Canada: Concluding Statement of the 2014 Article IV MissionNovember 26, 2014
The Canadian economy performed relatively well over the past year. An awaited pick-up in exports has lifted activity, but rebalancing of growth away from household consumption and residential investment remains incomplete, owing to tentative business investment. Going forward, external demand from stronger U.S. growth should support above-potential growth and a broadening recovery. Although key domestic vulnerabilities in the housing market and the household sector can interact with adverse external shocks to harm growth, risks appear contained from a financial stability perspective. An appropriate mix of policies should facilitate domestic rebalancing and mitigate key risks to ensure a durable recovery.
1. Canada’s economy experienced solid growth over the past year. The pace of activity has been solid in recent quarters except for a temporary setback early in the year. For 2014, GDP growth is estimated to be about 2¼ percent. Economic slack has been gradually declining with growth running modestly above potential in most quarters since 2013. An improving labor market gained momentum recently, with the unemployment rate falling to a post-crisis low of 6½ percent in October. Inflation has edged higher, albeit from last year’s subdued levels and partly driven by temporary factors, while wage pressures remained modest.
2. Exports are helping lift economic activity, but investment remains tentative and rebalancing towards a broader recovery is still incomplete:
Canada’s trade balance turned positive in the first half of 2014, with net exports providing a sizeable contribution to growth. Non-energy exports have led the rebound—benefiting from the firming U.S. recovery and a weaker Canadian dollar. Although the rebound in most sectors remains modest, a few (including the transportation sector) are performing strongly relative to external demand growth. Energy exports have also been strong, and Canadian crude oil continued gaining market share in the United States amid some easing in infrastructure bottlenecks.
Higher exports, however, have not yet translated into a meaningful pick-up in business investment, as firms remained cautious about the demand outlook. Following an initial rebound early in the recovery, investment has been weak over the past few years. Reflecting this tentativeness, investment decisions have tended to replace or upgrade capital, and hiring decisions have focused more on adding temporary capacity (e.g., one-third of jobs added so far in 2014 have been part-time—a share above its historical average).
3. Resilient private consumption amid high, albeit stable, household indebtedness remains an important driver of growth. Higher household wealth, rising disposable incomes, and relaxed financial conditions have continued supporting relatively strong private consumption. The household debt ratio has broadly stabilized—hovering over 150 percent of disposable income since 2013.
4. Housing has regained momentum, but with important differences across regions and markets. House prices have reaccelerated, mainly driven by brisk activity in major metropolitan areas—notably, Toronto, Vancouver, and Calgary. Housing demand from household formation and population growth, combined with supply-side constraints from land-use policies and geographical factors, may partly explain fundamental strength in these major real estate markets. Across market segments, single-family homes are a major source of price increases, and there are signs of overvaluation, especially associated with high-end buyers (reflected by uninsured mortgage credit growth). Tighter mortgage insurance rules, reduced affordability, and new construction of multi-family units appear to have contained price growth in other market segments. The mission welcomes new guidelines issued by the Office of the Superintendent of Financial Institutions (OSFI) to strengthen residential mortgage insurance underwriting practices.
5. Solid growth is envisaged to continue while becoming more balanced. Stronger exports and business investment, spurred by the U.S. recovery, are expected to sustain Canada’s growth above potential in the near term. Rising long-term interest rates and weaker terms-of-trade mostly due to lower oil prices would moderate private consumption and residential investment, with an expected ‘soft-landing’ in housing markets. Inflation is expected to remain close to the Bank of Canada’s target rate of 2 percent as the remaining slack in the economy is gradually reabsorbed and inflation expectations remain well anchored.
6. Balance of risks is modestly tilted to the downside for the Canadian economy. A faster-than-expected tightening of global financial conditions and a further decline in global oil prices from weaker demand are the key external downside risks facing Canada. While continued U.S. growth and a depreciating Canadian dollar would help dampen the adverse impact of these shocks, the net outcome for Canada can be negative. Deeper downside risks to growth involve a combination of external shocks that are amplified by high household balance sheet vulnerabilities and a sharper-than-expected correction in house prices. On the upside, U.S. demand may be stronger than expected, and a faster resolution of infrastructure bottlenecks could sustain increased activity in the energy sector.
