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Canada—2001 Article IV Consultation
1. The sound macroeconomic and structural policies put in place over the past decade have provided a solid foundation for the sustained expansion of the Canadian economy. Fiscal consolidation by both the federal and provincial governments has brought budgets into surplus and led to a sharp reduction in government debt as a ratio to GDP in recent years. Monetary policy has been successfully implemented using an inflation targeting framework. Among structural reforms, continuing efforts to remove barriers to interprovincial trade, improvements in the employment insurance system and in incentives for low-income working families, and the measures taken to bring the public old-age support system into actuarial balance have enhanced economic efficiency. All of these policies have paid off in the past few years with inflation and inflation expectations being maintained at low levels despite a marked acceleration in output and employment growth and a sharp decline in unemployment. Moreover, there are indications of a recent acceleration in labor productivity growth. The strong policy framework in place has positioned the real and financial economy to cope with any new major economic shock, including a slowdown in U.S. growth. The Canadian authorities are to be highly commended for their policy accomplishments.
2. The rapid pace of economic growth in recent years pushed the Canadian economy to a high level of resource utilization, raising the prospect that any remaining slack in the economy might quickly be exhausted, even given the uncertainty in estimating the economy's productive potential. In these circumstances, the risks stemming from capacity being absorbed at a very rapid pace have been appropriately considered in setting short-term economic policies over the last year. However, inflationary pressures have been largely absent, as growth in unit labor costs and second-round effects from higher energy prices remain well contained. Moreover, economic activity in Canada has maintained considerable momentum, which now appears useful in providing some protection from the effects of a slowdown in the United States. The uncertainty about the depth and duration of a U.S. slowdown and its impact on Canada raises a new set of issues for macroeconomic policy. Although the recently enacted tax cuts are fortuitously well-timed, the IMF staff believes that monetary policy should be the main instrument used in attempting to sustain the economic expansion, in the context of Canada's forward-looking inflation targeting framework.
3. The IMF staff agrees with the authorities that monetary policy should be set to reflect economic conditions in Canada and should aim to allow the economy to seek its productive potential without compromising the official inflation target. The past success in maintaining low inflation has established the credibility of the inflation targeting regime, giving the Bank of Canada room to maneuver and enhancing further its ability to follow an independent monetary policy. The Bank appropriately remains forward-looking in setting policy, focusing on a range of indicators of inflation and capacity pressures and the likely impact on Canada of external developments. In the period ahead, the Bank will have to be flexible, poised to act promptly and firmly should indications begin to emerge of a slowing in economic activity which would be sufficient to exert downward pressure on inflation that is inconsistent with the Bank's implementation of the inflation targeting framework. While there is no need for policies to respond to every shock emanating from the United States, monetary policy would need to be eased in the event of a substantial U.S. economic slowdown.
4. By the end of 2001, the Finance Minister and the Governor of the Bank of Canada will have to jointly determine whether the official inflation target should be modified. The current 1_3 percent inflation target, with the authorities' focus on keeping inflation around the mid-point of this range, has served Canada well, and its credibility has helped to enhance the effectiveness of the floating exchange rate regime in buffering the economy against external shocks. While there is only limited empirical evidence on the net benefits of moving from very low to even lower inflation rates, these additional benefits are probably relatively small, especially in comparison to the significant gains already achieved. The IMF staff is of the view that it would be useful to continue assessing options for further refining the current inflation target framework; however, in making a decision this year, there do not appear to be compelling reasons for more than moderate refinements to the inflation target. One option that merits further consideration would be to increase the accountability of the authorities by establishing periodic reviews of their performance in meeting the inflation target, so as to help anchor longer-term price expectations more firmly. The Bank of Canada in the past year also has strengthened its communications strategy by providing updates to the semi-annual monetary policy reports twice a year and by establishing fixed dates for announcing monetary policy decisions.
5. The IMF staff commends the authorities for the comprehensive income tax reforms and reductions introduced in the 2000 Budget and in the October 2000 Economic Statement and Fiscal Update and strongly endorses the fiscal policy framework that has been put in place. In light of the relatively high burden and significant distortions of income taxation in Canada, the tax reductions will offer considerable economic efficiency gains in the period ahead by increasing returns to work and investment and by contributing to the spread of new technology and entrepreneurship. The corporate income tax cuts, when fully implemented, will help bring average business taxation below current levels in the United States, significantly enhancing the competitiveness of Canadian firms. The IMF staff also welcomes the authorities' decision to commit themselves to trying to bring down the debt-to-GDP ratio more rapidly than previously envisaged by announcing each year, as economic conditions permit, a target for additional debt reduction.
