2012–14) and uninsured mortgages are non-recourse loans.2 So far, strategic defaults have not occurred in any significant way. Consumer insolvencies have increased by 40 percent over the past year but remain small as a share of total loans (Figure 5).


Canada: House Price Index

(Percent change y-o-y)

Citation: IMF Staff Country Reports 2016, 146; 10.5089/9781475530872.002.A001

Sources: CREA and IMF staff estimates.

Non-resource provinces (British Columbia and Ontario, accounting for 49 percent of national GDP)

  • British Columbia and Ontario are expected to grow by 2–3 percent this year.

  • House prices have been growing by 10–20 percent year-on-year, fueled by cheap borrowing costs, demographic pressures, land supply constraints and foreign demand. Ad hoc survey data suggest that in 2015 Chinese investors accounted for 14 percent of total sales volume ($9 billion) in Toronto and 33 percent of total sales ($12.7 billion) in Vancouver.3

  • Both British Columbia and Ontario account for 55 percent of total housing debt.

Incidence of Highly Indebted Households 1/

article image

Households with a debt-to-income ratio of 350 percent and above.

Sources: Bank of Canada’s Financial System Review 2015, Ipsos Reid and IMF staff estimates.

Rest of Canada (accounting for 28 percent of national GDP)

  • In Quebec where the economy has been growing at about 1 percent, house prices (Montreal) have been rising at a more moderate pace of 1–2 percent. Quebec and the Atlantic provinces account for 24 percent of total household debt.

1 Financial System Review, December 2015, Bank of Canada.2 In the event of default, the bank is not able to go after the other assets of the borrower if the house sells for less than what the borrower owes.3 Routledge, Fini and Poon, National Bank of Canada, 2016.

8. The external position is moderately weaker than implied by fundamentals. Despite the depreciated Canadian dollar, the current account has deteriorated. Mimicking the oil price descent, the Canadian dollar has fallen 33 percent against the U.S. dollar since the beginning of 2014. In real effective terms, the exchange rate is now about 20 percent lower than its 2010-peak. Nevertheless, lower export prices of oil and other commodities pushed the trade balance further into negative territory and the current account deficit rose from 2.3 percent of GDP in 2014 to 3.3 percent of GDP in 2015 (Figure 6 and Tables 23). With foreign direct investment recording a net outflow, the current account deficit was mostly financed by portfolio inflows and other investment. Staff estimates the current account gap to be between -2 and -1 percent of GDP, smaller than the External Balance Assessment estimate, when supply constraints are taken into account (Annex II). The real effective exchange rate is estimated to be overvalued by 0 to 5 percent relative to medium-term fundamentals and desirable policy settings.

Figure 6.
Figure 6.

External Sector Has Weakened

Citation: IMF Staff Country Reports 2016, 146; 10.5089/9781475530872.002.A001

Source: Statistics Canada, Bank of Canada and IMF staff estimates.1/ Bank of Canada measure for predicting Canadian exports. It captures the composition of demand in the U.S. and elsewhere, also controls for changes in relative prices.2/ Barnett and Charbonneau (2015).

Oil Prices and Exchange Rate

Citation: IMF Staff Country Reports 2016, 146; 10.5089/9781475530872.002.A001

Sources: Haver Analytics and IMF staff estimates.

9. The slowdown in the economy has weakened public finances, with performance at the provincial level diverging along the lines of their resource dependence. In recent years, both the federal and provincial governments have undertaken consolidation measures enabling a narrowing of the general government overall deficit from 4¾ percent of GDP in 2010 to 0.5 percent of GDP in 2014 (Table 5). This was undone by the oil shock, however, and the general government deficit widened again to 1.7 percent in 2015.

  • The federal government delivered a surplus (¼ percent of GDP) in 2014 (the first time since 2008), but slipped into a small deficit (¼ percent of GDP) in 2015. Revenue collections performed as expected, with solid personal income and corporate tax revenues, but were offset by higher than expected spending on most expenditure categories.

  • Alberta has been hit hard by the lower oil price, due to its heavy dependence on oil royalty revenues (20 percent of total revenues in 2014), and is expecting an operational deficit of 2¾ percent of GDP in FY2015–16 after two consecutive years of surpluses.6 In contrast, British Columbia and Quebec are expected to maintain operational balance, and Ontario is expected to narrow its operational deficit to 2 percent in FY2015–16, on the back of buoyant revenues and cuts in public wages and administrative costs.

