IMF Executive Board Concludes 2008 Article IV Consultation with CanadaPublic Information Notice (PIN) No. 08/19
February 25, 2008
Public Information Notices (PINs) form part of the IMF's efforts to promote transparency of the IMF's views and analysis of economic developments and policies. With the consent of the country (or countries) concerned, PINs are issued after Executive Board discussions of Article IV consultations with member countries, of its surveillance of developments at the regional level, of post-program monitoring, and of ex post assessments of member countries with longer-term program engagements. PINs are also issued after Executive Board discussions of general policy matters, unless otherwise decided by the Executive Board in a particular case. The staff report (use the free Adobe Acrobat Reader to view this pdf file) for the 2008 Article IV Consultation with Canada is also available.
On February, 6, 2008, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Canada.1
Canada's strong economic performance of the past decade continued in 2007. Real GDP growth was around 2½ percent in 2007, driven by robust growth in domestic demand—particularly private consumption and residential investment—of close to 4 percent. Domestic demand was boosted by large terms-of-trade gains and by improvement in employment—as the unemployment rate fell below 6 percent to its lowest level in 33 years.
Growth slowed toward the end of the year, and is expected to decelerate further to 1.8 percent in 2008 reflecting a sharp downturn in the United States, past currency appreciation, and a tightening of financial market conditions. Core inflation, which had been on the rise earlier in the year, declined in the second half of 2007 owing to stronger-than-expected exchange rate pass-through, although headline remained elevated due to rising gasoline prices.
Despite strong gains in the terms of trade, the external current account surplus narrowed to 1 percent of GDP in 2007 as real net exports declined sharply. The latter largely reflected a sharp deterioration in the manufacturing trade balance in response to the currency appreciation and the slowing U.S. economy, but also increasing imports. The Canadian dollar has appreciated by 45 percent in real effective terms since 2002, although domestic adjustment to the appreciation has been very smooth thanks to the flexible labor markets.
After maintaining a neutral monetary policy stance for most part of 2007, the Bank of Canada (BoC) reduced its policy rate to 4 percent—in two consecutive cuts of 25 basis points in December 2007 and January 2008—in response to the deteriorating economic prospects and declining core inflation. In its January statement, the BoC noted that the weak U.S. economic outlook and tighter credit conditions in Canada would likely continue to pose challenges for the Canadian economy, in response to which further monetary easing might be needed in the near term.
Financial conditions have been modestly affected by the spillovers from the global liquidity crunch in the money markets. Interbank spreads for major Canadian banks rose, although not as much as in other major markets. The extent of financial vulnerabilities has so far been limited owing to relatively low exposures to asset-backed securities, but uncertainties remain with respect to the impact of further deterioration in U.S. financial market conditions. An agreement in principle in late December to restructure the local frozen third-party ABCP has reduced contagion risks in other domestic financial markets. In its January 2008 Monetary Policy Report Update, the BoC noted that the average cost of borrowing for households and businesses had risen by 15-25 basis points relative to October 2007, and credit conditions could tighten further.
A prudent fiscal policy framework for the last decade has provided for 10 consecutive years of budget surpluses, and public debt ratios have declined. The budget surplus for fiscal year 2006/07 was estimated at 1 percent of GDP, half a percentage point above the budget forecast, reflecting buoyancy of corporate income tax revenue. In its October 2007 Economic Statement, the government emphasized tax relief (the federal goods and services tax rate was cut by 1 percentage point to 5 percent, effective January 1, 2008, and the corporate and personal income taxes have also been reduced), and debt reduction to be the key priorities for the use of budget over performance.
The government's structural policy blueprint—Advantage Canada, released in late 2006—emphasized boosting productivity as a high priority in the structural reform agenda. Key measures identified in the blueprint include: enhancing business productivity by reducing the high marginal effective tax rates (which was supported by the tax relief measures proposed in the Economic Statement), creating a dynamic and globally competitive financial system, and enhancing interprovincial labor mobility.
