Public Information Notice No. 03/18

Public Information Notice: IMF Concludes 2003 Article IV Consultation with Canada

February 25, 2003

On January 31, 2003, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Canada.¹

Background

Canada's strong policy framework has brought impressive economic results, and the Canadian economy has proven exceptionally resilient in the face of the recent global downturn. Economic activity slowed relatively modestly in 2001, with only one quarter of output decline recorded, and growth recovered strongly thereafter, averaging 4 percent over the subsequent four quarters.

As in many other countries, business investment and inventory adjustments led the slowdown and subsequent recovery, while household consumption and residential investment have remained robust. Household and business demand was supported by sustained productivity growth, rapid growth of employment and labor incomes and gains in real estate prices, which helped mitigate the impact of stock market declines on household net worth. The strength of the recovery and structural reforms contributed to rapid employment growth. However, the sharp increase in the participation rate meant that the unemployment rate—which had risen to 8 percent in December 2001 from a three-decade low of 6¾ percent in mid-2000—remained at 7½ percent by end 2002.

Net external demand also remained supportive of economic activity in 2001 and, to a lesser extent, in 2002. The current account surplus, although remaining substantial, fell to near 2 percent in the first three quarters of 2002, from 2¾ percent of GDP in 2001. Continued surpluses brought Canada's net foreign liability position to just under 19 percent of GDP by end-2001, half the level of the mid-1990s.

Despite a favorable macroeconomic performance, capital outflows, lower non-energy commodity prices, and the strength of the U.S. currency contributed to continued weakness of the Canadian dollar. The dollar reached historical lows against the U.S. currency in January 2002, and despite some recent strengthening has stayed close to these levels despite the widening of interest rate differentials. In real effective terms, the Canadian dollar remains roughly 5 percent below its average of the mid-1990s.

The rebound in activity is bringing the economy back toward potential, and inflation has picked up over the past year. After breaching the Bank of Canada's 1-3 percent target range in November, headline CPI inflation fell to 3.9 percent (y/y) in December from 4.3 percent in the previous month, and core inflation also fell to 2.7 percent from 3.1 percent. A number of special factors appear to have contributed to the recent pick-up in inflation, including the base effect of discounting in the wake of the September 11^th attacks, the effect of warmer-than-usual weather in the summer on recently-deregulated electricity prices, automobile insurance price hikes, and tobacco price increases, while the recent decline in inflation largely reflected the rebates provided by the Ontario government for past electricity price hikes. Most measures of inflation expectations continue to be consistent with a return to the mid-point of the 1-3 percent target range by year-end.

The Bank of Canada began to withdraw monetary stimulus in early 2002, raising its target overnight rate during April-July by a cumulative 75 basis points, to 2¾ percent, in recognition of the need to act preemptively given the narrowing of the output gap. However, since July, the Bank has left the target rate unchanged, noting that, while further reductions in monetary stimulus would eventually be required, weaker near-term prospects for the U.S. and global economy and the unsettled circumstances in global financial markets argued for a pause.

A significant improvement in the fiscal position had been achieved during the past decade—the general government fiscal balance moved from a deficit of 9 percent of GDP in the early 1990s to a surplus of 3 percent of GDP in 2000, and the ratio of net public debt fell sharply. This has provided room for fiscal policy to help cushion the effects of the slowdown in recent years while demonstrating a continued commitment to debt reduction. The federal fiscal surplus (public accounts basis) fell from 1¾ percent of GDP in FY 2000/01 to about ¾ percent of GDP in FY 2001/02, reflecting cyclical effects, cuts in personal and corporate income tax rates announced in October 2000, and spending increases introduced in the December 2001 budget. With a drop in provincial surpluses totaling ¾ percent of GDP, the general government surplus declined to 1¾ percent of GDP (national accounts basis) in 2001, from over 3 percent in 2000, and has fallen further in 2002.

Executive Board Assessment

Executive Directors broadly endorsed the staff appraisal. In reviewing developments over the past year, they highlighted the remarkable resilience of the Canadian economy in the face of the global downturn, which underscores Canada's sound policy framework and the authorities' skillful policy implementation. They noted that the inflation-targeting framework has helped to anchor expectations and permitted a timely monetary policy response, and that fiscal consolidation and debt reduction undertaken since the mid-1990s have provided room to further ease tax burdens and introduce modest discretionary spending stimulus.

Directors agreed that prospects for the Canadian economy remain sound, and that domestic vulnerabilities are relatively modest. Nevertheless, they cautioned that uncertainties about the strength of the U.S. recovery and financial market developments represented important risks to the outlook, especially against the backdrop of potential geopolitical risks. They suggested, therefore, that the key challenge facing the authorities will be to balance the shorter-term risks to the outlook against the need for policies to remain firmly geared toward preparing for the fiscal consequences of population aging and boosting Canada's long-term productive potential.