6. The federal government's medium-term budget position remains sound, even with full implementation of the major reforms to income taxation and new spending initiatives in priority areas such as health care and education that have been enacted or announced over the past year. The fiscal projections continue to incorporate a contingency reserve to allow for unanticipated developments and explicit economic prudence factors to offset the effects of potentially less favorable economic conditions. Uncertainties in the near-term economic outlook underscore the wisdom of this approach to budgeting and also the decision in the October 2000 Update not to allocate all of the "planning" surpluses in prospect. The IMF staff recommends that the bulk of any surplus funding realized each year (largely reflecting the economic prudence factors in the fiscal estimates and the unallocated portion of prospective planning surpluses) be dedicated to reducing government debt.
7. With their budgetary positions generally on solid footing, the provinces and territories are considering their options for new tax and spending initiatives. Such decisions, however, need to be framed in a longer-term perspective, reflecting the large potential fiscal costs arising from population aging and continuing growth in demand for health care, which is a major provincial responsibility. With increased grants from the federal government and their own resources, the provinces plan to raise spending on medical services to deal with current problems, but the health care system faces rising demand and cost pressures over the long term that are difficult to accurately predict. The IMF staff believes that it is essential for the provinces to begin to take steps to provide for these future needs, while at the same time continuing to improve the delivery and control the cost of medical services. The role of the federal government in providing resources to help meet these future needs also should be established.
8. Comprehensive reforms enacted during the 1990s to the Employment Insurance (EI) system and to social assistance programs and the introduction of the National Child Benefit, have enhanced the flexibility and efficiency of the labor market, boosting employment growth and helping to reduce structural unemployment. Pressures to ease the impact of some of these reforms—particularly the 1996 EI reforms—have intensified as they have become more binding. The Government has mitigated the intended effects of some of the reforms and has proposed to rollback others. In particular, the IMF staff sees the proposed elimination of the intensity rule, which was designed to discourage frequent use of the system, as sending the wrong signal. Frequent use of the system, along with the provision of extended EI benefits for high unemployment regions for a prolonged period of time, has had adverse effects on the behavior of both workers and employers, has significantly raised reservation wages in high unemployment regions, and has reduced labor mobility. In addition, the recent experience in the United States suggests that labor market flexibility is an important factor in fostering the rapid adoption of productivity-enhancing new technologies. Therefore, the IMF staff continues to endorse the implementation of new measures to reduce the frequency of EI use (such as experience rating of the EI premium rate, which would tie the rate for individual firms directly to the use of the system by their workers) and the elimination of regional extended benefits.
9. Canada has a highly advanced financial system that is among the soundest in the world. The profitability, asset quality, and capitalization levels of Canadian financial institutions remain high. In recent years, these firms have embarked on new and highly complex activities to optimize regulatory capital and maximize returns. While the complexity of some of these new activities pose significant challenges, the Financial Sector Stability Assessment undertaken last year concluded that the regulatory and supervisory structure in Canada is well developed, complies with the major international principles and standards, and is a source of international best practice in a number of areas. With its emphasis on a consolidated, risk-centered approach to supervision, the Office of the Superintendent of Financial Institutions has been well-positioned to address the challenges that it has faced, as illustrated by its recent decision on establishing capital requirements for the guarantees on life insurance segregated funds. Steps also have been taken to provide for closer coordination and harmonization of regulation and supervision at all levels of government, especially in securities regulation. The IMF staff welcomes the thrust of the new financial sector legislation, to be re-introduced early in the new Parliament, which is intended to enhance efficiency and competition in financial services, make the review process for bank mergers more transparent, further improve the regulatory framework, and strengthen consumer protection.
10. On numerous occasions, Canada has demonstrated its commitment to liberal trade through initiatives at the multilateral, regional, and bilateral levels, and the IMF staff urges the authorities to continue to pursue trade liberalization vigorously. Great strides have been made in reducing Canada's barriers to trade for a wide range of products, and Canada has been generous in providing favorable access to its markets for the least developed countries. However, high rates of protection have been retained in some sensitive sectors, such as in certain agricultural products and textiles and clothing. The IMF staff encourages the authorities to accelerate the reduction of tariffs on these products and to provide more duty-free access for the least developed countries, both to improve resource allocation in Canada and to promote growth in the neediest countries.
11. Canada's official development assistance (ODA) as a share of GNP has fallen in recent years, reaching 0.28 percent in 1999. In line with the Prime Minister's statement of the Government's intention to raise foreign aid and now that the fiscal situation has strengthened, the IMF staff encourages the authorities to begin to raise the level of ODA spending in line with Canada's long-standing commitment toward the target level of 0.7 percent of GNP.