Mission Concluding Statement 

Canada: Staff Concluding Statement of the 2016 Article IV Mission

May 9, 2016

The 2016 Canada Article IV consultation was focused on assessing the macro-financial impact of the oil shock and policies to bolster near-term domestic demand, mitigate downside risks, and position Canada for solid long-term growth. The key policy messages are:

• Monetary policy should stay accommodative, and further easing should be considered if the economy falters. It should not, however, solely bear the burden of supporting the economy given potential financial stability risks associated with a low interest rate environment.
• Fiscal policy should be pro-growth. The federal government has fiscal space and its plans to increase infrastructure spending in the 2016 Budget are appropriate. There is merit in and room for providing further fiscal support if downside risks materialize and the economy falters. Medium-term sustainability anchors should be strengthened to underscore fiscal credibility.
• Macroprudential policy has been broadly effective in alleviating financial stability risks and reducing tax payer exposure to mortgage finance. Additional macroprudential measures may be needed if housing market vulnerabilities intensify.
• Despite important progress, concerted efforts are needed to address several major recommendations that remain outstanding from the 2013 FSAP.
• Greater emphasis should be placed on structural reforms to boost productivity and external competitiveness to facilitate the transition to a more diversified economy.

CONTEXT

1. The oil shock is the first major test of Canada’s economic and financial resilience since the 2008 global financial crisis. While real GDP growth fell to 1.2 percent in 2015, down from 2.5 percent in 2014, because oil companies slashed investment spending, the Canadian economy overall is coping well. The pro-active move by the Bank of Canada to cut the policy rate twice in 2015 and exchange rate depreciation have helped cushion the effects of the oil shock, even as inflation remains anchored within the 1-3 percent target band. Unemployment has edged up, and the negative output gap has widened to about 1 percent of GDP. In March 2016, the new government announced its first Budget, emphasizing infrastructure investment and strengthening the middle class as central to growing the economy.

2. The effects of the oil shock have yet to fully play out. The economy is still adjusting to lower oil prices, in part because the reallocation of capital and labor from the resource to the non-resource sectors is, expectedly, taking time. Reflecting the impact of the oil shock and a slowing economy, financial vulnerabilities have become more apparent. Loan delinquencies are gradually rising, albeit from low levels. While the banking system’s direct exposure to the oil and gas sector is limited, its indirect exposure to resource rich provinces is more substantial, and will require higher provisions against deteriorating credit performance. More broadly, the weaker economy has reignited concerns about the elevated level of household debt and divergent trends in house prices, which are rapidly rising in Vancouver and Toronto and falling in Alberta. Public finances have also taken a hit in particular at the provincial level where performance has deviated along the lines of their resource dependence.

3. The external position is moderately weaker than implied by fundamentals. Despite a weaker currency, the current account has deteriorated. Staff estimates the current account gap to be between -2 and -1 percent of GDP, and the real effective exchange rate is modestly overvalued relative to medium-term fundamentals and desirable policy settings.

OUTLOOK, RISKS, AND SPILLOVERS

4. The economy is set for a modest recovery in the near term. GDP growth is projected to recover gradually to 1.75 percent in 2016, a further 2.25 percent in 2017, and converge to potential growth over the medium-term. Oil sector investment is projected to decline by about 30 percent in 2016, on top of the 40 percent decrease in 2015, as oil prices are likely to stay low relative to the long-term breakeven costs of oil companies. Non-energy exports are, however, expected to pick up as manufacturing regains competitiveness and activity in the U.S. remains robust, leading to a recovery in business investment. Private consumption is expected to remain solid, supported by still resilient labor markets and accommodative monetary policy. The fiscal stimulus will facilitate a faster return of the economy to potential.

5. The medium-term outlook hinges on the economy’s ability to adjust to lower oil prices. A smooth transition away from resource-driven growth will enable Canada to take advantage of shifting global trade patterns and achieve potential growth of around 2 percent in the medium term. However, this is still lower than the annual average of 2.25 percent over the past 15 years.

