## _cr0870

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---

### Introduction — overview and key questions
- The Canadian economy has performed strongly in the last few years but weaker external conditions will likely place a toll going forward.
- Key questions:
  - How closely linked is Canadian growth to U.S. growth?
  - What are the main spillover channels from U.S. conditions to Canada?
  - How well is the monetary framework operating?
  - How adaptable is the Canadian economy to economic shocks?
- Concluding policy direction: to limit fallout from U.S. developments and raise long-term growth, staff research suggests increasing product market flexibility and improving access to finance, particularly for small and dynamic firms.

### Summary of headline findings
- A one-percent decline in U.S. real GDP results in a ¾ percent reduction in Canadian output after 2 years.
- Financial conditions—changes in U.S. bond yields, equity prices, and short-term interest rates—are the largest source of U.S. spillovers to Canada, larger than trade or commodity-price channels in recent decades.
- Canada is unlikely to decouple from a U.S. downturn; tighter U.S. financial conditions will probably dampen Canadian growth.
- Bank of Canada is examining price-level-path-targeting (PLPT) vs. current inflation-targeting (IT); Canadian macroeconomic evolution since the mid-1990s is consistent with IT including elements of PLPT.
- Product-market rigidities and limited access to finance for dynamic small and medium enterprises may constrain long-term growth and adaptability; evidence points to lower job churning associated with firm turnover in Canada than in the United States, with similar job churning for continuing firms.

### I. U.S. Spillovers to Canada — empirical approach and results
- Integration metrics (1988–2006):
  - Sum of Canada-U.S. exports and imports expanded from 37 percent of Canadian GDP to 49 percent.
  - Cross-border holdings of financial assets increased from 53 percent of Canadian GDP to over 90 percent.
- Empirical strategy:
  - A vector autoregression (VAR) using quarterly growth for five regions since the early 1970s: the United States, the Euro area, Japan, Canada, and “the rest of the world.”
  - Global shocks identified via the rest-of-the-world aggregate.
  - Trade, commodity price, and financial variables added to identify channels.
- Main quantitative results:
  - Canadian real GDP rises steadily in response to a positive U.S. output shock, increasing by almost one percentage point after two years; magnitude is around three-quarters of the impact on U.S. output.
  - Almost no influence on Canadian output from shocks to the Euro area or Japan.
  - Canada’s response to rest-of-the-world growth shocks is just below ½ percentage point, around half of the impact from the United States.
- Subsample and volatility findings:
  - The response of Canadian GDP to U.S. shocks has been nearly halved since implementation of the CUSFTA, attributable to lower U.S. volatility.
  - The magnitude of a typical (one standard deviation) U.S. growth shock fell from 1.5 to 0.8 percentage point; the 70 to 80 percent response of Canadian GDP to U.S. shocks has remained broadly stable.
- Channel decomposition (trade, commodity prices, financial variables):
  - Trade explains about one-half of U.S.-Canada spillovers before the CUSFTA and somewhat less subsequently.
  - Contribution of financial conditions has increased from one-quarter to one-half.
  - Role of commodity prices has diminished in the last two decades.
- Conclusions and policy implications:
  - A one percent rise in U.S. real GDP is estimated to result in a ¾ percent increase in Canadian output; magnitude stable over time.
  - Financial conditions currently appear to be the largest source of U.S. spillovers to Canada (U.S. bond yields, equity markets, short-term interest rates).
  - Trade spillovers will rise as U.S. weakness spreads beyond residential investment and U.S. financial strains feed through to Canadian activity.

