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Annex 2
Economic Developments and Prospects¹

Highlights

• World economic growth strengthened in 2004, as growth picked up in the United States, the Euro area and Japan. U.S. economic growth slowed in the second quarter of 2004, but advance estimates indicate that growth picked up in the third quarter, and solid growth is forecast for next year.

World Economic Conditions

Global economic activity has strengthened in 2004 and forecasters expect robust growth in 2005

• Despite higher world energy prices, the global recovery has become increasingly well established, thanks to accommodative monetary and fiscal policies, rising corporate profitability and healthy business investment. In its September World Economic Outlook, the International Monetary Fund (IMF) forecasts world real GDP growth will reach 5.0 per cent in 2004, the highest growth rate in nearly three decades. World growth is projected to moderate to a still-strong 4.3 per cent in 2005.

• The economic situation in Japan improved markedly in 2004, thanks to healthy business investment and strong demand from China for Japanese exports. Despite a deceleration in the second half of the year, real GDP growth in Japan is expected to exceed 4 per cent in 2004, before falling back to just over 2 per cent in 2005.

• China is expected to grow at an impressive pace through the rest of 2004, driven mostly by abundant foreign direct investment. Growth is expected to gradually decelerate in 2005, partly in response to government policies aimed at easing growth to more sustainable levels. Strong growth in China has helped stimulate not only Japan, but other Asian economies such as Korea and Singapore.

• Growth in the Euro area appears to have regained some momentum recently. Growth is expected to reach 2.2 per cent in both 2004 and 2005. While the recovery is gradually gaining a firmer footing, it remains relatively uneven across the Euro area countries.

The outlook for the U.S. economy remains solid

• After strong growth of 4.5 per cent in the first quarter of 2004, U.S. real GDP growth slowed to 3.3 per cent in the second quarter, but then picked up again to 3.7 per cent in the third quarter according to advance estimates. Movements in growth in recent quarters have largely stemmed from swings in consumer spending, as business investment has posted strong gains throughout 2004.

• Going forward, business investment is expected to continue to be an important driver of growth, boding well for Canadian exports of machinery and equipment. The continued impact of high oil prices and the waning effects of last year’s tax cuts suggest that growth in consumer spending will be modest, although the recent improvement in the U.S. labour market, if sustained, will help support spending in this sector.

• Private sector forecasters expect the U.S. economy to grow by 4.4 per cent in 2004 and 3.5 per cent in 2005, slightly below expectations at the time of the March budget.

Canadian Economic Developments

The Canadian economy rebounded strongly from a series of shocks in 2003

• The Canadian economy has once again demonstrated remarkable resilience, rebounding sharply after a series of shocks in 2003, including the severe acute respiratory syndrome (SARS) outbreak, the discovery of a case of bovine spongiform encephalopathy (BSE) in Alberta and, in particular, the unprecedented appreciation of the Canadian dollar.

• Following the 2001 global slowdown, Canada outpaced the U.S. and other Group of Seven (G-7) countries in both GDP and employment growth.

• After slowing in mid-2003, real GDP growth strengthened to 3.3 per cent in the last quarter of 2003. Real GDP grew by 3.0 per cent in the first quarter of 2004, spurred by strong advances in domestic demand.

• In the second quarter, helped by surging exports, growth accelerated to 4.3 per cent, well above the 3.3 per cent recorded in the U.S.

• Nominal GDP rebounded even more strongly in 2004, growing 7.6 per cent in the first quarter and 10.2 per cent in the second.

Robust employment growth has resumed in all regions

• The series of shocks that hit the economy in 2003 slowed employment growth and pushed the unemployment rate to a high of 8.0 per cent in August of last year.

• However, robust job growth resumed in September 2003. Since August 2003 the economy has created nearly 400,000 jobs, all of which are full-time positions. The 2.5-per-cent increase in Canadian employment is well above the 1.7-per-cent increase recorded in the United States over the same period.

• With strong job creation in Canada, the unemployment rate fell steadily—despite near record rates of participation in the labour market—and stood at 7.1 per cent in October 2004, a rate not seen since mid-2001.

