Mission Concluding Statement 

November 26, 2013

This statement presents the preliminary assessment of the 2013 Article IV Consultation mission to Canada. Growth remained modest in 2013, as the expected transition from domestic demand- to export-led growth has proven elusive. The uncertain global environment weighed on exports and business investment, but competiveness challenges and infrastructure bottlenecks in the energy sector also played a role. Stronger external demand is expected to push growth above its potential rate from 2014, but the balance of risks is tilted on the downside. While residential investment and house price growth continued to moderate in 2013, elevated levels of household debt and high valuations in a number of housing markets remain a potential vulnerability. Policies should remain focused on sustaining growth until the rotation to exports and business investment gains firmer momentum, while assuring that the gradual unwinding of domestic imbalances continues and that the fiscal position is maintained on a sustainable trajectory.

1. The Canadian economy grew at a modest pace over the past year, as growth in exports and business investment disappointed. Growth has averaged 1.4 percent over the year leading up to the second quarter of 2013, compared to 2.6 percent the year before. Private consumption growth has remained robust, thanks to an increase in household wealth and still easy financial conditions, but business investment and exports made no contribution to growth. Machinery and equipment investment declined in the first half of 2013 and non-energy exports remained well below the levels reached after earlier recessions, owing to weak external demand and the persistent strength of the Canadian dollar. Temporary disruptions in a number of oil-related facilities and pipeline limitations have weighed on energy export growth. The greater degree of economic slack contributed to weaken inflationary pressures and the Bank of Canada kept the policy rate at 1 percent, the same level since September 2010. The federal government’s fiscal deficit declined at a faster-than-expected pace in 2012-13, but the impact on growth was partly offset by less restraint at other levels of government, with a number of provinces delaying the return to a balanced budget. Thanks to the macro-prudential measures adopted in the past, construction activity and house price growth converged to more sustainable trends. Household credit growth also continued to slow, but the household debt-to-income ratio reached a new high in mid-2013.

2. Staff expects growth to accelerate to 2¼ percent in 2014, from an estimated 1.6 percent this year. Our projected pick-up in the U.S. recovery (to over 3 percent on a q/q saar basis in the second half of 2014) is expected to boost Canadian exports. As final demand and capacity utilization increase, business investment is expected to strengthen, particularly spending on machinery and equipment. Investment in the energy sector is also projected to expand, with greater reliance on rail transportation and additional pipeline and refining capacity expected to reduce the volatility of the price of Canadian heavy oil. The combined additional contribution to growth from net exports and business investment will more than offset the anticipated weakening in the contribution from household consumption and residential investment, as households gradually reduce their debt burden, construction activity moderates to levels consistent with demographic trends, and house price growth slows further. Fiscal policy will remain a modest headwind, subtracting about 0.2 percentage points of GDP growth per year over the next three years. The gradual absorption of the existing economic slack is expected to drive inflation back to 2 percent by end 2015, with the policy interest rate projected to increase starting in early 2015.

3. The risks around this baseline scenario are predominantly on the downside. Significant downside risks surround the projected acceleration of the U.S. recovery next year, the main engine of Canada’s growth in our baseline scenario. Renewed political standoff over spending appropriations and the debt celing and a faster-than-expected increase in long-term rates in the context of exit from quantitative easing (QE) could negatively affect the U.S. recovery and hence demand for Canadian exports. Protracted weakness in the euro-area economic recovery and lower-than-anticipated growth in emerging markets would also hurt the prospects for Canada’s exports, including through lower commodity prices. Elevated house prices and household leverage could amplify the growth impact of these external shocks, potentially triggering a less friendly unwinding of domestic imbalances and further weakening of household spending. At the same time, a stronger performance of Canada’s housing sector poses upside risks to the growth outlook, but would also increase risks of a sharper correction of domestic imbalances down the road. On the domestic front, the long period of low productivity growth and strong Canadian dollar may have left a deeper dent in Canada’s exports potential (especially in the traditional manufacturing base), limiting the economy’s ability to benefit from the projected strengthening in external demand.

4. The energy sector is a source of both upside and downside risks to the outlook. Our baseline scenario incorporates continued growth in the exports of crude oil over the medium term, under the assumptions that capacity constraints will be relieved through the construction of new pipelines and U.S. demand will remain robust (with Canada gaining market share in the U.S. oil market). A more rapid growth in U.S. production of unconventional energy and/or delays in the expansion of transportation capacity would limit the demand for Canadian energy, put downward pressure on Canadian energy prices, and adversely affect exports and investment. At the same time, faster progress in solving the infrastructure bottlenecks would allow to increase Canadian energy producers’ access to international (non U.S.) markets and Canadian eastern provinces, boost production, and raise the price of Canadian energy. Maintaining an open regime for inward foreign direct investment (FDI) in the energy sector and addressing potential skills shortages in resource-rich provinces would also increase the upside potential from the energy sector.

