Economic Health Check
Canadian Economy Gains Steam, But More Balanced Growth Needed
February 3, 2014
- Economy expected to accelerate above potential in 2014
- Pickup in exports, business investment needed to generate more balanced growth
- With inflation below target, maintain low policy interest rate to support growth
Canada’s economy is expected to grow to 2¼ percent in 2014—up from an estimated 1¾ percent in 2013—and the pickup in exports and business investment will generate more balanced, sustainable growth, said the IMF in its regular assessment of the country’s economy.
The Canadian economy strengthened in 2013 after a subdued performance in 2012. But underlying growth has remained modest and the composition of growth does not yet point to the much needed rebalancing from household consumption and residential construction toward exports and business investment, the report said.
Looking ahead to 2014, the IMF expects Canada’s export growth to benefit from the projected upswing in the U.S. recovery. As demand and capacity utilization increase, business investment is expected to strengthen, particularly spending on machinery and equipment.
But the IMF pointed out that downside risks remain, primarily from external factors.
The biggest risk is from overshooting of long-term interest rates following the Fed’s exit from quantitative easing, which would hinder the pickup in economic activity in the United States. Another risk is a protracted weakness in the euro area economic recovery, which could hurt Canada mainly through confidence and financial channels, as well as through indirect trade links. The IMF also mentioned the possibility of lower-than-expected growth in emerging markets, which would lower commodity prices.
In addition, the IMF said that high household debt and house prices could amplify the growth impact of adverse external shocks.
Interest rates kept low
The IMF saw room to maintain the current highly accommodative monetary policy stance for a longer period than anticipated a year ago, given the low inflation rate, greater output gap, looming downside risks, and the ongoing moderation of the housing market.
The slowing trends in construction activity, house prices, and household credit, together with the projected increase in long-term rates as the U.S. Fed gradually exits from its monetary easing, also give the Bank of Canada more room to wait before raising policy rates.
Fiscal policy supports growth
The report emphasized that fiscal policy should strike the right balance between supporting growth and curbing spending. At the federal level, continued progress in fiscal consolidation is appropriate to rebuild the room for fiscal maneuver used during the crisis, but there is room to delay the adjustment needed to return to a balanced budget in 2015 if there is no meaningful increase in economic growth.
At the provincial level, there has been less progress in reducing fiscal deficits, and some provinces may need to consider additional measures, especially on the revenue side, to return to a balanced budget.
Housing prices still overvalued
The report noted that household debt remains high and, while house prices and construction growth have cooled off, high valuations and excess supply in a number of housing markets are sources of vulnerability. But if house prices and mortgage credit growth heat up on a more widespread and sustained basis, additional measures, such as higher down-payment requirements for first-time buyers, may be needed.
Over the longer term, rethinking the role of government-backed mortgage insurance may reduce the government exposure to housing sector risks and lead to a more efficient allocation of resources.
Sound financial sector
The IMF noted that Canada’s banking system is well capitalized, profitable, and nonperforming loans are low, but it urged the government to remain vigilant against the potential risks from the prolonged period of low interest rates. The recent financial sector assessment (FSAP) of Canada provides recommendations for the country on how to strengthen its financial system.