Oil platform off eastern coast of Canada. The IMF expects Canada’s exports to strengthen in 2013 (photo: North Foto/ZUMA Press/Newscom)
Economic Health Check
Economic activity in 2013 is expected to pick up during the second half of the year, thanks to the strengthening of the U.S. economy from mid-2013. But for the year as a whole the IMF expects GDP growth to be a modest 1.8 percent, which reflects weak activity at the end of 2012 carrying over to 2013.
In an interview with IMF Survey, to coincide with the publication of the IMF’s regular annual health check of the Canadian economy, Roberto Cardarelli, IMF mission chief for Canada, discusses the outlook for the country’s economy and goes over the findings of his team’s analysis. The staff team, including IMF economists Paulo Medas and Julien Reynaud, met with the Canadian authorities in Toronto and Ottawa in December 2012.
IMF Survey: What is the outlook for the Canadian economy? Is the uncertainty about the global economic environment, and in particular concerns about fiscal policy in the United States, having a big impact?
Cardarelli: Our outlook for the Canadian economy is a relatively rosy one, as we expect the pace of expansion to accelerate over the course of 2013 after the weakness experienced last year—but we project lower average growth for 2013 as a result of weak economic activity at the end of 2012 carrying over to 2013. The main reason for our optimism is that we expect export growth to strengthen, as the recovery in the U.S economy gradually steps up the pace. And we expect the more sustainable and less uncertain global recovery to unleash capital spending that firms have been postponing for a while now despite extremely favorable financing conditions.
These positive developments should more than offset the unfavorable conditions from weaker construction activity and more moderate consumption. The housing sector seems to have begun its descent toward a slower but more sustainable pace of expansion, while consumers’ reluctance to finance spending by adding to their already high debt burden is likely to continue.
So in our view, the risks surrounding this scenario continue to be predominantly on the downside. And indeed, given the very open nature of the Canadian economy, they are largely external.
Our staff report devotes quite a few pages to describing the numerous trade and financial linkages that make Canada particularly exposed to the U.S. economy. Two numbers stand out: about 75 percent of Canadian merchandise exports go to the United States, and about 25 percent of total financing for Canadian nonfinancial firms comes from across the border.
Certainly, the resolution of the “fiscal cliff” removed an important risk for Canada, but the materialization of the “sequester” or the financial turmoil that could follow the failure to raise the debt ceiling may put a dent in Canada’s prospects for 2013. But the report also shows that Canada has become quite exposed to adverse shocks involving global commodity prices.
IMF Survey: The report mentions the ongoing fiscal consolidation process. What does it entail, and why is it necessary?
Cardarelli: The strong fiscal position at the onset of the Great Recession allowed the Canadian government to implement one the largest stimulus packages among advanced economies. It’s also (and maybe largely) thanks to this intervention that the 2008–09 recession was relatively shallow and the recovery fast.
Just to give a sense of the amount of fiscal stimulus introduced, the general government overall fiscal balance went from a surplus of about 1½ percent of GDP in 2007 to a deficit slightly above 5 percent in 2010. As the economy recovered, the authorities began to remove the stimulus—appropriately so, as Canada’s exposure to potential new adverse shocks suggests it’s prudent to rebuild an adequate amount of fiscal space.
Since 2010, Canada’s fiscal position has improved and we expect the fiscal deficit to be almost halved by the end of this fiscal year (April 2013), in large measure reflecting the withdrawal of the stimulus measures. But both federal and provincial governments are also planning to return to balanced budgets in the medium term. To be sure, while the federal government looks set to return to a balanced budget by 2015–16, the road to that goal looks bumpier for some of the largest provinces.
IMF Survey: House prices in Canada remain strong and the level of household debt is very high. How worried are you about this situation?
Cardarelli: Indeed, house prices and household debt have increased significantly in Canada before the Great Recession, and, after a brief respite in 2009, over the last few years. Simple indicators such as house price-to-rent and price-to-income ratios suggest valuations are stretched.
Our analysis suggests an overvaluation in real terms of about 10 percent at a national level, although with significant variation across provinces. And both residential investment as a share of GDP and household debt-to-disposable income reached historical highs in 2012.
In our opinion, these levels are unsustainable and an adjustment is likely. But we also think that Canada is unlikely to experience a house boom-and-bust episode à la United States, thanks to Canadian banks’ more conservative lending practices, the relatively high levels of housing equity, and the broad scope of government-backed insurance for mortgages with high loan-to-value ratios. Our expectation is rather for a soft landing scenario where real house prices and housing construction gradually converge to a more sustainable level and household financial imbalances are unwound. This will in part reflect the macroprudential measures taken by the authorities and the expected interest rate increases over the medium term.
Nevertheless, we are concerned that the elevated household debt and house prices would make Canada more vulnerable to the adverse macroeconomic shocks that we discussed above: the impact on economic activity could be exacerbated by the distress among highly indebted Canadians, setting up a negative loop between banks’ balance sheets, house prices, and construction activity.
IMF Survey: What has been the impact of the strong currency on the economy?
Cardarelli: The strengthening of the Canadian dollar over the last decade has been driven by both temporary and more persistent factors. It reflects, to a large degree, the significant improvement in the terms of trade and as such is a reflection of the fact that Canadians are getting richer relatively to the rest of the world. At the same time, the strong Canadian dollar is also a reflection of the fact that Canada is in a healthier economic position than its largest trading partner (the United States) and is being perceived as a “safe haven” by investors.
In that context, the strong currency has also contributed to the weaker export performance and deterioration in the current account. Over time, as the U.S. economy strengthens and commodity prices moderate, we would expect some natural depreciation of the Canadian dollar, which will help boost exports and economic growth.
IMF Survey: Looking ahead, competitiveness is a major concern and there is talk about Canada’s “growth model” having run its course. What structural reforms are needed to put the Canadian economy on a sustainable and competitive path?
Cardarelli: A key structural challenge for Canada is improving its external competitiveness, especially by increasing its labor productivity (which has lagged compared with other trade partners, including the United States). We recognize that this is a complex issue, one that many other advanced economies are also facing, and that there is no silver bullet.
As noted in our staff report, the Canadian authorities have already taken a series of initiatives to boost productivity, but efforts will need to continue. For example, as noted by the Organization for Economic Cooperation and Development, business research and development is particularly low in Canada, despite significant government support. There is room for better, more targeted public support for investment in this area, as well as for measures aimed at increasing labor mobility and retraining the workforce toward sectors experiencing labor shortages.
It will also be important to keep a favorable business environment for domestic and foreign investors. Moreover, the authorities should continue efforts to promote deeper trade links with other countries to open up new markets, through multilateral and bilateral trade agreements.
