Canada -- Preliminary Conclusions of the 2005 IMF Article IV Consultation Mission

December 1, 2004

Describes the preliminary findings of IMF staff at the conclusion of certain missions (official staff visits, in most cases to member countries). Missions are undertaken as part of regular (usually annual) consultations under Article IV of the IMF's Articles of Agreement, in the context of a request to use IMF resources (borrow from the IMF), as part of discussions of staff monitored programs, and as part of other staff reviews of economic developments.

1. Canada's recent macroeconomic performance has been enviable, and has reflected the benefits of sound institutions and a strong policy framework. Inflation targeting has provided a transparent basis for the Bank's recent decision to shift its policy stance and-by firmly anchoring inflation expectations—will allow a patient and measured approach to further monetary tightening. The strong commitment to "budget balance or better" has yielded welcome progress toward the debt reduction needed to cope with the fiscal pressures of an aging population. These policy successes, together with recent structural reforms and a business-friendly environment, have helped Canada again record one of the fastest growth rates and highest living standards among the G-7 countries, and provide considerable confidence that this performance can be maintained in the year ahead.

2. Looking beyond the near term, however, important challenges remain. Exchange rate appreciation, commodity price volatility, prospective trade liberalization, and the potential spillovers from the resolution of global current account imbalances have increased the importance of flexible labor and product markets. In addition, Canada—like other industrial countries—faces a dramatic increase in the share of the elderly population in coming decades. Meeting these challenges will require sustained fiscal prudence and debt reduction, fundamental reform to control health care costs, and structural policies to maximize the productivity and flexibility of the Canadian economy.

The near-term outlook and monetary policy

3. The mission expects the economy to continue to perform solidly in the coming year. Like the Bank of Canada, we anticipate growth to remain at around 3 percent into 2005—roughly equal to the economy's potential growth rate—supported by strong profits, high world commodity prices, and a pickup of business investment. While the Canadian dollar's recent appreciation appears broadly consistent with medium-term fundamentals—including world commodity prices and a large current account surplus—its strength and the expected slowing of U.S. growth are likely to exert a dampening effect on real net exports.

4. The challenge remains to guard against the considerable uncertainties that remain. Although there are upsides to the outlook—especially if the U.S. economy remains resilient and oil prices fall more rapidly than suggested by futures markets—an even sharper drop in net exports cannot be ruled out in response to recent exchange rate appreciation. Moreover, global current account imbalances may require further significant exchange rate adjustments, which would compound the reallocation of resources across regions and sectors that is already needed to absorb recent relative price movements. Also, with the household saving rate at exceptionally low levels, a more abrupt slowing of consumer spending remains a possibility.

5. Against this background, the Bank of Canada has skillfully adjusted its policy stance and appears to have room to maintain a patient and measured approach to withdrawing stimulus. The Bank has appropriately started to increase interest rates, and further tightening will likely be needed given that real interest rates are well below neutral levels, economic slack has fallen, and monetary policy operates with long and variable lags. At the same time, the absence of wage pressures suggests that major capacity constraints have yet to emerge which, together with the risks described above and the remarkable success in anchoring inflation expectations, implies that a cautious and pragmatic approach to further interest rate hikes is consistent with achieving the inflation target.

6. The Bank's moves to further strengthen policy transparency and communication are commendable, especially given the heightened uncertainty surrounding the domestic and global outlook. Providing additional information on macroeconomic projections in the Monetary Policy Report (MPR) is a welcome innovation, and the Bank's active communication strategy has been effective in preparing markets for the shift in policy stance. There remains scope, however, for providing a richer background on policymakers' views on the distribution of risks and related policy implications at the time of the Bank's fixed action dates, especially when these are not accompanied by an MPR or an Update.

Fiscal policy framework

7. Canada's fiscal framework has been exceptionally successful in reducing public debt and creating a broad-based social consensus in support of prudent fiscal policies. The federal government's commitment to budget balance or better has delivered seven consecutive years of fiscal surpluses that have reduced net debt by almost 30 percent of GDP while still affording sizeable tax reduction—the best fiscal performance in the G-7. The public pension system is actuarially sound for at least the next 50 years, and most provinces have followed the federal government in cutting taxes and sharply reducing deficits, supported in some cases by balanced budget rules. The consistent strength of Canada's fiscal performance in recent years leaves it well on track to achieve the lowest general government debt ratio among the G-7.


8. The objective of reducing the federal debt-to-GDP ratio to 25 percent within ten years has added a welcome medium-term anchor to the fiscal framework. Keeping the debt-to-GDP ratio on a downward path over the next decade and beyond will be an important element in preparing Canada for the long-term fiscal challenge posed by population aging. Indeed, with the baby-boom generation entering retirement, sustained debt reduction at all levels of government is imperative to meet pressures on age-related programs.

9. However, recent agreements with the provinces have removed room for fiscal maneuver and increased the premium on fiscal prudence. The additional support for health and equalization transfers has all but eliminated the planning surplus in the coming two fiscal years, and fixed escalators on health care spending and equalization payments will increase the sensitivity of the federal budget to cyclical developments. Restoring the economic prudence factor is a very welcome step, while the projections that were contained in the Economic and Fiscal Update illustrate that there is very limited room for new initiatives in the forthcoming budget. Indeed, while planning surpluses are projected to re-emerge from FY 2007/08, given the uncertainties that surround these estimates and the importance of ensuring that a margin exists to avoid slipping into deficit in the event of unfavorable developments, the mission would caution against measures that place an undue weight on these future surpluses.