### II. Real implications of financial linkages between Canada and the United States — methods and findings
- Stylized facts on trade and finance:
  - Over three quarters of Canada’s merchandise exports (about one quarter of Canada’s GDP) are destined to the United States.
  - Estimates of the impact of a one-percentage-point change in U.S. real GDP growth on Canada’s real GDP growth range between 0.3 and 0.7 percentage point.
  - Canadian non-financial firms use U.S. financial markets extensively; about one-quarter of their funding is raised in the United States.
  - At end-2006 Canadian residents held U.S. securities worth close to 13 percent of GDP.
- Empirical approach:
  - Structural vector autoregressions (SVARs) with three variables per country: CPI inflation, real GDP growth, and the interest rate on a 3-month Treasury bill.
  - Assumption: U.S. variables can affect Canadian variables but not vice versa.
  - Sample: 1983Q1 through 2007Q1.
- Impulse-response evidence:
  - A one-percentage-point shock to U.S. growth raises Canada’s growth by around ½ percent in the short term; Canada’s short-term interest rate rises to re-equilibrate demand and supply.
  - A one-percentage-point tightening in U.S. short-term interest rates:
    - Canadian short-term interest rates increase by around the same amount as U.S. rates.
    - Canada’s annualized real GDP growth slows by about one percentage point in two to four quarters in response to the percentage-point tightening.
- Conceptual channels for tighter U.S. financial conditions:
  - Direct financial channel: tighter U.S. conditions make it more difficult/expensive for Canadian companies to obtain U.S. funding.
  - Indirect financial channel: tighter U.S. conditions lead to less accommodative Canadian financial markets, hurting firms reliant on domestic credit.
  - Trade channel: tighter U.S. conditions slow U.S. growth and lower demand for Canadian exports.
- Channel isolation experiments:
  - Turning off U.S. growth impact on Canadian variables isolates the trade channel.
  - Preventing Canada’s interest rate from changing in response to U.S. shocks isolates the indirect financial channel.
  - Findings:
    - The bulk of the impact of tighter U.S. financial conditions on Canada’s growth comes through financial effects.
    - The trade channel has little impact on activity when financial channels are active.
    - The direct financial channel accounts for most of the initial decline in output growth.
    - The indirect financial channel has smaller but more persistent effects.
- Robustness:
  - Results robust to including oil price, exchange rate, stock prices, spreads on corporate bonds, and financial conditions indices, and to alternative lag structures.
- Conclusions and policy implications:
  - U.S. financial markets substantially influence Canadian financial and real conditions due to U.S. funding for Canadian corporations and U.S. influence on Canadian financial conditions.
  - The current tightening in U.S. financial markets is likely to slow Canadian growth; spreads on Canadian money market borrowing have risen in tandem with U.S. rates and problems in U.S. structured products have pressured Canadian bank balance sheets.
  - Further research is needed because the 3 month Treasury bill used to measure U.S. financial conditions cannot fully capture complexities of recent developments.

### III. Why is Canada’s price level so predictable? — Bank of Canada research agenda
- Institutional context:
  - Bank of Canada, a pioneer of inflation targeting (IT), is studying switching to price-level-path-targeting (PLPT).
  - Research program examines merits of IT vs. PLPT and costs and benefits of a lower inflation target than the current 2 percent.
  - Bank intends to form a view well before renewal of the current monetary policy agreement with the government in 2011.
  - Current framework: the inflation target is the 2 percent mid-point of the 1 to 3 percent inflation-control range.
- Staff assessment:
  - Fund staff work indicates the evolution of Canadian macroeconomic variables since the mid-1990s has been consistent with the inflation-targeting monetary regime including elements of PLPT.
  - Canada may already be reaping some benefits from greater certainty about the future path of the price level.
  - Possible changes toward a PLPT regime would likely be treated by markets as an evolutionary step.

### Price-Level Targeting (PLPT) versus Inflation Targeting (IT): mechanism and welfare implications
- Main distinction: IT lets “bygones be bygones,” while PLPT requires past deviations of inflation from the target to be offset in the future to return the price level to a predetermined path.
- Uncertainty and welfare:
  - Under PLPT there is less uncertainty about the future price level (Figure 1 shows narrower two-standard-deviation bands).
  - Reducing price-level uncertainty can raise welfare by allowing individuals to better plan future decisions.
- Response to deflationary shocks:
  - Commitment to a price level path can generate expectations of higher future inflation, lowering the ex-ante real interest rate without requiring sharp reductions in nominal interest rates toward the zero bound.
- Inflation control consistency:
  - PLPT reduces uncertainty in inflation and would be consistent with keeping inflation inside the 1–3 percent target range a large proportion of the time.

