Mission Concluding Statement 

December 19, 2012

This statement presents the preliminary assessment of the 2012 Article IV mission to Canada. The Canadian economy slowed in 2012, with the uncertain global environment weighing on exports and business investment. Economic growth is expected to pick up above its potential rate over the course of 2013, although downside risks from external headwinds continue to loom large. The impact of these shocks on the Canadian economy would be exacerbated by the elevated level of household debt. The policy discussion focused on the need to sustain growth in the short term while gradually unwinding domestic imbalances, maintaining the fiscal position on stable footing, and progressing with the financial regulatory reform agenda.

1. The Canadian economy slowed in 2012. The economy rebounded strongly in 2010–11, thanks to effective policy action, a resilient financial sector, and high commodity prices. In 2012, however, domestic demand has expanded at a slower pace. A more moderate growth of credit and disposable income (partially reflecting ongoing fiscal consolidation) slowed private consumption growth; the housing sector cooled somewhat, albeit from very high levels; and the uncertain external environment weighed on business investment. At the same time, net exports continued to be a drag on growth, as weak external demand and the strong currency weighed on exports. Together with lower commodity prices this caused a sharp widening of the current account deficit, to around 4 percent of gross domestic product (GDP). The impact of the headwinds has been only partially offset by highly-accommodative financial conditions, with the Bank of Canada maintaining the policy rate at 1 percent. Moderate wage growth and the persistence of economic slack have contributed to maintain core inflation below 2 percent in the second half of 2012.

2. We expect economic activity to pick up over 2013, growing at a pace slightly above potential from the second half of the year. Uncertainty about the global economic environment, and in particular the impending “fiscal cliff” in the United States, is likely to constrain growth over the current quarter and the next. A positive resolution of that uncertainty and a strengthening of the U.S and global economy from mid-2013 would boost the Canadian economy through stronger exports and business investment. On the other hand, the contribution to growth from private consumption and housing will likely be lower than in the past few years, as high leverage is expected to contain household spending and residential investment (as a share of GDP) and house prices (in real terms) are projected to fall gradually to more sustainable levels. Overall, we expect GDP growth of just below 2 percent in 2013, accelerating to around 2¼ percent in 2014, a pace consistent with a gradual absorption of the output gap and a slow decline of the unemployment rate towards its natural rate.

3. The risks surrounding this scenario are tilted to the downside. A stronger pace of fiscal consolidation in the United States relative to our base case scenario would reinforce the external headwinds to the Canadian economy. Staff estimates that the impact on Canada from the “fiscal cliff” in the United States would be around ¾ of the effect in the U.S. economy. The risk of a worsening of the euro-area debt crisis continues to loom large, and would affect Canada though a tightening of financial conditions and negative confidence effect. To the extent that these shocks spill over more generally and reduce global demand, Canada would be hit by weaker exports and a decline of commodity prices, a risk that could also stem from the emergence of financial stress in a few emerging market economies. The impact of these shocks on the Canadian economy would be exacerbated by the elevated levels of household debt, which limit the scope for Canadian household to smooth consumption by borrowing and might force them to deleverage in the face of tighter financial and economic conditions. Domestically, while Canada is unlikely to suffer from a house boom-and-bust episode similar to the one experienced by the United States, the unwinding of domestic imbalances could prove more disruptive than anticipated in our baseline scenario, especially if household leverage were to keep rising.

4. In this context, the main challenge for Canada’s policymakers is to support growth in the short term while reducing the vulnerabilities that may arise from external shocks and domestic imbalances. The Canadian authorities, both at the federal and provincial level, have to balance several objectives: preventing the economic momentum from slowing further amid the heightened degree of external uncertainty; rebuilding the policy buffers that may be needed in case of further shocks; and managing the transition to a less leveraged household sector while supporting the long-term stability of the housing market. Looking further ahead, it will also be important to further advance the reform agenda for financial regulation and supervision, and continue to address the long-term public spending pressures from aging and the rising cost of providing health care.

5. The beginning of the monetary tightening cycle should be delayed until growth strengthens again. The current monetary policy stance is appropriately accommodative given the negative output gap, well-anchored inflation expectations, and a challenging global environment. Under our baseline scenario, a gradual monetary tightening should start in late 2013, when growth is expected to accelerate. If household imbalances continued to build up in the context of modest growth, further macro-prudential measures should be taken into account before considering an earlier start of monetary tightening. On the other hand, there is some space for further monetary easing if the economy were to weaken significantly.

6. The timing and pace of the ongoing fiscal consolidation process are appropriate, with room for supporting activity if the economy were to weaken. Progressing with fiscal consolidation is essential to rebuild a fiscal buffer against future adverse shocks. The ongoing fiscal adjustment is expected to reduce the deficit of the general government in 2013 by around ¾ percent of GDP, with an estimated drag on economic growth of about ½ percentage point.¹ While the consolidation plans of the federal government are well advanced and a budgetary balance by 2015 is well within reach, balancing the budget may require further efforts in some of the largest provinces, where the current consolidation plans rely on ambitious spending cuts, including freezes on wages that will be difficult to sustain in the medium term. If the economy weakened further, the federal and some provincial governments should allow the full operation of automatic stabilizers. In the event of a large adverse shock, the federal authorities could also consider a new temporary fiscal stimulus package, given the available policy space.

