Public Information Notice No. 05/43

Public Information Notice: IMF Executive Board Concludes 2005 Article IV Consultation with Canada

March 29, 2005

On February 16, 2005, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Canada.¹

Background

Canada has had a remarkable macroeconomic performance since the mid-1990s, including the fastest growth rate and strongest budget position among the large industrial countries. Although the economy was hit, in 2002-03, by exchange rate appreciation, a SARS outbreak, forest fires, a large power outage, and a case of "mad cow" disease, it rebounded strongly through late 2004. In recent months, aggregate demand has softened somewhat as net exports slowed, owing partly to the dampening effects of the stronger Canadian dollar.

The economy has been supported by robust domestic spending. Final domestic demand grew at an annual rate of around 3¾ percent since mid-2003, with buoyant household spending shored up by employment gains and increases in net wealth. At the same time, business investment expanded at a robust pace, boosted by strong corporate earnings, low interest rates, and falling costs for imports of capital goods. Low interest rates continued to benefit residential investment, contributing to strong increases in construction activity.

By contrast, net exports mostly weighed on economic activity as the Canadian dollar appreciated in recent years. In 2003, net exports subtracted 2½ percentage points from real GDP growth on the back of a 13 percent foreign exchange rate appreciation in real effective terms. Strong foreign demand for Canadian products temporarily boosted export growth in the first half of 2004, with favorable terms of trade also contributing to a record current account surplus. Beginning in the third quarter of 2004, however, the contribution of net exports to GDP growth turned sharply negative.

The Canadian dollar reached a 12-year high against its U.S. counterpart in late 2004, supported in part by the adjustment of currencies to global current account imbalances. More recently, short-term interest rate differentials with the United States have narrowed and pressure on the Canadian dollar has eased.

With a strengthening domestic currency and moderating aggregate demand growth, inflation in 2004 remained subdued. Despite a small increase in mid-2004, partly in response to higher energy prices, the year-on-year core inflation rate stood at 1¾ percent in December, slightly below the 2 percent mid-point of the Bank of Canada's target range. Wage pressures also remained well contained, possibly reflecting the strong rise in labor supply. The participation ratio remains close to a record high, apparently reflecting greater labor force attachment associated with rising education levels across cohorts. Despite a gradual drop in the unemployment rate, wage demands remained muted and unit labor costs were essentially flat.

As the economy rebounded in late 2003 and early 2004, economic slack narrowed, prompting the Bank to withdraw monetary stimulus. With the Bank's measure of output gap closed by the second quarter of 2004 and industrial capacity utilization approaching its 15-year peak, the Bank of Canada increased its overnight rate twice by 25 basis points to 2½ percent in September and October, noting that real interest rates were well below neutral levels. However, the Bank has since held its target rate steady, citing growing concern about the impact of the exchange rate on economic activity.

Fiscal policy continued to perform strongly in 2004, contributing to steady debt reduction. The federal budget reached its seventh consecutive surplus in FY 2003-04 (April to March) at ¾ percent of GDP, more than ½ percent of GDP higher than budgeted. The overachievement largely reflects tax revenue buoyancy, benefiting from the rebound in activity beginning in late 2003. Nonetheless, going forward, the room for fiscal maneuver is limited because of federal spending commitments, including significant increases in transfers to provinces over the medium term.

Provincial government budgets remained close to balance in aggregate. Health care spending continued to outpace revenue growth, prompting provincial demands for higher federal transfers and, in some cases, higher taxes. Nonetheless, the strength of federal finances left the general government with a FY2003-04 surplus estimated at around ½ percent of GDP.

Executive Board Assessment

Executive Directors agreed with the thrust of the staff appraisal. They commended Canada's enviable macroeconomic performance since the mid-1990s, including the fastest growth rate and the strongest budget position in the G-7. Canada's performance reflects sound institutions, structural reforms, and a strong macroeconomic policy framework. In particular, Directors noted that inflation targeting has provided a solid and transparent basis for monetary policy, while the strong commitment to "budget balance or better" has yielded welcome progress toward the debt reduction needed to cope with the fiscal pressures of an aging population.

Directors agreed that the economy is likely to continue to perform solidly in the coming year, supported by robust growth in consumer demand and business investment. They noted, however, that there are important risks to the outlook. Directors warned, in particular, of the possibility of a sharper-than-expected drop in net exports, particularly given the Canadian dollar's recent appreciation against the US dollar, and a more abrupt softening of consumer spending. Directors observed that the unwinding of global current account imbalances could result in further upward pressure on the Canadian dollar. In their view, the uncertainties surrounding prospects for exchange rates, global commodity prices, and the ongoing process of trade liberalization, place an additional premium on policies to improve fiscal prudence, economic flexibility and productivity.

Directors agreed that monetary tightening in the second half of 2004 was appropriate and that further tightening could eventually be needed. They suggested, however, that there is room for a cautious and pragmatic approach to withdrawing stimulus, consistent with meeting the inflation target, particularly considering the absence of wage pressures, the risks to the outlook, and well-anchored inflation expectations.