7. Lower oil prices present a challenge but also an opportunity. Canada has benefited from the boom in oil sands production despite intensified challenges to competitiveness in non-energy sectors. Lower oil prices would likely cool activity in oil-rich provinces, an engine of Canada’s growth in recent years, but benefit provinces reliant on manufacturing and services. Strong U.S. growth and a narrower price discount for Canadian oil (from oil sands relative to the U.S. benchmark) would provide some cushion. The Canadian economy’s ability to deliver productivity gains in other sectors will be increasingly important.
8. Monetary policy can afford to stay accommodative for now. The policy rate has appropriately been on hold at 1 percent since September 2010 to support domestic demand. The recent fall in oil prices should have a mild dampening effect on growth and CPI inflation. Given well-anchored inflation expectations and downside risks to export-driven growth, a monetary policy tightening cycle can await firmer signs to emerge of a more balanced and durable recovery with stronger business investment. At the same time, rising long-term interest rates driven by the expected U.S. monetary normalization could facilitate a needed moderation in Canada’s housing sector.
9. Macro-prudential policy remains an appropriate instrument to contain housing market vulnerabilities, but further targeted actions may be needed. In the context of very low interest rates, macro-prudential measures adopted since 2008 have been broadly effective in mitigating financial stability risks. They have helped curb growth in insured mortgage credit and strengthen credit standards, in addition to helping dampen house price increases. However, uninsured (low loan-to-value, LTV) mortgages are rising noticeably (by 10 percent per year)—comprising the bulk of mortgage originations. Further action may be needed if household balance sheet and housing market vulnerabilities resume rising. Targeted actions could include tighter standards, such as lower amortization limits for uninsured mortgages.
10. Action to further limit exposure of taxpayers to the housing market and encourage appropriate risk retention by the private sector would be desirable. The mission welcomes tightening measures implemented by the government-owned Canada Mortgage and Housing Corporation (CMHC) over the past year, which should also limit the government’s exposure to the housing sector.
In the near term, the authorities will need to implement their plans to prohibit the use of government-backed insured mortgages in non-CMHC securitization programs and gradually limit insurance of low-LTV mortgages to those that will be used in CMHC securitization.
While CMHC’s plan to increase capital is welcome, further reduction of portfolio insurance for both CMHC and private mortgage insurers and changes to introduce more risk-sharing should also be considered, which would complement current prudential measures.
More broadly, re-examining the dimensions of extensive government-backed mortgage insurance should remain on the authorities’ longer-term agenda, including managing a transition from financial market reliance on government-backed instruments as the public sector role recedes.
11. Financial sector performance remains strong. Canadian banks remain highly profitable, with favorable loan quality, low nonperforming loans, and improving capitalization. Stress tests conducted for the 2013 Financial Sector Assessment Program (FSAP) Update suggest that banks are resilient to credit, liquidity, and contagion risks arising from a tail risk scenario due to their strong capital position, stable funding sources, and low interbank exposures, as well as extensive government-guaranteed mortgage insurance. However, banks’ increasing exposure to capital markets and risks from foreign operations warrant close attention. Performance of life insurance and pension funds, meanwhile, has improved noticeably.
12. The international financial reform agenda has advanced, and some work on FSAP recommendations has started though key steps are still needed. Basel III Liquidity Coverage Ratio and leverage standards have been implemented and will take effect in January 2015, and banks are well positioned to meet the proposed requirements in advance of their implementation. The mission welcomes OSFI’s draft guideline for Derivatives Sound Practices and progress made on the federal authorities’ stress-testing framework, as well as the recent steps taken toward establishing a cooperative capital markets system. However, outstanding FSAP recommendations on financial sector oversight, safety nets, and macro-prudential frameworks remain to be addressed:
Enhanced coordination across federal and provincial authorities in supervision and stress-testing is needed. Subjecting all systemic federally- and provincially-regulated entities to common stress-testing frameworks would involve a heightened degree of collaboration. While discussions between federal and some provincial authorities have started, cooperation in supervision should be enhanced within respective mandates, including to reduce possible regulatory fragmentation.
