Public Information Notice No. 07/18

Public Information Notice: IMF Executive Board Concludes 2007 Article IV Consultation with Canada

February 13, 2007

On January 12, 2007, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Canada.¹

Background

After surging in the first quarter of 2006, real GDP growth in Canada slowed subsequently, in part reflecting a cooling in the United States, and 2006 growth is estimated to have eased to 2¾ percent. Nonetheless, employment gains have been significant, and the unemployment rate fell to 6.1 percent, its lowest level in more than 30 years. This has partly reflected large regional disparities in economic performance, with output, wages, and prices, especially housing prices, growing much faster in the resource-rich western provinces, particularly Alberta, than in the rest of the country.

Domestic demand remained the main driver of the economy, with private consumption expanding a robust 3¾ percent and business investment growing 8 percent. Residential investment, however, started declining in the second quarter, finishing the year as a whole only 2½ percent above its 2005 level. Net exports continued to be a drag on activity, reflecting the effects of past currency appreciation and a slowdown in the United States, especially on the manufacturing sector.

A sharp decline in natural gas prices and a fall in real net exports combined to reduce the estimated 2006 current account surplus to 1¾ percent of GDP. In recent months, the Canadian dollar has also weakened somewhat, partly in response to the decline in world energy prices and diminished market expectations of a narrowing of the interest rate differential vis-à-vis the United States, but the currency still remains roughly 35 percent higher against its U.S. counterpart than it was in late 2002.

After seven ¼ percentage-point hikes through May 2006, the Bank of Canada has since left its target rate unchanged at 4¼ percent, reflecting a view that the overnight rate was consistent with achieving the 2 percent inflation target over the medium term. Indeed, the more recent decline in energy prices has helped lower headline inflation below 2 percent, and wage pressures appear modest, despite a deceleration of productivity growth.

Financial sector performance remained strong in 2006, largely reflecting continuing benign global market conditions. Long-term interest rates remained low despite monetary tightening, as did spreads on private instruments, reflecting default rates that continue to be low. Bank profitability and capital are high by historical and international standards, and distant-to-default rates suggest this strength is also reflected in the rest of the financial sector.

The federal government delivered a larger-than-anticipated surplus of 1 percent of GDP in FY2005/06, as program spending fell in nominal terms for the first time since FY1996/97. Higher-than-expected surpluses are also projected for the current fiscal year, enabling the government to advance its target for lowering the federal debt to GDP ratio to 25 percent by one year to FY2012/13, even while cutting the federal Goods and Services Tax from 7 percent to 6 percent on July 1. Provincial fiscal positions also improved, in some cases due to resource revenues.

Executive Board Assessment

Directors commended the Canadian authorities for their sound monetary and fiscal frameworks, which have delivered enviable macroeconomic and policy performance since the mid-1990s.

The strong recent performance of the Canadian economy is likely to continue, although growth risks are tilted to the downside given the possibility of a larger-than-expected U.S. slowdown. Directors welcomed the envisaged policy measures, which build on the strength and flexibility of the macroeconomic framework, and seek to achieve durable improvements in productivity and competitiveness.

Directors commended the Bank of Canada for adroitly balancing the competing concerns regarding growth and inflation, including by keeping policy rates on hold since May. With rates in the neutral range and inflationary pressures contained, the current stance appears appropriate moving forward. Directors considered that the current inflation targeting framework has served the economy very well, and welcomed the authorities' decision to renew it without change for a further five years. They noted the Bank's intention to continue to analyze the pros and cons of possible further refinements.

Directors observed that the financial sector is well positioned to cope with a turning of the global credit cycle. At the same time, Directors saw some scope to improve financial sector efficiency and innovation by reducing regulatory impediments to bank entry and consolidation, as well as by moving toward establishing a national securities regulator. They looked forward to a further analysis of financial sector issues in the planned Financial Sector Assessment Program update.

Directors agreed that fiscal policy is appropriately focused on reducing debt, lowering taxes, and reforming the equalization system. However, long-term fiscal sustainability will require continued debt reduction as well as steps to contain public spending on health care. Directors welcomed the government's commitment to using interest savings from debt reduction to lower personal income taxes, and also to reduce effective marginal tax rates on investment. Most Directors viewed these steps as likely to provide larger efficiency gains than further cuts to the Goods and Services Tax (GST), although a few noted that the reduction of the GST could support a harmonization of provincial sales taxes with the GST, thus lowering marginal effective rates on investment. The reforms suggested by the O'Brien panel on reforming the equalization transfer system would appropriately make the system even more rules-based and predictable.

Directors welcomed the emphasis on enhancing productivity growth and prosperity in the government's plans, published recently in Advantage Canada. In addition to cutting effective tax rates on capital (which would be helped by action by provinces) and improving financial market competition, they noted that the business environment could be enhanced by phasing out restrictions relating to foreign direct investment, eliminating interprovincial barriers to trade in goods and to labor mobility, and increasing the flexibility of the immigration system.

Directors encouraged Canada to work towards increasing access to its markets for agricultural goods.

¹ Under Article IV of the IMF's Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country's authorities.