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Canada and the IMF
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On February 4, 2002, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Canada.1
After ending the 1990s with a very strong performance, underpinned by the sound macroeconomic and structural policies put in place during the decade, the Canadian economy has slowed substantially since late 2000. The slowdown in large part has reflected the slowing in the U.S. economy, which has reduced growth in Canada's exports and contributed to weakening private investment. In addition, consumption growth has moderated, owing to a slowing in real income growth, a softening in the employment situation, and an associated fall in consumer confidence. Given its proximity and close integration with the United States, Canada has been significantly affected in the aftermath of the September 11 terrorist attacks. The impact on the Canadian economy has included a significant disruption of commercial traffic in the Canada-U.S. border area, a decline in business confidence, and interruptions in activities such as air travel and tourism.
The slowing in economic activity in recent quarters has led to a decline in resource utilization. Labor shortages have diminished, with the unemployment rate rising from 7 percent at the beginning of 2001 to around 8 percent in December-January. Capacity utilization in the nonfarm goods-producing sector has fallen sharply, largely reflecting a downturn in manufacturing. In turn, inflationary pressures have subsided. CPI inflation, which moved above the Bank of Canada's 1-3 percent target range in mid-2001 due to rising energy prices, has fallen back well within the range subsequently. Core inflation has remained stable at around the mid-point of the target range since mid-2001. Increases in labor compensation and unit labor costs remain contained.
The current account surplus continued to increase during the early part of 2001 despite slowing export growth, as imports declined in the early part of the year. Subsequently, the surplus has declined as export growth weakened further and non-energy commodity prices fell. In the first nine months of 2001, the surplus in the current account amounted to 3½ percent of GDP (annual rate), compared with a surplus of 2½ percent in 2000.
In response to the slowing in the economy, the Bank of Canada has lowered interest rates by 375 basis points since the beginning of 2001 to 2 percent at present. The Bank of Canada stepped up the pace of interest rate reductions after August 2001, amid signs of slower-than-expected growth in Canada and further weakness in the United States and the rest of the world. In September, following the terrorist attacks in the United States, the Bank of Canada lowered interest rates by 50 basis points, in tandem with the Federal Reserve. It lowered rates further at its regularly scheduled policy announcement dates in October and November by 75 and 50 basis points, respectively, and by 25 basis points in January 2002.
The authorities' commitment to promoting fiscal discipline over the past decade has been reflected in a substantial turnaround in the budget balance from a deficit of 5¾ percent of GDP in 1993/94 to a surplus of more than 1½ percent of GDP in 2000/01 (public accounts basis). With substantial fiscal consolidation also taking place at the provincial level during this period, the general government balance shifted from a deficit of 6¾ percent of GDP in 1994 to a surplus of 3¼ percent of GDP in 2000 (national accounts basis), leading to a decline in the ratio of general government net debt from 88½ percent of GDP in 1995 to 66 percent in 2000.
The Government's 2001 Budget, which covers the remainder of 2001/02 and 2002/03-2003/04, seeks to support economic activity while preserving the authorities' framework of medium-term fiscal discipline. New initiatives amount to $7 billion during 2001/02-2003/04 (¼ percent of cumulative GDP), mainly to strengthen national security. The budget is expected to be in balance in 2001/02-2003/04, while the Government strongly signaled its intention to continue with debt reduction in the medium term. Most of the reduction in the surplus in 2001/02 reflects the effects of previously enacted tax and expenditure measures.
Executive Board Assessment
Executive Directors commended the authorities for the sound macroeconomic and structural policies implemented and sustained over the past decade, which have put the Canadian economy in a good position to weather the current global economic slowdown and the uncertainty following the terrorist attacks in the United States last September. Monetary policy has successfully maintained low inflation, and the Bank of Canada's policy management over the past year has further enhanced the credibility of the monetary policy framework. In this context, Directors welcomed the authorities' decision in May 2001 to maintain the 1-3 percent inflation target range and the refinements to the framework introduced at that time. Fiscal consolidation by all levels of government has brought budgets into surplus and led to a sharp reduction in government debt as a share of GDP. Important structural reforms, including reductions in personal and corporate income taxes and improvements in the employment insurance system, have enhanced economic efficiency, and improvements in the financial regulatory framework have further strengthened the financial system.
Directors again strongly endorsed the inflation-targeting framework within which monetary policy is conducted. They believed that monetary policy should continue to be the main instrument used in attempting to limit the impact of the current global economic downturn and to promote the economy's quick recovery. At this point, prospects for an economic turnaround during 2002 look quite favorable. Nevertheless, with inflationary pressures likely to remain subdued, and little sign of sustained upward pressure on wages, Directors believed that there remains scope for further monetary policy easing to support economic activity should economic prospects weaken.
