Mission Concluding Statements
Canada and the IMF
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November 19, 2003
1. The Canadian economy proved exceptionally resilient in the face of the global downturn and is well-positioned to cope with recent challenges. Growth in recent years exceeded that in most other industrial countries by substantial margins and, despite a series of adverse shocks and a weakening of activity this year, most indicators point to recovery into 2004. This performance owes much to the skillful implementation of the authorities' monetary and fiscal policy framework, as well as the structural reforms introduced since the early 1990s, which have laid a solid foundation for growth and increased Canada's capacity to respond flexibly to changing circumstances.
2. We agree with official and consensus forecasts that Canada's near-term outlook is broadly favorable. The economy appears to have shaken off the effects of the SARS outbreak and the electricity blackout, and the risks to the trade sector from the appreciation of the Canadian dollar are likely to be at least partly balanced by the improvement in U.S. growth prospects. As a result, growth should rise from around 2 percent in 2003 to about 3 percent in 2004. The rebound would be underpinned by continued strength of household consumption and residential investment, as well as a pickup in machinery and equipment investment, reflecting the support being provided by low interest rates. With the output gap expected to close only in early 2005, inflation is expected to remain subdued.
3. Nonetheless, the risks appear somewhat skewed to the downside. Foremost is the possibility that the dollar's strength could weigh more heavily on net exports, business profits, and labor market conditions. Although household balance sheets appear strong, low saving rates also suggest the possibility that the momentum to the economy that has been provided by consumer demand could flag, especially if housing price inflation moderates, or if real labor earnings do not improve.
4. Longer-term prospects depend importantly on future productivity growth. Efficiency gains will be essential for Canada to remain competitive and to generate the income and saving necessary to cope with population aging. However, with productivity slowing during the past year and nonresidential investment (especially in high-tech equipment) at a relatively low rate, the challenge will be to ensure that the policy environment supports a resumption of the strong growth achieved since the mid-1990s.
5. These considerations suggest the need for supportive macroeconomic policies, continued debt reduction, and efficiency-enhancing structural reforms. With inflation low and the economy operating below potential, and the room for fiscal maneuver limited under existing medium-term budgetary frameworks at both the federal and provincial levels, monetary policy should remain accommodative. Budget surpluses have eroded at all levels of government, and fiscal authorities will need to remain focused on sustaining debt reduction and preparing for impending demographic pressures on retirement and health care systems. In addition, a continued emphasis on financial sector, labor, trade, and other structural policy reforms will help strengthen Canada's longer-term growth potential and allow the economy to take full advantage of the increased integration of global markets.
6. The Bank of Canada's present setting for the overnight rate appears consistent with a gradual return of the economy to its potential. With the recent opening of an output gap, the appreciation of the dollar weighing on activity, and core inflation expected to remain low, monetary policy can remain accommodative for some time. To be sure, the signals offered by inflation data have been clouded by special factors during the recent year, and considerable uncertainty attaches to estimates of the output gap. However, given the credibility won by the Bank over the past decade, and with some indicators suggesting that economic slack may be larger than conventional estimates, there is room to respond if the risks to the recovery intensify and further support to domestic demand is needed.
7. The more uncertain operating environment for monetary policy has increased the premium on effective communications. The Bank has demonstrated a commendable commitment to transparency and improving the public understanding of its decision-making process, including by providing more detailed presentations of its inflation forecast. However, with growing uncertainty surrounding both the usefulness of many of the Bank's forward-looking indicators and the likely impact of domestic and international shocks, there may be merit in further boosting transparency, including by publishing additional details of the Bank's macroeconomic forecast and its sensitivity to alternative assumptions and shocks.
8. Canada's commitment to exchange rate flexibility has been helpful in facilitating the adjustment of global macroeconomic imbalances. Although the speed of appreciation of the Canadian dollar has raised concern, its strength has partly reflected the broader weakness of the U.S. dollar and does not appear to be out of line with underlying fundamentals, especially considering Canada's current account surplus and improved net foreign liability position, and world commodity price developments.
9. The recent Economic and Fiscal Update provided a welcome reaffirmation of the authorities' commitment to keeping the debt-to-GDP ratio on a permanent downward path. Compared with most other industrial countries, Canada is better positioned to cope with the impending fiscal pressures stemming from population aging as a result of the fiscal consolidation achieved over the past decade at both the federal and provincial levels, as well as the reforms to the Canada Pension Plan. Nonetheless, with age-related spending projected to rise sharply in coming decades—especially on health care—sustained surpluses will be essential in order to ensure fiscal sustainability and intergenerational equity.
10. The short-term fiscal outlook has become more challenging, however. At the federal level, the economic slowdown and the spending initiatives introduced with the 2003 Budget, particularly on health-care related transfers to the provinces, have used up much of the planning surpluses that were projected last year. Especially as signs emerge in coming months that activity is firming, it will be important to ensure that the forthcoming budget demonstrates a firm commitment to achieving the planned contingency reserve set out in the recent Fiscal Update and to rebuilding the economic prudence factor at the earliest opportunity. The fiscal position of many of the provinces has also become more difficult, and welcome steps have been taken or promised to avoid unduly compromising balanced-budget commitments.
11. These developments have underscored that difficult issues at both the federal and provincial levels still need to be tackled to keep the public debt ratio on a downward track.
