February 19, 1998
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| Public Information Notices (PINs) are issued, (i) at the request of a member country, following the conclusion of the Article IV consultation for countries seeking to make known the views of the IMF to the public. This action is intended to strengthen IMF surveillance over the economic policies of member countries by increasing the transparency of the IMF's assessment of these policies; and (ii) following policy discussions in the Executive Board at the decision of the Board. |
The IMF Executive Board on January 30, 1998 concluded the 1997 Article IV consultation1 with Canada.
Background
Following a slowdown in 1995 and in early 1996, real GDP growth rose at an annual rate of 3 1/4 percent in the second half of 1996 and 4 1/4 percent in the first three quarters of 1997. Activity has been supported by strong increases in private investment and personal consumption. With relatively weak growth in personal income, the strength in consumption can be attributed to declines in interest rates and increases in wealth associated with a sharp rise in stock prices. While excess capacity has declined in the past year, it is estimated that output was about 1 3/4 percent below potential in mid-1997. After edging up from 9 1/2 percent in 1995 to near 10 percent in the latter part of 1996, the unemployment rate declined to 9 percent in July 1997 and remained at around that level through November 1997, before falling to 8.6 percent in December. For most of the period since 1993, core CPI inflation (the CPI excluding food, energy, and changes in indirect taxes) has been maintained within the lower half of the Bank of Canada's official target range of 1 to 3 percent. Core inflation was 0.8 percent (annual rate) at the end of 1997.
Since May 1995, the Bank of Canada has adopted a generally accommodative monetary policy. Beginning in the latter part of 1996, the Bank sought to maintain monetary conditions roughly unchanged, and in late June 1997, the Bank raised the operating band for the overnight interest rate by 25 basis points to counter an easing in monetary conditions stemming from a depreciation of the Canadian dollar. The Bank moved to tighten monetary conditions modestly in October 1997, when it raised the overnight rate operating band by 25 basis points. At that time, it noted that there was growing evidence that the economy was expanding rapidly and absorbing unused capacity, and that indicators of future growth had been strong. In late November, in mid-December, and again in late January 1998, the Bank of Canada raised the overnight rate operating band by a total of 125 basis points to counteract an easing of monetary conditions, as downward pressure on the Canadian dollar increased sharply toward the end of 1997 and early in 1998, reflecting fallout from the financial crisis in Asia.
The current Government has reduced the federal fiscal deficit from 5.8 percent of GDP in 1993/94 (fiscal year ending March 1994) to 1.1 percent of GDP in 1996/97. Most of this improvement reflected the adoption of strict limits on spending, and the structural budget deficit (i.e., the estimate of the deficit measured at full employment) declined from 5 percent of GDP to around 1/2 percent of GDP over the period. The provinces also have moved to improve their budget positions in recent years, with the aggregate fiscal position of the provinces shifting from a deficit of 3.7 percent of GDP in 1992 (national accounts basis) to near balance in 1996. Nevertheless, the ratio of net general government debt to GDP increased from about 43 percent in 1990 to what now appears to be of peak of 67 percent in 1996; the ratio is expected to decline significantly in coming years.
After coming under bouts of pressure in the early 1990s, the Canadian dollar traded in a narrow range of 72-74 U.S. cents from mid-1995 to June 1997. In late June, its value slipped below 72 U.S. cents, but it rebounded after the Bank of Canada's move to raise short-term interest rates. Since mid-November, the Canadian dollar has been under downward pressure, reflecting market expectations that the financial crisis in Asia will have more of a detrimental effect on the Canadian than the U.S. economy, particularly through its impact on commodity prices. As a result, the Canadian dollar's value fell below 69 U.S. cents in January 1998. On a real effective basis, the Canadian dollar in December 1997 was about 2 1/2 percent above its low in March 1995, but it was nearly 25 percent below its previous peak in June 1991. The external current account balance shifted from a deficit of $7 1/2 billion (1 percent of GDP) in 1995 to a surplus of nearly $4 billion (0.4 percent of GDP) in 1996. In the first three quarters of 1997, the current account deteriorated substantially, registering a deficit of 1.8 percent of GDP, as imports rose in response to strong consumption and investment demand, while export growth declined.
Executive Board Assessment
Executive Directors commended the authorities for their sustained efforts and the success of their economic policies, and for the progress that has been made since the previous Article IV consultation.
Directors welcomed the strong fundamentals in the Canadian economy. The federal government budget now is expected to be balanced no later than the next fiscal year, and all the provincial governments are also expected to balance their budgets by the turn of the century. Determined implementation of monetary policy by the Bank of Canada to achieve its inflation targets has given Canada one of the lowest inflation rates among major industrial countries. Sound macroeconomic policies have been reflected in a decline in interest rates--to their lowest levels in decades--and improved resource allocation; and the result has been the strong rebound in economic growth and substantial gains in employment over the past year.
Nonetheless, Directors noted, the authorities will face significant new challenges in the period immediately ahead. In particular, monetary policy will have to be managed carefully to ensure that economic growth converges smoothly to its potential path, while taking account of the possible effects of the Asian crisis on the Canadian economy. Fiscal policy will have to ensure that the budget is balanced, as the government has promised, and that the ratio of government debt/GDP is put on a steady downward path. At the same time, the still-high rate of unemployment remains a matter of concern and calls for a strengthening of structural reforms in the labor market.