Strengthening macro-prudential and crisis management frameworks will increase the resilience of the financial system. Providing a mandate for macro-prudential oversight to a single entity would strengthen transparency and accountability, and reinforce Canada’s ability to identify and respond to future crises. Such an entity should have participation broad enough to allow for a complete and integrated view of systemic risks, and powers to collect all necessary data for systemic risk analysis. To this end, the mission welcomes the authorities’ recent efforts to identify financial sector data gaps. For crisis preparedness, a mandate should be given to an entity that could operationalize a coordination framework to support timely and effective decision-making in a crisis situation and test the capacity of the authorities (federal and provincial) to respond to crisis scenarios.
13. Fiscal consolidation should proceed at the general government level, but the federal government can afford to adopt a more neutral stance going forward. The improvement in Canada’s fiscal position in recent years reflects consolidation efforts at the federal level while needed fiscal adjustment at the provincial level has been lagging. With key fiscal challenges concentrated at the provincial level, particularly arising from looming aging-related spending pressures, it is critical that the composition of fiscal adjustment shifts towards the provinces.
Federal authorities have achieved significant consolidation in public finances—rebuilding policy space and allowing a shift to a more neutral position. The federal government is expected to reach its balanced budget target in FY2015–16, along with putting its debt firmly on a downward path. Given this strong fiscal footing, shifting to a neutral stance at this stage would still be consistent with achieving the authorities’ remaining fiscal goals. The recently announced tax cuts and enhanced child benefits to support families go in this direction. The mission sees merit in using available fiscal resources for targeted growth-friendly measures (e.g., aimed at R&D, SMEs, venture capital, and strategic infrastructure projects) in support of business investment and productivity or reducing federal income taxes that could provide more tax space to provinces. In terms of the policy mix, a more neutral fiscal stance would help monetary policy rebuild its space faster as the recovery proceeds.
Consolidation plans at the provincial level should proceed, especially in provinces with higher levels of public debt. While adjustment plans rely on ambitious expenditure restraint, raising concerns about their durability, it would be essential for provinces to successfully pursue strategic spending reviews. Still, the adjustment plans may need to be complemented with revenue measures to meet balanced budget targets.
14. Strengthening medium-term fiscal frameworks would support sound public finances at different levels of government.
To lock in gains from consolidation and increase effectiveness of fiscal policy, a medium-term framework at the federal level can be beneficial. Explicit medium-term fiscal targets and regular spending reviews would be key features of such a framework. If the federal authorities were to introduce balanced budget legislation, as is currently being discussed, it would be important for a new rules-based framework to be transparent, easy-to-communicate, and ensure convergence towards the authorities’ medium-term objectives, while allowing for flexibility in the face of shocks to avoid procyclicality. The Parliamentary Budget Office could play a role in monitoring implementation of the rule.
Regular spending reviews should become an integral part of provincial budgetary frameworks, with a possible role for independent fiscal agencies. Such progress could support provinces in their adjustment, particularly with respect to the imperative of controlling aging-related spending.
15. There is scope for improving coordination of fiscal policy between different levels of government. Long-term challenges to contain aging-related spending call for extending long-term fiscal forecasts at the provincial level and publishing consolidated general government fiscal forecasts in consultation with provinces. To this end, a useful step could include a data sharing mechanism for long-term fiscal assumptions and forecasts.
16. Further advancing structural policies is important to address lagging productivity. The authorities’ policies, including in the context of G-20 commitments, cover many reform areas. Reform efforts to increase productivity should continue—focusing on improving skills-job matching, promoting penetration of information and communication technologies, and fostering business investment in R&D. Enhancing interprovincial and international trade, including through implementation of major trade agreements, improving competition in network sectors, and addressing infrastructure constraints in energy exports would also play a key role in boosting Canada’s growth over the medium term.
The mission thanks the Canadian authorities for their hospitality and for the candid discussions during our meetings.