Public Information Notice No. 06/68

Public Information Notice: IMF Executive Board Concludes 2006 Article IV Consultation with Canada

June 16, 2006

On May 22, 2006, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Canada.¹

Background

Canada's strong macroeconomic framework helped deliver another year of strong economic performance, with GDP growth remaining close to 3 percent in 2005. High commodity prices have provided a particular stimulus to the resource-rich western provinces, but preliminary national accounts data for 2005 also suggest that activity remained strong in much of the rest of the country, despite the appreciated exchange rate. However, early national accounts data for 2006 suggest some easing of activity in January/February, with strength in the services sector having been offset by a dip in manufacturing.

As in previous years, economic activity has been supported by strong final domestic demand, which expanded 4¼ percent in 2005. Household spending was boosted by asset price appreciation and outstripped income growth causing the personal saving rate to drop into negative territory. Business investment maintained a robust pace especially in the second half of 2005, facilitated by strong corporate earnings, low interest rates, and falling prices of imported capital goods. Stepped-up development of Canada's natural gas and oil sands reserves added significantly to investment demand.

Net exports continued to be a drag on economic activity in 2005, subtracting 1½ percentage points from real GDP. However, buoyed by strong gains in the terms of trade, the current account balance remained at 2¼ percent of GDP. Largely based on the strength of commodity prices, the real effective exchange rate appreciated a further 6 percent over the previous year. In nominal terms, the Canadian dollar has recently appreciated against the U.S. dollar to levels not seen since the late 1970s.

Canadian labor market conditions and productivity growth have been robust. Employment growth averaged a solid 2¼ percent (annualized) during the first four months of 2006, although the unemployment rate rose slightly to 6.4 percent in April. Recent data revisions lifted labor productivity growth in the business sector to 2.2 percent in 2005, twice the previous estimate and narrowing the productivity growth gap with the United States to ½ percentage point-the smallest in five years. At the same time, wage and unit labor cost growth has picked up, with the latter reaching 3¼ percent (year-on-year) in the fourth quarter of 2005.

Notwithstanding higher energy prices, inflation has remained subdued. Headline CPI inflation remained well within the Bank of Canada's 1 to 3 percent target band except in September 2005, when a spike in energy prices in the aftermath of hurricane Katrina caused a temporary overshoot. Core inflation has stayed below 2 percent since early 2004, with the strong currency and global competition keeping prices of imported goods low, and well-anchored inflation expectations helping to contain the spillover of energy price shocks into other prices.

After pausing for almost a year, the Bank of Canada resumed withdrawing monetary stimulus in September 2005. Reflecting the assessment that the economy was operating near capacity, the Bank has since raised its target for the overnight interest rate to 4 percent in six consecutive ¼ percentage point steps. In its April statement, the Bank observed that global competition and the past appreciation of the Canadian dollar continued to pose challenges for a number of sectors but judged the economy to be operating at, or just above, its production capacity. Against this background, it noted that some modest further increase in the policy interest rate might be required.

The FY 2006/07 budget contained welcome commitments to reduce public debt, contain expenditure growth, and lower the tax burden, including through a number of tax cuts aimed at boosting incentives for work, saving, and investment. At the same time, the budget included an explicit commitment to reduce federal debt by C$3 billion annually. The government also took advantage of the C$8 billion surplus in FY 2005/06 (the ninth consecutive federal budget surplus) to advance the earlier objective to lower the debt-to-GDP ratio to 25 percent by one year to FY 2013/14.

Executive Board Assessment

Directors commended Canada's enviable macroeconomic and policy performance since the mid-1990s, reflecting the benefits of firm commitments to debt reduction and to an inflation target. They noted that, while high commodity prices have benefited the resource-rich western provinces in particular, activity has remained strong in much of the rest of the country despite the appreciated exchange rate, which owes much to the economy's flexibility and regional diversity.

