Economic Update (May 2001)
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Annex 1
Recent Economic Developments and Outlook^[1]

Highlights

• The Canadian economy enjoyed a strong economic performance over the past four years: gross domestic product (GDP) growth averaged 41/4 per cent, over 1.5 million jobs were created, the unemployment rate fell significantly to 6.8 per cent in 2000, productivity growth improved, and real per capita personal disposable income rose 2.9 per cent last year.

• Overall, private sector forecasters have lowered their expectations for 2001 growth in Canada from 3.5 per cent at the time of the October 2000 Economic Statement and Budget Update to 2.4 per cent in the March 2001 private sector survey. Expected growth in 2002 is now 3.4 per cent, up slightly from the October Statement.

• Since the Canadian economic turnaround began in earnest in 1996, Canada has enjoyed strong real GDP growth averaging 41/4 per cent compared with just 2.8 per cent over the previous four years. Indeed, in the fourth quarter of 2000, real GDP advanced for the 22nd consecutive quarter.

• Since 1996 growth has been well balanced between robust foreign demand – particularly from the United States – and a strong expansion of domestic demand.

• Since the end of 1996 sustained demand growth has generated a marked improvement in labour market conditions.

• Over this period the Canadian economy has generated over 1.5 million jobs, virtually all of which have been full-time. In the last 12 months alone 240,000 new jobs have been created.

• The unemployment rate has dropped sharply from 9.5 per cent at the beginning of 1997 to an average of 6.8 per cent in 2000.

• Improved employment prospects prompted a resurgence in labour market participation, which rose to its highest level in nine years at the end of 2000.

• After a pause in January and February of 2001, employment growth resumed in March and April, with a total of 55,000 jobs created.

• Since 1996 Canada had the best job creation rate of any G-7 country.

• Over that period employment growth in Canada was more than double the G-7 average and over 1.5 times the rate of employment growth in the United States.

• Since 1996 a significant force behind Canada’s strong economic performance has been business investment in ICTgoods.

• Over this period business investment in these areas has averaged growth of 27.4 per cent, over four times the rate of growth of all other business investment and over six times the rate of growth of the overall economy.

• Strong growth in business investment is translating into a noticeable improvement in our productivity performance.

• Since 1996 growth in business sector labour productivity (output per hour) has begun to increase, advancing to 1.7 per cent annually compared to 1.2 per cent annually over the previous two decades.

• Total factor productivity growth, which accounts for the productivity of both labour and capital, has improved even more over the past four years, growing by 1.5 per cent annually compared with 0.4 per cent annually over the previous two decades.

• Strong employment growth, combined with the recent pickup in our productivity performance, has led to improved growth in real per capita personal disposable income – an important indicator of living standards.

• From 1992 to 1996 weak employment and productivity growth caused real per capita personal disposable income to fall by an average of 0.4 per cent per year.

• Since 1996 strong growth in employment and improved productivity growth have meant that real per capita personal disposable income growth has averaged 1.7 per cent.

• In 2000 real per capita personal disposable income enjoyed its strongest annual growth since the late 1980s, rising 2.9 per cent.

• Strong growth in exports, particularly to the United States, has meant that Canada now enjoys its most favourable trade balance and current account balance on record. In 2000 our current account balance rose to a record $18.9 billion surplus (or 1.8 per cent of GDP) – a sharp contrast to the record high current account deficit of close to $28 billion (or 3.9 per cent of GDP) in 1993.

• The elimination of our current account deficit has pushed Canada’s net foreign debt as a share of GDP down to its lowest level since the 1950s. Since 1993 Canada’s net debt to foreigners has dropped from 44 per cent of GDP to just 23 per cent in 2000.

• This benefits us by reducing our net investment income flows to foreigners and lowering our exposure to global financial market shocks.

• The outlook for global economic growth this year has weakened, from 4.2 per cent at the time of the October 2000 Economic Statement and Budget Update to 3.2 per cent by April 2001, led by a deceleration in economic activity in the United States. While forecasters expect this slowdown to be relatively short-lived, downside risks to global growth have clearly increased.

• While the European Union is expected to record a better performance than the United States this year, growth for the European Union is expected to slow to a below-potential pace as well, providing no offset to the impact of slower U.S. growth on the global economy.

• Ongoing structural problems in the Japanese financial system continue to pose a barrier to economic recovery in that country. And, with weaker global demand conditions, growth in the Japanese economy is expected to remain very weak in 2001.

• Slower growth in advanced economies is expected to contribute to weaker growth prospects for developing economies in Asia and Latin America.

• While weakening global demand has obvious implications for the outlook for the Canadian economy, what is most significant is the performance of our most important trading partner, the United States.

• In the second half of 2000, a sharp slowdown in demand for U.S. manufactured goods led to a buildup in manufacturing inventories.

• In response, U.S. manufacturers pared output growth by half in the third quarter of 2000, and reduced output in the fourth quarter of 2000 and first quarter of 2001.