5. Monetary policy would need to remain accommodative until there are firmer signs that a sustainable transition from household spending to exports and investment is taking hold. Given the greater output gap, the low inflation rate, well-anchored inflation expectations, and downside risks around the pickup in growth next year, staff’s view is that policymakers can afford to wait before starting to raise policy rates towards more normal levels. The slowing trends in construction activity, house prices, and household credit, together with the projected increase in long-term rates as the Fed gradually exits from QE, also give the Bank of Canada more room to wait before raising policy rates. Additional macro-prudential measures remain the first line of defense against a renewed acceleration in housing imbalances, although the authorities would likely need to consider bringing forward the tightening cycle if this acceleration were to happen in the context of stronger growth. At the same time, the high level of household debt and elevated house prices would limit the room for conventional monetary policy easing if growth were to disappoint.

6. Fiscal adjustment plans should strike the right balance between supporting growth and rebuilding the fiscal space. At the federal level, continued progress in fiscal consolidation is appropriate to rebuild the room for fiscal maneuver used during the crisis, but there is room to delay the adjustment needed to return to a balanced budget in 2015 if there is no meaningful pick-up in economic growth. At the provincial level, consolidation plans are facing increasing challenges on the backdrop of disappointing economic growth, and some provinces may need to consider additional measures, especially on the revenue side, to return to a balanced budget.

7. Addressing long-term fiscal challenges remains an important priority. Canada has a relatively low net public debt ratio compared to most other advanced economies. Still, it is not immune to long-term spending pressures, mainly coming from population aging and continued growth in per capita health care costs. While important steps have been taken recently at the provincial level to limit health care spending growth, it is important to ensure that the recent moderation is maintained into the future and the savings are obtained through efficiency gains in addition to budgetary restrictions. Establishing independent budget offices at the provincial level (as in the case of Ontario’s Financial Accountability Office) and having them publish long-term fiscal sustainability analysis would help raise public awareness of the challenges ahead, and build consensus around the needed policy measures. The mission welcomed the recently announced intention by the federal government to introduce a rule requiring balancing the budget in normal economic times, as this would allow locking in recent progress in deficit reduction, but it would be important to design it in a way that avoids imposing a pro-cyclical bias to fiscal policy. Federal and especially energy-abundant provincial jurisdictions should also consider changing their fiscal frameworks to better manage the volatility associated with commodity prices and save the revenue windfall. In this regard, Alberta’s recently legislated fiscal framework is a step in the right direction.

8. Over the long run, the need for extensive government backed mortgage insurance should be re-examined. The current system has its advantages, including as a macro-prudential tool. However, it exposes the fiscal budget to financial system risks and might distort the allocation of resources in favor of mortgages and away from more productive uses of capital. Against this background, the government’s recent initiatives to impose limits on government-backed mortgage insurance have been appropriate. Looking ahead, further measures should be considered to encourage appropriate risk retention by the private sector and increase the market share of private mortgage insurers. Importantly, any structural change should be made gradually over time to avoid any unintended consequence on financial stability.

9. While Canada’s financial sector is healthy, it is essential to remain vigilant against the potential risks from the prolonged period of low interest rates. Canada’s banking system is characterized by elevated capitalization, strong profitability, and high quality of assets. Stress tests conducted as part of the recent IMF “Financial Stability Assessment Program” (FSAP) mission demonstrate the resilience of major Canadian banks and insurance companies to credit, liquidity, and contagion risks arising from a severe stress scenario. Pension funds and life insurance companies appear to have coped well with a prolonged period of low interest rates, although their increased reliance on non-traditional investment strategies continues to deserve close scrutiny from regulators. Continued expansion abroad of both Canadian banks and life insurance companies, while contributing to diversification, also calls for enhanced monitoring.

10. Staff welcomes the progress made by the authorities on the international financial reform agenda over the past year. Basel III capital standards have been introduced this year and the authorities plan to introduce Basel III liquidity standards next year. The six largest federally regulated deposit-taking financial institutions have been designated as systemically important by the Office of the Superintendent of Financial Institutions (OSFI) and one provincially regulated institution has been designated as systemically important by the Autorité des marchés financiers (AMF) and will be therefore subject to higher capital standard requirements, in addition to enhanced disclosure, supervisory and recovery and resolution planning requirements. Significant progress has been made towards strengthening the resilience of the repo market by expanding the functions of the central counterparty established last year. To enhance the safety and soundness of the over-the-counter (OTC) derivatives market, the largest global central counterparty for the OTC interest rate derivatives market was designated for oversight because of its systemic importance to the Canadian financial system. The recent agreement among two major provinces and the federal government to establish a cooperative capital markets regulator could prove a useful step in further harmonizing securities market regulation and oversight nationally.

11. There are a few areas where the resilience of Canadian financial sector could be strengthened further. Canada’s compliance with international standards for regulation and supervision of banks and insurers is strong. Still, staff called for more clarity around the legal independence of OSFI and for assigning stronger prudential responsibilities to this regulator, including for the supervision of insurance groups. The mission also saw room for stronger coordination across federal and provincial authorities in both the supervision and stress-testing of all large depository institutions, whether provincially or federally regulated. It also suggested that a clear mandate could be given to an entity to carry out macro-prudential oversight, with participation broad enough to allow a complete view of systemic risks across all financial institutions and markets, and with powers to collect the data required for the analysis of systemic risks.

The mission thanks the Canadian authorities for their hospitality and for the open and frank discussions during our meetings.