### Empirical observation for Canada since the adoption of a 2 percent target
- Historical pattern:
  - Since adoption of the 2 percent inflation target in December 1994, Canada’s price level has strayed little from the path implied by that target (Figure 2).
  - The CPI has tended to revert to the 2-percent path so that average inflation has been very close to 2 percent since December 1994.
- Possible explanations considered:
  - Chance: inflationary and disinflationary shocks may have nearly exactly offset each other over the sample period.
  - Implicit PLPT-like behavior due to interpretation of the monetary framework: the Bank’s aim to keep inflation within the 1–3 percent control range could lead it to tighten more after positive shocks, creating mean-reverting price gaps similar to PLPT.
  - Accountability considerations: backward-looking evaluation (e.g., average inflation over the IT period) can induce behavior equivalent to PLPT.
  - Shorter-than-expected lags in monetary transmission: ex post shorter lags could lead to more aggressive responses creating an impression of PLPT elements.
- Model evidence:
  - A small macroeconomic model for Canada and the United States (forward- and backward-looking Phillips curve, output gap equation, inflation-forecast-based interest-rate reaction function, interest parity linking countries, stochastic processes) is used to contrast happenstance vs. perceived PLPT.
  - Results indicate it is highly unlikely that the apparent stationarity of the price gap reflects a lucky outcome.
  - Data are more consistent with a model in which inflation expectations and interest rates are determined assuming monetary policy includes an element of PLPT.
- Conclusions and policy implications:
  - Canadian inflation dynamics since the mid-1990s align with the perception that monetary policy contains an element of PLPT.
  - Canadians may already be benefiting from greater certainty about the future path of the price level.
  - Net benefits of formally switching to PLPT may be smaller than simple IT vs PLPT comparisons imply.
  - A move to PLPT would likely be treated by markets as an evolutionary step.

### Access to finance for small borrowers in Canada: banking structure and broad concerns
- System structure:
  - The five largest banks account for 85 percent of total bank assets.
  - These banks are sheltered from takeovers by the “widely-held” rule and from mergers through an effective prohibition.
  - Banks maintain low-risk balance sheets while enjoying high returns on equity.
- Resulting concern: potential lack of incentive to serve small borrowers, higher-cost credit appraisal, and uncertain returns.

### SME financing: approvals, satisfaction, and underserved segments
- Loan approval and satisfaction:
  - About 80 percent of loan requests by SMEs are approved.
  - Degree of dissatisfaction among SME owners in Canada is somewhat higher than in the United States but lower than in most other OECD countries (Figure 1).
- Broader financial services concerns:
  - Almost half of Canadian entrepreneurs report dealing with finances as a major challenge of operating an SME.
  - Specific complaints: high account manager turnover, difficulty establishing stable and predictable bank relationships, and insufficient support for record keeping, account reconciliation, and tax preparation.
- Financing for innovative and higher-risk SMEs:
  - SMEs in knowledge-based industries have substantially lower satisfaction with credit suppliers.
  - Only 70 percent of loan requests by these more risky, innovative SMEs are accepted.
  - Evidence suggests limited variation in loan terms across firms—firms exceeding banks’ low risk tolerance may be denied credit rather than charged higher premiums.
- Venture capital (VC) market shortcomings:
  - Canadian VC funds invest relatively small amounts per company, provide too little managerial support, and achieve paltry average returns compared to U.S. counterparts.
  - Problems particularly acute among tax-advantaged labor-sponsored venture capital corporations.