Outlook, Risks, and Spillovers

A. Outlook

10. A modest recovery in the near term. GDP growth is projected to recover gradually to 1.7 percent in 2016 and 2.2 percent in 2017. The projection assumes another 30 percent decline in investment spending by the energy sector in 2016 since oil prices are likely to be range-bound as markets search for a new equilibrium; a gradual pick up in non-energy exports, as manufacturing regains competitiveness and U.S. demand remains strong; and in line with this, growth in business investment is expected to strengthen starting in 2017 as the drag from cuts in energy-related investment spending dissipates and stronger non-energy exports absorb available capacity. Imports are projected to increase over the medium term and real business credit gradually recovers to sustain the expansion in business investment. Private consumption is expected to remain solid, supported by easy monetary policy and steady increase in household credit. Fiscal stimulus is expected to boost growth and facilitate a faster return to potential.7


Real Credit Growth 1/

(Percent change, y/y)

Citation: IMF Staff Country Reports 2016, 146; 10.5089/9781475530872.002.A001

Sources: Haver Analytics and IMF staff estimates.1/ The explanatory variables for forecasting household credit growth include household consumption and household borrowing interest rates, and those for business credit growth include business investment and business borrowing interest rates.

Canada: Country Financial Stability Map

Citation: IMF Staff Country Reports 2016, 146; 10.5089/9781475530872.002.A001

Note: Away from center signifies higher risks, easier monetary and financial conditions, or higher risk appetite.

11. Cautious optimism over the medium-term outlook. The oil shock has prompted a fundamental process of structural adjustment. Capital and labor are being reallocated from the resource to the non-resource sectors (Figure 2).8 The manufacturing and services sectors are expected to benefit although it will take time for capacity that was eroded during the oil boom years to be restored. How this transformation plays out will determine the outcome on growth. In this context, supportive demand policies would help facilitate the structural adjustment and make structural reforms that have upfront costs more palatable. Staff assumes a smooth transition that will enable Canada to take advantage of shifting global trade patterns and raise potential growth to about 2 percent in the medium term, which is still lower than the annual average of 2¼ percent over the past 15 years (Table 4).

B. Risks

12. Risks to the outlook are tilted to the downside (Risk Assessment Matrix and Box 5).

  • Persistently low energy prices pose an important risk to the economy. Oil companies have already cut cost significantly. A protracted period of low oil prices could force some firms to permanently shut down production, as room for generating additional cost savings or productivity gains would be limited. This would trigger second round effects on investment and growth, as banks shed bad loans and curtail lending. Over the long term, deep industry cutbacks on investment will affect the ability of the oil industry to ramp up production once oil markets start to rebalance.

  • Higher uncertainty about global growth prospects and a lack of effective policy response to offset headwinds could lead to persistent weakness in global trade and investment. The U.S. economy is Canada’s dominant trading partner, but other economies (Asia and Europe) are still important export markets.

  • Spillovers from China to Canada would mostly be felt through a slowdown in trade9 and weaker commodity prices since there is little direct exposure of Canadian banks to China. According to BOC estimates, if Chinese growth slows by one percentage point Canadian growth would slip one-tenth of a percentage point. 10 By comparison, if the same decline happened to the U.S., the impact on Canada’s GDP would be six times greater.11

  • Tighter global financial conditions due to higher risk aversion and pressure on banks in Europe, or a significant and sudden depreciation of the renminbi could be disruptive to the global financial system, with implications for financial conditions in Canada. A disorderly U.S. monetary policy normalization could also raise Canada’s long-term government bond yields as they have generally moved in line with those in the U.S.12 Shorter yields are likely to rise by less, reflecting perceived differences in monetary policy prospects.

  • The key domestic risk is a sharp correction in the housing market. A severe recession that triggers a sharp rise in the unemployment rate could destabilize housing markets, setting off adverse feedback loops in the economy, and leading to greater financial stability risks.13 Given extensive government-backed mortgage insurance, the impact of a severe housing downturn on the federal fiscal position could be considerable and potentially limit the room for fiscal stimulus down the road (Annex III).

