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Canada: Staff Concluding Statement of the 2016 Article IV Mission
May 9, 2016
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IMF COMMUNICATIONS DEPARTMENT |
| Media Relations |
|---|
| E-mail: media@imf.org |
| Phone: 202-623-7100 |
May 9, 2016
IMF COMMUNICATIONS DEPARTMENT |
| Media Relations |
|---|
| E-mail: media@imf.org |
| Phone: 202-623-7100 |
A Concluding Statement describes the preliminary findings of IMF staff at the end of an official staff visit (or ‘mission’), in most cases to a member country. 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, or as part of other staff monitoring of economic developments.
The authorities have consented to the publication of this statement. The views expressed in this statement are those of the IMF staff and do not necessarily represent the views of the IMF’s Executive Board. Based on the preliminary findings of this mission, staff will prepare a report that, subject to management approval, will be presented to the IMF Executive Board for discussion and decision.
The 2016 Canada Article IV consultation was focused on assessing the macro-financial impact of the oil shock and policies to bolster near-term domestic demand, mitigate downside risks, and position Canada for solid long-term growth. The key policy messages are:
CONTEXT
1. The oil shock is the first major test of Canada’s economic and financial resilience since the 2008 global financial crisis. While real GDP growth fell to 1.2 percent in 2015, down from 2.5 percent in 2014, because oil companies slashed investment spending, the Canadian economy overall is coping well. The pro-active move by the Bank of Canada to cut the policy rate twice in 2015 and exchange rate depreciation have helped cushion the effects of the oil shock, even as inflation remains anchored within the 1-3 percent target band. Unemployment has edged up, and the negative output gap has widened to about 1 percent of GDP. In March 2016, the new government announced its first Budget, emphasizing infrastructure investment and strengthening the middle class as central to growing the economy.
2. The effects of the oil shock have yet to fully play out. The economy is still adjusting to lower oil prices, in part because the reallocation of capital and labor from the resource to the non-resource sectors is, expectedly, taking time. Reflecting the impact of the oil shock and a slowing economy, financial vulnerabilities have become more apparent. Loan delinquencies are gradually rising, albeit from low levels. While the banking system’s direct exposure to the oil and gas sector is limited, its indirect exposure to resource rich provinces is more substantial, and will require higher provisions against deteriorating credit performance. More broadly, the weaker economy has reignited concerns about the elevated level of household debt and divergent trends in house prices, which are rapidly rising in Vancouver and Toronto and falling in Alberta. Public finances have also taken a hit in particular at the provincial level where performance has deviated along the lines of their resource dependence.
3. The external position is moderately weaker than implied by fundamentals. Despite a weaker currency, the current account has deteriorated. Staff estimates the current account gap to be between -2 and -1 percent of GDP, and the real effective exchange rate is modestly overvalued relative to medium-term fundamentals and desirable policy settings.
OUTLOOK, RISKS, AND SPILLOVERS
4. The economy is set for a modest recovery in the near term. GDP growth is projected to recover gradually to 1.75 percent in 2016, a further 2.25 percent in 2017, and converge to potential growth over the medium-term. Oil sector investment is projected to decline by about 30 percent in 2016, on top of the 40 percent decrease in 2015, as oil prices are likely to stay low relative to the long-term breakeven costs of oil companies. Non-energy exports are, however, expected to pick up as manufacturing regains competitiveness and activity in the U.S. remains robust, leading to a recovery in business investment. Private consumption is expected to remain solid, supported by still resilient labor markets and accommodative monetary policy. The fiscal stimulus will facilitate a faster return of the economy to potential.
5. The medium-term outlook hinges on the economy’s ability to adjust to lower oil prices. A smooth transition away from resource-driven growth will enable Canada to take advantage of shifting global trade patterns and achieve potential growth of around 2 percent in the medium term. However, this is still lower than the annual average of 2.25 percent over the past 15 years.
6. Risks to the outlook are tilted to the downside.
7. There is also upside potential to the medium-term outlook. A better-than-expected recovery in Canadian exports would strengthen business investment and facilitate a faster reallocation of resources from the energy to the non-energy sectors.
8. Furthermore, Canada’s strong fundamentals will help mitigate the impact if downside risks materialize. Canada has strong institutions and a track record of consistent policies. It enjoys a positive net international investment position because it owns substantial assets overseas. This provides a natural hedge to currency risk on aggregate debt. Its flexible exchange rate is also an important shock absorber.
9. There are potential outward spillovers from Canada to the Caribbean.
POLICY CHALLENGES
Monetary policy
10. The current monetary policy stance is appropriate. The Bank of Canada should stand ready to cut the policy rate if downside risks materialize and the economy falters. However, with the policy rate at 0.5 percent, the room for additional cuts is limited.