In view of the uncertain global economic outlook and risks associated with developments in financial markets, Directors broadly endorsed the Bank of Canada's cautious approach to withdrawing monetary stimulus. While there was the view that it could be difficult to draw a clear-cut line between one-time and more lasting effects, there was general agreement that the recent pickup in core inflation appears to have largely reflected temporary factors and that inflation expectations seem to be well anchored. Therefore, a gradual approach to withdrawing stimulus seems to be consistent with the forward-looking, inflation-targeting framework. Looking forward, Directors agreed that a further tightening of monetary conditions would likely be needed, as the economy is now operating close to its potential. They welcomed the authorities' commitment to act decisively, if needed, to ensure that price pressures do not become embedded into inflation expectations.

Directors agreed that Canada's flexible exchange rate regime continued to serve the country well, as it has been effective in cushioning the economy from external shocks. The depreciation of the currency over the last decade has helped to offset the effects of changes in world commodity prices and mitigate the impact of the global downturn. Directors also observed that Canada's strong economic fundamentals favor a continued appreciation of the Canadian dollar over the medium term.

Directors commended the authorities' prudent fiscal management, and welcomed the re-affirmation of their commitment to budget surpluses and debt reduction, especially given looming demographic pressures. They noted that this strategy has paid important dividends in recent years, as debt reduction has provided room for tax cuts and a measured fiscal response to the recent downturn. With the retirement of the baby-boom generation starting later this decade, rising health-care costs, and the debt-to-GDP ratio still high, Directors considered it important to maintain the debt ratio on a steady downward trajectory, though many would not see the need to recommend a specific long-term target for debt reduction at this time. In this context, and given limited budgetary resources in the coming two years, Directors encouraged a close adherence to the existing budgetary framework and efforts to ensure that new initiatives are accommodated, to the extent possible, through the reprioritization of existing programs. A few Directors observed that tax burdens remained high vis-à-vis the United States, and they saw some room for further tax reductions over the medium-term as a means of boosting employment and the economy's productive capacity.

Financial pressures on the public health care system are likely to increase given demographic trends. Directors therefore stressed that reform of the system would need to be consistent with meeting longer-term federal and provincial fiscal constraints, while boosting the quality and breadth of service. Meeting these competing challenges would be difficult in light of pressures to extend coverage, and Directors suggested that further emphasis could be given to incentives that encourage efficiencies on the part of both providers and patients.

Directors commended the authorities for the substantial reforms that had been introduced over the past decade, which had contributed to the strong performance of the labor market. However, they noted that further reductions in the level of structural unemployment would be desirable, and suggested that there remain opportunities in a number of areas to further promote employment and productivity. In particular, they stressed that further reform of the Employment Insurance system—including the scaling back of regional-extended benefits, moving to a system of experience rating, and funding those Employment Insurance programs directed at broader social objectives through other revenue sources—would provide additional room to lower premiums and enhance labor market flexibility.

Directors commended Canada's strong supervisory and prudential framework, which has contributed to the banking sector remaining sound in the face of the economic downturn. They stressed that supervisors would need to remain vigilant to the risk of further pressure on asset quality.

Directors welcomed the authorities' continued commitment to implementing a strong anti-money laundering and counter-terrorism financing framework. They also welcomed steps being taken to establish a framework for approving bank mergers.

Directors commended the authorities on their pro-active response in strengthening corporate governance and preserving investor confidence, and emphasized the importance of effectively applying these new standards and institutions. In this regard, a key challenge would be to make sure that efforts to harmonize with other countries' policies in this area preserve the benefits of Canada's more principles- and disclosure-based system, and do not impose an excessive regulatory burden, especially on smaller firms. Some Directors also suggested that moving from a system of multiple securities market regulators to a more national system would serve well the goals of improved corporate governance and easing regulatory costs.

Directors welcomed Canada's long-standing commitment to trade liberalization and, in particular, the authorities' recent announcement of an extension of duty/quota-free access to imports from the least-developed countries. Directors stressed that further liberalization,

including in the areas of textile and clothing products and "supply-managed" agricultural products, would help improve domestic efficiency and provide an important impetus to multilateral efforts, including in the context of the Doha Round, to boost development through trade.

Directors welcomed the authorities' recent commitment to substantially increase the level of official development assistance (ODA) by doubling Canada's ODA commitment by 2010. However, they noted that more ambitious efforts would be needed to achieve the authorities' long-standing commitment to achieving the U.N. target of 0.7 percent of GNP.