Mission Concluding Statement 

Canada- 2011 Article IV Consultation Mission Concluding Statement

October 31, 2011

This statement presents the preliminary assessment of the 2011 Article IV mission to Canada. Growth in the Canadian economy is moderating after a strong recovery from the crisis. The outlook is broadly favorable under a baseline scenario, but subject to downside risks, reflecting more adverse external economic conditions. The policy discussions focused on the strategy to deal with the challenging external environment and domestic balance-sheet vulnerabilities while gradually unwinding the macroeconomic policy stimulus, and the progress with the regulatory reform agenda.

Context and outlook

1. After a strong recovery from the crisis, growth in Canada is moderating. Thanks to a decisive policy response, a resilient financial sector, and high commodity prices, the economy expanded well above its potential growth rate in 2010. Core inflation remained contained in the context of ongoing economic slack. The uncertain outlook and stable inflation expectations has led the Bank of Canada to keep its policy rate constant at 1 percent since September 2010. The current account deficit has remained relatively high, at around 3 percent of GDP, a significant shift from the surpluses of the pre-crisis years, as export volumes remained weak following the crisis. Economic activity declined in the second quarter of 2011, despite resilient domestic demand, mostly due to transient factors (supply disruptions following Japan’s earthquake and wildfires hampering commodity exports).

2. The baseline medium-term outlook is broadly favorable, but risks are tilted to the downside given the challenging external environment. While near-term uncertainty is high, recent indicators point to a modest recovery in the second half of the year. We project annual growth at about 2 percent on average in 2011 and 2012, constrained by weak demand in trading partners, a strong Canadian dollar, and fiscal adjustment. Investment is expected to rise further as a percent of GDP, while private consumption would be relatively subdued. Important downside risks remain, including external headwinds from financial market spillovers of turmoil in Europe; a weaker U.S. economy; and lower commodity prices under a scenario of weaker global activity. The domestic impact of significant adverse external shocks could be amplified by elevated household debt and house prices. At the same time, the impact of shocks such as a decline in commodity prices could be cushioned by a weaker exchange rate.

3. In this context, the mission sees the following policy priorities for Canada:

i. Managing the transition to a neutral macroeconomic policy stance and pressing ahead with the reforms needed to address long-term fiscal challenges, while remaining flexible given the heightened risk of adverse international financial spillovers;

ii. Dealing with the challenges posed by elevated household debt in the context of buoyant house prices and an uncertain economic outlook.

iii. Continuing to move forward with the domestic and international reform agenda for financial regulation and supervision.

Withdrawing extraordinary policy support amid heightened external risks

4. Under our baseline, an accommodative monetary policy stance will remain appropriate for some time given stable inflation expectations, ongoing economic slack, forthcoming fiscal drag, and heightened external risks. There is some space for further monetary easing if the economy were to weaken, and the Bank of Canada should be prepared to quickly respond to liquidity strains in a scenario of heightened international financial turbulence by redeploying the tools it successfully used during the crisis. On the other hand, should the recovery be accompanied by further sustained increases in mortgage debt spurred by low interest rates, a tightening of macro-prudential policies by the government may be needed (such as further adjustments to mortgage insurance arrangements). More generally, the inflation targeting regime has served the Canadian economy well and we look forward to the conclusions of the ongoing review of the inflation control agreement, which provides an opportunity to incorporate the lessons from the crisis.

5. Fiscal policy is appropriately shifting toward consolidation in the aftermath of the effective stimulus program. The federal government is leading the initial fiscal effort, with a significant reduction envisaged for the budget deficit in 2011 and 2012, including by unwinding the stimulus measures. For provincial and local governments we expect a broadly stable deficit in 2011 on the basis of data for the first half of the year, and some deficit reduction in 2012. Overall, staff projects a reduction in the general government deficit in 2012 of around 1 percent of GDP (implying a drag on economic growth of about ½ percentage point), which is appropriate under our baseline scenario of resilient domestic demand and a widening current account deficit.

6. In an uncertain global economic environment, macroeconomic policies should react flexibly to significant changes in the economic outlook. We see the full operation of automatic fiscal stabilizers and a reduction in the monetary policy rate as the first line of response should the recovery falter—particularly in the case of lower external demand. Should the outlook for domestic demand weaken materially, there is some space to loosen the fiscal stance relative to plans, and temporary stimulus may become appropriate in a major downside scenario, while maintaining the medium-term consolidation plans.

7. We support the authorities’ objective of returning to a stronger fiscal position in the medium term. This is necessary to put gross and net public debt on a declining path relative to GDP, thus placing public finances on a stronger footing to deal with the long-term spending pressures from population aging and the rise in health-care costs.