• As a result, overall U.S. economic growth slowed from an average of 5.2 per cent in the first half of 2000 to an average of 1.6 per cent over the final two quarters of the year, before recovering modestly to 2.0 per cent in the first quarter of 2001.

• Within the U.S. manufacturing sector, the sharpest declines were seen in the automotive and ICT goods industries.

• Following a period of very robust growth, sales of new motor vehicles began to ease in the U.S. in early 2000. However, intense competition for market share within the sector led manufacturers to extend incentive programs and sustain high levels of production, despite falling demand. As a result, inventory levels began to rise and production had to be curtailed sharply beginning in the second half of 2000.

• Output of the ICT goods industries grew a very strong 66.8 per cent on average over the first three quarters of 2000, fuelled by rapid growth in business investment in high technology. These industries account for 8.5 per cent of U.S. industrial output, compared with 5.7 per cent for the motor vehicles and parts industry.

• However, as business confidence was shaken by volatility in equity markets, demand fell sharply in the following two quarters. As a result, output growth of the ICT goods industries fell to 25.2 per cent in the final quarter of 2000, and declined further to 5.1 per cent in the first quarter of 2001 – declines which contributed significantly to the overall slowdown in U.S. economic growth.

• The delayed response by automotive manufacturers to the slowdown in demand for new vehicles in the United States left a considerable buildup in inventories in mid-2000, which led to large declines in production. Declining inventories this year have removed much of this overhang in the automotive sector.

• Inventory accumulation in the ICT goods industries also increased in late 2000, reflecting a carry-over from the very strong output growth in previous quarters and expectations that the downturn in demand would be relatively short-lived. Some correction is also apparent in those industries thus far in 2001.

• The rapid run-up in equity prices from the mid-1990s through early 2000 was partly reversed by the "dot.com" correction, creating large-scale volatility in equity markets and reducing stock valuations within the ICT sector. As uncertainty rose through the course of the year, equity prices in other sectors were increasingly affected, and by early 2001 most sectors had witnessed declines in stock market prices from their levels at the beginning of 2000.

• Declines in market valuation have meant that the ratio of U.S. household net worth to personal disposable income declined in 2000 for the first time since 1994. It should be noted, however, that the decline in 2000 only partly unwound the very strong gains enjoyed over the previous five years. For example, in the fourth quarter of 2000, the ratio of net worth to disposable income was close to its average level in 1999, and remained over 20 per cent above its level in 1995.

• Nevertheless, growing uncertainty over future economic conditions and declines in stock market wealth have translated into a sharp decline in consumer confidence in the United States in late 2000 and into early 2001. There is a risk that this could be exacerbated by recent employment weakness (employment fell by 223,000 in April).

• At the time of the October 2000 Economic Statement and Budget Update, private sector economists believed that growth in the U.S. would slow from 5.0 per cent in 2000 to 3.5 per cent in 2001 – a more sustainable, yet still robust, pace.

• However, the recent declines in U.S. manufacturing output and consumer and business confidence have led private sector forecasters to reduce their expectations of U.S. growth for 2001.

• By May 2001 the average private sector forecast for real U.S. GDP growth had fallen to 2.0 per cent, with weakness concentrated in the first half of the year. However, forecasters expect growth to pick up to close to 3 per cent by the final quarter of 2001.

• Given Canada’s strong trade links with the U.S. and the close ties between the manufacturing sectors of the two economies, the slowdown in the United States has spilled over into Canada.

• After averaging 4.5 per cent in the first three quarters of 2000, real GDP growth in Canada slowed to 2.6 per cent in the fourth quarter of the year, led by a 1.7-per-cent contraction in real manufacturing output.

• As has been the case in the United States, the output of automotive industries as well as the ICT sector has been hit hardest – not surprisingly, as the majority of Canadian ICT and automotive output is destined for U.S. markets.

• Although these two sectors together accounted for only 5 per cent of total output and 25 per cent of manufacturing output, they were responsible for one-fifth of total output growth in the first three quarters of 2000.

• The strong international linkages in these industries imply that slower demand from the U.S. for these commodities has impacted not only on manufacturing output, but on trade between Canada and the U.S. as well.

• Slowing demand from the United States also contributed to a rise in inventories in Canada. In response, Canadian manufacturers have sharply reduced the pace of inventory accumulation at the end of 2000 and in early 2001, particularly in the automotive and ICT industries.

• This suggests that the realignment between output and demand growth required for a subsequent output growth recovery is underway.

• Rising uncertainty over demand conditions in our largest trading partner, in combination with volatility in financial markets, has impacted on measures of confidence in Canada.

• This has been particularly evident in business confidence, which has declined sharply since early 2000 in tandem with declines in equity markets. For example, the Conference Board of Canada’s Index of Business Confidence has declined 27.5 per cent since the first quarter of 2000. As well, Statistics Canada’s Quarterly Business Conditions Survey showed a sharp decline in confidence in manufacturing industries in its January 2001 survey, which was followed by a partial rebound in the April survey.

