Mission Concluding Statement 

CANADA: Staff Concluding Statement of the 2018 Article IV Mission

June 4, 2018

Context

1. The economy has continued to perform well, but challenges remain. Growth has been robust and a key domestic vulnerability has moderated somewhat, as the housing market is finally showing signs of cooling down in response to several rounds of macroprudential measures and monetary tightening. However, economic anxiety is high due to trade tensions, uncertainty about the outcome of NAFTA negotiations, and the impact of the U.S Tax Cuts and Jobs Act on Canada’s medium-term competitiveness. Near-term growth will be supported by higher oil prices and strong U.S. growth, but weak productivity continues to weigh on longer-term prospects. The current favorable economic environment presents an opportunity to rebuild policy buffers, and forge ahead with structural reforms to boost Canada’s global competitiveness.

2. Against this backdrop, the 2018 Article IV consultation focused on policies to secure stronger, more inclusive, and sustainable growth. The consultation assessed the growth and risk outlook; policies and reforms to sustain the recent recovery and raise long-term potential growth; the implications of the U.S. tax reform for Canada; housing market imbalances and affordability issues; and policies to strengthen financial system resilience as household and corporate debt climbed to historic highs.

Outlook and Risks

3. Real GDP expanded by 3 percent in 2017, the highest growth rate among G7 economies in the year. Private consumption has been the largest contributor to Canada’s recent rapid growth, with exports and business investment still lagging. Growth is expected to moderate to more sustainable levels as the impact of monetary and macroprudential policy tightening takes effect. Real GDP is projected to slow to 2.1 percent in 2018 and to 2.0 percent in 2019. Tax cuts and stronger government spending in the U.S. are expected to support demand for Canadian exports in the near-term and contribute to a narrowing of the current account deficit. Over the medium-term, weak external competitiveness, sluggish labor productivity growth, and population aging are expected to limit potential growth to about 1¾ percent, significantly lower than its historical average.

4. The outlook is subject to significant risks, both domestic and external. A key domestic risk is a sharp correction in the housing market, which could be triggered by a sudden shift in price expectations or a faster-than-expected increase in mortgage interest rates. While the banking system is profitable, it is heavily exposed to household and corporate debt. In this context, risks to financial stability and growth could emerge, if the house price correction is accompanied by a rise in unemployment and sharp contraction in private consumption. External risks are more acute than in the recent past and relate to the impact of policy changes in the U.S. and NAFTA.

• The impact of U.S. tax reform on near-term growth in the U.S. and the subsequent impact on Canada are subject to considerable uncertainty, with both economies currently operating near full capacity and some tax provisions (notably on the international aspects of the reform) without historical precedent. Likewise, the medium-term impact of lower tax rates in the U.S. could make Canada a less attractive destination for investment, leading to heightened uncertainty about Canada’s medium-term growth prospects.
• Contention over several key issues have prolonged NAFTA negotiations. Failure to reach an agreement within a reasonable timeframe could impact investment and growth for an extended period. In the event negotiations fail and there is a reversion to tariff rates that satisfy WTO rules, long-run Canadian real GDP could be reduced by 0.4 percent relative to the baseline forecast and by even more if non-tariff trade costs increase.
• Other risks include structurally weaker growth in key advanced economies, a sharp slowdown in China, and tighter global financial conditions triggered by an abrupt change in global risk appetite. On the other hand, higher oil prices prompted by either rising global prices or an easing in domestic transportation constraints could present upside risks to the outlook.

Key Policy Messages

5. With growth above potential, the priority of fiscal policy should be on rebuilding buffers. Provinces, especially those that are running high deficits or debt, should restore fiscal discipline and take the lead in implementing more ambitious fiscal adjustments. At the federal level, the overall size of the planned adjustment is appropriate, but it could be frontloaded to build buffers faster. If the economy overperforms, a larger portion of fiscal savings could be used for deficit and debt reduction. Rebuilding fiscal space creates room in the budget to finance policies that promote growth and reduce income inequality, and to enhance the economy’s resilience to adverse shocks.