6. Risks to the outlook are tilted to the downside.

• Oil prices. Persistently low oil prices pose an important risk to the economy, as this could force some firms to permanently shut down production. Over the long term, deep industry cutbacks on investment will affect the ability of the oil industry to ramp up production once oil markets start to rebalance.
• Global growth and financial conditions. Higher uncertainty about global growth prospects and a lack of effective policy response to offset headwinds could lead to persistent weakness in global trade and investment. Tighter global financial conditions due to higher risk aversion and pressure on banks in Europe, or a larger-than-expected increase in the U.S. term premium in the context of the Fed’s normalization, could raise funding cost for Canada.
• Domestic housing market. A severe recession that triggers a sharp rise in the unemployment rate could destabilize housing markets, setting off adverse feedback loops in the economy and leading to greater financial stability risks. Given extensive government-backed mortgage insurance, the impact of a severe housing downturn on the federal fiscal position could be considerable and potentially limit the room for fiscal stimulus down the road.

7. There is also upside potential to the medium-term outlook. A better-than-expected recovery in Canadian exports would strengthen business investment and facilitate a faster reallocation of resources from the energy to the non-energy sectors.

8. Furthermore, Canada’s strong fundamentals will help mitigate the impact if downside risks materialize. Canada has strong institutions and a track record of consistent policies. It enjoys a positive net international investment position because it owns substantial assets overseas. This provides a natural hedge to currency risk on aggregate debt. Its flexible exchange rate is also an important shock absorber.

9. There are potential outward spillovers from Canada to the Caribbean.

• Canadian banks have had a long historical connection to the region, but low returns have led to banks scaling back operations, including closing branches. A materialization of downside risks could exacerbate Canadian banks’ ongoing rationalization of their operations in the region. Tourism revenues may also suffer as Canada is a major source of tourist traffic to the region, second only to the U.S.
• There has been no material reduction in Canadian banks’ correspondent banking relationships (CBRs) in the Caribbean. A recent World Bank survey of correspondent banking found that relative to U.S. and UK banks, Canadian banks have not materially terminated or restricted CBRs. At the same time, however, Canadian banks are choosing not to step into the gap left behind by retreating global banks, partly because higher regulatory compliance costs have made the risk-reward equation challenging.
• In this context, Canadian banks are looking for greater clarity in national and international standards (including those determined by the Financial Action Task Force) to counter money laundering and offshore tax evasion and avoidance. OSFI does not at present retain data on CBRs in the Caribbean or other regions, but is encouraged to more actively monitor developments in this area.

POLICY CHALLENGES

Monetary policy

10. The current monetary policy stance is appropriate. The Bank of Canada should stand ready to cut the policy rate if downside risks materialize and the economy falters. However, with the policy rate at 0.5 percent, the room for additional cuts is limited.

11. It would be appropriate to seek recourse to unconventional monetary policy measures in the event that the economy slows significantly and deflationary risks emerge, but clear communication would be critical. Staff welcomes the Bank of Canada’s recently updated framework for unconventional monetary policy, which includes forward guidance, large-scale asset purchases, negative interest rates, and funding for credit. The Bank is not committed to any specific order in which these policy measures will be used. Staff agrees that the efficacy of each measure will depend on the economic and financial context and, in some cases, the measures could be mutually reinforcing when used in combination. In the event unconventional monetary policy measures are put to use, the Bank should communicate clearly its diagnosis of the problem and the merits as well as the transmission channels of the measures it plans to pursue.

12. Monetary policy is a blunt tool to address housing market vulnerabilities and macroprudential policy should remain the first line of defense in safeguarding financial stability. The costs of using monetary policy for financial stability objectives, or “leaning against the wind”, outweigh the benefits, except in circumstances where credit growth is exceptionally high for an extended period. Hence, macroprudential policy should generally be the first port of call to address financial stability risks, and this has indeed been the case in Canada. That being said, the Bank sees a role for monetary policy in financial stability and its risk management approach to monetary policy takes into account financial stability considerations within its flexible inflation targeting framework.

Fiscal policy

13. The federal government’s pro-growth 2016 budget is appropriate. Low interest rates and the low debt burden provide fiscal space without undermining the outlook for medium-term debt sustainability. Against this backdrop, the stimulus measures in the 2016 Budget are welcome since they will also help alleviate the burden on monetary policy in providing near-term demand support. A more active role for fiscal policy will strengthen the overall policy mix by reducing the need for further monetary easing and thus limit the scope for excessive risk taking in a low interest rate environment. The stimulus package includes discretionary measures totaling 1.25 percent of GDP, more than 40 percent of which are allocated to mostly shovel-ready infrastructure. Staff estimates that the measures would boost annual growth by 0.5 percentage point of GDP in each of the next two fiscal years, based on a conservative fiscal multiplier. In line with this, the overall deficit will increase from 0.25 percent of GDP in 2015 to around 1 percent of GDP in 2016 and 2017.