Directors agreed that the near-term macroeconomic outlook appears broadly favorable. Growth is likely to remain around most estimates of Canada's potential growth rate through 2007, in part reflecting the support that continued high commodity prices are likely to provide to incomes and domestic demand. However, Directors noted that the outlook is subject to risks, including from the potential for a rapid adjustment of global imbalances and the low household saving rate. Against this background, and in the light of the increased intensity of global competition in goods and services and for investment and given the coming retirement of the baby boom generation, Directors agreed on the importance of maintaining prudent fiscal and monetary policies and further improving the economy's flexibility.

Directors commended the Bank of Canada for continuing carefully to withdraw monetary stimulus in recent months. Further modest increases in the overnight interest rate will likely be required to bring headline inflation back to target, although the Bank's credible commitment to price stability provides scope to respond flexibly to macroeconomic developments. In particular, with the economy operating near its potential, Directors suggested that the support to activity from favorable terms of trade will need to be balanced against the drag from an appreciated exchange rate, whose strength continues to largely reflect fundamentals, including high commodity prices.

Directors considered that Canada's inflation targeting framework has been successful in keeping inflation and inflation expectations low, and that there is no need for significant amendments to it. They welcomed the Bank of Canada's commendable record of transparency.

Directors welcomed the new government's commitment to lowering the tax burden, maintaining fiscal surpluses, and continuing debt reduction. The emphasis on limiting the growth of government spending is appropriate, and the planned reductions in corporate rates and the early elimination of the federal capital tax are warranted given the relatively high level of Canada's marginal effective corporate tax rates. Most Directors considered that reducing marginal personal income tax rates and promoting tax-deferred saving would have provided greater incentives to save and invest than cutting the goods and services tax (GST) rate. Some Directors cautioned that the large number of tax deductions and credits proposed in the budget could increase the complexity of the tax code.

Directors supported the new government's prudent fiscal framework, which has benefited from steps to strengthen fiscal transparency, the decision to pay down federal debt by C$3 billion a year, and the advancement by one year of the objective of lowering the federal debt-to-GDP ratio to 25 percent. Directors agreed that the establishment of a Parliamentary Budget Officer and the medium-term debt anchor could help support the social consensus for prudent fiscal policies.

Directors called attention to the fiscal challenges to all levels of government arising from the rapid increase in provincial and territorial outlays on health care. Some Directors observed that allowing provinces greater flexibility in using price and other market-based mechanisms could help to align better the demand for and supply of health care. Directors welcomed the forthcoming review of the system of federal equalization payments to provinces, while underscoring the importance of ensuring that regional disparities in fiscal capacity are not exacerbated due to the boom in oil and gas prices.

Directors agreed that the financial system is well placed to support economic growth, but called for further improvement in the system's efficiency and resilience to better confront the increased global competition for financial services. In this respect, Directors welcomed the upcoming regular review of federal financial sector legislation as well as Canada's agreement in principle to undertake an FSAP in 2007 or shortly thereafter. Greater clarity regarding the new government's bank merger policy would allow a more transparent examination of potential benefits and costs of merger proposals. Directors welcomed the provinces' efforts toward the harmonization of securities regulation, and the federal government's intention to pursue a common securities regulator as a more effective approach. Directors supported measures to improve the funding situation of defined benefit pension plans.

Directors observed that, although Canada has been among the fastest growing industrial countries in recent years, there is scope to boost productivity through labor and product market reform. They emphasized the desirability of continuing to reduce welfare walls to improve labor participation among low-income groups, amending the immigration process to help address skills shortages, and simplifying the recognition of occupational qualifications across provinces. Consideration could also be given to funding the Employment Insurance system's social benefits through general revenues, rather than the payroll tax, and to curbing extended regional benefits to boost employment and economic efficiency.

Directors suggested that sector-specific constraints and thresholds for review under the Investment Canada Act seem outmoded and may discourage foreign direct investment. They advocated regulatory reform in the electricity sector, where productivity growth has been lower and markups higher than in many other industrial countries. Directors urged Canada to work to widen access to its markets for agricultural goods, including those subject to supply management schemes.

Directors commended the authorities for their commitment to double Canada's International Assistance Envelope by the end of the decade.

¹ Under Article IV of the IMF's Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country's authorities.