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- News Release 2004-082 -
December 1, 2004
International Monetary Fund -
2005 Article IV Consultation with Canada
Preliminary Conclusions of the IMF Mission
1. Canada’s recent macroeconomic performance has been enviable,
and has reflected the benefits of sound institutions and a strong policy
framework. Inflation targeting has provided a transparent basis for
the Bank’s recent decision to shift its policy stance and—by firmly
anchoring inflation expectations—will allow a patient and measured
approach to further monetary tightening. The strong commitment to “budget
balance or better” has yielded welcome progress toward the debt reduction
needed to cope with the fiscal pressures of an aging population. These
policy successes, together with recent structural reforms and a
business-friendly environment, have helped Canada again record one of the
fastest growth rates and highest living standards among the G-7 countries,
and provide considerable confidence that this performance can be maintained
in the year ahead.
2. Looking beyond the near term, however, important challenges
remain. Exchange rate appreciation, commodity price volatility,
prospective trade liberalization, and the potential spillovers from the
resolution of global current account imbalances have increased the
importance of flexible labor and product markets. In addition, Canada—like
other industrial countries—faces a dramatic increase in the share of the
elderly population in coming decades. Meeting these challenges will require
sustained fiscal prudence and debt reduction, fundamental reform to control
health care costs, and structural policies to maximize the productivity and
flexibility of the Canadian economy.
The near-term outlook and monetary policy
3. The mission expects the economy to continue to perform solidly
in the coming year. Like the Bank of Canada, we anticipate
growth to remain at around 3 percent into 2005— roughly equal to the
economy’s potential growth rate—supported by strong profits, high world
commodity prices, and a pickup of business investment. While the Canadian
dollar’s recent appreciation appears broadly consistent with medium-term
fundamentals—including world commodity prices and a large current account
surplus-its strength and the expected slowing of U.S. growth are likely to
exert a dampening effect on real net exports.
4. The challenge remains to guard against the considerable
uncertainties that remain. Although there are upsides to the outlook—especially
if the U.S. economy remains resilient and oil prices fall more rapidly than
suggested by futures markets—an even sharper drop in net exports cannot be
ruled out in response to recent exchange rate appreciation. Moreover, global
current account imbalances may require further significant exchange rate
adjustments, which would compound the reallocation of resources across
regions and sectors that is already needed to absorb recent relative price
movements. Also, with the household saving rate at exceptionally low levels,
a more abrupt slowing of consumer spending remains a possibility.
5. Against this background, the Bank of Canada has skillfully
adjusted its policy stance and appears to have room to maintain a patient
and measured approach to withdrawing stimulus. The Bank has
appropriately started to increase interest rates, and further tightening
will likely be needed given that real interest rates are well below neutral
levels, economic slack has fallen, and monetary policy operates with long
and variable lags. At the same time, the absence of wage pressures suggests
that major capacity constraints have yet to emerge which, together with the
risks described above and the remarkable success in anchoring inflation
expectations, implies that a cautious and pragmatic approach to further
interest rate hikes is consistent with achieving the inflation target.
6. The Bank’s moves to further strengthen policy transparency and
communication are commendable, especially given the heightened uncertainty
surrounding the domestic and global outlook. Providing additional
information on macroeconomic projections in the Monetary Policy Report (MPR)
is a welcome innovation, and the Bank’s active communication strategy has
been effective in preparing markets for the shift in policy stance. There
remains scope, however, for providing a richer background on policymakers’
views on the distribution of risks and related policy implications at the
time of the Bank’s fixed action dates, especially when these are not
accompanied by an MPR or an Update.
Fiscal policy framework
7. Canada’s fiscal framework has been exceptionally successful in
reducing public debt and creating a broad-based social consensus in support
of prudent fiscal policies. The federal government’s commitment to
budget balance or better has delivered seven consecutive years of fiscal
surpluses that have reduced net debt by almost 30 percent of GDP while still
affording sizeable tax reduction—the best fiscal performance in the G-7.
The public pension system is actuarially sound for at least the next 50
years, and most provinces have followed the federal government in cutting
taxes and sharply reducing deficits, supported in some cases by balanced
budget rules. The consistent strength of Canada’s fiscal performance in
recent years leaves it well on track to achieve the lowest general
government debt ratio among the G-7.
8. The objective of reducing the federal debt-to-GDP ratio to 25
percent within ten years has added a welcome medium-term anchor to the
fiscal framework. Keeping the debt-to-GDP ratio on a downward path
over the next decade and beyond will be an important element in preparing
Canada for the long-term fiscal challenge posed by population aging. Indeed,
with the baby-boom generation entering retirement, sustained debt reduction
at all levels of government is imperative to meet pressures on age-related
programs.
9. However, recent agreements with the provinces have removed room
for fiscal maneuver and increased the premium on fiscal prudence. The
additional support for health and equalization transfers has all but
eliminated the planning surplus in the coming two fiscal years, and fixed
escalators on health care spending and equalization payments will increase
the sensitivity of the federal budget to cyclical developments. Restoring
the economic prudence factor is a very welcome step, while the projections
that were contained in the Economic and Fiscal Update illustrate that
there is very limited room for new initiatives in the forthcoming budget.
Indeed, while planning surpluses are projected to re-emerge from FY 2007/08,
given the uncertainties that surround these estimates and the importance of
ensuring that a margin exists to avoid slipping into deficit in the event of
unfavorable developments, the mission would caution against measures that
place an undue weight on these future surpluses.