11. It would be appropriate to seek recourse to unconventional monetary policy measures in the event that the economy slows significantly and deflationary risks emerge, but clear communication would be critical. Staff welcomes the Bank of Canada’s recently updated framework for unconventional monetary policy, which includes forward guidance, large-scale asset purchases, negative interest rates, and funding for credit. The Bank is not committed to any specific order in which these policy measures will be used. Staff agrees that the efficacy of each measure will depend on the economic and financial context and, in some cases, the measures could be mutually reinforcing when used in combination. In the event unconventional monetary policy measures are put to use, the Bank should communicate clearly its diagnosis of the problem and the merits as well as the transmission channels of the measures it plans to pursue.
12. Monetary policy is a blunt tool to address housing market vulnerabilities and macroprudential policy should remain the first line of defense in safeguarding financial stability. The costs of using monetary policy for financial stability objectives, or “leaning against the wind”, outweigh the benefits, except in circumstances where credit growth is exceptionally high for an extended period. Hence, macroprudential policy should generally be the first port of call to address financial stability risks, and this has indeed been the case in Canada. That being said, the Bank sees a role for monetary policy in financial stability and its risk management approach to monetary policy takes into account financial stability considerations within its flexible inflation targeting framework.
Fiscal policy
13. The federal government’s pro-growth 2016 budget is appropriate. Low interest rates and the low debt burden provide fiscal space without undermining the outlook for medium-term debt sustainability. Against this backdrop, the stimulus measures in the 2016 Budget are welcome since they will also help alleviate the burden on monetary policy in providing near-term demand support. A more active role for fiscal policy will strengthen the overall policy mix by reducing the need for further monetary easing and thus limit the scope for excessive risk taking in a low interest rate environment. The stimulus package includes discretionary measures totaling 1.25 percent of GDP, more than 40 percent of which are allocated to mostly shovel-ready infrastructure. Staff estimates that the measures would boost annual growth by 0.5 percentage point of GDP in each of the next two fiscal years, based on a conservative fiscal multiplier. In line with this, the overall deficit will increase from 0.25 percent of GDP in 2015 to around 1 percent of GDP in 2016 and 2017.
14. If the economy takes a turn for the worse, additional fiscal easing should be considered, for which there is room. The additional fiscal easing should be temporary and could be achieved by bringing forward planned infrastructure spending or by temporarily cutting personal and corporate income taxes.
15. At the provincial level, greater caution is needed. Among the larger provinces, Quebec has relatively high debt, while Ontario has a relatively high deficit. In these provinces, fiscal consolidation should proceed, but at a gradual pace in order not to offset the federal government stimulus and support the continuing recovery. Due to its heavy dependence on oil royalties, Alberta’s operational balance has turned negative, but it still has very low debt. Given that its economy is also significantly weaker than the rest of the country, automatic stabilizers should be allowed to operate fully.
16. Strengthening the medium-term fiscal framework will be important to bolster fiscal credibility. Any stimulus package should be accompanied by a credible medium-term consolidation plan. Medium-term consolidation will also help improve the external position.
17. Maximizing the benefit of infrastructure spending and focusing “Phase 2” of the infrastructure project on raising productivity will require close cooperation and coordination between federal and provincial authorities. The federal government should take the lead in developing a nation-wide infrastructure plan that identifies infrastructure gaps and prioritizes projects that enhance the economy’s productive capacity. Priority projects could include those that reduce urban transportation congestion, and improve and expand trade corridors. As the first step, a forum to bring together and engage all relevant stakeholders should be established. Furthermore, new and innovative sources of funding are needed to support the infrastructure plan to limit the impact on debt at the provincial and municipal level. We welcome the financing options elaborated in the 2016 Budget that include greater involvement of public pension plans, user fees, and more creative use of public private partnerships.
18. As a longer-term reform agenda, the authorities should consider the impact of escalating healthcare costs and aging pressures on provincial finances. Fiscal gaps at the provincial level could emerge and widen over time, with material implications on provincial debt burdens within a 15–20 year time frame. This puts the onus first and foremost on provinces to adjust their budgetary priorities.
Financial sector policy
19. The authorities continue to be vigilant to housing-related risks. A host of macroprudential measures have been introduced since 2008, including most recently in December 2015, to reduce risk taking and limit taxpayer exposure to the housing sector. These measures have been broadly effective, slowing the pace of mortgage credit expansion from above 10 percent in 2010–2011 to about 5 percent in 2015 and improving the risk profile of new mortgage loans.
20. Nevertheless, further macroprudential measures will be needed if housing sector vulnerabilities intensify. Growing disparities in regional housing markets call for measures that target specific imbalances. The mission welcomes OSFI’s initiative to introduce a risk-based floor for banks’ internal capital models for uninsured mortgages. Beyond this, the authorities could consider introducing a cap on LTI (loan-to-income) to address regional imbalances. This measure would be superior to debt service-to-income limits which become less binding in a low interest rate environment.