• However, the declines in these measures of business confidence largely reflect the impact of weaker foreign demand faced by larger manufacturing firms. This was illustrated by a recently released survey by the Canadian Federation of Independent Business, which revealed that small and medium-sized businesses – which are much more dependent on domestic demand conditions – remain confident over their future prospects.

• While consumer confidence has also fallen modestly in recent quarters, it remains close to its historical average and above levels seen during the Mexican peso crisis of 1994 and the Asian crisis of 1997.

• This has been demonstrated by the resilience of consumer spending and housing demand thus far in 2001.

• The declines in business confidence and concerns about slower U.S. demand led firms to curb investment spending in the fourth quarter of 2000.

• In particular, firms cut back on investment in ICT goods – which had grown an astounding 48.0 per cent on average over the previous three quarters.

• This sharp turnaround in high-technology business investment was a substantial contributor to the slowdown in final domestic demand in the final quarter of 2000. And, as a substantial share of these capital goods are imported, this was also reflected in a sharp decline in imports in the quarter.

• While it is clear that the slowdown in the U.S. has spilled over into Canada, it is important to note that there are several factors which place Canada in good stead to weather the current economic slowdown.

• Much of the slowdown in Canada has been concentrated in several manufacturing industries, with other sectors experiencing stronger growth in recent quarters.

• Industries such as aerospace and energy have continued to benefit from strong demand for their products, growing by 10.1 per cent and 8.6 per cent respectively thus far in 2001. As well, the continued strength of residential investment has translated into stronger growth in the construction industries (8.7 per cent thus far in 2001).

• Most importantly, growth in service industry output – representing close to two-thirds of total economic activity in Canada – has been very solid. While it has moderated slightly recently, growth remains robust, averaging 31/4 per cent in the final quarter of 2000 and thus far in 2001.

• Large tax cuts were introduced in the February 2000 budget and the October 2000 Economic Statement and Budget Update.

• These federal tax cuts amount to $3.9 billion in 2000, growing rapidly to $17.3 billion in 2001 and $19.9 billion by 2002.

• At the same time, some provinces have also announced tax cuts, amounting to a further $3.1 billion in 2000, $7.5 billion in 2001 and $10.9 billion in 2002.

• Together, tax cuts at all levels of government amount to 0.7 per cent of GDP in 2000, 2.3 per cent of GDP in 2001 and 2.7 per cent of GDP in 2002. This represents a large fiscal stimulus to the economy, especially in 2001.

• Low and stable inflation has allowed the Bank of Canada to respond to the economic slowdown by reducing the Bank Rate by a full percentage point since the beginning of January. Lower interest rates will provide support to business investment, housing markets and consumer durable expenditure.

• For instance, one-year mortgage interest rates have declined by one percentage point since the end of 2000, which means that a homeowner with a typica lone-year mortgage of $100,000 will save about $700 annually.

Forecasters have lowered expectations of Canada’s GDP growth for 2001

• Private sector forecasters have lowered their expectations for growth in the Canadian economy in 2001, from 3.5 per cent at the time of the October Economic Statement and Budget Update to 2.4 per cent in the most recent survey conducted in March 2001.

• The survey suggests that most private sector forecasters expect the slowdown to be concentrated in the first half of 2001, with growth returning to approximately 3 per cent by year-end and rising to 3.4 per cent in 2002.

• Consumer price index (CPI) inflation is expected to decline modestly this year and next, falling to 2.4 per cent on average in 2001 and 2.0 per cent in 2002, in line with expectations at the time of the October Statement.

• Expectations of lower output growth have been accompanied by private sector forecasts of lower short-term interest rates. At the time of the March survey, private sector forecasters expected short-term rates to remain near current levels in both 2001 and 2002, compared with forecasts of 5.8 per cent and 5.5 per cent, respectively, at the time of the October Statement.

• The survey also revealed a wide range of forecasts for this year, which underscores the uncertainty in the current economic environment.

• This reflects the increased downside risk to the outlook, in particular if the U.S. recovery is slowed by a retrenchment in consumer spending caused by signs of weakening in the U.S. job market and wealth losses associated with declines in equity prices. In that context, the April U.S. employment decline of 223,000 and accompanying increase in the unemployment rate from 4.3 per cent to 4.5 per cent is a cause for concern.

• The lowest 20 per cent of private sector forecasts averaged real GDP growth of 1.8 per cent for 2001.

Evolution of the average of private sector forecasts for Canada

Sources: September 2000 and March 2001 Department of Finance surveys of private sector forecasters.

• While major international organizations recognize the negative impact of a slowing U.S. economy on Canadian growth, they continue to be positive about Canada’s prospects for real GDP and employment growth.

• In its April forecast the IMF expects Canada to outperform the U.S. in terms of real GDP growth, and to be above the average for the G-7, in 2001. Canada is also expected to continue to lead the G-7 countries in employment growth in 2001.

Note

[1] Incorporates data available up to May 11, 2001. [return]

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