• The consolidation plans of the federal government, which aim at budgetary balance by 2015/16, rely on the expiration of stimulus measures, a strict containment of current spending growth, as well as higher revenues as the economy expands. The ongoing Deficit Reduction Action Plan should identify further expenditure savings, helping to underpin the medium-term objectives.
• The provincial governments have set ambitious plans to reach balanced budgets over the next several years, complementing the plans of the federal government. As the provinces’ consolidation plans rely heavily on expenditure restraint for broad programs, further specificity on the measures to underpin these ambitious goals would enhance the transparency and credibility of their plans.
• The federal government and the provinces will need to move ahead in a concerted effort to deal with the longer-term fiscal challenges posed by rising health costs and the impact of aging. The review of transfers of the federal government to the provinces, which must be completed before 2014/15, could provide an opportunity in this regard. Regular and comprehensive fiscal sustainability reporting covering all levels of government would also help build consensus around the need for reforms. In this respect, the recent fiscal sustainability studies prepared by the PBO are an important first step forward.

Containing the risks associated with high household debt and house prices

8. With the elevated level of household debt and high house prices posing macroeconomic risks, the authorities have appropriately adopted macro-prudential measures to curb the build-up of mortgage debt. Household debt is at a historical high relative to disposable income, and various indicators suggest that house prices in some regions are above levels consistent with economic fundamentals. The authorities have responded by tightening mortgage insurance standards, including through increases in minimum down payments, a reduction of the maximum amortization period, and a requirement that all borrowers use the five-year fixed mortgage rate when qualifying for the mortgage even for short-term or variable rate loans. These measures, together with rising uncertainty because of global financial market turmoil, have reduced the pace of mortgage credit growth, and may lead to a more subdued pace of household borrowing and a moderation in house prices going forward.

9. Should household debt and house prices continue to rise much more rapidly than disposable income, further macro-prudential measures may be needed to prevent a more disruptive adjustment down the road. A correction of the housing market—triggered, for example, by an external shock resulting in significant job losses and/or sharp declines in asset price valuations—would weigh on consumption (including through wealth effects) and construction activity. The sizable share of high LTV mortgages insured by the Canadian Mortgage Housing Corporation (CMHC) and the government backstop to private insurers would cushion the impact of increased mortgage delinquencies on financial institutions, but would weigh on the public purse. Measures to minimize these risks over time could include larger down-payment requirements for new mortgages and a further tightening of the existing cap on debt service-to-income ratios. Continued tight supervision of the financial institutions would also ensure conservative underwriting standards and an adherence to the existing regulations.

Financial stability—moving forward with the regulatory reform agenda

10. The Canadian banking sector is well supervised and in a solid position. Profitability has recovered, in line with sound asset quality. Average returns on equity are high, at around 15 percent, backed by growing loan volumes and low levels of arrears. Banks are well capitalized for the transition to Basel III requirements, and the authorities maintain high prudential standards and rigorous supervision. Stress-testing scenarios developed by the authorities show manageable losses for the financial system under adverse scenarios, including a significant deterioration in households’ ability to service debt. In the event of increased international financial turbulence emanating from sovereign strains in Europe, the main source for potential stress to Canadian banks would likely be through reduced access to wholesale funding, rather than direct exposures to European countries, underscoring the need for prudent liquidity buffers. Canada’s institutional arrangements are supportive of an appropriately coordinated response from the authorities, as evidenced by their proactive approach during the crisis.

11. At the same time, a scenario of low interest rates for a prolonged period could adversely affect financial institutions. Such a scenario could encourage excessive borrowing by economic agents and risk-taking by banks, underscoring the need for continued close supervision. While the insurance sector is well capitalized and hedged, a prolonged period of low interest rates would weigh on its profitability. Capital levels in the sector are well above requirements, and balance sheets are actively hedged against interest rate, equity, and foreign currency risks. Insurance firms have reacted to the risk of persistently low rates by reallocating part of their portfolio to non-fixed income securities as well as changing pricing strategies and product menus, but these could prove insufficient to prevent a decline in profitability should low interest rates persist. A continuation of a low-interest rate, high-volatility environment would also present challenges for the solvency of pension funds with defined benefits. While these have adopted strategies to reduce mismatches in their balance sheet, in such an environment plan sponsors may have to adopt measures such as higher contributions to reduce the risk of underfunding.

12. Canada is moving forward with the international and domestic financial reform agenda. The Canadian authorities are moving ahead with the action plan to adopt the Basel III capital and liquidity requirements within the timelines prescribed by the BCBS, including the publication of regulatory guidance relating to non-viability contingency capital and transitioning for non-qualifying instruments. The authorities have made substantial progress with the development of recovery and orderly resolution plans for Canada’s largest banks—a key component of the crisis resolution framework. Progress towards the establishment of a central counterparty (CCP) for repo markets is on track, as is the process of moving OTC derivatives clearance to CCPs, which will help reduce counterparty risk and enhance transparency. Finally, we welcome the government’s intention to launch a national securities regulator in 2012, as the regulation of security markets at the national level would strengthen oversight and enrich an already strong institutional financial stability framework.

The mission is grateful to the Canadian authorities for their hospitality and for the very open discussions during our mission.