• Employment growth has been broadly shared across the provinces since August 2003, with each region recording significant growth.

Increased employment has supported healthy income growth and high levels of consumer confidence

• The strong pace of job creation, particularly in full-time positions, has supported income growth and pushed consumer confidence well above historical averages in all regions of the country.

• In the first half of 2004 real personal disposable income per capita rose 3.3 per cent relative to the second half of 2003. Real consumer spending also increased a strong 3.7 per cent over the same period thanks to rising income, high consumer confidence and historically low interest rates.

Historically low borrowing costs have continued to improve housing affordability and support housing activity

• Low interest rates, as well as rising disposable income due to healthy employment growth, have improved housing affordability, which was near its best level on record in the second quarter.

• These factors have supported continued robust growth in real business residential investment, which stood at 9.6 per cent in the first half of 2004. Housing starts reached an annualized average of over 229,000 in the first nine months of the year—the highest level in 17 years and well above the historical average of about 180,000.

Corporate profits have reached near record levels, thanks in part to rising commodity prices

• Corporate profits rose 28.5 per cent in the first half of 2004, and the gain was broadly based. For example, oil and gas firms benefited from higher prices and strong international demand. Wood and paper manufacturers also saw increased profits as strong North American demand for housing boosted the price of wood and paper prices picked up. Currently total corporate profits in Canada stand at 13.8 per cent of GDP, the highest level in 30 years.

• Reflecting in part the strength in profits, business confidence remains at a high level—more than half of firms surveyed by the Conference Board of Canada in the third quarter believe that their financial position and their profitability will improve over the next six months.

Businesses continue to invest at a healthy pace, particularly in machinery and equipment

• The strength in corporate profits and business confidence has supported business non-residential investment, which rose by a solid 4.1 per cent in the second quarter of 2004, the sixth consecutive increase.

• High energy prices have encouraged engineering construction in the oil and gas sector, which in turn contributed to a rebound in non-residential construction in the second quarter.

• Investment in machinery and equipment (M&E) increased 4.5 per cent in the second quarter after growing by nearly 10 per cent in the first, helped by the stronger Canadian dollar, which has made imported M&E more affordable. This growth in investment in M&E should support further gains in productivity, a key factor in raising Canadian living standards over the long run.

Exports were affected by the dollar’s rapid increase in 2003 but rebounded sharply in 2004…

• Despite strong growth in U.S. demand, Canadian exports fell in 2003, in part because of the rapid and sizeable appreciation of the Canadian dollar.

• However, during the first half of 2004 exports rebounded, reflecting stronger external demand and the ability of Canadian businesses to adjust quickly to changing economic conditions.

• On the import side, the stronger Canadian dollar, along with continued strength in Canadian domestic demand, contributed to sustained growth in imports over much of 2003 and the first half of 2004.

…contributing to near record current account surpluses and further reductions in Canada’s net foreign debt

• Recent robust growth in exports has been complemented by favourable movements in the terms of trade—prices of exports relative to prices of imports—reflecting, in part, higher commodity prices. As a result, Canada’s current account surplus rose to nearly $42 billion in the second quarter of 2004—the second highest on record and the 20th consecutive quarterly surplus.

• Ongoing current account surpluses have generated a sustained reduction in Canada’s net foreign debt as a share of GDP, which stood at 13.7 per cent in the second quarter of 2004, the lowest level in almost 50 years. This means that more of the income that Canadians earn is staying in Canada.

• These developments stand in stark contrast to the U.S., where large current account deficits have raised net foreign debt to over 20 per cent of GDP.