7. At the same time, it will be important to continue to address long-term spending pressures. Canada has a relatively low net public debt ratio compared to most other advanced economies. Still, it is not immune to long-term spending pressures from population aging and rising health costs. Staff analysis suggests that placing the general government debt on a sustainable long-term path would require reforms that durably contain these pressures, as well as higher revenues. Renewed efforts at the provincial level to slow the growth of health care spending would be particularly important in this regard, with progress measured against a long-term fiscal sustainability benchmark. In addition, publishing a comprehensive fiscal sustainability report covering all levels of government and including a discussion of policy options would help gain the necessary public support for reforms.

8. The authorities’ gradual tightening of mortgage insurance rules was appropriate, but further macro-prudential measures should be considered if household leverage continues to rise. Household debt in relation to income reached new historical highs in 2012, and remains high in relation to assets. Moreover, staff analysis suggests that real house prices and residential investment as a share of GDP remain above levels consistent with economic fundamentals. In this context, staff welcomed the introduction of a new round of measures in the second half of 2012, which tightened the rules for government-backed mortgage insurance and lending mortgage standards. While it is too early to ascertain the full impact of the latest round, staff believes that the cumulative effect of all measures taken since 2008 has slowed the growth of household indebtedness and the housing sector. However, should the household debt to income ratio continue to rise, additional measures may be needed. Higher down payment requirements (tighter loan-to-value [LTV] limits for first buyers), lower caps on debt-service -to-income ratios, and tighter LTV on refinancing are some of the possible options.

9. While the Canadian banking system is healthy, it is important to remain vigilant against the risk of contagion from adverse shocks. Canada’s banking system is well capitalized, has posted another year of strong profits, and continues to show low nonperforming loans, also owing to high prudential standards and rigorous supervision. Going forward, however, pressures on margins from low interest rates and slowing growth in household loans may result in a more challenging environment for banks, and induce them to increase their exposure to more volatile capital market operations and expand their operations abroad. Moreover, despite the significant strength of the system, Canadian banks are not immune to the risk of increased global financial turbulence, which would reduce their access to wholesale funding. Stress-testing scenarios developed by the authorities show manageable losses for the financial system under adverse scenarios. Consideration could be given to publishing the results of the tests, as this would promote a better awareness of the risks, induce more realistic risk pricing, and enhance market discipline.

10. It is important to continue monitoring the risks to financial stability from the non-bank sector, particularly from the low interest rate environment. Persistently low interest rates have continued to challenge the financial positions of institutions with long-duration liabilities, such as defined-benefit pension plans and life insurance companies. This challenging environment increases the risks of underfunding for pension funds, and may require higher contributions. To reduce interest rate risk and achieve a better matching of assets and liabilities, many pension plans have adopted liability-driven investment strategies, but this may expose them to a new configuration of risks in the cases where it involves the use of leverage. Life insurance companies have reacted by redesigning and re-pricing their products but also by investing into alternative (non-fixed income) assets. While there is little evidence that the search for yield has led to excessive risk taking so far, it is essential to remain vigilant.

11. An appropriate response to these risks would be to take further steps to enhance the resilience of the financial system. Staff welcomes Canadian authorities’ strong determination to move ahead with the international financial reform agenda, often taking a leadership role among other jurisdictions. In particular, staff supports the decision by the authorities to implement Basel III capital requirements by January 2013, and welcomes their intention to implement liquidity standards once they are finalized. Staff welcomes the establishment in 2012 of a central counterparty service for fixed-income repos, which will increase the resilience of this important core funding market by mitigating counterparty risk. Progress has continued towards enhancing the resolution framework, with the first generation resolution plans for the largest banks expected to be completed by the end of 2012 and revised recovery plans expected to be submitted in 2013. Efforts to establish a single securities regulator for Canada should continue, as this would reduce compliance costs, simplify systemic risk monitoring, and facilitate coordination with other agencies and policy intervention. Finally, staff welcomes the intention of the authorities to undertake an update of the FSAP in 2013.

12. Over the medium term, a key challenge for Canadian policymakers is to manage the structural changes in the economy associated with the growing commodity sector. Higher productivity growth is essential for Canadian firms to respond to persistent competitive pressures from a strong currency and the opening of global trade markets to emerging and developed economies. While recognizing that this is a complex issue and that the authorities have done much to address the problem (including through corporate tax reductions and improvement in the employment insurance program and immigration system) more can be done. For example, there is room for a better, more targeted, support to investment in research and development and for measures aimed at increasing labor mobility and retrain the workforce towards sectors experiencing labor shortages. Continued efforts in opening up new markets, through multilateral and bilateral trade agreements, could also boost competition and innovation. Finally, consideration could be given to adopting a fiscal framework that mitigates the macro-economic and fiscal impact of commodity price volatility, for example by excluding revenues from the most volatile commodities. This would allow a better assessment of the underlying fiscal stance and the identification of the appropriate level of stabilization savings during commodity price booms, particularly for resource-rich provinces.

The staff is grateful to the Canadian authorities for their hospitality and very open discussions during our mission.

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¹ The general government is defined as federal, provincial, territorial and local governments, and the Canada and Quebec Pension Plans.