March 9, 2009
This statement presents the preliminary assessment of the 2009 Article IV mission to Canada. The period ahead will be challenging in light of the sharp deterioration in the global environment and Canada’s strong international linkages, particularly with the United States. However, Canada is better placed than many countries to weather the global financial turbulence and worldwide recession, thanks to sound policy management and proactive steps to maintain economic and financial stability. We see the key policy priorities as continued vigilance, and readiness to respond if tail risks are realized.
Context and outlook
1. Canada entered the global financial turmoil on a solid footing. Through 2007, Canada experienced strong growth, price stability, fiscal and current account surpluses, historically low unemployment, and financial stability. This favorable outturn reflected strong fiscal discipline, sound and credible monetary policy, and robust financial supervision and regulation. It also reflected supportive global growth and booming commodity prices.
2. Toward end-2008, however, the global environment deteriorated rapidly. On the heels of intense international financial turbulence, economic activity contracted sharply in advanced economies, and global trade collapsed. In early 2009, confidence and production plunged worldwide, while financial market conditions improved somewhat but remained at highly stressed levels. Going forward, fiscal and monetary stimulus in various countries will limit the global downturn, although still-severe financial conditions will pose headwinds to growth. Meanwhile, widening output gaps will feed disinflationary pressures, exacerbated by softening commodity prices amid subpar worldwide demand. Risks to the outlook are to the downside, and include protracted financial strains and intensified macro-financial feedback.
3. The global deterioration is adversely affecting Canada through its strong international linkages. In the fourth quarter, real exports fell by 17.5 percent (annual rate), and the external current account balance registered the first deficit in 10 years. Domestic demand shrank as well, as households and businesses retrenched amid falling commodity and asset prices, and headline GDP declined at the fastest rate since 1991. Going into January, the economic environment continued to deteriorate; the unemployment rate rose to 7.2 percent and rising economic slack contributed to a fall in core inflation from 2.5 percent to 1.9 percent (year on year).
4. Looking ahead, output is likely to contract significantly in the near term, recovering as the full effects of policy stimulus are felt. Further export declines and soft commodity prices are likely to weigh on employment and income, while uncertainties about near-term prospects may restrain investment. With economic slack widening, core inflation will decline. Downside risks predominate, including negative spillovers if the global environment worsens more than expected.
5. At the same time, the strains evident in other countries are markedly less serious in Canada. Canada’s housing markets have been less overheated than elsewhere and booms have been localized rather than general. Financial conditions have tightened, as reflected in spreads and lending standards; but strains are considerably less severe than in other major countries, and credit growth remains solid, both of which reflect a resilient financial system.
6. Canada has responded proactively to the worsening economic outlook. Fiscal stimulus incorporated in Budget 2009 will ameliorate the downturn, and in tandem with the Bank of Canada’s aggressive easing of monetary policy, will mitigate deflation risks. The financial system is stable, and recent steps taken to expand the toolkit for financial stabilization are appropriate given the uncertain outlook. Looking ahead, the main task for policies is to remain vigilant and stand ready to respond if tail risks materialize.
Macroeconomic policies
7. The mission supports the large, timely, and well-targeted fiscal stimulus in Budget 2009. The stimulus package is appropriately sized—well above the Fund’s benchmark of 2 percent of GDP. It is also prudently based on a worse economic outturn than private sector forecasts. With sizeable infrastructure spending and permanent tax cuts, it is weighted toward items that are most effective in stimulating demand. Its steps to boost the safety net will protect Canada’s most vulnerable, and training enhancements will facilitate reallocation of displaced workers. The budget appropriately leverages provincial stimulus, and provinces’ intentions to launch supplementary packages are welcome. The mission also welcomes the move to cut external tariffs, which is in line with Canada’s long-standing commitment to trade liberalization and openness.
8. The near-term focus is appropriately on implementation, and in particular on mobilizing spending. The framework for monitoring deployment of the budget will promote maximum effectiveness and provide opportunities to assess both its implementation and the prevailing economic environment. Looking ahead, if downside risks to the global economy materialize, Canada is well positioned to participate in further possible global policy actions. Meanwhile, automatic stabilizers could be given full play, letting the safety net accommodate increased demands on it in the downturn.
9. The mission also welcomes the authorities’ commitment to medium-term fiscal prudence. In this connection, Budget 2009 rightly notes the aim to avoid long-term structural deficits. This commitment, along with a strong track record of budgetary responsibility and its low debt/GDP ratio (the lowest in the G-7), underpin Canada’s fiscal credibility. The aim to return the debt/GDP to a downward path over the medium term is appropriate. However, the considerable uncertainty surrounding the outlook would complicate setting numerical targets at present; targets could be recalibrated when the outlook is clearer, further bolstering fiscal credibility.