10. Nonetheless, the ongoing Expenditure Review provides a helpful
opportunity to reassess policy priorities. Given the substantial
additional transfers that have been provided to provinces, the focus should
now turn to maximizing the productive use of the government’s scarce
resources. In this context, it would seem appropriate to weigh carefully the
merits of existing and promised spending programs versus further reducing
the relatively high tax burden.
11. More needs to be done to ensure the sustainability and
efficiency of the health care system. The latest federal-provincial
agreement has provided stable funding for provincial health programs and
mechanisms to improve accountability and comparability across provinces. The
major challenge, however, will be to improve the system’s efficiency—Canada’s
spending on health care as a share of GDP is high by OECD standards—especially
through measures that improve incentives for cost containment by health care
providers and consumers. A diversity of provincial strategies to control
costs and reform public systems should be encouraged, since this will
provide opportunities to test different approaches and identify best
practices.
12. The upcoming review of the Equalization program offers a
welcome opportunity for reform. The key challenge will be to design
a system that provides a transparent and equitable basis for the allocation
of payments across provinces, while avoiding the year-to-year instability of
the previous system.
13. Helpful steps have been taken to further enhance Canada’s
already high level of fiscal transparency. These include providing
details on the basis for fiscal projections in the Economic and Fiscal
Update and the reestablishment of the Office of the Comptroller General.
To be sure, recent fiscal surpluses have been greater than projected.
However, this partly reflects the explicitly prudent framework as well as
favorable economic developments, and the effectiveness and durability of the
Canadian fiscal framework is impressive when compared with other countries’
attempts to impose budget discipline. Nonetheless, it is important to ensure
that public confidence in the process remains strong and sustains the social
consensus for continued debt reduction, and we welcome the opportunity to
offer an international perspective to the review of the government’s
fiscal forecasting practices.
Increasing economic efficiency
14. Canada has been the fastest growing G-7 economy since 1997.
However, this has partly reflected rapid increases in labor
participation that will be difficult to sustain, particularly in the face of
population aging. The demographic shift and the ongoing challenges from
increasingly globalized markets underscore the importance of further
structural reforms for ensuring continued gains in standards of living and
quality of life.
15. Structural policies in recent years have laid a solid
foundation for future growth and created a favorable environment for
business, but there is more to be done:
- The tax burden remains relatively high despite tax cuts at both the
federal and provincial level. Given limited room for significant
rate reductions at present, an emphasis is needed on measures that yield
the greatest efficiency gain. On the business front, these could include
further aligning capital cost allowances with economic depreciation, as
well as ensuring that the tax system does not act as a disincentive for
small- and medium-sized enterprises to exploit advantages of scale and
scope. The effective tax burden on households is also relatively high
and measures to reduce taxes on saving could improve incentives. At the
provincial level, eliminating the burden of provincial taxes on capital,
including by integrating sales taxes with the GST, could also yield
significant gains.
- The Employment Insurance system remains an uneasy combination of
unemployment insurance and social assistance. Funding the latter
function through general revenues would be more efficient and
transparent, and every effort should be made to reinforce the insurance
principle of the program through experience rating of employers and
employees. Care will be needed to resist further eroding the mid-1990s
reforms and to ensure that the premium rate can be set at a low rate
that balances the system over the cycle and avoids the need for annual
adjustments.
- Reforms in other social programs could help increase labor
utilization and efficiency. Even with recent gains in labor
participation, there remains room to further improve labor supply by
reducing incentives for early retirement in the public pension system—such
as by amending benefit calculations and curbing excessive use of
disability benefits—and by lowering “welfare walls” in the social
transfer system.
- Reducing regulatory barriers to trade and competition. Regulatory
frameworks and infrastructure investment could be strengthened,
particularly in the electricity sector where technical and fiscal risks
still need to be addressed. Encouragingly, there appears to be renewed
commitment to reducing barriers to interprovincial trade, and further
efforts to promote innovation and technology diffusion would also be
helpful, including by reducing restrictions on foreign investment in
network industries.
- Maintaining the momentum for multilateral trade liberalization.
Canada can play an important leadership role in efforts to complete the
Doha Round, including by further relaxing trade barriers for “supply-managed”
agricultural products, which should help improve domestic efficiency and
lend more impetus to multilateral liberalization.
16. Canada’s sound financial system has helped support economic
growth and further reforms could promote flexibility in a rapidly changing
global environment. Both the banking and insurance sectors have
posted a remarkable performance in recent years, capital ratios are robust,
and the system is well positioned to respond to prospective financial
conditions. The regulatory and supervisory system in Canada is
sophisticated, but improvements could support Canadian institutions’
efforts to remain competitive:
- The regulatory framework governing bank mergers could be further
clarified. Addressing this would reduce uncertainty and could enable
efficiency gains.
- Adopting a single national securities regulator, as recommended
by the Wise Persons Committee, would reduce compliance and
administrative costs. The upcoming review of financial sector regulation
may also provide scope for reducing regulatory overlap.
- Useful steps have been taken to harmonizing the regulation of
defined benefit pension plans. Consideration could also be given to
enhancing incentives for funding and ensuring that the recent decision
to extend the funding period for one large plan is applied consistently
to other bankruptcy cases.
17. Recent commitments to promoting foreign development and
assistance are commendable. The plan to raise the international
assistance envelope by 8 percent next fiscal year is welcome, as is Canada’s
support for African development, including the cancellation of official debt
owed to Canada by several African countries and Canada’s leadership role
in the U.K.-sponsored Commission for Africa.
- News Release 2004-082 -
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