### Housing finance: market structure, instruments, and securitization
- Non-prime mortgage market:
  - Potential market exists given high percentages of self-employed and recent immigrants, but the non-prime mortgage market in Canada is much smaller than in the United States (Figure 2).
  - Smaller non-prime market contained contagion from the U.S. mortgage crisis but may limit access to wealth creation.
- Mortgage instrument choice:
  - Virtual absence of mortgages with maturities exceeding 7 years in Canada.
  - Explanation: limited competition and banks’ desire to match assets with short-maturity liabilities, funding mortgages primarily from deposit base.
- Securitization and market deepening:
  - Higher volumes of mortgage securitization could reduce banks’ balance-sheet mismatches and raise competition.
  - Specialized institutions for non-prime mortgages and longer-term securities could fund longer mortgages.
  - Current Canadian mortgage securitization program is limited: open only to insured mortgages and issues securities mostly with a 5-year tenor.
- Conclusions and policy implications (access to finance):
  - Core finding: Large Canadian banks seem unwilling to price risk.
  - Consequences:
    - Innovative, potentially high-growth SMEs face obstacles to financing; venture capital market problems exacerbate this.
    - Consumer choice in mortgage finance is limited; the non-prime mortgage market is in its infancy, and some mortgage instruments common elsewhere are not offered in Canada.

### Canadian firm and job dynamics: reallocation, productivity, and regional differences
- Recent reallocation and productivity context:
  - Commodity price hikes over the last 5 years have driven large transfers of capital and labor from manufacturing-based central provinces to natural-resources-based western provinces.
  - Despite labor market frictions, unemployment rates have steadily declined across all provinces due to net gains in construction, mining, services, and interprovincial migration.
  - Canada’s productivity performance (overall labor and total factor productivity) has been disappointing relative to the United States.
- Analytical approach:
  - Uses Canadian Longitudinal Employment Analysis Program data and the U.S. Business Employment Dynamics database; controls for firm size, industry, region, and time.
- Key empirical findings on job dynamics and reallocation:
  - Job churning at continuing firms is similar in Canada and the United States during 1993-2004.
  - Job reallocation associated with firm births and deaths is higher in the United States.
  - Panel regressions show a significant negative Canada dummy for job reallocation associated with births and deaths; effect is smaller and only marginally significant for overall job reallocation.
  - Regional variation:
    - Raw data: job creation and destruction rates higher in British Columbia and Alberta than in Ontario and Quebec.
    - Regressions controlling for industry and firm size indicate much of variation is explained by sector and firm size, but province dummies remain significant—British Columbia and Alberta display more dynamic labor and product markets than Ontario and Quebec.
  - Between-sector versus within-sector reallocation:
    - Job reallocation caused by sectoral shifts is small—shifts across sectors account for less than ten percent of job creation and destruction.
    - This share fell during 1999-2003, confirming idiosyncratic within-sector shocks dominate job reallocation.
- Conclusions and policy implications (firm and job dynamics):
  - Canada has sufficiently flexible labor markets to absorb significant sectoral shocks without creating high frictional unemployment.
  - The United States appears better at facilitating creative destruction, which may partly explain its superior productivity performance.
  - Canada’s lower rates of job reallocation associated with firm births and deaths imply more limited opportunities for productivity gains via creative destruction.
  - These rigidities appear more pervasive in product markets than in labor markets and are more pronounced in central provinces than in western provinces.
  - Policy implication: Reducing product market restrictions in the central provinces could enhance productivity by facilitating creative destruction.

*Source: Summary of the introduction and Chapters I–III and related sections of the selected issues paper.*

### Introduction............................................................................................................

### _cr0870 - Introduction............................................................................................................

### Introduction — overview and key questions
- The Canadian economy has performed strongly in the last few years but weaker external conditions will likely place a toll going forward.
- Key questions addressed:
  - How closely linked is Canadian growth to U.S. growth?
  - What are the main spillover channels from U.S. conditions to Canada?
  - How well is the monetary framework operating?
  - How adaptable is the Canadian economy to economic shocks?

