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Canada -- 2003 IMF Article IV Consultation, Statement of the IMF Mission
November 15, 2002
1. On the heels of exceptional macroeconomic performance since the mid-1990s, the Canadian economy has remained remarkably resilient in the face of the global downturn. Following a modest output decline in late 2001, a strong and broad-based recovery has been achieved, and Canada's real GDP growth has outstripped that in all other G-7 countries. Moreover, despite weak demand abroad, Canada's external current account has remained in significant surplus and net foreign liabilities have continued to fall. Although inflation has picked up, this appears to reflect mainly temporary factors that are expected to dissipate by early next year.
2. The economy's strong performance owes much to the sound policy framework and its skillful implementation. Inflation targets have helped to anchor expectations and permitted a forceful injection of monetary stimulus in the face of last year's shocks. Fiscal consolidation and debt reduction since the mid-1990s provided room for an easing of tax burdens, modest discretionary spending measures, as well as the working of the automatic stabilizers. Structural reforms that have been undertaken since the early 1990s, coupled with the sound macroeconomic policy framework, have helped to foster significant productivity gains and to lay the foundation for strong and sustained economic growth.
3. Canada's macroeconomic prospects continue to be favorable. Although the completion of inventory adjustments and softer net external demand are likely to weigh on GDP growth through the first half of next year, final domestic demand is expected to be supported by continued household spending and a further recovery of business fixed investment. As a result, the IMF staff now expect that growth would ease from just under 3½ percent in 2002 to about 3 percent in 2003. The excess supply gap is expected to be gradually closed by the end of 2003, and with one-off factors dissipating, inflation would return to around 2 percent. Modest gains in world commodity prices and gradual recoveries abroad would leave the current account surplus in the range of 2-3 percent of GDP, a level consistent with Canada becoming a net foreign creditor for the first time in its history by the end of the decade.
4. Nonetheless, important risks and policy challenges remain. The global macroeconomic environment remains highly uncertain, especially given lingering concerns about the strength and durability of the U.S. recovery, vulnerabilities in global financial markets, and geopolitical risks. The Canadian authorities will need to remain vigilant with regard to these shorter term fragilities, while also ensuring that policies are firmly geared toward boosting Canada's long-run productive potential and preparing for the fiscal consequences of population aging.
5. In the face of these uncertainties, the Bank of Canada's measured approach to withdrawing monetary stimulus is appropriate. Against the background of the uncertain global recovery and financial headwinds, the gradual and pragmatic approach to raising interest rates toward a more neutral level has been consistent with the forward-looking, inflation-targeting framework. Although inflation may breach the target range in coming months, this seems likely to reflect temporary factors rather than generalized price pressures, and inflation expectations remain well anchored. Nonetheless, monetary conditions are still accommodative and some indicators suggest that economic slack has been largely taken up. The mission welcomes, therefore, the monetary authorities' recognition that further withdrawals of stimulus will be required in the period ahead and the commitment to act decisively if needed to ensure that price pressures do not become embedded into inflation expectations.
6. Canada's flexible exchange rate regime has been effective in cushioning the economy from external shocks. Although the factors underlying the weakness of the Canadian dollar in recent years remain subject to considerable debate, the depreciation has played a helpful role in offsetting the effects of world commodity price movements and in mitigating the impact of the global cyclical decline. Canada's fundamental strengths continue to favor a gradual appreciation of its currency over the medium term.
7. The authorities' re-affirmation of their commitment to budget surpluses and debt reduction is commendable, especially in the face of looming demographic pressures. This policy approach has paid important dividends in recent years. Lower debt and debt service costs have provided room for tax cuts and enhancements to spending programs, and in the face of the recent downturn there was scope for allowing the automatic stabilizers to work and for a modest counter-cyclical response. Looking ahead, with the retirement of the baby-boom generation starting later this decade, rising health care costs, and the debt/GDP ratio still high, it will be important to maintain the debt/GDP ratio on a steady downward trajectory. The recent Fiscal Update shows that, after restoring the Contingency Reserve and prudence factor, there will be only limited room in the next two years for new policy initiatives, especially since the economy may be somewhat weaker than earlier envisaged. This underscores the importance of the commitment to reprioritize existing programs in order to increase room for the new initiatives that were announced in September.