  • In a tail risk scenario, all these risks could occur concurrently and intertwine, aggravating macro-financial spillover channels. The probability of such an event occurring is low, but the impact obviously would be very significant. The stress tests of the 2014 FSAP show that the banking system would be able to withstand a major recession scenario that includes a 50 percent drop in oil prices, an increase in the unemployment rate to a peak of 13.2 percent, and a 34 percent decline over 3 years (22 percent in the first year) in house prices. All banks would fall below the supervisory threshold, but the recapitalization needs would be manageable. Furthermore, since the time of the FSAP, banks have improved their capital position. Finally, the Canada Mortgage and Housing Corporation (CMHC) and the private mortgage insurers own earnings and loss absorption capacity provide another layer of cushion between losses on mortgage insurance and the fiscal impact on the government.

13. There is also upside potential to the medium-term outlook. A better than expected recovery in Canadian exports would strengthen business investment and facilitate a faster reallocation of resources from the energy to the non-energy sectors.

14. Furthermore, Canada’s strong fundamentals will help mitigate the impact if downside risks materialize. Canada has strong institutions and a track record of consistent policies. Its growth performance has been among the strongest in major advanced economies post-2008. Furthermore, despite rising short-term external debt, Canada enjoys a positive net international investment position because it owns substantial assets overseas. This provides a natural hedge to currency risk on aggregate debt. Its flexible exchange rate is also an important shock absorber.

C. Spillovers

15. There are potential outward spillovers from Canada to the Caribbean.

  • Canadian banks have had a long historical connection to the region, but low returns and bad debts have led to banks scaling back operations, including closing branches. A materialization of downside risks could exacerbate Canadian banks’ ongoing rationalization of their operations in the region. Tourism revenues may also suffer as Canada is a major source of tourist traffic to the region, second only to the U.S.

  • A recent World Bank perception survey of correspondent banking relationships (CBRs) indicated pressure on CBRs of local/regional banks in the Caribbean, but did not indicate any material reduction in Canadian banks’ CBRs in the region. The Office of the Superintendent of Financial Institutions (OSFI) does not at present collect data on this trend. While it is challenging to gather reliable and conclusive evidence of withdrawal of CBRs, OSFI should take steps to actively monitor the trends in CBRs provided by Canadian banks.

  • Canadian banks are choosing not to step into the gap left behind by retreating global banks, partly because higher regulatory compliance costs have made the risk-reward equation challenging. In this context, Canadian banks are looking for greater clarity in national and international standards, including with respect to regulations to counter money laundering and offshore tax evasion and avoidance (Box 4).


Canadian Banks’ Claims on Caribbean

(In billions of USD)

Citation: IMF Staff Country Reports 2016, 146; 10.5089/9781475530872.002.A001

Sources: Bank of Canada and IMF staff estimates.

Selected Bank Caribbean Exposures and NPLs


Citation: IMF Staff Country Reports 2016, 146; 10.5089/9781475530872.002.A001

Sources: Bank of Canada and IMF staff estimates.

Canada: Risk Assessment Matrix14

(Scale—low, medium, and high)

article image

Canada: Correspondent Banking Relationships with the Caribbean

A long history. Canadian banks have been in the Caribbean since the 19th century, when Royal Bank of Canada (as Merchants Bank of Halifax) and Scotiabank first set up shop in Bermuda and Jamaica. Today, the two banks and Canadian Imperial Bank of Commerce have numerous branches spread across the archipelago and account for 75–80 percent of all banking assets in Barbados, Grenada and the Bahamas, and 60 percent of the assets of the ECCU banking system. Scotiabank has the largest footprint with C$32 billion in total loans to the region.

Recent trends. Global banks have recently been terminating or restricting their corresponding banking relationships (CBRs) with local/regional banks across the world. In particular, the Caribbean has been potentially affected by declining CBRs, with even central banks not being immune. While it has been challenging to gather conclusive data on these trends, a recent World Bank perception survey1 indicated pressure on CBRs of local/regional banks in the Caribbean. The potential drivers behind the withdrawal of CBRs are multiple and may relate to business strategy and/or cost/benefit analysis, including in the context of implementation of regulatory obligations, such as capital and liquidity rules, AML/CFT, economic and trade sanctions, and tax transparency. In some instances, withdrawals of CBRs can result from unclear, poorly communicated, or conflicting regulatory expectations. So far, there is no evidence of a macroeconomic impact from the withdrawals of CBRs, and it seems most institutions have found replacements for lost CBRs with varying degrees of difficulty. Concerns have been expressed that pressure from withdrawal of CBRs may be leading to higher costs for remittances and related services, but supporting evidence is still lacking.