Directors agreed that more monetary policy restraint had appeared to be called for. The possible effects of the Asian crisis need to be taken into consideration in formulating policy in the period immediately ahead, but the economy continues to exhibit considerable strength, and economic activity is approaching capacity limits. While it was difficult to draw the implications for the stance of monetary policy of the recent widening of the current account deficit and the weakening of the Canadian dollar, Directors expressed understanding of the considerations that had led the Bank of Canada to raise the Bank Rate. More broadly, Directors acknowledged that the economy's productive capacity was not known with a great deal of certainty, and, as the economy approached its estimated capacity limits, it would be appropriate for the authorities to use monetary policy to probe for the actual level of capacity. However, the authorities would need to proceed cautiously, adjusting policy in small steps, with an eye on indications of developing bottlenecks, capacity constraints, and wage pressures. In this way, it could be possible to raise output to a higher level and reduce unemployment to a lower level without triggering a rise in inflation, if structural changes have taken place that raise potential output.
With regard to the inflation target after 1998, Directors generally recommended retention of the current 1-3 percent official inflation target range for the next few years. They noted that continuation of the current target range would allow the economy further time to adjust to a low inflation environment. It would also provide experience in operating monetary policy with inflation targets when the economy is at high rates of resource utilization. In this manner, a better basis would be established for deciding on a longer-term target consistent with the eventual achievement of the objective of price stability. Directors also welcomed the Bank of Canada's approach of basing monetary policy on a number of monetary indicators and not tying them to the mechanical application of the Monetary Conditions Index. Some Directors recommended a timely announcement of the inflation target for 1999 to help reduce any possible uncertainty in the markets about the monetary strategy.
Directors strongly welcomed that policies and fiscal plans now appear to be in place to eliminate fiscal imbalances at both the federal and provincial levels in the period immediately ahead. In these circumstances, the focus of the policy debate has shifted toward the question of how best to use the expected fiscal dividend. Directors noted that there were no easy answers concerning which path the government should choose for the budget position and the resulting reduction in the ratio of public debt/GDP, particularly in the absence of clear criteria for agreeing on the optimal debt/GDP ratio. Nevertheless, Directors supported the objective of bringing down the debt/GDP ratio more rapidly than would be the case if the budget were maintained in balance. This policy approach could yield many benefits, including reducing the economy's vulnerability to shocks, lowering real interest rates, and helping to address the challenges of an aging population.
Directors also recognized the merit of addressing other priorities, such as efficiency-enhancing tax and spending measures. With respect to using part of the fiscal dividend for purposes other than reducing the debt, they agreed that priority should be given to those tax or spending measures that would enhance efficiency and equity in the economy. They recommended that resources not applied to debt reduction be used primarily to reduce high tax rates and the degree of distortions in the tax system. With regard to additional spending, Directors said that new initiatives should concentrate on reducing poverty traps and other disincentives to work, enhancing equality of opportunity, and improving human capital.
Directors noted that as the provinces put their budgets on sustainable long-term paths, they would need to factor in prospective increases in health care financing requirements as the average age of the population rises. With this in mind, the provinces will need to consider running budget surpluses over the medium term to provide sufficient resources to meet these requirements. The federal government was also likely to be called on to provide additional resources for health care spending, and this possibility should be reflected in its longer-term fiscal plans.
Directors welcomed the recent strong growth in employment, but noted that relatively high rates of unemployment in Canada remained a concern. Expected strong output growth will continue to support employment creation, and recent labor reforms will work to reduce the structural rate of unemployment over time. Nevertheless, Directors considered that further reform of the Employment Insurance (EI) system could help reduce structural unemployment. In particular, they thought that steps could be taken to tighten restrictions on frequent use of the system and to eliminate regional extended benefits. To deal with frequent use, reductions in EI premiums could be tied more closely to the experience with unemployment in individual firms, instead of reducing them across the board.
Directors commended the authorities for their resolve to deal with the critical challenges that the public pension system faces in light of the aging of the population. They noted that measures proposed to restructure existing income supplements and tax credits to senior citizens, and the reforms enacted to address the long-term financing needs of the Canada Pension Plan, would meet these challenges. They encouraged the authorities to act promptly to enact the proposed Seniors Benefit.
Directors noted that progress in implementing measures to reduce internal barriers to trade under the auspices of the Agreement on Internal Trade had been slower than envisaged, and they urged the authorities to push forward with reforms in a timely manner, which would also contribute to liberalizing the labor market. With respect to international trade, Directors commended Canada's consistent support for free trade. Progress in Canada's unilateral initiative to simplify its tariff system was also commended. However, some Directors recommended further liberalization of trade in agricultural commodities, textiles and clothing, and some service sectors, including the financial sector, which would increase real income and provide welfare gains to Canadian consumers. Directors noted the decline in Canada's official development assistance and, in view of the stronger fiscal position, encouraged the authorities to work toward achieving over time their commitment to the target for foreign assistance of 0.7 percent of GNP.