10. Nonetheless, the ongoing Expenditure Review provides a helpful opportunity to reassess policy priorities. Given the substantial additional transfers that have been provided to provinces, the focus should now turn to maximizing the productive use of the government's scarce resources. In this context, it would seem appropriate to weigh carefully the merits of existing and promised spending programs versus further reducing the relatively high tax burden.

11. More needs to be done to ensure the sustainability and efficiency of the health care system. The latest federal-provincial agreement has provided stable funding for provincial health programs and mechanisms to improve accountability and comparability across provinces. The major challenge, however, will be to improve the system's efficiency—Canada's spending on health care as a share of GDP is high by OECD standards—especially through measures that improve incentives for cost containment by health care providers and consumers. A diversity of provincial strategies to control costs and reform public systems should be encouraged, since this will provide opportunities to test different approaches and identify best practices.

12. The upcoming review of the Equalization program offers a welcome opportunity for reform. The key challenge will be to design a system that provides a transparent and equitable basis for the allocation of payments across provinces, while avoiding the year-to-year instability of the previous system.

13. Helpful steps have been taken to further enhance Canada's already high level of fiscal transparency. These include providing details on the basis for fiscal projections in the Economic and Fiscal Update and the reestablishment of the Office of the Comptroller General. To be sure, recent fiscal surpluses have been greater than projected. However, this partly reflects the explicitly prudent framework as well as favorable economic developments, and the effectiveness and durability of the Canadian fiscal framework is impressive when compared with other countries' attempts to impose budget discipline. Nonetheless, it is important to ensure that public confidence in the process remains strong and sustains the social consensus for continued debt reduction, and we welcome the opportunity to offer an international perspective to the review of the government's fiscal forecasting practices.

Increasing economic efficiency

14. Canada has been the fastest growing G-7 economy since 1997. However, this has partly reflected rapid increases in labor participation that will be difficult to sustain, particularly in the face of population aging. The demographic shift and the ongoing challenges from increasingly globalized markets underscore the importance of further structural reforms for ensuring continued gains in standards of living and quality of life.

15. Structural policies in recent years have laid a solid foundation for future growth and created a favorable environment for business, but there is more to be done:

· The tax burden remains relatively high despite tax cuts at both the federal and provincial level. Given limited room for significant rate reductions at present, an emphasis is needed on measures that yield the greatest efficiency gain. On the business front, these could include further aligning capital cost allowances with economic depreciation, as well as ensuring that the tax system does not act as a disincentive for small- and medium-sized enterprises to exploit advantages of scale and scope. The effective tax burden on households is also relatively high and measures to reduce taxes on saving could improve incentives. At the provincial level, eliminating the burden of provincial taxes on capital, including by integrating sales taxes with the GST, could also yield significant gains.

· The Employment Insurance system remains an uneasy combination of unemployment insurance and social assistance. Funding the latter function through general revenues would be more efficient and transparent, and every effort should be made to reinforce the insurance principle of the program through experience rating of employers and employees. Care will be needed to resist further eroding the mid-1990s reforms and to ensure that the premium rate can be set at a low rate that balances the system over the cycle and avoids the need for annual adjustments.

· Reforms in other social programs could help increase labor utilization and efficiency. Even with recent gains in labor participation, there remains room to further improve labor supply by reducing incentives for early retirement in the public pension system—such as by amending benefit calculations and curbing excessive use of disability benefits—and by lowering "welfare walls" in the social transfer system.

· Reducing regulatory barriers to trade and competition. Regulatory frameworks and infrastructure investment could be strengthened, particularly in the electricity sector where technical and fiscal risks still need to be addressed. Encouragingly, there appears to be renewed commitment to reducing barriers to interprovincial trade, and further efforts to promote innovation and technology diffusion would also be helpful, including by reducing restrictions on foreign investment in network industries.

· Maintaining the momentum for multilateral trade liberalization. Canada can play an important leadership role in efforts to complete the Doha Round, including by further relaxing trade barriers for "supply-managed" agricultural products, which should help improve domestic efficiency and lend more impetus to multilateral liberalization.

16. Canada's sound financial system has helped support economic growth and further reforms could promote flexibility in a rapidly changing global environment. Both the banking and insurance sectors have posted a remarkable performance in recent years, capital ratios are robust, and the system is well positioned to respond to prospective financial conditions. The regulatory and supervisory system in Canada is sophisticated, but improvements could support Canadian institutions' efforts to remain competitive:

· The regulatory framework governing bank mergers could be further clarified. Addressing this would reduce uncertainty and could enable efficiency gains.

· Adopting a single national securities regulator, as recommended by the Wise Persons Committee, would reduce compliance and administrative costs. The upcoming review of financial sector regulation may also provide scope for reducing regulatory overlap.

· Useful steps have been taken to harmonizing the regulation of defined benefit pension plans. Consideration could also be given to enhancing incentives for funding and ensuring that the recent decision to extend the funding period for one large plan is applied consistently to other bankruptcy cases.

17. Recent commitments to promoting foreign development and assistance are commendable. The plan to raise the international assistance envelope by 8 percent next fiscal year is welcome, as is Canada's support for African development, including the cancellation of official debt owed to Canada by several African countries and Canada's leadership role in the U.K.-sponsored Commission for Africa.


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