Risk-reward equation. While Canadian banks have no immediate plans to significantly cut CBRs, they are taking a hard look at the risk-return tradeoffs. On the one hand, the cost of regulatory compliance has increased, notably as U.S. regulators have taken a more concerted approach to enforcing AML/CFT regulations and bilateral initiatives like the 2010 U.S. Foreign Account Tax Compliance Act to combat tax evasion. On the other hand, Caribbean consumer businesses have low profit margins and the target consumer population in the region could not bear higher fees, so boosting profit margins through the repricing of bank services is not a feasible option. At the present time, Canadian banks see little scope for expanding their presence to fill the gap left by retreating global banks.

1 Withdrawal from Correspondent Banking: Where, Why, and What To Do About It? World Bank, November 2015.

Canada: The Estimated Impact of Lower Oil Prices and Risk Scenarios

Factors driving the decline in oil prices

Relative to 2014, oil prices fell, in annual average terms, by roughly 50 percent in 2015. Futures markets prices suggest a further decline in 2016 and only a very gradual recovery afterwards. As detailed in Arezki and others (2016) and shown in the Chart, changes in oil price projections since the April 2014 WEO can be decomposed into three key factors: increases in oil supply, weaker global activity (as proxied by global real GDP growth), and improved energy efficiency. This decomposition is done using historical and forecast data on oil supply from the International Energy Agency’s (IEA) World Energy Outlook and the oil model described in Benes and others (2015). Higher oil supply is estimated to account for almost the entire decline in oil prices in 2015, but its importance will diminish over time; weaker global activity and improved energy efficiency would become more important drivers of changes in oil prices after 2016. The IMF model G20MOD is used to illustrate how these individual factors affect Canada’s medium-term growth path.


Decomposition of the Change in Oil Prices: 2014 WEO versus April 2016 WEO

(US$ per barrel)

Citation: IMF Staff Country Reports 2016, 146; 10.5089/9781475530872.002.A001

Source: IMF staff calculations.

Estimating the net impact of lower oil prices on Canada’s economy

The factors that drive the decline in oil prices matter for Canada’s medium-term economic outlook.

  • If only supply factors were at play, Canada’s GDP level would be lower by 0.5 percent compared to 2014 projections. In this case, the positive impact on the global economy and the U.S. economy in particular, accrue over time and generate demand for Canadian exports, which partially offsets the negative effects on investment and consumption from lower oil prices.

  • A demand-induced decline in oil prices would have the largest effect on economic growth in the medium term. The demand and supply factors together (Scenario 2) would lower Canada’s GDP in the medium term by 4 percent compared to what was projected in 2014.


Canada: Estimated Impact of Lower Oil Prices

Citation: IMF Staff Country Reports 2016, 146; 10.5089/9781475530872.002.A001

Source: IMF Staff estimates.

The transmission effects work as follows: similar to Scenario 1, lower oil prices would significantly reduce investment and weaker domestic income would lower private consumption. However, the decline in global aggregate demand added to Scenario 2 (represented by the red-shaded share of the fall in oil prices in the Chart above) would weigh on Canada’s exports. As a result, under Scenario 2, global aggregate demand would not be able to offset the negative effects on investment and consumption from lower oil prices.

  • Changes in the oil price caused by improvements in energy efficiency are estimated to have a small effect on Canada’s GDP.

Risk scenarios

Four scenarios are considered, drawing on the G20MOD simulation exercises elaborated in recent WEOs. In the first scenario, lower-than-expected private investment and higher-than-expected private saving lead to secular stagnation and weaker domestic demand in advanced economies (AEs). In the second scenario, investors’ expectations of lower future growth results in lower investment and weaker domestic demand in the emerging market economies (EMs). The third scenario combines the first two scenarios. The fourth scenario illustrates the impact on Canada’s growth if G20 countries implement their Brisbane Growth Strategy commitments in terms of product and labor market reforms.

Secular stagnation in AEs has a larger negative effect on Canadian growth compared with a structural slowdown in EMs, even though the latter triggers a larger decline of oil prices. Under the AE secular stagnation scenario, Canada’s GDP level by 2021 would be about 1.5 percent lower than currently projected, while an EM structural slowdown would reduce Canada’s GDP by about 0.8 percent by 2021. The two scenarios combined would significantly dent Canada’s outlook through both weaker U.S. demand and lower commodity prices. In this case, Canada’s GDP level by 2021 would be about 2.3 percent lower than currently projected. Finally, if G20 countries press ahead with product and labor market reform commitments, losses in medium-term output would narrow by 0.4 percentage points compared to Scenario 3.


