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Describes the preliminary findings of IMF staff at the conclusion of certain missions (official staff visits, in most cases to member countries). Missions are undertaken as part of regular (usually annual) consultations under Article IV of the IMF's Articles of Agreement, in the context of a request to use IMF resources (borrow from the IMF), as part of discussions of staff monitored programs, and as part of other staff reviews of economic developments.

INTERNATIONAL MONETARY FUND

Canada -- 2002 Article IV Consultation

Statement of the IMF Mission

December 7, 2001

1. The sound macroeconomic and structural policies implemented and sustained by the Canadian authorities during the past decade have put the economy in a good position to weather the current global economic slowdown and the uncertainty following the tragic events of last September. Monetary policy has successfully maintained low inflation, and the Bank of Canada's policy management over the past year has further enhanced the credibility of the monetary policy framework. In this context, we welcome the authorities' decision last May to maintain the 1-3 percent inflation target range and the refinements to the framework introduced at that time. Fiscal consolidation by all levels of government has brought budgets into surplus and led to a sharp reduction in government debt as a share of GDP. Important structural reforms, including reductions in personal and corporate income taxes and improvements in the employment insurance (EI) system and financial regulatory framework, have enhanced economic efficiency and further strengthened the financial system.

2. The economic slowdown that started in late 2000 has been sharper than originally anticipated, mainly due to a more rapid slowing than expected in the United States. Looking ahead, the IMF staff projects a turnaround in both Canada and the United States starting in early 2002, with the recovery gathering pace during the year. On this basis, real GDP growth in Canada would be 1½ percent in 2001, ¾ percent in 2002, and 3½ percent in 2003. However, there are substantial downside risks to the outlook, stemming mainly from the uncertainty about the depth and duration of the U.S. slowdown, which has been compounded by the terrorist attacks.

3. We believe that monetary policy should be the main instrument used in attempting to limit the impact of the downturn. The Bank of Canada has responded promptly to signs of increasing economic weakness in recent quarters, reducing interest rates by 350 basis points since the beginning of the year. With inflationary pressures likely to remain subdued, in part due to the slackening in resource utilization and lower energy prices, and no signs of sustained upward pressure on wages, there remains scope for monetary policy to support economic activity. Within the context of its forward-looking inflation target framework, the Bank of Canada should use this room if economic prospects remain weak.

4. A flexible exchange rate arrangement has continued to serve Canada well. The recent depreciation in the exchange rate of the Canadian dollar primarily reflects cyclical conditions and helps to cushion the impact on Canada of the U.S. slowdown and the weakness in commodity prices. Canada's strong macroeconomic fundamentals should support the value of the currency over the longer term.

5. Fiscal stimulus is already being provided to the economy through the working of the automatic fiscal stabilizers, as well as the tax cuts legislated last year. The progress over the past decade in strengthening Canada's fiscal position provides room for continuing to allow the automatic stabilizers to function and for some new policy initiatives in priority areas, like national security, even if this would imply a shift to a small deficit next fiscal year. The Government should underscore that the decline in the fiscal balance reflected the impact of a series of temporary adverse shocks and did not represent any drawing back from its medium-term objective of bringing down the debt-to-GDP ratio.

6. It is important to recognize that there are limits to the extent to which fiscal policy can counteract the effects of a substantial adverse shock, especially one emanating from the United States. However, in the event of a significantly deeper and more persistent downturn than is currently envisaged, some discretionary fiscal policy actions to stimulate the economy could be considered. The need for such actions would be reinforced to the extent that provincial governments may be pushed to tighten policies by legislated balanced budget constraints. In these circumstances, any stimulus package would need to be tightly focused on boosting short-term economic activity, and it would have to be made clear that the measures would be temporary or that needed offsetting actions would be taken when the economy recovers to ensure that the objective of reducing the debt-to-GDP ratio over time is not compromised. Any perceived weakening of the commitment to debt reduction would tend to be penalized by an adverse impact on long-term interest rates.

7. Provincial and territorial governments have strengthened their finances in recent years, and they have been able to pursue tax reductions and new spending initiatives while continuing to reduce debt. Faced with pressures on their budgets from the current weakness in economic activity, several provinces are already moving to take measures in order to meet their legislated balanced budget requirements. They also face other significant pressures, especially those associated with health care. Improving health-care services is a priority of both the federal and provincial governments in the near term, and efforts should continue to be made toward more efficient delivery and greater cost control in medical services. The aging of the baby-boom generation will increase the burden on the health care system, and steps should be taken by all levels of government to start addressing these prospective needs as soon as possible.

8. The reductions in federal and provincial income tax burdens in recent years, including the substantial cuts in federal corporate and personal income taxes enacted in 2000, are welcome and should offer considerable efficiency gains in the period ahead. When the cuts are fully implemented, capital gains taxes and average corporate income tax rates will be below current levels in the United States. However, combined federal and provincial personal income tax rates in Canada will remain higher than comparable U.S. rates, and the previous gap between these tax rates will be largely re-established as the tax cuts enacted in the United States during 2001 go into effect. While we do not see a pressing case for simply matching the tax cuts in the United States, there is still scope for enhancing economic efficiency and the rewards to entrepreneurship by reducing marginal tax rates and, more importantly, by increasing the income thresholds at which they apply.

9. It will be important to resist pressures to extend EI benefits and further roll back some of the fundamental EI reforms achieved during the 1990s. The current system already contains a mechanism to provide for additional benefits in the event of cyclical downturns. Moreover, we continue to believe that the Government should reduce disincentives remaining in the EI system. Priorities with respect to education, training, and other assistance to facilitate labor market adjustment are important, and would best be addressed through other programs. Frequent use of EI, along with the automatic provision of benefits for high-unemployment regions for indefinite periods of time, has distorted incentives for both workers and employers, contributed to raising reservation wages, and hampered labor mobility. Consideration needs to be given to discourage frequent use of the system by eliminating the provision of regional extended benefits on an indefinite basis and implementing experience rating of the EI premium rate (which would link the rate for individual firms to the frequency of use of the system by their workers). The planned reductions in overall EI contribution rates over the next few years provide a good opportunity to start introducing experience rating into the system at least on a partial basis.

10. The financial system in Canada is among the most highly advanced and sound in the world, and it is supported by a well-developed regulatory and supervisory framework. In this context, we welcome the financial system reform legislation enacted last February. Financial institutions are well capitalized and provisioned, and appear well positioned to manage pressures arising from the anticipated slowdown in economic activity, including the adverse impact on corporate and household balance sheets. Nevertheless, more profound and protracted weakness in the Canadian and U.S. economies could create difficulties in parts of the financial system, and the staff agree with the authorities that they should remain alert to any such pressures.

11. Canada has long been a leader in trade liberalization initiatives at the multilateral, regional, and bilateral levels, and we urge the authorities to continue to pursue trade liberalization vigorously. While Canada has significantly reduced its barriers to trade across a wide range of products, protection levels remain high in sensitive sectors, mainly "supply-managed" agricultural products, textiles, and clothing. Canada has been generous in providing favorable access to its market for the least developed countries, but the exports of these countries to Canada still face quotas and high tariffs on some products, especially textiles and clothing. At a minimum, we strongly encourage the authorities to accelerate trade liberalization in these products in advance of the current schedule. This would help improve resource allocation in Canada and promote growth in the neediest countries.

12. Canada's official development assistance (ODA) as a share of GNP has declined by almost half since 1992 to only 0.25 percent of GNP in 2000. The IMF staff encourages the authorities to begin raising ODA spending toward Canada's long-standing development-assistance target of 0.7 percent of GNP.