Public Information Notice No. 09/66

Public Information Notice: IMF Executive Board Concludes 2009 Article IV Consultation with Canada

May 22, 2009

On May 11, 2009, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Canada.¹

Background

Canada entered the crisis on a solid footing, reflecting a strong macroeconomic framework, rigorous financial regulation, and robust corporate balance sheets. Through 2007, sound macroeconomic and financial policies along with a commodity boom delivered strong growth, stable inflation, fiscal and current account surpluses, historically low unemployment and financial stability. But nevertheless, the crisis has significantly affected Canada's economic and financial conditions, given its openness to trade and financial flows.

Real GDP contracted by 3.4 percent (seasonally adjusted annual rate) in the fourth quarter of 2008 after a weak performance earlier in the year, driven by a 5-percent decline in domestic demand as the terms of trade, credit conditions, equity prices, and employment deteriorated abruptly. Net external trade contributed positively to growth, as imports plummeted more than exports. The economy contracted further in early 2009, reflecting the sharp downturn in the United States and further tightening of financial conditions, but is expected to rebound moderately later in the year boosted by fiscal and monetary stimulus. GDP is projected to fall 2½ percent year-over-year in 2009 before recovering somewhat at a 1.2-percent rate in 2010. Unemployment is expected to reach a 10-year high of around 9¼ percent in mid-2010, while the increasing output gap should dampen price pressures, with headline inflation averaging about zero in 2009.

In late 2008, Canada’s current account position turned negative, for the first time in a decade, as the terms of trade fell by over 30 percent (seasonally adjusted annual rate) and real exports plummeted by about 20 percent (saar). The latter largely reflected both a sharp deterioration in manufacturing trade in response to the U.S. downturn and the impact of past currency appreciation. The Canadian dollar has served as an effective shock absorber, following trends in commodity prices: a 35­percent appreciation in real effective terms during boom years (2002 to 2007) and a 12­percent depreciation in the fourth quarter of 2008.

The Bank of Canada (BoC) has cut policy rates by 425 basis points since December 2007 to ¼ percent—a historic low and an effective lower bound—and expanded liquidity through enhanced facilities. The BoC has committed to keep the policy interest rate at its current level through the end of the second quarter in 2010 (conditional on the inflation outlook), and increased the length of its repo facilities. It has also announced a framework for quantitative and credit easing, to be deployed if downside risks to growth materialize. The need for these unconventional measures would be assessed at each monetary policy meeting, with due attention to risks to the Bank’s balance sheet and the exit strategy.

Building on the permanent tax relief measures announced in October 2007, the authorities tabled further fiscal stimulus of around 2.8 percent of GDP in January 2009. Taking into account supplementary provincial actions announced following the federal budget, the measures are among the largest across G-20 countries. The stimulus relies mainly on infrastructure spending, support to the vulnerable sectors, enhanced social safety nets and retraining programs for job reallocation, and tax reductions and incentives. Its deployment is being monitored via quarterly parliamentary reviews. The package and the economic downturn will end an 11-year string of fiscal surpluses, which allowed Canada to achieve the lowest debt-to-GDP ratio among G-7 countries.

The financial system has avoided systemic pressures amid the global turbulence, thanks in good part to strong supervision and regulation. No institution has failed or required public capital injection, and banks have raised capital in markets (albeit at an elevated cost). Despite this resilience, the crisis has widened interbank spreads, credit conditions have tightened, and borrowing costs have risen significantly. Meanwhile, the plunge in equity markets has put strains on life insurers, pension funds and mutual funds. However, since the beginning of the year financial conditions have generally improved in Canada.

The authorities have taken proactive steps to safeguard financial stability. They have launched facilities to offer guarantees on wholesale borrowing for banks and insurance companies, and purchased mortgage-backed securities to ease liquidity pressures, and announced additional support to certain credit markets. In addition, the authorities have obtained the mandate for public capital injections and for the creation of a bridge bank by the Canadian Deposit Insurance Corporation, if needed.

Executive Board Assessment

Executive Directors commended Canada’s impressive macroeconomic track record, strong policy framework and proactive response to the crisis. These factors place Canada in a better position than most countries to weather the global financial crisis, and the financial strains evident elsewhere are markedly less serious in Canada. Directors observed, however, that the near-term economic outlook will be challenging in light of the sharp deterioration in the global environment and Canada’s strong international linkages. They saw risks, including from macro-financial linkages, as tilted to the downside, and called for continued vigilance and readiness to act, if tail risks materialize.

Against this background, Directors welcomed the Bank of Canada’s aggressive monetary easing, expanded facilities, and the recently announced framework for the conduct of monetary policy at low interest rates. They concurred that maintaining a highly accommodative stance in the foreseeable future would limit downside risks to economic growth and inflation, while continuing to support financial stability. Directors saw continued clear communication to bolster the commitment to a sustained accommodative stance as appropriate. In a downside risk scenario, the Bank of Canada could pursue further unconventional measures, with due attention to the exit strategy and the soundness of the Bank’s balance sheet.

Directors agreed that the policy of a freely-floating exchange rate has continued to serve Canada well, given the country’s openness to international trade and financial flows. In particular, the flexible exchange rate has served as an effective “shock absorber” in the context of sizable commodities shocks. They noted the staff’s assessment that the value of the Canadian dollar is broadly in line with economic fundamentals, having weakened with the decline in commodity prices.

Executive Directors commended the authorities’ bold fiscal stimulus package, utilizing the space provided by past strong fiscal performance, and agreed that the near-term focus should be on implementation. They saw the federal stimulus package as timely, appropriately sized, diversified, and well structured, with steps to facilitate labor reallocation and protect the vulnerable. The quarterly monitoring framework will be useful to assess implementation and effectiveness of budget outlays. Directors also commended Canada for further liberalizing its trade regime by lowering tariffs.

Directors agreed that Canada would be well-positioned to participate in a further, internationally coordinated stimulus effort, if warranted. Given Canada’s strong fiscal position—with the lowest debt-to-GDP ratio among G-7 countries—and the authorities’ commitment to medium-term structural surpluses, further fiscal expansion would not put at risk debt sustainability. It would be important to ensure that any further measures are quickly applicable and self-reversing. Meanwhile, Directors considered it appropriate to allow automatic stabilizers to operate.

Looking beyond the crisis, Directors welcomed the authorities’ objective to maintain Canada’s fiscal credibility. They saw scope to recalibrate the debt targets, once the outlook clarifies, to underpin that objective. Future debt reduction would also provide fiscal space needed for future costs related to population aging and health care.

Directors noted the resilience of Canada’s banks relative to their international peers, observing that no Canadian bank has required public capital injections or guarantees. Rigorous limits on leverage, robust regulatory capital ratios, effective supervision, and smooth cooperation across regulatory agencies have underpinned financial stability. Directors commended the authorities for the proactive steps taken to safeguard financial stability, including developing facilities to inject capital and provide guarantees if needed. They called for continued vigilance in view of the challenging credit cycle underway. Vigilance will be particularly warranted with regard to exposures to commodity-affected sectors, non-banks such as insurers and pension plans, and highly indebted households, with a special focus on cross-institution spillovers. Looking further ahead, consolidation of securities regulation pursued by the government would further strengthen the framework for preserving financial stability.