Public Information Notice No. 00/11

Public Information Notice: IMF Concludes Article IV Consultation with Canada

February 18, 2000

On February 2, 2000, the Executive Board concluded the 2000 Article IV consultation with Canada.¹

Background

The Canadian economy bounced back strongly from the effects of the Asian financial crisis and the turmoil in world financial markets last year, reflecting a rebound in commodity prices, continued strong U.S. growth, and strengthening domestic demand, particularly investment spending. After slowing significantly in late 1997 and in the first three quarters of 1998, output growth accelerated in the final quarter of 1998, with the recovery from the effects of some labor stoppages, and it rose at an annual rate of 4 percent during the first three quarters of 1999. The unemployment rate declined by a whole percentage point to an average of 8¼ percent in 1998, as employment growth picked up sharply. Subsequently, it has declined further, reaching 6.8 percent in January 2000, its lowest level in more than two decades. Core inflation (the CPI excluding food, energy, and the effects of changes in indirect taxes) has fluctuated within a narrow range around the lower end of the 1-3 percent official target range since early 1997. It picked up a bit in March-April 1999 and has fluctuated in a narrow range around 1½ percent (annual rate) through December. The overall CPI, however, has risen more rapidly, increasing by about 2½ percent annual rate during 1999, largely reflecting movements in energy and food prices.

The current account deficit rose slightly to 1¾ percent of GDP in 1998, but it declined to ½ percent in the first three quarters of 1999. Export growth rebounded sharply during 1999, owing to buoyant growth in U.S. markets and to the recovery in commodity prices. At the same time, growth in the value of imports slowed from its relatively rapid pace in 1998, despite the pickup in domestic demand, as the strengthening Canadian dollar helped to hold down import prices.

Following a 100 basis point increase in short-term interest rates in August 1998, the Bank of Canada matched the moves by the U.S. Federal Reserve and reduced interest rates in September-November 1998 by a cumulative 75 basis points. The Bank reduced short-term interest rates by 25 basis points in both March and May 1999 in order to support continued economic expansion and maintain inflation comfortably within the target range. Subsequently, Canadian interest rates were left unchanged, as U.S. interest rates were increased in June and August by a cumulative 50 basis points. The decision not to follow the Federal Reserve's rate hikes at that time reflected the Bank's assessment that monetary conditions in Canada were consistent with the inflation target. The Bank of Canada raised rates by 25 basis points in November 1999 and again in February 2000, in line with increases by the U.S. Federal Reserve.

Over the past six years, decisive efforts by the Government produced a dramatic turnaround in the federal fiscal position, which shifted from a deficit of $42 billion (5¾ percent of GDP) in 1993/94 to a surplus of nearly $3 billion (¼ percent of GDP) in 1998/99 (fiscal year ending March 31). Substantial fiscal consolidation also occurred at the provincial level during this period, helping to shift the general government balance from a deficit of more than 5½ percent of GDP in 1994 to a surplus of about 1 percent of GDP in 1998 (national accounts basis). Largely as a result of restraint in public consumption and controls on capital spending, the aggregate budgetary balance of the provinces moved into a small surplus in 1997, before slipping back into a small deficit in 1998, as the Asian crisis and lower commodity prices reduced revenues in some provinces and other provinces used a portion of their "fiscal dividends" to cut income taxes. The ratio of general government net debt to GDP has declined from a peak of 70 percent of GDP in 1995 to about 62 percent in 1998, but at that level, it still remains above the average of all G-7 countries.

Executive Board Assessment

Executive Directors commended the authorities for maintaining sound macroeconomic and structural policies over most of the past decade, which had underpinned the strong performance of the Canadian economy, now in its eighth consecutive year of expansion. As a result of the Bank of Canada's successful inflation targeting policy, inflation had been maintained at a level among the lowest of the major industrial countries. Sharp improvements in federal and provincial fiscal balances had resulted in a decline in the ratio of government debt to GDP in recent years, and the prospects were good for further reductions over the medium term. Directors also noted that important structural reforms had been adopted, including improvements in the employment insurance system, the more complete financing of the public old-age support system, the continuing removal of barriers to interprovincial trade, and a restructuring of provincial social assistance programs. Directors considered that these policy efforts had been reflected in a drop in the unemployment rate to its lowest level in two decades, low and stable inflation expectations, significant reductions in real and nominal interest rates, and a stable external position—with the external current account shifting toward surplus as commodity prices recovered.

