Public Information Notice No. 99/9

Public Information Notice: IMF Concludes Article IV Consultation with Canada

February 5, 1999

On January 22, 1999, the Executive Board concluded the Article IV consultation with Canada¹.

Background

During 1998, output, income, and the external balance were adversely affected by a substantial decline in commodity prices and by slower activity in a number of Canada’s overseas markets. Over the seven quarters through the first quarter of 1998, real GDP grew at an average annual rate of 3¾ percent. Growth slowed to about 1½ percent (annual rate) in the second and third quarters of 1998, owing to the effects of the Asian crisis and several strikes, including the General Motors strike. Consumption growth moderated during 1998 reflecting a slower rise in disposable personal income and diminishing consumer confidence, particularly in the wake of the turmoil in world financial markets and a sharp drop in Canadian stock prices. At the same time, private fixed investment also slowed due to a marked weakening in the pace of inventory accumulation and a slowdown in equipment purchases, related to expectations of weaker sales and declining corporate profitability. In contrast, employment growth was strong in the second half of 1998, and the unemployment rate declined to 8 percent in November and December 1998 from 8.6 percent in December 1997. Since early 1997, core CPI inflation (the CPI excluding food, energy, and the effects of changes in indirect taxes) has generally remained at the lower end of the 1–3 percent official inflation target range.

The external current account deficit widened from 1½ percent of GDP in 1997 to 2 percent in the first three quarters of 1998. Export growth slowed significantly, largely because of the effects of lower economic activity in Asian markets and a decline in commodity prices (especially lumber, petroleum, and metals). At the same time, although growth in domestic demand in Canada slowed, import growth remained robust.

Monetary conditions in Canada were allowed to ease after February 1998, as the Canadian dollar faced periodic bouts of selling pressure. This pressure intensified in July–August 1998, prompting the Bank of Canada to raise interest rates by 100 basis points in late August. Following the Bank’s August policy action and reduced turmoil in world financial markets the Canadian dollar’s value recovered, rising to around 65 U.S. cents in December, and market interest rates—especially long-term rates—declined. In late September, mid-October, and mid-November, the Bank of Canada followed short-term interest rate reductions by the U.S. Federal Reserve with cuts in the bank rate in Canada by 25 basis points on each occasion. Market interest rates in January were below their levels prior to the Bank’s August policy action, with long-term interest rates roughly 100 basis points below their late August levels.

Decisive efforts by the current Government since coming to office in 1993 have produced a marked improvement in the federal fiscal position, with the budget shifting from a deficit of $42 billion (5¾ percent of GDP) in 1993/94 (fiscal year ending March 1994) to a surplus of $3½ billion (nearly ½ percent of GDP) in 1997/98. The provincial governments also improved their finances, with the aggregate provincial fiscal position shifting from a deficit of about 2¾ percent of GDP in 1993/94 to a deficit of slightly less than ½ percent of GDP in 1997/98. The strength of the fiscal adjustment at all levels of government has resulted in a decline in the net general government debt from a high of 69 percent of GDP (national accounts basis) in 1996 to 65¾ percent in 1997.

Executive Board Assessment

Executive Directors commended the authorities for the consistent implementation of strong policies in recent years, which had allowed the economy to continue to perform well despite the sharp drop in commodity prices and instability in world financial markets. Directors welcomed the continued improvement of the budget positions at all levels of government, which offered promising prospects that the ratio of government debt to GDP would fall significantly over the next several years. Directors also noted that important steps had been taken to improve the financing of the old age support system, and that all levels of government were working to deal with the financial challenges faced by the health care system. At the same time, Canada’s inflation targeting approach had been very successful in reducing inflation and maintaining it at one of the lowest levels among the major industrial countries. Directors considered that those policies had established a firm foundation for the sustained favorable performance of the Canadian economy in years to come.

Nevertheless, Directors pointed out that the near-term prospects of the economy remained uncertain, with external factors posing the main risk to Canada’s ability to sustain strong economic growth. A few Directors also expressed some concern over the potential negative impact of the declining personal savings rate on the outlook for the economy. On monetary policy, Directors noted that if the prospects for growth were to worsen, the Bank of Canada would have scope for reducing interest rates further—following a series of interest rate cuts inthe latter part of 1998—but it would have to proceed cautiously to ensure that its actions did not undermine market confidence in the Canadian dollar. A sharp fall in the currency could put upward pressure on long-term interest rates, and potentially could undo the intended effects of the policy easing.

