Oil pump in Morinville, Alberta: despite the sharp drop in oil prices, Canada responded proactively to cushion its effects on the economy (photo: Corey Hochachka/Newscom)
Economic Health Check
The Canadian economy has struggled for more than a year, as oil, a major Canadian export, lost more than half its value since 2014 and led to a slump in business investment, with energy firms scaling back investment plans. As a result, real GDP growth slowed to 1.2 percent in 2015.
But 2016 will likely see the country return to growth at 1.7 percent and converge to potential growth of around 2 percent over the medium term, the report says.
A supportive monetary policy and exchange rate depreciation have helped cushion the effects of the oil shock. Inflation remains low and the labor market has held up relatively well, with the unemployment rate edging up only slightly above the 7 percent mark (from about 6½ percent in late 2014). There are risks to this growth outlook, however, the report notes. The economic and financial effects of the oil shock have yet to fully play out and there are increasing financial vulnerabilities, as reflected in rising loan delinquencies, albeit from low levels.
More broadly, the weaker economy has raised concerns about vulnerabilities related to the housing market. Low interest rates have fueled a rise in household debt.
Stirring up policy mix: more fiscal, less monetary stimulus
Given the weak economic environment, monetary policy needs to stay accommodative, and further interest rate reductions could be considered if the economy slows. It should not, however, solely bear the burden of supporting the economy, given potential financial stability risks associated with a low interest rate environment.
Here, fiscal policy can step in to alleviate the burden on monetary policy in providing near-term demand support. In this regard, the IMF welcomes the stimulus measures in the 2016 federal budget that sharply boosts spending on a raft of initiatives from infrastructure projects to social benefits.
With low government net debt (compared with the size of the economy) and borrowing costs, the report says that Canada has the space for fiscal expansion to support the economy. In addition, IMF staff’s debt sustainability analyses do not suggest major concern about debt dynamics under different stress scenarios.
Wide regional differences
At the provincial level, however, greater caution is needed. Among the larger provinces, Quebec has relatively high debt, while Ontario has a relatively high deficit. In these provinces, fiscal consolidation should proceed, but at a gradual pace in order not to offset the federal government stimulus and to support the continuing recovery. Due to its heavy dependence on oil royalties, Alberta’s fiscal balance has turned negative, but it still has very low debt. Given that its economy is also significantly weaker than the rest of the country, automatic stabilizers (changes in spending and taxes that happen naturally as the economy fluctuates) should be allowed to operate fully. Over the medium term, Alberta should draw on both revenue and expenditure-side measures to close its fiscal gap.
Strengthening the medium-term fiscal framework is important to bolster credibility. The report endorses the authorities’ commitment to putting the debt-to-GDP ratio on a downward path but calls for a new fiscal rule to anchor debt sustainability and sustain market confidence.
Tax and spending policies for long-term growth
The country’s long-term policy challenge is to make the best use of the available fiscal space to accelerate structural reforms, catalyze private investment, and diversify Canada’s future sources of growth. Political resolve and close collaboration between the federal and provincial governments are needed to push the agenda forward and ensure efficient implementation. A nationwide infrastructure plan would help raise the quality and efficiency of infrastructure investment.
More broadly, a multi-pronged approach is needed to improve productivity growth and external competitiveness. In particular, the report notes that fiscal policy, through targeted research and development tax incentives to promote innovation and competition, more generous childcare subsidies to encourage women to join the labor market, and expanded publicly-funded training programs to help workers retool their skills, would place Canada in a better position to compete in existing and new export markets.
Remain vigilant against housing market vulnerabilities
Macroprudential measures have been broadly effective in containing the growth of mortgage credit, but these could be further tightened if imbalances in the housing market threaten to intensify, the report recommended.
Prudential policies have strengthened banks’ balance sheets and helped ensure system stability. The report welcomed the progress made in implementing key recommendations of the 2014 Financial Sector Assessment Program Update, including the establishment of the new Capital Markets Regulatory Authority to better monitor systemic risk in capital markets, and encouraged the authorities to make further improvements where needed.