12. Considerable progress has been made in enhancing the efficiency and equity of the tax system in recent years, and the policy focus now will need to be placed on expenditure control rather than broad-based tax cuts.
13. The public pension system and other age-related programs appear sound but further reforms may still be warranted on efficiency and equity grounds. For example, improving the actuarial fairness of the adjustment to CPP benefits for those who retire before or after the statutory retirement age, or gradual increases in the retirement age to take into account increases in longevity, could help encourage labor market attachment and possibly enable an eventual reduction in the CPP premium rate. Increases in the retirement age could also help reduce the burden on the old-age security system, while encouraging greater accumulation of private retirement savings.
14. The government's fiscal framework has succeeded in disciplining policies and achieving a substantial fiscal correction, but could usefully be complemented by a clearer longer-term anchor. Recent statements suggest that the authorities may be considering the adoption of a more explicit longer-term debt objective, which could provide a more transparent basis for weighing the longer-term implications of policy options, and similar commitments by the provinces could also be helpful. In addition, a longer-term debt objective could provide a basis for recasting the existing two-year planning framework in terms of a commitment to achieving a specific fiscal surplus over the cycle, enabling a clearer and more flexible response to macroeconomic and other shocks.
Financial sector issues
15. The Canadian financial system has remained resilient in the face of the recent slowdown and spillovers from U.S. accounting scandals. In the banking sector, loan losses have fallen, revenues have strengthened, and credit quality has improved, reflecting progress made by banks in raising operating efficiency and strengthening internal risk management systems. The authorities have also responded effectively to increased global concerns regarding corporate accounting and governance standards by increasing the stringency of disclosure requirements, introducing a new Public Accountability Board to improve the quality of the audit process, developing new corporate governance guidelines, and strengthening enforcement of securities market regulations.
16. The challenge remains to ensure that financial sector regulation continues to foster a healthy and efficient financial system that enables Canada to compete effectively in the face of the increasing integration of global capital markets. Legislation in 2001 took important steps to facilitate this process, while at the same time strengthening consumer protection. However, in view of recent concerns regarding the effectiveness of the new bank merger-review policy, it will be important to ensure that the guidelines that will be finalized next year provide a transparent framework for allowing mergers to go forward unless there is a compelling public-interest concern. In addition, the fragmentation of securities market regulation and legislation across provincial lines appears to have resulted in an additional administrative burden and a risk of regulatory arbitrage. Greater harmonization—with the eventual aim of establishing a single regulator—would support the financial sector's ability to remain globally competitive.
17. The weak financial position of many defined-benefit pension plans could weigh on corporate profitability and suggests the need for strengthened oversight. In order to ensure adequate funding levels through future economic cycles and greater transparency, further consideration could be given to: amendments to the accounting treatment of pension plans that would require more transparent disclosure of funding shortfalls; tightening rules governing contribution holidays in order to avoid discouraging pension surpluses; and continued efforts toward developing a more uniform system of pension regulation.
18. Boosting Canada's productivity growth remains a key long-term challenge. Although the economy's productivity growth accelerated during the 1990s, it still fell short of U.S. rates, seemingly reflecting lower rates of investment, especially in high-tech equipment and R&D, as well as the weaker performance of firms that were less exposed to foreign competition. To be sure, Canadian productivity compares well with many other industrial countries, but the widening of the Canada-U.S. productivity gap is a concern, especially against the background of the increasing integration of North American markets.
19. There remain important opportunities for regulatory and other policies aimed at spurring productivity. The key priorities are to ensure that personal and corporate taxes and the retirement system provide the appropriate incentives to save and invest, and that the financial system is well placed to intermediate capital both domestically and internationally, including in the specific areas identified above. At the same time, a further strengthening and streamlining of regulatory policies, including in the electricity sector, would help to promote an efficient allocation of resources.
20. Social policies still represent an important avenue for improving the productive efficiency of the Canadian economy. The EI system has provided a ready source of funding for broader social policy objectives—including extended benefits in high unemployment regions—but at the cost of significant and distortionary cross-subsidization across industries and regions. The pending review of the system could provide a useful opportunity to consider introducing experience-rated premiums and alternative funding options for the social objectives presently being supported by the system.
21. Continued trade and agricultural policy reforms could also boost the economy's potential. Canada's trade system remains among the most open and transparent in the world, and welcome steps were taken in January 2003 to extend duty- and quota-free access to 48 least-developed countries. However, easing import barriers further—especially in the area of agriculture—and exerting further discipline over the use of anti-dumping and countervailing duties would encourage greater competitive efficiencies and complement Canada's overseas development objectives. Canada can also play an important leadership role in efforts to bridge differences among the participants of the Doha Round.
22. Care will be needed to ensure that Canada's environmental policy commitments are implemented in a manner that minimizes adverse fiscal and supply-side consequences. The authorities have adopted ambitious emissions-reduction targets, but have coupled these with commitments to limit the adjustment costs borne by the energy and industrial sectors. In this light, consideration may need to be given to instruments—including additional taxes on energy consumption—that could help achieve these goals while minimizing the adverse effects on competitiveness, output, and the longer-term fiscal position.
IMF EXTERNAL RELATIONS DEPARTMENT