14. If the economy takes a turn for the worse, additional fiscal easing should be considered, for which there is room. The additional fiscal easing should be temporary and could be achieved by bringing forward planned infrastructure spending or by temporarily cutting personal and corporate income taxes.

15. At the provincial level, 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 support the continuing recovery. Due to its heavy dependence on oil royalties, Alberta’s operational 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 should be allowed to operate fully.

16. Strengthening the medium-term fiscal framework will be important to bolster fiscal credibility. Any stimulus package should be accompanied by a credible medium-term consolidation plan. Medium-term consolidation will also help improve the external position.

• The federal government’s commitment to putting the debt to GDP ratio on a downward path is appropriate. In this context, the current balanced budget rule should be replaced by a new fiscal rule that is transparent, easy to communicate, and sufficiently flexible to avoid pro-cyclicality (possible options were elaborated in the 2014 Article IV consultations). The new rule should be embedded in a multi-year fiscal framework that details measures consistent with the revenue and expenditure projections.
• At the provincial level, fiscal rules should be modified to target the overall balance that includes capital spending, rather than the operational balance. This would clearly establish a link between deficit and debt targets and enhance the credibility of provinces where debt reduction is a medium-term fiscal objective (e.g. Quebec and Ontario).

17. Maximizing the benefit of infrastructure spending and focusing “Phase 2” of the infrastructure project on raising productivity will require close cooperation and coordination between federal and provincial authorities. The federal government should take the lead in developing a nation-wide infrastructure plan that identifies infrastructure gaps and prioritizes projects that enhance the economy’s productive capacity. Priority projects could include those that reduce urban transportation congestion, and improve and expand trade corridors. As the first step, a forum to bring together and engage all relevant stakeholders should be established. Furthermore, new and innovative sources of funding are needed to support the infrastructure plan to limit the impact on debt at the provincial and municipal level. We welcome the financing options elaborated in the 2016 Budget that include greater involvement of public pension plans, user fees, and more creative use of public private partnerships.

18. As a longer-term reform agenda, the authorities should consider the impact of escalating healthcare costs and aging pressures on provincial finances. Fiscal gaps at the provincial level could emerge and widen over time, with material implications on provincial debt burdens within a 15–20 year time frame. This puts the onus first and foremost on provinces to adjust their budgetary priorities.

Financial sector policy

19. The authorities continue to be vigilant to housing-related risks. A host of macroprudential measures have been introduced since 2008, including most recently in December 2015, to reduce risk taking and limit taxpayer exposure to the housing sector. These measures have been broadly effective, slowing the pace of mortgage credit expansion from above 10 percent in 2010–2011 to about 5 percent in 2015 and improving the risk profile of new mortgage loans.

20. Nevertheless, further macroprudential measures will be needed if housing sector vulnerabilities intensify. Growing disparities in regional housing markets call for measures that target specific imbalances. The mission welcomes OSFI’s initiative to introduce a risk-based floor for banks’ internal capital models for uninsured mortgages. Beyond this, the authorities could consider introducing a cap on LTI (loan-to-income) to address regional imbalances. This measure would be superior to debt service-to-income limits which become less binding in a low interest rate environment.

21. Government-backed mortgage insurance has played an important countercyclical role during times of stress, but this benefit needs to be weighed against the potential cost to taxpayers. Government guarantees of insured mortgages are still a sizable 36 percent of GDP as of 2015, even though the government receives premium income from CMHC and private insurers. Possible next steps to shrink the government’s footprint in the mortgage insurance space could include lender risk sharing by introducing higher deductibles for insured mortgages, and further fine-tuning insurance premiums and securitization fees. Nevertheless, any reform should proceed gradually to preserve the countercyclical role and social objective of facilitating access to housing finance.

22. Important progress has been made in implementing the 2013 FSAP recommendations. The new Capital Markets Regulatory Authority, which brings together the federal regulator and six provincial regulators to strengthen Canada’s capacity to identify and manage systemic risk on a national basis, is a bold step toward enhancing the cooperation between federal and provincial regulators. Other measures have also been taken to engage with provincial regulators, including the Bank of Canada providing technical assistance on macro stress testing and model design. Also, CMHC has taken the lead in publishing the results of its stress test, and the Bank is considering how best to integrate quantitative analysis from its models into its financial stability assessment presented in the Financial System Review. This would enhance both the transparency and credibility of financial sector policies.