Canada’s Macroeconomic and Structural Framework

Canada has the most favourable fiscal position among G-7 countries

• Canada’s improved ability to weather economic shocks is driven in large part by reforms to the macroeconomic and structural environment that were implemented over the last decade. According to the Organisation for Economic Co-operation and Development (OECD), "the Canadian economy has delivered solid performance for nearly a decade with increased resilience to economic shocks, demonstrating the benefits of a well designed macroeconomic framework and the pay off from a range of structural reforms implemented since the late 1980s."^[2]

• In the early 1990s Canada’s total government deficit was larger than the average of G-7 countries. However, significant fiscal improvements at all levels of government enabled Canada’s total government sector to post a surplus in 1997. In 2003 Canada’s total government sector recorded a surplus of 1.2 per cent of GDP, compared to the average G-7 deficit-to-GDP ratio of 4.6 per cent. Canada’s fiscal turnaround is unmatched by any other G-7 country.

• According to the OECD, Canada is the only G-7 country expected to post a total government budget surplus in 2004 and 2005, and the IMF calls Canada’s fiscal position the "most favourable among G-7 countries."^[3]

• Canada’s total government debt burden moved from being the second highest in the G-7 in 1998 to the second lowest in 2003. Canada’s total government sector net financial liabilities stood at 34.9 per cent of GDP in 2003, compared to the average G-7 ratio of 51.1 per cent.

• A strong fiscal position has allowed the Government of Canada to deliver significant tax relief to all Canadians, enhancing incentives to work, save and invest, while also creating a tax advantage for Canadian businesses and entrepreneurs vis-à-vis the United States, without risking a return to deficits.

• As well, the Government has been able to make significant investments in important economic and social priorities.

• Since balancing the budget, the Government has invested substantial resources in research and development and knowledge creation, which support stronger economic growth and a higher quality of life.

• A wide range of government initiatives help the Canadian workforce become increasingly well-educated, adaptable and skilled, while measures in support of low- and modest-income families improve the chance that Canadian children will grow up to be healthy, contributing members of society.

More than a decade of low and stable inflation, together with fiscal discipline, has contributed to lower interest rates

• The credibility of Canada’s monetary policy, achieved through more than a decade of low and stable inflation, has complemented reform on the fiscal front.

• Since 1993 inflation in Canada has averaged 1.8 per cent—very close to the mid-point of the current inflation-targeting range of 1 to 3 per cent agreed upon by the Bank of Canada and the Government of Canada.

• Low and stable inflation, together with a strong fiscal position, gives the Bank of Canada the flexibility to respond quickly and decisively to changing economic conditions.

• Furthermore, by eliminating the deficit and moving to sustained fiscal surpluses after 1997, Canada has improved its international fiscal credibility, restoring its triple-A rating in financial markets, which in turn has led to reductions in risk premiums and interest rates.

• Lower interest rates have reduced the debt burden, freeing up resources to fund the priorities of Canadians and providing strong support to interest-sensitive sectors, such as housing, consumer expenditures and business investment.

Sound fiscal and monetary policies have contributed to renewed employment and productivity growth…

• Improved fiscal and monetary policies have created the conditions for stronger growth in employment and productivity, two factors which have driven strong gains in Canadian living standards since 1997.

• Canada achieved exceptionally strong employment growth between 1997 and 2003—by far the best in the G-7 and nearly double the pace recorded in the U.S. Over the same period, productivity growth improved noticeably following a period of lacklustre growth during the 1980s and early 1990s.

• As the population ages, it will be increasingly difficult to improve living standards through increased employment because of the shrinking size of the working-age population. Instead, Canada must increasingly rely on productivity growth.

…and have laid the foundation for a sustained improvement in Canadian living standards

• Between 1980 and 1996 Canada ranked second last among the G-7 countries in growth in real GDP per capita, the most commonly used measure of average living standards.

• However, thanks to stronger employment and productivity growth, Canada recorded the strongest growth in living standards among all G-7 countries between 1997 and 2003. The average standard of living of Canadians increased more in the past 7 years than in the previous 17.

Private Sector Economic Forecasts

• The Department of Finance surveys about 20 private sector economic forecasters on a quarterly basis regarding their outlook for the Canadian economy. The Minister of Finance, along with departmental officials, also meets with a group of private sector economists to discuss risks and uncertainties associated with the outlook.

