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Country Study: Canada

Author(s):
Clinton Shiells, Antonio Spilimbergo, Vladimir Klyuev, and Raghuram Rajan
Published Date:
December 2006
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Vladimir Klyuev

Over the last decade, Canada has enjoyed robust GDP growth, declining unemployment, low and stable inflation, and a string of fiscal and current account surpluses. These outcomes owe much to sound macroeconomic policies as well as a favorable external environment. IMF staff analysis has focused on these policies and the economy’s salient features, including its close trade integration with the United States, large commodity sector, and substantial decentralization and regional diversity.

Canada is an open economy whose trade is dominated by the United States. Kose (2004) finds that Canadian-U.S. free trade agreements have substantially increased trade and financial flows while increasing business-cycle synchronicity. Justiniano (2005), using factor analysis, finds that the U.S. cycle explains about half the variation in Canada’s real GDP and industrial production. Ivaschenko and Swiston (2005), using a small monetary model, find spillovers from U.S. activity are significant but can be mitigated by a speedy monetary policy response, while U.S. monetary policy has relatively modest effects on Canada.

Canada’s lack of productivity catch-up with the United States since 1995 is analyzed in Cardarelli and Kose (2004), who find that it is explained by Canada’s industrial structure rather than increased trade integration with the United States. Although productivity differentials across sectors have been similar, the United States has been much more successful in shifting resources toward high-productivity industries.

Canada’s impressive GDP growth over the last decade despite somewhat lackluster productivity performance is explained by a substantial rise in labor force participation, particularly among women. Tsounta (2006) finds that reforms in the Canadian tax and benefit system in the mid-1990s account for at least a third of the observed increase in female participation during 1995–2001.

Since the early 1980s, Canada, like the United States, has experienced a secular decline in the household saving rate. Faulkner-MacDonagh (2004), who estimates a long-run relationship between the saving rate and household net worth, inflation, interest rates, and government spending, finds this has reflected improvement in the fiscal balance, success in fighting inflation, and increases in households’ net worth. Klyuev and Mills (2006), using an error-correction framework on saving behavior in four “Anglo-Saxon” economies, find that, in contrast to the experience in the United States, the decline in the Canadian household saving rate in recent years has not coincided with a rise in home-equity withdrawal.

Canada’s large commodity sector makes the country susceptible to terms of trade shocks that spill over into its “commodity currency,” which has appreciated strongly in the last four years as oil and other commodity prices have soared. Lee and Mühleisen (2004) and Bayoumi and Mühleisen (2006) argue that this appreciation has largely been in line with the fundamentals. The latter paper, in particular, argues that the relationship between the Canadian dollar and energy prices has tightened over time, reflecting the growing importance of net energy exports.

Another of Canada’s challenges is that it has a regionally specialized economy, with manufacturing concentrated in the central provinces and raw materials production elsewhere. Klyuev and Luzio (2006) find that despite some convergence over the last decade, Canadian regions are still significantly more diverse than their U.S. counterparts in terms of industrial structure and their responses to macroeconomic shocks.

By making asymmetric shocks more likely, regional diversity underscores the need for flexible markets. Bayoumi, Sutton, and Swiston (2006) find that Canada’s labor markets are flexible by international standards, with migration playing a significant role in this adjustment. Flexibility is particularly notable from the province of Ontario westward, while adjustment is more sluggish in Quebec and the Atlantic provinces. This may reflect the finding by Kaufman, Swagel, and Dunaway (2003) that the Employment Insurance system discourages migration and impedes convergence in per capita output. Moving beyond the labor market, Bayoumi and Cardarelli (2005) find that the Canadian economy is characterized by a relatively high degree of flexibility, as demonstrated by substantial changes in the industrial structure over time, high rates of firm entry and exit and of job creation and destruction, and speedy adjustment to macroeconomic disturbances.

Canada was among the pioneers of inflation targeting (IT). Bayoumi and Klyuev (2006) examine the contribution of the IT regime to reducing Canada’s macroeconomic volatility. They find that the greater stability in the IT period can be attributed primarily to high credibility of the new regime, which made inflation expectations more forward looking, rather than to changes in the monetary reaction function or tamer shocks. Roldós (2006) finds marked changes in the monetary transmission mechanism in Canada around 1990 and shows that the shift from indirect (bank-based) to direct (market-based) financing has contributed to this change by increasing the responsiveness of aggregate demand to the real interest rate. Luzio (2004) examines the information content of real return bonds and finds them useful for gauging market expectations of real yields and inflation.

Turning to financial stability and efficiency, a key policy issue is whether to allow further mergers in a banking system dominated by six large banking groups (LBGs). Ivaschenko (2005) finds that the Canadian banking system is relatively competitive and efficient despite this concentration. De Nicoló, Tieman, and Corker (2005), who calculate market-based soundness indicators for the six LBGs, find that the low correlation of risk profiles across LBGs enhances the resilience of Canada’s financial system. De Masi and Ivaschenko (2003) focus on financial and regulatory spillovers from the United States to Canada, documenting the negative impact of U.S. corporate scandals on equity valuation in Canada and the responses of Canada’s corporate governance system to these scandals and the subsequent tightening of the regulatory framework in the United States.

Canada has had an enviable fiscal record in recent years, moving from chronic deficits and rising public debt to nine consecutive federal budget surpluses. Cardarelli (2003) finds the country’s long-term fiscal prospects to be relatively favorable even in the face of demographic pressures, although Mühleisen (2004) points out scope for simplification and better targeting of public pension benefits, and the health care system cost pressures remain a challenge (De Masi and Towe, 2003). Using the Fund’s Global Fiscal Model, Bayoumi and Botman (2005) demonstrate significant macroeconomic benefits of debt reduction, while Botman (2006) uses the model to compare the efficiency gains from different tax cuts and concludes that the efficiency gains from cutting the goods and services tax (Canada’s value-added tax (VAT)) are relatively low.

Turning to the fiscal framework, Mühleisen and others (2005) emphasize that macroeconomic uncertainty implies that a considerable cushion is required to ensure that Canada’s asymmetric “balanced budget or better” objective can be met. They find a tendency for the authorities to build that cushion partly by using conservative macroeconomic and fiscal assumptions, and suggest that the transparency of the budget process could be improved.

References

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    BayoumiT. and V.Klyuev2006“Canadian Inflation Targeting and Macroeconomic Volatility in Retrospect and Prospect,” inCanada: Selected Issues IMF Country Report 06/229.

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    BayoumiT and M.Mühleisen2006“Energy, the Exchange Rate, and the Economy: Macroeconomic Benefits of Canada’s Oil Sands Production,”IMF Working Paper 06/70.

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    BayoumiT.B.Sutton and A.Swiston2006“Shocking Aspects of Canadian Labor Markets,”IMF Working Paper 06/83.

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    CardarelliR.2003“Assessing the Long-Term Fiscal Position of Canada,” inCanada: Selected Issues IMF Country Report 03/34.

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    De MasiP. and I.Ivaschenko2003“Corporate Governance in Canada,” inCanada: Selected Issues IMF Country Report 03/34.

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    KlyuevV. and R.Luzio2006“Regional Dimensions of the Canadian Economy,” inCanada: Selected Issues IMF Country Report 06/229.

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    RoldósJ.2006“Disintermediation and Monetary Transmission in Canada,”IMF Working Paper 06/84.

    TsountaE.2006“Why Are Women Working So Much More in Canada? An International Perspective,”IMF Working Paper 06/92.

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