Directors considered Canada's inflation targeting framework successful, noting that it has brought down inflation and helped to anchor expectations. They commended the Bank of Canada for further strengthening policy transparency and stepping up its communication activities. They welcomed the additional information that is now provided on macroeconomic projections in the Monetary Policy Report (MPR), and observed that the Bank of Canada has been effective in preparing markets for the recent shift in its policy stance. Some Directors suggested that more background information on policymakers' views on the distribution of risks and related policy implications would be useful to markets, while others believed that the current communications strategy strikes an appropriate balance between transparency and candor.

Directors commended the authorities' fiscal framework, which has delivered a broad-based social consensus for fiscal prudence. The commitment to budget balance or better has resulted in seven consecutive surpluses and a large reduction in federal debt, while allowing for a sizable tax reduction. In this regard, Directors welcomed the federal government's recently announced objective of lowering the federal debt-to-GDP ratio to 25 percent within ten years. The addition of such an explicit medium-term anchor to the fiscal framework could be especially useful for ensuring that the longer-term costs of budget measures are taken fully into account, and for coping with large shocks that require a temporary breach of the commitment to balanced budget or better.

Directors observed that recent spending commitments, including increased transfers to provinces, have limited the room for fiscal maneuver and meant that the forthcoming budget will need to focus on key priorities. Directors agreed that Equalization payments should not become an entitlement, and urged the authorities to use the upcoming review to design a system which provides a transparent and equitable basis for payments across provinces, while avoiding the year-to-year volatility of the previous system. Directors hoped the ongoing expenditure review will serve as the basis for a careful evaluation of the merits of spending programs versus further reducing the relatively high tax burden. In light of the medium-term commitments to provinces and the importance of transparency regarding the longer-term impact of fiscal measures, many Directors supported a longer-term budget planning horizon. However, they cautioned against placing an undue weight on the planning surpluses projected to reemerge from fiscal year 2007/08, given the uncertainties that surround the fiscal forecast.

Directors noted that there remain longer-term challenges to fiscal balances from population aging, in particular with regard to growing health care spending. They considered that, despite large increases in transfers to provincial health plans, steps are still needed to ensure the sustainability of the health care system. Directors therefore emphasized the importance of health care reform including greater focus on improving incentives for cost containment by both health care providers and consumers. In this regard, a few Directors observed that the government made a commitment to increase transfers to provinces without explicitly requiring reforms to improve the efficiency of health care spending.

Directors commended the authorities' efforts to enhance further Canada's already high level of fiscal transparency. They considered that the larger-than-anticipated federal budget surpluses in recent years reflect the transparent and prudent fiscal framework in addition to favorable economic developments. Directors emphasized that it remains important to sustain the social consensus for continued debt reduction while at the same time allowing well-informed debate on the relative merits of spending programs versus tax cuts. In this context, some Directors suggested that adopting a five-year fiscal planning horizon would be helpful in demonstrating the longer-term fiscal impact of policy measures, including recent commitments to the provinces.

Directors agreed that recent structural policies have laid a solid foundation for future growth. At the same time, they noted that further structural reforms would assist in dealing with the demographic shift, the ongoing challenges from increasingly global markets, and lowering the underlying rate of unemployment. In this context, Directors underscored the importance of sustaining fiscal prudence, continuing structural reforms to maximize productivity, and strengthening incentives to save and invest. Directors also called for controlling health care costs in order to prepare the economy for the effects of population aging. Given the limited fiscal room, tax reductions would need to be focused on measures that yield the greatest efficiency gain while preserving the prudent fiscal balance. Reforms to reduce both incentives for early retirement in the public pension system and disincentives in the social transfer system could help increase labor utilization. Many Directors noted that reinforcing the insurance principle of the Employment Insurance program and funding the social assistance component of the program through general revenues could enhance economic efficiency and transparency, as could further reductions in regulatory barriers to trade and competition.

Directors commended the strength and soundness of Canada's well-managed financial system. Capital ratios are robust, and the system is well-positioned to respond to monetary tightening. Directors noted that further reforms could enhance the system's ability to benefit from a rapidly changing global environment. They agreed that adopting a single national securities regulator would help reduce compliance and administrative costs, and that clarifying the regulatory framework governing bank mergers would reduce uncertainty and possibly allow institutions to reap efficiency gains. A number of Directors wondered whether the dominance of six large Canadian banks does not reflect a lack of competitiveness in the banking system, while others pointed out that banking system efficiency was not necessarily tied to the number of large banks in a country. Directors also encouraged the authorities to consider enhancing incentives for firms to fund their defined benefit pension plans, and to use the upcoming review of financial sector regulation as an opportunity to reduce regulatory overlap.

Directors commended Canada's support for multilateral trade liberalization and encouraged the authorities to continue its important leadership role in efforts to complete the Doha Round, including by further relaxing trade barriers for "supply-managed" agricultural products. They welcomed Canada's recent commitments to promoting foreign development and assistance-in particular, the intended doubling of its official development assistance envelope by the end of the decade and the support for African development, including the cancellation of official debt owed to Canada by several African countries.