Canada -- 2010 Article IV Mission: Concluding Statement
October 28, 2010
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.
This statement presents the preliminary assessment of the 2010 Article IV mission to Canada. Canada has emerged rapidly from the global recession, thanks to a strong policy response and a resilient financial system. However, the pace of recovery has slowed in recent months, and near-term external risks have increased. We see as a key priority for policies to remain focused on supporting the recovery while dealing with long-term challenges. Domestic and external risks warrant continued vigilance, and readiness to respond if tail risks are realized.
Context and outlook
1. Canada has rapidly emerged from the crisis. Output recovered forcefully
at end-2009 and early 2010, on the back of extraordinary and timely monetary and fiscal stimulus. In particular, the Bank of Canada cut policy rates to virtually zero, while governments launched a sizeable, targeted and temporary fiscal stimulus. Employment continued to recover, regaining pre-crisis levels, and the unemployment rate declined but remained elevated. Headline inflation moderated in the context of sizeable economic slack, while medium-run expectations remained anchored at the Bank’s target. Financial conditions improved, with lending standards continuing to normalize. Indeed, stimulus measures proved more effective in supporting demand as Canada’s financial system maintained stability, reflecting a strong supervisory and regulatory framework and proactive steps to ward off financial strains. More generally, Canada’s strong performance owed to a credible and time-tested framework for macroeconomic policy management, including the Bank’s inflation targeting regime, and prudent fiscal planning.
2. However, recent data reveal that the pace of the expansion has slowed over recent months. The recovery decelerated in the second quarter of 2010, in the context of slowing global demand and a strengthening Canadian dollar on the back of rising commodity prices. Household spending growth has also eased, as the effect of the policy stimulus diminished, and the housing market cooled. In addition, risks to the outlook have increased, including increasingly stretched household balance sheets in Canada, and elevated housing market fragilities in the United States.
3. In this context, the mission sees three main policy challenges for Canada:
• Managing the exit toward a neutral macroeconomic policy stance;
• Cementing fiscal stabilization; and
• Incorporating the lessons from the crisis for financial supervision and regulation.
Managing the exit
4. The exit from extraordinary macroeconomic stimulus will need to balance risks to the outlook with Canada’s relatively advanced cyclical position. The Bank of Canada’s recent decision to pause in its tightening cycle rightly acknowledges this balance, including the moderation in domestic and global growth. Maintaining the existing level of monetary stimulus is appropriate in light of this conjuncture, and will also help offset the drag associated with the wind-down of fiscal stimulus.
5. The stance of fiscal policy will also need to strike a balance, and is appropriately set to shift from expansion to consolidation. Canada’s planned near-term adjustment is significant, reflecting both the end of a large stimulus package and an appropriate desire to put fiscal policy back on a sustainable course. Indeed, in light of the risks to the outlook, Canada has smoothed its approach to the near-term consolidation by reducing the rise in Employment Insurance premia. The Government has also indicated that it will be flexible with respect to the deadlines for completion of unfinished infrastructure projects under the Economic Action Plan. These actions are welcome. Monetary and fiscal authorities should be prepared to act should the downside risks materialize.
6. The government’s fiscal strategy appropriately charts a course to fiscal balance over the medium term. The plan to eliminate the deficit by FY2015-16 would put the net debt-to-GDP ratio on a downward trajectory from already low levels, maintaining Canada’s standing as having the strongest fiscal position in the G-7. In addition, the framework laid out in the Update of Economic and Fiscal Projections uses appropriately conservative adjustments to its near-term growth assumptions in light of uncertainties about the economic outlook. The plan includes appropriately ambitious goals for restraining program spending, with the aim to return its ratio to GDP to the historically low levels observed before the global recession; indeed, program spending would be essentially frozen in inflation-adjusted terms. In the event that this adjustment proves difficult to implement, other steps would need to be considered, such as steps to restrain growth in transfers to provinces or enhance revenues.
7. The fiscal strategy includes welcome, growth-friendly measures to support Canada’s long-run economic potential. Continued public infrastructure spending will strengthen the backbone of Canada’s economy, while ongoing steps to further reduce the marginal effective tax rate on capital formation will encourage private investment. In this context, Canada’s intention to eliminate all remaining tariffs on manufacturing inputs and machinery and equipment is noteworthy, and shows leadership at a time of heightened risks of protectionism internationally. Complementary structural reforms could include further steps to reduce interprovincial barriers to labor mobility, as well as stepped-up efforts to reform product markets and liberalize FDI.
8. For the longer-run, restraining growth in health care spending will be an essential ingredient in fiscal stability. Like many advanced countries, Canada faces the twin long-run challenges of population aging and health-care inflation. Left unchecked, growth in health care spending would put increasing and unsustainable pressure on the fiscal positions of Canada’s governments. Increasing transparency and communication about these challenges and their long-run implications would help to increase public awareness and contribute to the debate about possible solutions. Options could include developing arrangements for provinces to share experiences in managing costs and reaping efficiency gains, in renewing federal transfers to provinces and territories in support of health care after current arrangements expire in 2013-14.
Financial stability—lessons from the crisis
9. Canada’s financial stability arrangements continue to serve it well. Unlike a number of its peers, Canada’s financial system maintained the ability to intermediate funds during the crisis, and avoided the systemic strains evident elsewhere. While measures of financial stress such as arrears and nonperforming loans have risen, they remain at modest levels, while capitalization is strong by international comparison. This good performance reflects a sound approach to financial stability, with strong cooperation among the relevant agencies, high prudential standards, strict supervision, and a proactive policy response to the crisis. Looking ahead, the authorities are rightly alert to potential risks surrounding elevated household debt in Canada and financial institutions’ exposures to the U.S. economy; continued stress testing for downside risk scenarios is appropriate. They have also appropriately responded to emerging risks in the housing market by tightening mortgage standards in 2008 and earlier this year.
10. Canada is well positioned to update its framework in line with emerging international initiatives. The transition to the Basel III framework of higher capital and liquidity standards should be smooth, given the already high requirements and the sound balance-sheet positions of the banks. Indeed, the factors underlying Canada’s resilience to financial strains that emerged during the crisis—including a well-regulated mortgage market, limited reliance on wholesale funding, consolidated supervision of commercial and investment banking activities, a conservative leverage ratio, and close cooperation among entities responsible for financial stability—have importantly informed the international debate on financial regulatory reform. Going forward, Canada’s emphasis is appropriately on strengthening the infrastructure for OTC derivatives markets, improving the resolution mechanism via contingent capital, and calibrating macroprudential tools, such as countercyclical capital buffers.
11. The initiative toward national securities regulation is another essential part of this framework. In this connection, the steady progress toward this goal is welcome. The creation of a national securities regulator will both bridge potential gaps in the supervision and regulation of what are essentially national markets, and create a venue for bringing securities regulation into the ambit of national coordinating initiatives for promoting financial stability.
The mission thanks the Canadian authorities for their hospitality and for the open and frank discussions during our mission, which have proven invaluable in enhancing our understanding of the situation in Canada and the attendant policy challenges. We look forward to your feedback on our preliminary conclusions.