10. The Bank of Canada’s proactive and aggressive monetary easing is appropriate given the subpar economic outlook. Since December 2007, the Bank of Canada has cut its policy rate by 400 basis points to a record low 0.5 percent, most recently easing on March 3. In addition, expanded Bank of Canada facilities (longer terms and a greater variety of collateral) have bolstered liquidity, complementing reductions in the policy rate. With the credit intermediation mechanism working more smoothly than in other countries, the monetary stance will impart a significant boost to demand. Complementing monetary policy, the floating exchange rate policy has also served Canada well, serving as a shock absorber. The recent depreciation of the exchange rate, which has occurred in line with the decline in commodities prices, will dampen disinflationary pressures and support activity.
11. Going forward, maintaining an accommodative monetary stance will be appropriate given the disinflationary pressures associated with the recession. Maintaining an easy stance will limit the downside risks to inflation and inflation expectations, with the latter anchored by the Bank of Canada’s strong commitment to price stability under its inflation-targeting framework. Indeed, medium-term inflation expectations have been relatively stable despite downward pressure on near-term inflation from collapsing commodities prices and rising economic slack. Continuing to clearly communicate the Bank’s views on the price stability outlook will signal commitment to maintain an easy stance for as long as needed to avoid an undershooting of inflation and inflation expectations. The Bank of Canada has also appropriately kept open the possibility of using more aggressive measures, if needed to combat deflationary pressures.
Financial sector policies
12. Canada’s financial system has displayed remarkable stability amid the global turbulence. While no major financial system has been entirely immune from global spillovers, Canadian banks were well capitalized coming into the downturn and have avoided the catastrophic losses experienced by banks in other major countries. Accordingly, and in contrast to banks elsewhere, Canadian banks have not required public capital injections, instead raising capital in markets (albeit at high costs, reflecting heightened global risk aversion). Moreover, bank credit growth has held up well, partly reflecting substitution from financial markets (including those abroad) that have come under stress. Notwithstanding the non-bank ABCP crisis, financial market conditions have generally remained less strained than elsewhere, although equity prices have declined broadly in line with foreign markets.
13. This outcome reflects strong regulation and supervision, along with structural factors in the Canadian financial market. Banks and their securities operations have been subject to rigorous consolidated supervision and regulation by OSFI, including limits on leverage, and target capital ratios well above Basel standards. In addition, five-year reviews have ensured that federal regulatory legislation is modernized periodically, while interaction among officials in the context of the Financial Institutions Supervisory Committee (FISC) and other forums supports smooth exchange of information. On the structural side, banks have a profitable and stable domestic retail market, and generally seem to exhibit a lower tolerance for risk. Due to all these factors, banks maintain prudent balance-sheet structures, and have less exposure to “toxic” structured assets than international peers.
14. Looking ahead, the coming credit cycle is likely to be challenging. The economic downturn will pressure bank credit quality. Mortgage delinquencies are already rising (albeit from low levels), particularly in Western provinces hit hard by collapsing commodity prices. In addition, high household debt is of concern in an environment of rising unemployment and effects of falling asset prices on net wealth, notwithstanding modest debt-service levels due to low interest rates. In this context, pressures on banks may feed back into tighter credit conditions, dampening growth. Meanwhile, major insurers and pension funds have been adversely affected by the stock market decline.
15. Against this backdrop, the key policy priority remains forestalling an adverse macro-financial feedback loop. Along with the appropriately supportive stance of macroeconomic policies, the Canadian authorities’ proactive approach to financial stability will limit this risk. The approach has included a range of precautionary steps:
• offering guarantees on bank and insurance liabilities under the CLAF and CLIAF;
• creating authority for transactions to maintain financial stability (including capital injections);
• increasing purchases of insured mortgage securities to boost bank liquidity and support the mortgage market;
• introducing the Canadian Secured Credit Facility to bolster vehicle and equipment financing for businesses and consumers;
• increasing the resources of Export Development Canada and the Business Development Bank of Canada, to support economic activity;
• and expanding CDIC’s resources and options for dealing with troubled institutions.
More generally, continued close consultation among Federal supervisors and regulators, in the context of the FISC and other forums, could focus on risks to individual institutions, risks of spillovers across institutions (including between banks and non-banks), and macro-prudential risks such as those related to high household debt. In addition, continued close cooperation between Federal and provincial supervisors would manage any potential spillovers between provincial and national markets.
16. Consolidating and enhancing securities regulation would further strengthen the already robust financial stability framework. Over time, bringing a greater financial stability focus to securities regulation, and achieving greater national integration (in line with the recommendations in the 2008 IMF Financial System Stability Assessment Update), would provide a more holistic perspective to financial stability arrangements. In this connection, the mission welcomes the authorities’ intentions as expressed in Budget 2009 to follow the recommendations of the Expert Panel on Securities Regulation.