23. However, the authorities are yet to take action on a number of major FSAP recommendations. The FSAP called for giving a regulatory entity a clear mandate to monitor systemic risk to facilitate macro-prudential oversight and carry out system-wide crisis preparedness. The Senior Advisory Committee (SAC) plays this role on a de facto basis. However, the SAC does not have a mandate for crisis management nor are the members given an explicit financial stability mandate for macroprudential oversight. Furthermore, consistent with Basel Core Principles, legislation should be amended to give OSFI sole decision-making authority on prudential criteria. It is important for a prudential authority to make prudential decisions for safety and soundness reasons without the potential for ministerial discretion. While this has not been a problem in practice, ministerial power to override supervisory judgment impinges on operational independence, which is a critical input to supervisory effectiveness. Finally, the ability to conduct group-wide supervision is a key component of the Insurance Core principles to promote a consolidated view of risks and prevent arbitrage across differently regulated structures in the group. Legislation should be amended to give OSFI the authority to take supervisory measures at the level of the holding company.

Structural reform

24. The timing is right for a renewed push on structural reforms to raise Canada’s productivity growth, which has lagged behind its peers and contributed to the erosion of its external competitiveness. The exchange rate depreciation over the last two years has significantly improved the price competitiveness of Canadian non-energy exporters. However, the past erosion of capacity in the manufacturing sector may not be easily reversed and places constraints on the pace and extent of export recovery. Higher labor productivity growth is necessary to restore capacity in the manufacturing sector and, more generally, improve Canada’s ability to compete in existing and new export markets. To this end, a multi-pronged approach to promote innovation and investment in physical and human capital is needed.

Promoting innovation. Investment in private R&D could generate a significant growth dividend, which makes a strong case for supportive fiscal policy. The current fiscal regime gives generous tax incentives to small and medium-sized enterprises (SMEs) relative to large firms. However, subsidizing SMEs based on their size alone may not be optimal:

• First, it is new rather than small firms that are more likely to introduce new ideas, business models and technologies into the marketplace. High start-up rates (firms 0-2 years old) increase both the likelihood of radical innovation and competitive pressures on incumbents to innovate and adopt new technologies. Canada today has among the lowest start-up rates in the OECD.
• Second, size-based tax preferences can create disincentives for firms to grow larger, creating a “small business trap”, and contributing less to productivity and employment growth. About 60 percent of small firms in Canada are more than six years old.
• Third, large innovative firms may have a greater impact on business innovation. Through their pivotal role in supply chains, these firms can drive innovation in smaller firms. Their presence is critical to anchor innovation clusters and can help foster a more deeply engrained innovation culture among other cluster members. Large firms also have more resources with which to invest, innovate and export, and they tend to be more productive than small firms.

While fiscal policy can play an important role in promoting innovation, the government should evaluate R&D subsidy policies to ensure that they are cost effective and simple so as to minimize compliance costs and facilitate firm entry, and strike an appropriate balance between direct and indirect support. The overall effective tax rate should not penalize firms from scaling up. In particular, preferential tax treatment of small firms should be reconsidered. Well designed tax relief targeted to new firms can promote entrepreneurship and innovation, as demonstrated by the successful initiatives in Chile and France.

Boosting labor force participation and talent base. The current gap (10 percentage points) between male and female labor force participation should be narrowed. Staff analysis indicates that higher female labor force participation has a strong impact on productivity growth. The new Canada Child Benefit is a step in the right direction in providing benefits to low and middle income families, but could be better targeted to boost female labor force participation, including providing more generous child care subsidies to working parents.

Investment in human capital and skills training. Canada has a highly educated workforce but more vocational and specialized skills training would help retool the labor force to facilitate labor mobility to high value added activities and meet the challenges of a changing global economy. Canada spends about half of the OECD average on publicly funded training, leaving significant room for improvement.

Investment in physical capital. The federal government’s planned increase in infrastructure spending will help catalyze private business investment. In addition, lowering interprovincial barriers to trade as well as policies to promote competition in the network sectors would create the right conditions to expand domestic business investment and attract FDI.
We would like to thank the authorities and private sector counterparts for their cooperation and hospitality.