Directors noted that resource utilization had risen significantly in the last year, and that there is considerable uncertainty as to how much slack might remain in the economy. Although core inflation has so far remained well-contained, Directors considered that the rapid pace of growth raises the prospect that any remaining slack could be exhausted quite quickly. However, the authorities' success in maintaining low inflation had established the credibility of the inflation targeting regime, and Directors were of the view that this provided the Bank of Canada with some room to maneuver in testing the economy's productive limits. Nevertheless, Directors noted that it would be important to ensure that the limits of potential output were not approached with undue speed, in order to minimize the risk of hitting capacity constraints before monetary policy could rein in excess demand pressures. They, therefore, welcomed the authorities' intention to respond promptly if signs of pressure on capacity or inflation should emerge, and noted that their pragmatic monitoring of a wide range of indicators should help in this assessment.

Directors supported the Government's intention to use the prospective fiscal surpluses to continue bringing down the ratio of public debt to GDP, while also acting to reform the income tax system and to increase spending moderately in priority areas of health care and education. However, in striking the balance among these competing goals, Directors recommended that debt reduction and income tax reform should be the top priorities. Many Directors believed that it would be prudent to target somewhat larger surpluses now—especially in view of the presently favorable economic conditions—in order to better prepare for the longer-term fiscal cost of an aging population (especially in the area of health care). Some Directors were of the view that the authorities' debt reduction strategy, which envisages using any unspent portion of the contingency reserve to pay down debt, was appropriate—as Canada's debt-to-GDP position did not raise fundamental sustainability issues.

At the same time, Directors noted that reducing the high burden of personal and corporate income taxes offered considerable scope for economic efficiency gains. They, therefore, strongly supported the Government's intention to introduce a multi-year plan to lower taxes and reduce tax distortions, while cautioning that the plan would need to be carefully phased so as to ensure its consistency with debt-reduction goals.

Directors noted that recent reforms in the Employment Insurance (EI) system were contributing to improved efficiency and flexibility of the labor market and to reducing structural unemployment. They welcomed the authorities' continuing commitment to these reforms in order to help the economy to operate at lower average levels of unemployment without triggering inflation. Furthermore, pointing to the still relatively high level of structural unemployment, a number of Directors believed that it would be appropriate to take additional steps to address remaining employment disincentives in the EI system. These Directors considered that phasing out the system of regional extended unemployment benefits would help to reduce disincentives to labor mobility. It was also suggested that tying the EI premiums for individual firms to the use of the system by their workers could yield additional improvements in the functioning of the labor market.

Directors commended the Canadian authorities on their demonstrated commitment to liberal trade through unilateral, regional, and multilateral initiatives. Nevertheless, they pointed out that Canada retained high rates of protection in certain sensitive sectors, such as agriculture and textiles and clothing. Directors encouraged the authorities to achieve greater liberalization in these areas in order to enhance the efficiency of the Canadian economy, as well as to improve economic prospects for many developing countries.

Directors welcomed Canada's participation in the pilot program of Financial System Stability Assessments. They noted that Canada's financial system was sound and stable, underpinned by strong balance sheets of banks and nonbanks. Directors also noted that there was a high degree of compliance with the major international principles and standards on banking, insurance, and securities regulation and supervision, and on transparency and the payments system, and considered Canada to be a source of best international practice in a number of areas. Indeed, Directors considered that the Canadian authorities had gone beyond the international standards to address certain more complex risks in the financial system. As in other major industrial countries with advanced banking systems, ongoing innovations in financial markets and global competitive pressures would pose a number of challenges. Directors agreed that the Canadian authorities were already substantially addressing these challenges through their well-developed supervisory framework-with its emphasis on a consolidated, risk-centered approach. Nevertheless, they considered that the growing importance of the securities industry suggested that coordinating and harmonizing the regulatory framework for the industry at the provincial level would require increased attention.

Directors welcomed the Prime Minister's recent statement that the Government intended to increase foreign aid in the next budget, and encouraged the authorities to move toward achieving their long-standing commitment to reach a development-assistance target of 0.7 percent of GNP.

Directors noted that the quality, coverage, periodicity, and timeliness of Canadian economic data were excellent both in the context of the Article IV consultation and for purposes of ongoing surveillance.