21. Government-backed mortgage insurance has played an important countercyclical role during times of stress, but this benefit needs to be weighed against the potential cost to taxpayers. Government guarantees of insured mortgages are still a sizable 36 percent of GDP as of 2015, even though the government receives premium income from CMHC and private insurers. Possible next steps to shrink the government’s footprint in the mortgage insurance space could include lender risk sharing by introducing higher deductibles for insured mortgages, and further fine-tuning insurance premiums and securitization fees. Nevertheless, any reform should proceed gradually to preserve the countercyclical role and social objective of facilitating access to housing finance.
22. Important progress has been made in implementing the 2013 FSAP recommendations. The new Capital Markets Regulatory Authority, which brings together the federal regulator and six provincial regulators to strengthen Canada’s capacity to identify and manage systemic risk on a national basis, is a bold step toward enhancing the cooperation between federal and provincial regulators. Other measures have also been taken to engage with provincial regulators, including the Bank of Canada providing technical assistance on macro stress testing and model design. Also, CMHC has taken the lead in publishing the results of its stress test, and the Bank is considering how best to integrate quantitative analysis from its models into its financial stability assessment presented in the Financial System Review. This would enhance both the transparency and credibility of financial sector policies.
23. However, the authorities are yet to take action on a number of major FSAP recommendations. The FSAP called for giving a regulatory entity a clear mandate to monitor systemic risk to facilitate macro-prudential oversight and carry out system-wide crisis preparedness. The Senior Advisory Committee (SAC) plays this role on a de facto basis. However, the SAC does not have a mandate for crisis management nor are the members given an explicit financial stability mandate for macroprudential oversight. Furthermore, consistent with Basel Core Principles, legislation should be amended to give OSFI sole decision-making authority on prudential criteria. It is important for a prudential authority to make prudential decisions for safety and soundness reasons without the potential for ministerial discretion. While this has not been a problem in practice, ministerial power to override supervisory judgment impinges on operational independence, which is a critical input to supervisory effectiveness. Finally, the ability to conduct group-wide supervision is a key component of the Insurance Core principles to promote a consolidated view of risks and prevent arbitrage across differently regulated structures in the group. Legislation should be amended to give OSFI the authority to take supervisory measures at the level of the holding company.
Structural reform
24. The timing is right for a renewed push on structural reforms to raise Canada’s productivity growth, which has lagged behind its peers and contributed to the erosion of its external competitiveness. The exchange rate depreciation over the last two years has significantly improved the price competitiveness of Canadian non-energy exporters. However, the past erosion of capacity in the manufacturing sector may not be easily reversed and places constraints on the pace and extent of export recovery. Higher labor productivity growth is necessary to restore capacity in the manufacturing sector and, more generally, improve Canada’s ability to compete in existing and new export markets. To this end, a multi-pronged approach to promote innovation and investment in physical and human capital is needed.
Promoting innovation. Investment in private R&D could generate a significant growth dividend, which makes a strong case for supportive fiscal policy. The current fiscal regime gives generous tax incentives to small and medium-sized enterprises (SMEs) relative to large firms. However, subsidizing SMEs based on their size alone may not be optimal:
While fiscal policy can play an important role in promoting innovation, the government should evaluate R&D subsidy policies to ensure that they are cost effective and simple so as to minimize compliance costs and facilitate firm entry, and strike an appropriate balance between direct and indirect support. The overall effective tax rate should not penalize firms from scaling up. In particular, preferential tax treatment of small firms should be reconsidered. Well designed tax relief targeted to new firms can promote entrepreneurship and innovation, as demonstrated by the successful initiatives in Chile and France.
Boosting labor force participation and talent base. The current gap (10 percentage points) between male and female labor force participation should be narrowed. Staff analysis indicates that higher female labor force participation has a strong impact on productivity growth. The new Canada Child Benefit is a step in the right direction in providing benefits to low and middle income families, but could be better targeted to boost female labor force participation, including providing more generous child care subsidies to working parents.
Investment in human capital and skills training. Canada has a highly educated workforce but more vocational and specialized skills training would help retool the labor force to facilitate labor mobility to high value added activities and meet the challenges of a changing global economy. Canada spends about half of the OECD average on publicly funded training, leaving significant room for improvement.
Investment in physical capital. The federal government’s planned increase in infrastructure spending will help catalyze private business investment. In addition, lowering interprovincial barriers to trade as well as policies to promote competition in the network sectors would create the right conditions to expand domestic business investment and attract FDI.
We would like to thank the authorities and private sector counterparts for their cooperation and hospitality.