• The economic forecasts reported here reflect the survey of private sector forecasters conducted by the Department following the release of the second-quarter National Accounts by Statistics Canada on August 31 and further consultations with private sector forecasters in early November. The Department’s survey of private sector forecasters is the basis for the economic assumptions that underlie the five-year status quo fiscal projections provided in Annexes 3 and 4.

The Canadian Economic Outlook

Private sector forecasters expect improved economic growth in Canada for 2004 and 2005

• Private sector forecasters expect real GDP to grow by 3.0 per cent in 2004, up from 2.7 per cent at the time of the March 2004 budget. Growth is expected to rise to 3.2 per cent in 2005, slightly lower than the 3.3-per-cent forecast at the time of the 2004 budget. According to the IMF, Canada is expected to have the second fastest growth rate in 2005 among G-7 countries, behind only the United States.

• Private sector forecasters have significantly raised their forecast for GDP inflation in 2004, reflecting much stronger-than-expected growth in commodity prices. As a result, they expect nominal GDP to grow 6.2 per cent this year and 5.3 per cent in 2005, compared to 4.1 per cent and 5.1 per cent, respectively, at the time of the 2004 budget.

• Private sector forecasters now expect nominal GDP in 2004 to be $29.5 billion higher than they expected at the time of the 2004 budget. Their nominal GDP forecast for 2005 has been revised up by $33.9 billion.

With stronger growth, private sector forecasters expect monetary stimulus to be gradually withdrawn

• Private sector forecasters expect the Bank of Canada to continue raising its target interest rate between now and the end of 2005. However, short-term interest rates have remained low in 2004 at 2.1 per cent, little changed from the time of the 2004 budget. Forecasters now expect that short-term rates in 2005 will average 3.2 per cent, slightly higher than forecast at the time of the March budget.

• Forecasters expect long-term rates to average 4.7 per cent in 2004 and 5.0 per cent in 2005, moderately lower than expected at the time of the March budget.

Risks and Uncertainties

Despite the solid global growth outlook, persistently high oil prices pose a downside risk

• A key risk to the global economic outlook is the path of oil prices. In October, the price of oil reached over US$55 per barrel, higher than at any time since the second oil crisis in the late 1970s. However, in real terms this remains below the historic high reached in 1980.

• If prices remain at current levels, or rise further, the global expansion could be weaker than expected. Growth would be particularly affected in oil-importing countries such as China and India, which have a higher intensity of oil use than the U.S. and Canada.

World oil demand rose considerably in 2003 and is forecast to rise further, with nearly half of the increase in 2004 coming from China and other non-OECD Asian countries

• The recent spike in oil prices has been the result of several factors: strong growth in world demand, notably from China and other non-OECD Asian countries, which are forecast to account for almost 50 per cent of the increase in world demand for oil in 2004; little excess capacity in most OPEC (Organization of the Petroleum Exporting Countries) nations; weather-related damages to oil production facilities in the Gulf of Mexico; uncertainty surrounding Yukos Oil Company’s production in Russia; and concerns about possible supply disruptions in Saudi Arabia, Venezuela, Nigeria and Iraq.

• The increase in world demand for oil is projected to slow somewhat in 2005, largely due to weaker demand growth in China and other non-OECD Asian countries. However, these countries will continue to account for a sizeable share of the expected increase in overall world oil demand.

An increase in the price of oil transfers purchasing power from consumers to oil producers, both within and across countries

• Since the March budget, world oil prices have risen by about US$20 a barrel. Based on the number of barrels of oil consumed in Canada per day in 2003 (by businesses and households), a US$20-per-barrel price increase over the course of a year reduces the purchasing power of oil consumers by about $21 billion. On a per capita basis, U.S. oil consumers incur a similar loss.

• However, higher oil prices lead to a gain for oil producers, with transfers occurring both within and across countries. Since Canada sells more oil on the world market than it buys, the US$20 price increase results in a net income flow of approximately $9 billion from the rest of the world to Canada. This stems from an outflow of $10 billion from Canada to other oil-producing countries (Canada imports about half of its oil consumption), which is more than offset by an inflow of $19 billion from oil consumers in the United States.