8. Reforms to the health care system will need to be consistent with longer-term fiscal constraints. The system has come under increasing financial strains in recent years, and surveys and cross-country studies suggest that health care outcomes have been less than wholly satisfactory, despite relatively large outlays as a share of GDP. Moreover, cost pressures are likely to intensify with the introduction of new technologies and pharmaceuticals, and the expected increase in the elderly population. Therefore, the recent public debate on reform options has been timely. It will be important to ensure that reforms pay due attention to the cost-effectiveness-as well as the equity and quality-of health care delivery, in order to ensure that the system is sustainable and consistent with federal and provincial fiscal constraints over the long run. Meeting these competing challenges will be difficult and-especially in light of pressures to extend coverage to a broader range of services-emphasis needs to be given to increased use of incentive-based systems that would encourage efficiencies and cost containment by both providers and patients.
9. In many other areas, the fiscal authorities have laid a solid foundation for the future. Recent tax measures have lowered the tax burden and improved the incentives to work, save, and invest; the 1997 reforms and contribution rate increases have put the Canadian Pension Plan (CPP) on a sound footing; and the 1996 reforms to the Employment Insurance (EI) system have improved labor market flexibility and reduced structural unemployment. Nonetheless, tax burdens in Canada are still high and there remain opportunities to build on past reforms to promote employment and productivity:
10. A more explicit long-term fiscal anchor could be helpful in supporting the current prudent framework for fiscal policy making. Thus far, the commitment to balanced budgets has been highly successful in disciplining policies on a year-to-year basis and achieving a significant pay-down of government debt. At the same time, however, a substantial further reduction in the debt/GDP ratio-going beyond that projected in the October Fiscal Update-would pay substantial dividends, by helping ensure that the fiscal burden of demographic trends does not fall unduly on future generations. Against this background, a clearer commitment to the amount of debt reduction being sought over the next decade could provide a useful supplement to the existing framework, and help to guide decisions on tax and expenditure proposals that have important longer-term implications.
11. The provinces and territories have made substantial strides in strengthening their finances, but they too face longer-term pressures. Looking forward, the provinces will need to work closely with the federal authorities to implement the necessary reforms of health care systems and age-related spending programs. In this regard, the provinces and territories could also benefit from adopting fiscal frameworks that take into account the longer-term pressures from population aging.
12. Canada's strong supervisory and prudential framework has contributed to the banking sector remaining sound in the face of the economic downturn. Although strains have emerged, mainly reflecting exposures to the U.S. corporate sector, systemic capital and risk management remain strong. Nonetheless, supervisors will need to remain vigilant, especially to the risk of further pressure on asset quality if the U.S. economy were to experience a downturn. From a structural perspective, the authorities have shown a welcome commitment to implementing and further strengthening the anti-money-laundering and counter-terrorism-financing framework. A framework for bank mergers has also been established, but the criteria that would govern such decisions still need to be clarified.
13. The authorities have been commendably pro-active in strengthening corporate governance and preserving investor confidence. The new Canadian Public Accountability Board, the strengthening of accounting and disclosure standards, and the steps by the stock exchanges to tighten corporate governance requirements are welcome developments. As in other countries, it will be important to ensure the effective application of these new standards and institutions. In Canada's case, the key challenge will be to ensure that pressures to harmonize with recent U.S. efforts in this area do not unduly erode Canada's more principles- and disclosure-based system, or impose an excessive regulatory burden, especially on smaller firms. The goals of improved corporate governance and easing regulatory costs would also be well served by moving from a system of multiple securities market regulators to a more national system.
14. Canada remains at the forefront in the area of trade liberalization. In particular, this year's announcement of an extension of duty/quota free access to imports from the least developed countries provides a welcome demonstration of Canada's commitment to the goal of increasing access to the poorest countries. Further liberalization, including in the areas of textile and clothing products, as well as tariff rate quotas on "supply-managed" agricultural products, would help improve domestic efficiency and lend an important impetus to multilateral efforts, including in the context of the Doha Round, to boost development through trade.
15. The authorities' recent commitment to ratifying the Kyoto Accord is welcome. The challenge will be to achieve the Accord's objectives in a manner that minimizes macroeconomic dislocations and shares the costs, especially given regional differences in emissions of green house gases across Canada and the unwillingness of other major trading partners to adopt the Accord's targets. Market-oriented instruments that encourage efficiencies and conservation on the part of both consumers and producers would help to meet these goals.
16. The authorities' recent commitment to boost official development assistance (ODA) is commendable. However, even doubling Canada's ODA by 2010 would still leave it well short of the authorities' long-standing commitment to achieving the U.N. target of 0.7 percent of GNP and more ambitious efforts are encouraged.
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