Executive Board Assessment
Executive Directors commended Canada's impressive macroeconomic track record since the mid-1990s, which has been underpinned by sound monetary and fiscal policies and favorable external conditions. They welcomed, in particular, the strong GDP growth and declining unemployment, low and stable inflation, and consecutive fiscal surpluses with attendant reductions in the federal debt-to-GDP ratio achieved during this period.
Looking ahead, Directors observed that the near-term economic outlook would be affected by a potential sharp slowing of the U.S. economy, the effects of past currency appreciation, and tighter credit conditions—although domestic demand would likely remain solid. Against this background, Directors welcomed the recent measured easing of policies, noting that Canada's strong monetary framework, as well as exemplary budgetary performance, have provided room for supportive policy actions. More generally, Directors considered that the economy, grounded in strong fundamentals, is well poised to meet the near-term challenges. At the same time, they welcomed the authorities' recognition of the uncertainties in the evolution of both domestic and external demand. Directors also supported the authorities' continued attention to medium-term considerations of productivity growth and policy reforms.
Directors commended the Bank of Canada's recent move to reduce policy rates in December and January. In light of a potential further deterioration of the economic outlook, Directors welcomed the authorities' intention to monitor developments closely and act as required. Some noted that there may be room for further reductions in the overnight rate in the near term. Directors took note of the Bank's ongoing examination of possible refinements to its monetary policy framework. In view of the proven success of the present inflation targeting framework, they concurred with the authorities and staff that there must be compelling evidence in support of price level path targeting before changing the monetary regime. Directors welcomed the Bank's commitment to increasing the transparency of its decision-making process.
Turning to fiscal policy, Directors considered it appropriate to allow automatic stabilizers to operate. They agreed that the budgetary over-performance projected for the current year had provided room for the tax relief, and noted that this would be timely given weaker economic prospects. Directors pointed out, however, that some of the revenue gains underlying the budget surplus could prove temporary, which underscored the importance of maintaining expenditure restraint over the medium term.
Directors commended the government's objective of lowering the tax burden and continuing debt reduction as highlighted in the 2007 Economic Statement. In particular, they welcomed the authorities' objective to eliminate general government debt by 2021, and agreed that this would help provide the fiscal space needed to meet impending costs related to population aging.
In light of the relatively high level of Canada's marginal effective corporate tax rates, Directors welcomed the reduction in the general corporate income tax rate in January, and planned further reductions over the medium term. Several Directors noted that lowering marginal effective tax rates on saving and capital could provide greater efficiency benefits rather than lowering consumption taxes. Directors welcomed the steps taken to reform the equalization system by moving to a more rules-based system for equalization transfers.
Directors agreed that the Canadian dollar is broadly in line with the economy's fundamentals given high commodity prices. They observed that the domestic adjustment to the 45 percent appreciation in the real effective exchange rate since 2002 has so far been remarkably smooth, reflecting flexible labor markets—although some Directors noted that the appreciation has posed increasing challenges for many exporters.
Directors were reassured by the findings of the recent Financial Sector Assessment Program Update, which indicated that the Canadian banking system is sound, profitable, and largely robust to adverse shocks. The agreement in principle to restructure the non-bank ABCP market has mitigated a major risk to financial market conditions.
Directors welcomed the relative resilience of Canadian banks to financial market strains compared with many other countries, while stressing the importance of continuing vigilance in this area. At the same time, a number of Directors noted that a further opening of the Canadian banking system to takeovers would boost market flexibility, support financial innovation, and widen access to finance. Some Directors, however, felt that the benefits from such a policy were outweighed by benefits of the current system in terms of resilience.
While noting that the "passport plus" system of provincial market regulation under implementation is a significant improvement in securities market regulation compared with the current fragmented system, Directors believed that there would be benefits in embracing a single securities regulator, as in many other industrialized countries, to improve further the efficiency and effectiveness of securities' market regulation
Directors supported the authorities' focus on structural reforms to boost productivity, as outlined in Advantage Canada. There was scope for further product market reform, by reducing restrictions on inward foreign direct investment in network industries and removing barriers to interprovincial trade in goods and services. Directors welcomed the creation of a Competition Policy Review panel to examine possible changes to enhance competition.