Rising oil prices raise gasoline and other energy prices, which negatively affects consumers

• Canadian households are affected by higher world oil prices via higher gasoline and heating fuel prices, which usually move in response to changes in the price of crude oil. Indeed, gasoline prices in Canada reached record levels in 2004, although their current levels and recent run-up are not unprecedented in real terms.

• Since gasoline and heating fuel are necessities for most households, in the short term rising prices reduce the income available to purchase other goods and services. This reduces real consumer spending in Canada and dampens exports, as consumers in other countries—particularly the U.S.—demand fewer imports.^[4]

• Higher oil prices also lead to higher input costs for firms in the non-energy sector. Since firms are generally unable to pass the higher costs on to consumers immediately, this may lead to lower profits, reduced business investment or production cutbacks for these firms.

However, rising oil prices also induce oil producers to increase drilling activity and investment in Canada

• On the positive side, higher oil prices stimulate investment and production in Canada’s energy sector, supporting output and employment growth.

• Coinciding with the recent rise in the price of crude oil since the beginning of 2002, output in the oil and gas extraction industry has increased markedly in Canada. Over this period employment in this industry has increased nearly 10 per cent, while employment in support activities for oil and gas extraction (and mining) has increased more than 50 per cent.

• High oil and gas prices also prompt producers to invest more in drilling activity aimed at boosting production. Based on data for the first nine months of the year, the Canadian Association of Oilwell Drilling Contractors expects drilling activity to reach record highs this year and next.

The Canadian dollar has risen significantly, driven in part by stronger commodity prices…

• Since the beginning of 2003, the Canadian dollar has appreciated more than 30 per cent against the U.S. dollar reflecting, in part, rising commodity prices. The Canadian dollar often rises against the U.S. dollar when commodity prices are strong, as has been the case recently. In addition, adjustments to global current account imbalances have contributed to the recent appreciation of the Canadian dollar.

• An appreciation of the Canadian dollar driven by rising commodity prices would normally be accompanied by stronger activity in the commodity-producing sector, which would partly offset the negative effects on non-commodity exporters. To the extent that higher commodity prices reflect strong global demand, this would also provide some offset in the non-commodity sectors.

…but also by an ongoing adjustment to global current account imbalances…

• On the other hand, an appreciation of the Canadian dollar due to ongoing portfolio adjustments to global current account imbalances poses a greater risk to Canadian growth because the appreciation does not reflect an improvement in Canada’s underlying growth prospects. Such a portfolio shift appears to have occurred in 2003, when all major currencies including the Canadian dollar appreciated against the U.S. dollar.

• The timing and magnitude of further portfolio-driven adjustments to the Canadian dollar are highly uncertain. Nevertheless, the recent resilience shown by exporters in the face of a stronger Canadian dollar in 2003 suggests that any impact may be short-lived.

…that partly reflects large and growing U.S. fiscal deficits

• Over the medium term, the growing U.S. budget deficit remains the principal downside risk. The on-budget deficit reached US$568 billion in 2003–04, its highest level on record, or nearly 5.0 per cent of GDP.

• If not corrected, the U.S. fiscal imbalance could put upward pressure on interest rates, crowd out investment and dampen growth in the United States. On the other hand, a serious effort to reduce the deficit would temporarily lower growth directly. In either case, Canadian and world growth would be negatively affected.

• While the Canadian economy faces a number of downside risks over the near to medium term, a strong monetary, fiscal and structural framework means that the Canadian economy is well positioned to deal with these risks.

¹ This annex incorporates data available up to November 5, 2004.
Figures are at annual rates unless otherwise noted. [Return]

² OECD, Economic and Development Review Committee, Economic Survey of Canada (October 2004). [Return]

³ IMF, World Economic Outlook (September 2004). [Return]

⁴ For instance, the IMF estimates that every US$10-per-barrel increase in crude oil subtracts 0.4 percentage points from U.S. real GDP growth. [Return]

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