6. To demonstrate the government’s commitment to well-managed public finances, the fiscal framework could explicitly incorporate fiscal rules. Fiscal rules are most effective when they are simple, flexible, and enforceable in the face of changing economic circumstances. The federal fiscal rule could include both a debt rule to anchor the course of medium-term fiscal policy, with the aim of reducing net federal debt to less than 30 percent of GDP as envisaged in the Budget 2018 forecast, and operational rules to guide annual budget decisions. Provincial fiscal rules should consider the sources of budget deficits and strike the right balance between stabilizing debt levels and protecting public investment.

7. It is time for a careful rethink of corporate taxation to improve efficiency and preserve Canada’s position in a rapidly changing international tax environment. Given its centrality to the architecture of the tax system as a whole, this requires a holistic review, which Canada has not had for some time. The U.S. tax reform increases the urgency of moving ahead with the review. Its impact remains highly uncertain, but the potential effects, through both real activity and profit shifting, could be substantial. The review should weigh the pros and cons of incremental approaches to change, such as more generous capital cost allowance, against more radical options, such as moving to some form of rent tax at the corporate level. Any changes should be implemented in a fiscally responsible way, including appropriate revenue-raising measures, and bearing in mind that corporate taxation is only one of several important determinants of business investment.

8. Monetary policy should be tightened gradually. Inflationary pressures are building and higher interest rates will help activity and inflation converge toward more sustainable levels. Nevertheless, the current balance of risks around the outlook warrants gradual policy normalization. In this context, the Bank of Canada’s approach appears to be broadly appropriate.

9. Macroprudential policy settings are appropriate but continued vigilance is needed. Current measures appear to be containing housing-related financial sector risk. Nevertheless, the banking system remains highly exposed to household debt and vulnerable to a sharp reversal in house prices. If housing vulnerabilities continue to rise, new lending by banks should be subject to loan-to-income limits. At the same time, coordinated monitoring between federal and provincial regulators are required to mitigate other potential and emerging risks to financial stability, including the increasing use of home-equity lines of credit, the rise of less regulated mortgage lending, and the rapid growth in exchange-traded funds. Improving access to beneficial ownership information and financial intelligence, in line with Canada’s recent AML/CFT assessment, would help mitigate money laundering risks in the real estate sector.

10. A broad set of supply-side policies is needed to durably manage housing affordability concerns. Deteriorating housing affordability raises not only important social concerns, but also economic ones, as worsening affordability impedes labor mobility. Addressing housing supply issues, particularly in the regions around Toronto and Vancouver, will require complementary transportation, immigration, and housing strategies at all levels of government. Greater emphasis should be given to increasing urban density and accelerating the delivery of land ready for development. This would require shortening the approval process for building permits and re-zoning applications, and re-evaluating rent control policies to ensure that they do not constrain rental property supply. Current funding and other incentives should be assessed to make sure that the right type of housing supply (e.g. purpose-built rental housing) is being developed to meet affordability objectives.

11. Trade policies and structural reforms targeted at boosting productivity and medium-term growth should remain a key focus of the government’s policy agenda to enhance Canada’s competitiveness.

• A NAFTA agreement that further improves trade opportunities and promotes competition should be reached within a reasonable timeframe. Rapid ratification of CPTPP would also enhance Canada’s ability to seize the potential benefits offered by greater market access and export diversification.
• Federal and provincial governments should do more to reduce inter-provincial barriers to trade and the free-movement of skilled labor. Regulatory red-tape remains substantial despite CFTA.
• The government should establish clear performance targets for innovation programs, such as the Supercluster Initiatives, and ensure that funding is stage-gated conditional on performance. Projects should be selected based on arms-length criteria.
• Closer coordination between federal and subnational governments to consolidate information on project plans and expand the use of common standards of project evaluation is important for efficient infrastructure investments. With the appointment of a new CEO, the Canada Infrastructure Bank should move expeditiously to attract private sector and institutional investment to new revenue-generating infrastructure projects.
• Further deregulation in some product markets (e.g. electricity, transportation, retail distribution and professional services) should help attract foreign direct investment. Tangible progress in this area could mitigate risks from the U.S. tax reform.
• Canada’s immigration policies can help counteract population aging and strengthen the labor force, but immigrant flows need to be carefully managed to maintain public support for the program. The authorities should strive to improve the labor market outcomes of immigrants, expand regional absorptive capacity, and facilitate the integration of immigrants into local communities.

The IMF team would like to thank the authorities and private sector counterparts for their warm hospitality and constructive dialogue.