### Summary of findings presented across chapters
- Spillovers from the United States to Canada have remained remarkably stable over time: a one-percent decline in U.S. real GDP results in a ¾ percent reduction in Canadian output after 2 years.
- Financial conditions—changes in U.S. bond yields, equity prices, and short-term interest rates—are the largest source of U.S. spillovers to Canada, larger than trade or commodity-price channels in recent decades.
- Canada is unlikely to decouple from a U.S. downturn; tighter U.S. financial conditions will probably dampen Canadian growth.
- The Bank of Canada is examining price-level-path-targeting (PLPT) vs. the current inflation-targeting (IT) framework; Canadian macroeconomic evolution since the mid-1990s is consistent with IT including elements of PLPT.
- Product-market rigidities and limited access to finance for dynamic small and medium enterprises may constrain long-term growth and adaptability; evidence points to lower job churning associated with firm turnover in Canada than in the United States, with similar job churning for continuing firms.

*Concluding policy direction in the introduction: to limit fallout from U.S. developments and raise long-term growth, staff research suggests increasing product market flexibility and improving access to finance, particularly for small and dynamic firms.*

*Italic line: Summary of the introduction section of the selected issues paper.*

### I. U.S. Spillovers to Canada — empirical approach and results
- Integration metrics (1988–2006):
  - Sum of Canada-U.S. exports and imports expanded from 37 percent of Canadian GDP to 49 percent.
  - Cross-border holdings of financial assets increased from 53 percent of Canadian GDP to over 90 percent.
- Empirical strategy:
  - A vector autoregression (VAR) using quarterly growth for five regions since the early 1970s: the United States, the Euro area, Japan, Canada, and “the rest of the world.”
  - Global shocks identified via the rest-of-the-world aggregate.
  - Trade, commodity price, and financial variables added to identify channels.
- Main quantitative results:
  - Canadian real GDP rises steadily in response to a positive U.S. output shock, increasing by almost one percentage point after two years; magnitude is around three-quarters of the impact on U.S. output.
  - There is almost no influence on Canadian output from shocks to the Euro area or Japan.
  - Canada’s response to rest-of-the-world growth shocks is just below ½ percentage point, around half of the impact from the United States.
- Subsample and volatility findings:
  - The response of Canadian GDP to U.S. shocks has been nearly halved since implementation of the CUSFTA, attributable to lower U.S. volatility.
  - The magnitude of a typical (one standard deviation) U.S. growth shock fell from 1.5 to 0.8 percentage point; the 70 to 80 percent response of Canadian GDP to U.S. shocks has remained broadly stable.
- Channel decomposition (trade, commodity prices, financial variables):
  - Trade explains about one-half of U.S.-Canada spillovers before the CUSFTA and somewhat less subsequently.
  - Contribution of financial conditions has increased from one-quarter to one-half.
  - Role of commodity prices has diminished in the last two decades.
- Conclusions and policy implications:
  - A one percent rise in U.S. real GDP is estimated to result in a ¾ percent increase in Canadian output; magnitude stable over time.
  - Financial conditions currently appear to be the largest source of U.S. spillovers to Canada (U.S. bond yields, equity markets, short-term interest rates).
  - Canada is unlikely to decouple from the U.S. downturn; trade spillovers will rise as U.S. weakness spreads beyond residential investment and U.S. financial strains feed through to Canadian activity.

