Public Information Notice No. 01/38

Public Information Notice: IMF Concludes Article IV Consultation with Canada

April 23, 2001

On March 23, 2001, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Canada.¹

Background

The Canadian economy ended the 1990s with a very strong performance, underpinned by the sound macroeconomic policies put in place during the decade. Following a slowdown in growth in late 1997 and 1998 largely associated with the fallout from the Asian crisis, the pace of economic growth has been vigorous and broadly based. Real GDP grew at an average annual rate of about 5 percent between the fourth quarter of 1998 and the third quarter of 2000, broadly in line with growth in the United States. In the fourth quarter of 2000, growth slowed to 2½ percent, reflecting the effects of a slowdown in U.S. economic activity in the second half of the year. The strong pace of economic growth in the last two years has pushed the economy to levels of resource utilization that have not been seen during the past 25 years. The unemployment rate fell to 6½ percent in June, its lowest level since the mid-1970s, but it rose somewhat subsequently to almost 7 percent in the first two months of 2001, partly owing to an increase in the participation rate. Despite indications of higher levels of resource utilization, inflationary pressures remain quiescent. Core inflation hovered within a narrow range around 1½ percent between mid-1998 and November 2000, but was at the mid-point of the official 1-3 percent target range in the first two months of 2001. Overall inflation has risen more rapidly, largely reflecting the impact of energy prices. CPI inflation was 1¾ percent in 1999, 2¾ percent in 2000, and 3 percent (annual rate) in early 2001. Wage pressures remained well contained, and unit labor costs, which remained virtually unchanged in 1999, rose at an annual rate of almost 1 percent in the first three quarters of 2000. Inflationary expectations continue to be anchored around the mid-point of the official target range, suggesting continued high credibility in the authorities' inflation target.

The external current account shifted from a deficit of ½ percent of GDP in 1999 to a surplus of 1¾ percent of GDP in 2000, reflecting strong U.S. demand growth, together with some recovery in commodity prices. A sharply improving trade surplus has been mainly propelled by buoyant export growth to the United States. The deficit in net investment income has also declined, partly reflecting the cumulative effects of lower interest rates and a more recent rebound in foreign earnings of Canadian corporations.

The Bank of Canada raised interest rates markedly in 2000 as estimates of slack in the economy were narrowing rapidly and owing to concerns about potential inflationary spillovers from faster-than-expected U.S. growth. However, following the sharp turnaround in the U.S. outlook, the Bank of Canada lowered the bank rate by 25 basis points, 50 basis points, and 25 basis points on its scheduled monetary policy announcement dates of January 23, March 6, and April 17, 2001, respectively. The Bank of Canada's decision was motivated by concerns regarding near-term Canadian economic prospects stemming from indications that the U.S. slowdown would be more abrupt than expected.

The authorities' commitment to promoting lasting fiscal discipline has been reflected in an impressive turnaround in the federal fiscal position, which shifted from a deficit of 5¾ percent of GDP in 1993/94 to a surplus of 1¼ percent in 1999/00 (on a public accounts basis, fiscal year ending March 31). In the October 2000 Economic Statement and Budget Update, the authorities presented a mini-budget, which expanded the comprehensive reductions in personal and corporate income taxes presented in The Budget Plan 2000, introduced some modest additional spending initiatives, and announced a minimum of Can $10 billion in government debt to be repaid in 2000/01. Strong fiscal consolidation at the federal and provincial levels, have allowed the general government balance to improve from a deficit of 6¾ percent of GDP in 1994 to a surplus of 3½ percent in 2000 (national accounts basis). As a result, the general government net debt declined from about 87 percent of GDP in 1994 to 75 percent in 1999.

Executive Board Assessment

Directors commended the authorities for maintaining sound macroeconomic and structural policies over most of the past decade, which had provided a solid foundation for the sustained expansion of the Canadian economy. Fiscal consolidation by both the federal and provincial governments has brought budgets into surplus and led to a sharp reduction in government debt as a ratio to GDP in recent years. Monetary policy has been conducted very successfully, within an inflation-targeting framework. Economic efficiency has been enhanced by the adoption of important structural reforms, including continuing efforts to remove barriers to interprovincial trade, improvements in the employment insurance system and in work incentives (especially for low-income families), and measures to bring the public old-age support system into actuarial balance. Directors considered that these policies have paid off in the past few years with low and stable inflation and inflation expectations; a sharp decline in unemployment; and indications, more recently, of an acceleration in labor productivity growth. The strong policy framework has put the real and financial economy in a good position to cope with any major economic shock.

Directors indicated that, looking forward, the major uncertainty facing Canadian policymakers was the depth and duration of the U.S. economic slowdown and its impact on Canada. They considered that Canada is in a good position to cope with the challenges of an uncertain global economic environment. In particular, Directors noted that the momentum that has been maintained in Canadian economic activity and sustained strength in consumer and business confidence appear likely to provide some cushion against the effects of the slowdown in the United States. They also noted that the recently enacted tax cuts are fortuitously timed. At the same time, Directors noted that the Canadian economy would be adversely affected if the slowdown in the United States proved to be sharper and more prolonged than envisaged. They agreed that monetary policy should be the main instrument used in attempting to sustain the economic expansion, and welcomed the recent lowering of interest rates by the Bank of Canada. In addition, if economic developments turned out to be less favorable than expected, the automatic fiscal stabilizers should also be allowed to work. Directors also commended the forward-looking measures introduced in the public pension plan aimed at dealing with its long-term financing problems, including the decision to invest part of the funds in private securities.