Directors judged that a flexible exchange rate regime has continued to serve Canada well. They agreed that the recent depreciation of the exchange rate has primarily reflected cyclical conditions and has helped to cushion the impact on Canada of the U.S. slowdown and the weakness in commodity prices. Directors felt that Canada's strong macroeconomic fundamentals should support the value of the currency over the longer term.
Directors welcomed the fiscal support that is being provided to the economy through the working of the automatic fiscal stabilizers, as well as previously enacted tax and expenditure measures. They noted that the progress over the past decade in strengthening Canada's fiscal balance has provided room for allowing the stabilizers to function and for the new initiatives in priority areas, such as national security, within the context of a sound overall fiscal framework. Directors thought that the authorities had acted prudently in refraining from a major discretionary stimulus in present circumstances, which would probably have had only a limited economic impact and could have undermined the hard-won credibility of the authorities' commitment to fiscal consolidation. However, some Directors encouraged the authorities not to rule out the possibility of additional discretionary stimulus, if the cyclical downturn proves to be deeper or more persistent than presently envisaged. Directors welcomed the authorities' continued commitment to the medium-term objective of bringing down the government debt-to-GDP ratio.
Directors lauded the authorities for the high degree of fiscal transparency in Canada, as noted in the IMF's recent Report on the Observance of Standards and Codes. In this context, they welcomed the authorities' intention to rebuild the contingency reserve and economic prudence factor in the budget consistent with the approach used in preparing the budget in recent years.
Directors welcomed the improvement in provincial and territorial government finances in recent years, which have allowed the provinces and territories to pursue tax reductions and new spending initiatives while continuing to reduce debt. However, Directors noted that in the period ahead the provinces are likely to face significant pressures on their budgets, particularly those associated with health care in view of the aging of the baby-boom generation. Directors underscored that all levels of government should start taking steps toward addressing these prospective needs as soon as possible.
In view of the continued relatively high unemployment rate and the need to promote labor mobility, Directors urged the authorities to resist pressures to extend employment insurance (EI) benefits or to further roll back some of the fundamental EI reforms achieved during the 1990s. They agreed with the staff's suggestion that the Government should reduce the disincentives to work that remain in the EI system. Frequent use of the system would be discouraged by eliminating the provision of regional extended benefits on an indefinite basis and by implementing experience rating of the EI premium rate (which would link the rate for individual firms to the frequency of use of the system by their workers). Directors recognized the importance of education, training, and other assistance to facilitate labor market adjustment, but suggested that these priorities would best be addressed through other programs.
Directors viewed the financial system in Canada as being among the most highly advanced and sound in the world and supported by a well-developed regulatory and supervisory framework. They welcomed the financial system reform legislation enacted in early 2001, which could be expected to further improve the efficiency of the Canadian financial system over the longer term. Directors noted that Canadian financial institutions are well capitalized and provisioned and appear well positioned to manage pressures arising from the current economic slowdown. However, Directors cautioned that more profound and protracted weakness in the Canadian and U.S. economies could create difficulties in parts of the financial system, and they welcomed the authorities' intention to remain alert to any such pressures.
Directors commended Canada for the lead it has taken in implementing strong legislation against money laundering and terrorist financing. In this context, they welcomed the legislation that came into full effect in late 2001 that brought Canada into full compliance with all of the recommendations of the Financial Action Task Force (FATF) on money laundering that required action. They also welcomed the new law tabled last October to address criminal activity by terrorists, which was consistent with the FATF's anti-terrorist-financing recommendations. Directors also took note of the high marks awarded by OECD to Canada's anti-bribery legislation.
Directors recognized Canada as a long-standing leader in trade liberalization initiatives at the multilateral, regional, and bilateral levels. They acknowledged that Canada has an open trade regime, but they noted that protection levels remain high in some sensitive sectors, particularly certain agricultural products, textiles, and clothing. In addition, although Canada has provided favorable market access for the least-developed countries, exports from these countries still face quotas and high tariffs on some products, particularly textiles, clothing, and footwear. Directors urged the authorities to accelerate trade liberalization in these products for the benefit of both Canada and other countries. Directors called for progress toward achieving duty- and quota-free market access for the exports of least-developed countries, consistent with the objectives of the Doha Ministerial Declaration.
Directors welcomed the actions in the 2001 Budget to increase foreign aid following several years of declining Official Development Assistance (ODA). They encouraged the authorities to continue to raise the level of ODA spending toward Canada's long-standing objective of 0.7 percent of GNP.
Directors noted that the quality, coverage, periodicity, and timeliness of Canadian economic data were excellent both in the context of the Article IV consultation and for purposes of ongoing surveillance.
1 Under Article IV of the IMF's Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country's authorities. This PIN summarizes the views of the Executive Board as expressed during the February 4, 2002 Executive Board discussion based on the staff report.
IMF EXTERNAL RELATIONS DEPARTMENT