### II. Real implications of financial linkages between Canada and the United States — methods and findings
- Stylized facts on trade and finance:
  - Over three quarters of Canada’s merchandise exports (about one quarter of Canada’s GDP) are destined to the United States.
  - Estimates of the impact of a one-percentage-point change in U.S. real GDP growth on Canada’s real GDP growth range between 0.3 and 0.7 percentage point.
  - Canadian non-financial firms use U.S. financial markets extensively; about one-quarter of their funding is raised in the United States.
  - At end-2006 Canadian residents held U.S. securities worth close to 13 percent of GDP.
- Empirical approach:
  - Structural vector autoregressions (SVARs) with three variables per country: CPI inflation, real GDP growth, and the interest rate on a 3-month Treasury bill.
  - Assumption: U.S. variables can affect Canadian variables but not vice versa.
  - Sample: 1983Q1 through 2007Q1.
- Impulse-response evidence:
  - A one-percentage-point shock to U.S. growth raises Canada’s growth by around ½ percent in the short term; Canada’s short-term interest rate rises to re-equilibrate demand and supply.
  - A one-percentage-point tightening in U.S. short-term interest rates:
    - Canadian short-term interest rates increase by around the same amount as U.S. rates.
    - Canada’s annualized real GDP growth slows by about one percentage point in two to four quarters in response to the percentage-point tightening.
- Conceptual channels for tighter U.S. financial conditions:
  - Direct financial channel: tighter U.S. conditions make it more difficult/expensive for Canadian companies to obtain U.S. funding.
  - Indirect financial channel: tighter U.S. conditions lead to less accommodative Canadian financial markets, hurting firms reliant on domestic credit.
  - Trade channel: tighter U.S. conditions slow U.S. growth and lower demand for Canadian exports.
- Channel isolation experiments:
  - Turning off U.S. growth impact on Canadian variables isolates the trade channel.
  - Preventing Canada’s interest rate from changing in response to U.S. shocks isolates the indirect financial channel.
  - Findings: the bulk of the impact of tighter U.S. financial conditions on Canada’s growth comes through financial effects:
    - The trade channel has little impact on activity when financial channels are active.
    - The direct financial channel accounts for most of the initial decline in output growth.
    - The indirect financial channel has smaller but more persistent effects.
- Robustness:
  - Results are robust to extending SVARs to include oil price, exchange rate, stock prices, spreads on corporate bonds, and financial conditions indices, and to alternative lag structures.
- Conclusions and policy implications:
  - U.S. financial markets have a substantial influence on Canadian financial and real conditions due to U.S. funding for Canadian corporations and U.S. influence on Canadian financial conditions.
  - The current tightening in U.S. financial markets is likely to slow Canadian growth; spreads on Canadian money market borrowing have risen in tandem with U.S. rates and problems in U.S. structured products have pressured Canadian bank balance sheets.
  - Further research is needed for more precise measurement because the 3 month Treasury bill used to measure U.S. financial conditions cannot fully capture complexities of recent developments.

### III. Why is Canada’s price level so predictable? — Bank of Canada research agenda
- Institutional context:
  - The Bank of Canada, a pioneer of inflation targeting (IT), is studying the possibility of switching to price-level-path-targeting (PLPT).
  - The Bank has initiated a research program to examine the relative merits of IT vs. PLPT and the costs and benefits of a lower inflation target than the current 2 percent.
  - The Bank intends to form a view well before the renewal of the current monetary policy agreement with the government in 2011.
  - Current framework: the inflation target is the 2 percent mid-point of the 1 to 3 percent inflation-control range.
- Staff assessment:
  - Fund staff work indicates the evolution of Canadian macroeconomic variables since the mid-1990s has been consistent with the inflation-targeting monetary regime including elements of PLPT.
  - Canada may already be reaping some of the benefits from greater certainty about the future path of the price level.
  - Possible changes toward a PLPT regime would likely be treated by markets as an evolutionary step.

*Italic line: Extracted from the introduction and Chapters I–III of the selected issues paper.*

### 2. The main difference between the two regimes is the treatment of past deviations

### 2. The main difference between the two regimes is the treatment of past deviations

### Price-Level Targeting (PLPT) versus Inflation Targeting (IT): mechanism and welfare implications
- Main distinction: IT lets “bygones be bygones,” while PLPT requires past deviations of inflation from the target to be offset in the future to return the price level to a predetermined path.
- Uncertainty and welfare:
  - Under PLPT there is less uncertainty about the future price level (Figure 1 shows narrower two-standard-deviation bands).
  - Reducing price-level uncertainty can raise welfare by allowing individuals to better plan future decisions.
- Response to deflationary shocks:
  - Commitment to a price level path can generate expectations of higher future inflation, lowering the ex-ante real interest rate without requiring sharp reductions in nominal interest rates toward the zero bound.
- Inflation control consistency:
  - PLPT reduces uncertainty in inflation and would be consistent with keeping inflation inside the 1–3 percent target range a large proportion of the time.