Directors agreed with the authorities' view that monetary policy should be set to reflect economic conditions in Canada and should aim to allow the economy to seek its productive potential without compromising the official inflation target. The past success in maintaining low inflation has established the credibility of the inflation-targeting regime, enhancing the Bank of Canada's ability to follow an independent monetary policy. Directors noted that, consistent with the inflation-targeting framework, the Bank should be flexible, poised to act promptly to lower interest rates, should indications of a significant slowing in economic activity begin to emerge.

Directors observed that, in the context of reaching a decision this year on a new inflation target, the current 1−3 percent range has served Canada well, and its credibility has helped to enhance the effectiveness of the floating exchange rate regime in buffering the economy against external shocks. While Directors thought that, at this juncture, there appeared to be no compelling reasons for a major change in the inflation-targeting framework, they were of the view that it would be useful to continue assessing options for further refining the framework. They welcomed the move to strengthen the Bank of Canada's monetary policy strategy in the past year by providing updates twice a year to the semi-annual monetary policy reports and by establishing fixed dates for announcing monetary policy changes. In particular, Directors thought that the move to fixed announcement dates had usefully served to focus the debate on monetary policy more on economic developments in Canada.

Directors welcomed the Canadian authorities' prudent fiscal policy framework with its emphasis on continued debt reduction, efficiency-enhancing tax reforms, and limited new spending initiatives focused on investments in education, research, and health care. In particular, they commended the authorities for the comprehensive income tax reforms and reductions that were introduced in 2000. These reforms will offer considerable economic efficiency gains in the period ahead by increasing returns to work and investment, and by contributing to the spread of new technology and entrepreneurship. They further noted that corporate tax changes will help to enhance the competitiveness of Canadian firms. Directors also welcomed the authorities' decision to commit themselves to trying to bring down the debt-to-GDP ratio more rapidly than previously envisaged by announcing each year, as economic conditions permit, a target for additional debt reduction. In this context, they commended the authorities' use of this mechanism to condition tax cuts on changing economic conditions. Directors welcomed the fact that the federal government's medium-term budget position remains sound, even with full implementation of the major reforms to income taxation and new spending initiatives in priority areas such as health care and education.

Directors observed that the budgetary positions of the provinces and territories are generally on a solid footing, but they recommended that the options for new tax and spending initiatives being considered be framed in a longer-term perspective, reflecting the large potential fiscal costs arising from population aging and continuing growth in demand for health care. Since health care is a major provincial responsibility, Directors indicated that the provinces should begin taking steps to provide for the rising demand and cost pressures that the medical services system will face over the longer term. They added that the role of the federal government in providing resources to help deal with these costs would also need to be evaluated.

Directors noted that the comprehensive reforms enacted during the 1990s to the Employment Insurance (EI) system and to social assistance programs and the introduction of the National Child Benefit have enhanced the flexibility and efficiency of the labor market, boosting employment growth, and have helped to reduce structural unemployment. They called on the authorities to resist pressures to ease the impact of some of these reforms and expressed concern at the proposals to roll back some of the reforms. Directors supported new steps to improve labor market efficiency, including by reducing the frequency of EI use and eliminating regional extended benefits.

Directors indicated that Canada has a highly advanced financial system, with high levels of profitability, asset quality, and capitalization. The regulatory and supervisory structure is well developed, complies with the major international principles and standards, and is a source of international best practice in a number of areas, as shown by the Financial Sector Stability Assessment (FSSA) undertaken last year. Canada's emphasis on a consolidated, risk-centered approach to supervision has put the supervisory and regulatory authorities in a good position to address the challenges faced in recent years with financial institutions embarking on new and highly complex activities. Directors noted that the authorities have moved to address most of the issues discussed in the FSSA, most notably the strengthening of prudential requirements for insurance segregated funds. They also welcomed the thrust of the new financial sector legislation, which is intended to enhance efficiency and competition in financial services, make the review process for bank mergers more transparent, further improve the regulatory framework, and strengthen consumer protection.

Directors commended Canada's demonstrated commitment to liberal trade. Canada has made great strides to reduce barriers to trade for a wide range of products, and has provided favorable access to its markets for the least-developed countries. However, high rates of protection have been retained in some sensitive sectors, notably in certain agricultural products, textiles, and clothing. Directors encouraged the authorities to accelerate the reduction of tariffs on these products and to provide more duty-free access for the least-developed countries, both to improve resource allocation in Canada and to promote growth in the neediest countries.

Directors welcomed the technical and financial assistance that Canada has provided to low-income countries, including through the HIPC Initiative. Noting the Prime Minister's statement that the government intends to increase foreign aid, they encouraged the authorities to begin raising the level of Official Development Assistance (ODA) spending towards Canada's long-standing commitment to reach a level of ODA spending equivalent to
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.