Directors commended the impressive fiscal consolidation in recent years. They recommended that fiscal policy retain its medium-term focus to bring down the ratio of government debt to GDP, and they considered that in the absence of further significant adverse economic shocks, it would be appropriate to pursue budget surpluses over the next few years. Given relatively favorable fiscal prospects, ample scope existed for running budget surpluses, while at the same time introducing new measures each year to begin to address the government’s other fiscal priorities with respect to income taxes and spending. Once a significant reduction in the debt ratio had been achieved, resources would be available to complete a reform of the income tax system and/or to meet health care and education spending needs. A few Directors, however, noted that the aim of maintaining a budgetary surplus over the medium term might prove somewhat ambitious, and could limit the resources available for the government to undertake the much-needed fiscal structural reforms.

Directors noted that, in the event that economic growth in Canada weakens, the fiscal consolidation in recent years and the government’s hard-won policy credibility would provide an opportunity to allow the automatic fiscal stabilizers to function. A few Directors also agreed that in the face of a significant downturn in Canada’s economy, especially in the context of a broader fall in world economic activity, an easing of fiscal policy beyond the operation of the automatic stabilizers could be warranted.

Directors welcomed the efforts of the provinces to implement plans to maintain or achieve budget balance or surpluses by 2000. They stressed, however, that fiscal consolidation at both the provincial and federal levels had been reflected in substantial efforts to contain the growth in outlays for medical services and to improve the efficiency of the health care system, but they were doubtful that that approach could be relied upon to contain the increases in health care costs that were likely in the future.

Directors noted the relatively high ratio of personal income taxes to GDP in Canada, and the significant distortions caused by high marginal tax rates. They recommended that priority be given to reforming personal income taxes to improve incentives to save and to work. However, a phased approach would be needed because such reforms would be costly in terms of forgone revenues.

Directors welcomed recent efforts to improve the flexibility and efficiency of the labor market through reforms in the Employment Insurance (EI) system. They noted that the 1996 EI reforms were having their intended effects, but thought that further efforts were needed to deal with the employment disincentives that remained in the EI system. They believed that the elimination of regional extended unemployment benefits would facilitate greater labor market efficiency.

Directors considered that the flexibility and efficiency of the labor market had also been enhanced in recent years through the efforts of most provinces to reform social assistanceprograms by reducing benefits and establishing work and/or training requirements for employable social assistance recipients. Directors broadly supported those initiatives, but also believed that further efforts were needed to reduce remaining incentives to employable recipients to remain on social assistance, which seemed to perpetuate a "poverty trap." Directors noted that the introduction of the National Child Benefit was an important step in addressing the poverty trap problem, and they encouraged additional coordinated efforts by the federal and provincial authorities to reduce the high marginal effective income tax rates faced by social assistance recipients.

Directors welcomed ongoing progress in reducing interprovincial barriers to the free flow of goods, services, workers, and capital under the Agreement on Internal Trade. They noted that it was important to continue pushing forward with those reforms, which could complement other measures to improve the efficiency of the labor market. With respect to reforms in the financial sector, Directors observed that the recent report of the Task Force on the Future of the Financial Services Sector showed considerable scope for increasing competition by reducing barriers to entry faced by both domestic and foreign investors.

Directors commended the Canadian authorities for their long-standing pursuit of liberal international trade through regional and multilateral forums. They considered that the recent completion of Canada’s unilateral initiative to simplify its tariff system was a significant step toward a more transparent and open trade regime. Nevertheless, some Directors pointed to the high levels of protection remaining in some sectors, particularly agriculture, textiles, and clothing, and encouraged the authorities to take every available opportunity in the context of multilateral and regional negotiations to achieve greater trade liberalization in those traditionally sensitive sectors.

Directors warmly welcomed the authorities’ commitment to improving the effectiveness of official development assistance and moving toward a target for such assistance of 0.7 percent of GNP, and they encouraged the authorities to make further progress toward reaching that goal.

Directors noted that comprehensive high-quality data are available for Canada on a timely basis.