### Empirical observation for Canada since the adoption of a 2 percent target
- Historical pattern:
  - Since adoption of the 2 percent inflation target in December 1994, Canada’s price level has strayed little from the path implied by that target (Figure 2).
  - The CPI has tended to revert to the 2-percent path so that average inflation has been very close to 2 percent since December 1994.
- Possible explanations considered:
  - Chance: inflationary and disinflationary shocks may have nearly exactly offset each other over the sample period.
  - Implicit PLPT-like behavior due to interpretation of the monetary framework:
    - The Bank of Canada’s aim to keep inflation within the 1–3 percent control range could lead it to tighten more after positive shocks to avoid inflation above 3 percent—creating a mean-reverting price gap similar to PLPT.
  - Accountability considerations:
    - Backward-looking evaluation (e.g., average inflation over the IT period) can induce behavior equivalent to PLPT.
  - Shorter-than-expected lags in monetary transmission:
    - If lags are shorter ex post, the Bank may have responded more aggressively than needed for gradual reversion, creating an impression of PLPT elements.
- Model evidence:
  - A small macroeconomic model for Canada and the United States (forward- and backward-looking Phillips curve, output gap equation, inflation-forecast-based interest-rate reaction function, interest parity linking countries, stochastic processes) is used to contrast happenstance vs. perceived PLPT.
  - Results indicate it is highly unlikely that the apparent stationarity of the price gap reflects a lucky outcome.
  - Data are more consistent with a model in which inflation expectations and interest rates are determined assuming monetary policy includes an element of PLPT.

### Conclusions and policy implications (price-level vs inflation targeting)
- Canadian inflation dynamics since the mid-1990s align with the perception that monetary policy contains an element of PLPT.
- Implications:
  - Canadians may already be benefiting from greater certainty about the future path of the price level.
  - Net benefits of formally switching to PLPT may be smaller than simple IT vs PLPT comparisons imply.
  - A move to PLPT would likely be treated by markets as an evolutionary step.

---

### Access to finance for small borrowers in Canada: banking structure and broad concerns
- System structure:
  - The five largest banks account for 85 percent of total bank assets.
  - These banks are sheltered from takeovers by the “widely-held” rule and from mergers through an effective prohibition.
  - Banks maintain low-risk balance sheets while enjoying high returns on equity.
- Resulting concern: potential lack of incentive to serve small borrowers, higher-cost credit appraisal, and uncertain returns.

### SME financing: approvals, satisfaction, and underserved segments
- Loan approval and satisfaction:
  - About 80 percent of loan requests by SMEs are approved.
  - Degree of dissatisfaction among SME owners in Canada is somewhat higher than in the United States but lower than in most other OECD countries (Figure 1).
- Broader financial services concerns:
  - Almost half of Canadian entrepreneurs report dealing with finances as a major challenge of operating an SME.
  - Specific complaints: high account manager turnover, difficulty establishing stable and predictable bank relationships, and insufficient support for record keeping, account reconciliation, and tax preparation.
- Financing for innovative and higher-risk SMEs:
  - SMEs in knowledge-based industries have substantially lower satisfaction with credit suppliers.
  - Only 70 percent of loan requests by these more risky, innovative SMEs are accepted.
  - Evidence suggests limited variation in loan terms across firms—firms exceeding banks’ low risk tolerance may be denied credit rather than charged higher premiums.
- Venture capital (VC) market shortcomings:
  - Canadian VC funds invest relatively small amounts per company, provide too little managerial support, and achieve paltry average returns compared to U.S. counterparts.
  - Problems particularly acute among tax-advantaged labor-sponsored venture capital corporations.