Canada: Downside Risk Scenario

Citation: IMF Staff Country Reports 2016, 146; 10.5089/9781475530872.002.A001

Source:IMF Staff estimates.

Policy Challenges

The policy mix over the near-term should cushion the adverse effects of lower oil prices on the economy while safeguarding financial stability. If downside risks materialize, there is scope for both monetary and fiscal policy to provide additional stimulus to the economy, even as macroprudential measures are stepped up to mitigate potential financial stability risks. With accommodative policies in place, the timing is right for a renewed push on structural reform to position Canada in the long term for new growth opportunities (for traction of past Fund advice, see Annex I).

A. Monetary Policy

16. The current monetary policy stance is appropriate. The BOC should stand ready to cut the policy rate if downside risks materialize and the economy falters. However, with the policy rate at 0.5 percent, the room for additional cuts is limited (Figure 7).

Figure 7.
Figure 7.

Monetary and Financial Market Conditions Remain Favorable

Citation: IMF Staff Country Reports 2016, 146; 10.5089/9781475530872.002.A001

Source: Haver Analytics, Consensus Economics, Statistics Canada, Bank of Canada, Bloomberg, and IMF Staff estimates.1/ Estimated rate as of May 2016 using Bloomberg’s World Interest Rate Implied Probability (WIRP).2/ Weighted average of various mortgage and consumer loan interest rates minus federal bond average yield.3/ Estimated effective bank lending rates to business minus federal bond average yield.4/ FTSE TMX Canada all corporate bond average yield minus federal bond average yield.

17. It would be appropriate to seek recourse to unconventional monetary policy measures in the event that the economy slows significantly and deflationary risks emerge, but clear communication would be critical. Staff welcomes the BOC’s recently updated framework for unconventional monetary policy, which includes forward guidance, large-scale asset purchases, negative interest rates, and funding for credit (Annex IV). The BOC is not committed to any specific order in which these policy measures will be used. Staff agrees that the efficacy of each measure will depend on the economic and financial context and, in some cases, the measures could be mutually reinforcing when used in combination. In the event unconventional monetary policy measures are put to use, the BOC should communicate clearly its diagnosis of the problem and the merits as well as the transmission channels of the measures it plans to pursue.

18. Monetary policy is a blunt tool to address housing market vulnerabilities and macroprudential policy should remain the first line of defense in safeguarding financial stability. The costs of using monetary policy for financial stability objectives, or “leaning against the wind”, outweigh the benefits, except in circumstances where credit growth is exceptionally high for an extended period. Hence, macroprudential policy should generally be the first port of call to address financial stability risks, and this has indeed been the case in Canada. That being said, the BOC sees a role for monetary policy in financial stability and staff agrees that its risk management approach to monetary policy appropriately takes into account financial stability considerations within its flexible inflation targeting framework.

B. Fiscal Policy

19. The federal government has the fiscal space to support the economy. Canada’s overall fiscal position remains strong (Table 5). Although the general government’s gross debt is relatively high at about 90 percent of GDP, the gross debt of the federal government is considerably lower at 40 percent of GDP. Including financial assets would further reduce the federal government (net) debt to 23 percent of GDP.

20. The federal government’s pro-growth 2016 budget is appropriate. Low interest rates and the low debt burden provide fiscal space without undermining the outlook for medium-term debt sustainability (Annex III). Against this backdrop, the stimulus measures in the 2016 Budget are welcome since they will also help alleviate the burden on monetary policy in providing near-term demand support. A more active role for fiscal policy will strengthen the overall policy mix by reducing the need for further monetary easing and thus limit the scope for excessive risk taking in a low interest rate environment. The stimulus package includes discretionary measures totaling 1¼ percent of GDP spread over FY2016–17 and FY2017–18, more than 40 percent of which are allocated to mostly shovel-ready infrastructure projects. Staff estimates that the measures would boost annual growth by ½ percentage point of GDP in each of the next two fiscal years, based on a conservative fiscal multiplier.15 In line with this, the overall deficit will increase from ¼ percent of GDP in 2015 to around 1 percent of GDP in 2016 and 2017.