Public Information Notice No. 13/17

Canada: IMF Executive Board Concludes 2012 Article IV Consultation

February 14, 2013

On February 11, 2013, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Canada.¹¹

Background

After a strong rebound in 2010–11, the Canadian economy slowed in 2012 reflecting lower growth of private domestic demand, continued external headwinds, and ongoing fiscal adjustment. Slower growth of disposable income and consumer credit put pressure on consumption. The housing sector cooled off somewhat, albeit from very high levels, and the uncertain external environment weighed on business investment. The authorities moved ahead with plans to return to balanced budgets over the medium term, so fiscal policy also held growth in check. At the same time, weak external demand and the strong currency depressed 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).

Economic growth is expected to pick up again later in 2013, accelerating to around 2½ percent by 2014–15. Private consumption and residential investment are expected to contribute less to growth than in the recent past, as households deleverage and the housing sector continues to cool off. But business investment and net exports will benefit from the expected strengthening of the U.S economy. However, near-term adverse risks remain elevated, in particular from continued uncertainty on U.S. fiscal policy, further turbulence from Europe, and a decline in commodity prices driven by an economic slowdown in emerging markets. While high household debt and still elevated house prices leave Canada more vulnerable to external shocks, a less gradual unwinding of domestic imbalances than in staff forecasts could also lead to lower growth.

With regard to policy, fiscal consolidation continued in 2012. The federal government has led the effort, but most provinces are also moving ahead with plans to restrain spending. As a result, the general government’s cyclically-adjusted fiscal deficit fell by a cumulative estimated 1¾ percentage points over the last two years and net debt, at around 34½ percent of GDP, is below most of its international peers. The federal authorities are targeting a balanced budget by mid-decade with some policy flexibility in case the downside risks materialize.

With economic growth faltering, major downside risks still lingering, and well-anchored inflationary expectations, monetary policy has remained accommodative. The inflation rate fell to the bottom of the Bank of Canada target band in late 2012, reflecting weaker economic activity, lower commodity prices, and the stronger currency. The target for the overnight rate has remained unchanged at 1 percent since September 2010, and market expectations are for monetary tightening to begin later in 2013.

Canadian financial markets have benefited from improved global financial conditions. Credit conditions remains highly favorable and should help support business investment going forward. Canada’s banks are well capitalized and profitable, but remain exposed to potential spillovers from renewed distress in global financial markets which could lead to higher funding costs and liquidity strains.

Executive Board Assessment

Executive Directors commended the authorities for their sound macroeconomic and financial sector management. They noted that, after recovering rapidly from the 2009 recession, economic growth slowed in 2012. While growth is expected to pick up later in 2013, the balance of risks remains tilted to the downside as the high level of household debt may amplify the impact of adverse external shocks. In this regard, Directors noted that Canada’s main challenge is to support growth in the short term while reducing the vulnerabilities that may arise from external shocks and domestic imbalances.

Directors agreed that the current monetary policy stance is appropriately accommodative. They noted that, given the negative output gap, well-anchored inflation expectations, and a challenging global environment, the tightening cycle should start only when growth strengthens again. Most Directors also agreed that there remains scope for further monetary policy easing to support economic activity should growth prospects weaken significantly. A few Directors believed, however, that further easing is unlikely to be effective and would exacerbate financial risks posed by prolonged low interest rates. Directors concurred that further macro-prudential measures are the first line of defense against the risks from high household leverage.

Directors supported the authorities’ medium-term fiscal consolidation plans, as this will allow rebuilding key buffers against future adverse shocks. They agreed, however, that automatic stabilizers should be allowed to work fully in the event economic growth weakens. Directors stressed the importance of moving ahead with fiscal consolidation in some of the largest provinces.

Directors noted that placing the general government debt on a sustainable long-term path would require reforms that durably contain spending and boost revenues. Renewed efforts at the provincial level to slow the growth of health care spending would be particularly important in this regard. 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.

Directors considered the housing sector to be an important source of vulnerability, noting the rising household debt-to-income ratio. They welcomed the authorities’ tightening of the rules for government-backed mortgage insurance and mortgage lending standards, which has helped slow the pace of increase in household leverage and house prices. Directors concurred that, should the household debt-to-income ratio continue to rise, additional measures may be needed.

Directors commended Canada’s strong financial regulation and supervision system, which has helped maintain a well-capitalized and profitable banking system. They stressed the need to remain vigilant against the risk of contagion from external shocks and the build-up of financial vulnerabilities from the prolonged period of low interest rates. Directors welcomed the authorities’ continued commitment to implement the international financial reform agenda, and their decision to undertake an update of the Financial Sector Assessment Program in 2013.

Directors concurred that the strong endowment of commodities presents both opportunities and challenges. They noted that the sustained improvement of Canada’s terms of trade, driven by higher commodity prices, had a positive impact on economic growth and government revenues. At the same time, structural changes associated with the growing commodity sector should be managed by increasing productivity and opening up new markets. More generally, improvements in productivity will be needed to increase Canada’s external competitiveness. They also agreed that it would be useful for the authorities or resource-rich provinces to consider adopting a fiscal framework that mitigates the transmission of commodity price volatility to the broader economy.