### Housing finance: market structure, instruments, and securitization
- Non-prime mortgage market:
  - Potential market exists given high percentages of self-employed and recent immigrants, but the non-prime mortgage market in Canada is much smaller than in the United States (Figure 2).
  - Smaller non-prime market contained contagion from the U.S. mortgage crisis but may limit access to wealth creation.
- Mortgage instrument choice:
  - Virtual absence of mortgages with maturities exceeding 7 years in Canada.
  - Explanation: limited competition and banks’ desire to match assets with short-maturity liabilities, funding mortgages primarily from deposit base.
- Securitization and market deepening:
  - Higher volumes of mortgage securitization could reduce banks’ balance-sheet mismatches and raise competition.
  - Specialized institutions for non-prime mortgages and longer-term securities could fund longer mortgages.
  - Current Canadian mortgage securitization program is limited: open only to insured mortgages and issues securities mostly with a 5-year tenor.

### Conclusions and policy implications (access to finance)
- Core finding: Large Canadian banks seem unwilling to price risk.
- Consequences:
  - Some economic sectors may be underserved, notably:
    - Innovative, potentially high-growth SMEs face obstacles to financing; venture capital market problems exacerbate this.
    - Consumer choice in mortgage finance is limited; the non-prime mortgage market is in its infancy, and some mortgage instruments common elsewhere are not offered in Canada.

---

### Canadian firm and job dynamics: reallocation, productivity, and regional differences
- Recent reallocation and productivity context:
  - Commodity price hikes over the last 5 years have driven large transfers of capital and labor from manufacturing-based central provinces to natural-resources-based western provinces.
  - Despite labor market frictions, unemployment rates have steadily declined across all provinces due to net gains in construction, mining, services, and interprovincial migration.
  - Nevertheless, Canada’s productivity performance (overall labor and total factor productivity) has been disappointing relative to the United States.
- Analytical approach:
  - The paper uses comprehensive Canadian Longitudinal Employment Analysis Program data and the U.S. Business Employment Dynamics database to compare job flows across countries beyond manufacturing.
  - The model and regressions control for firm size, industry, region, and time.

### Key empirical findings on job dynamics and reallocation
- Job churning and creative destruction:
  - Job churning at continuing firms is similar in Canada and the United States during 1993-2004.
  - Job reallocation associated with firm births and deaths is higher in the United States.
  - Panel regressions show a significant negative Canada dummy for job reallocation associated with births and deaths; effect is smaller and only marginally significant for overall job reallocation.
- Regional variation within Canada:
  - Raw data: job creation and destruction rates higher in British Columbia and Alberta than in Ontario and Quebec.
  - Regressions controlling for industry and firm size indicate much of variation is explained by sector and firm size, but province dummies remain significant—British Columbia and Alberta display more dynamic labor and product markets than Ontario and Quebec.
- Between-sector versus within-sector reallocation:
  - Job reallocation caused by sectoral shifts is small—shifts across sectors account for less than ten percent of job creation and destruction.
  - This share fell during 1999-2003 (early part of the commodity boom), confirming that idiosyncratic within-sector shocks dominate job reallocation.

### Conclusions and policy implications (firm and job dynamics)
- Labor market flexibility:
  - Canada has sufficiently flexible labor markets to absorb significant sectoral shocks without creating high frictional unemployment.
- Creative destruction and productivity:
  - The United States appears better at facilitating creative destruction, which may partly explain its superior productivity performance.
  - Canada’s lower rates of job reallocation associated with firm births and deaths imply more limited opportunities for productivity gains via creative destruction.
  - These rigidities appear more pervasive in product markets than in labor markets and are more pronounced in central provinces than in western provinces.
- Policy implication:
  - Reducing product market restrictions in the central provinces could enhance productivity by facilitating creative destruction.

*Source: Summary of IMF Working Papers and IMF staff analysis contained in the supplied content.*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2008/_cr0870.pdf_