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Canada: recession and recovery.

*Douglas D. Peters is Senior Vice-president and Chief Economist, Toronto Dominion Bank, Toronto, Canada.

The Canadian economy has been affected by the Gulf War, a value-added tax, the free trade agreement with the U. S. and a tight monetary policy that culminated in a serious recession. A significant recovery is expected by summer 1991 as interest rates ease and the U.S. economy recovers.

A NUMBER OF interesting economic events have impinged on the Canadian economy in recent years that will affect the future of this northern half of the North American continent. These include not only the Gulf War of recent weeks and the rise in oil prices in mid-1990, but also the imposition of a new multistage value-added tax system and a monetary policy that produced economy-numbing high real interest rates in a period of adjustment to a free trade environment with its much larger neighbor. Perhaps this northern experience will provide some insights for business economists in the United States that would be useful in their own analysis.


January 1991 marked the second anniversary of the implementation of United States-Canada Free Trade Agreement (FTA). That agreement was intended to be an efficiency-producing, trade-enhancing agreement with staged tariff reductions and reduced trade impediments. It cannot and should not be judged by the effects it may have had on improving the two countries balance of trade or international current account over those two introductory years. Both Canada and the United States faced huge international current account deficits when the agreement came into force and the FTA could not be expected to cure either. What the FTA can do is to widen markets for businesses in both countries, adding to their efficiency and thus making those firms better able to compete internationally from a widened "domestic" base. It may be too early to observe any substantial effect of this rise in efficiency as yet.

Two factors have made it particularly difficult for Canadian firms to adjust to the FTA. One factor is high real interest rates, which over the past two years have averaged from 3 to 6 percentage points higher in Canada than in the United States. Another related factor is an appreciated Canadian dollar that has risen in terms of United States dollars by about 12 percent since FTA negotiations began in early 1988. In terms of a trade-weighted index, a similar appreciation of the Canadian dollar has taken place. This has placed Canadian exporters, particularly manufacturers, and Canadian producers of import-competing goods at a distinct disadvantage. These were precisely the producers who were intended to benefit from the FTA. They, however, found that their costs for borrowed funds were much higher than those of their competitors in the United States, and that their prices had to be sharply lower than those of their United States counterparts to compensate for the higher-valued Canadian dollar. The result, which is not unexpected, was that many could not compete and wound up in bankruptcy court.


The Canadian government, after many years of discussion, introduced a multistage value-added tax called the Goods and Services Tax (GST) on January 1, 1991. Similar tax systems have been in place for many years in Europe and in other parts of the world; this is the most recent, widely accepted trend in taxation. The Canadian GST is a two-pronged tax and income policy. It replaces the Federal Sales Tax, which was largely imposed on manufactured goods; this tax rate had been raised by the federal government from 9 percent to 13.5 percent over the past six years. It was clear to almost everyone, especially manufacturers, that the old tax was a bad tax and should be replaced. The replacement is a value-added tax that is added to each stage of production and finally imposed on retail purchases at a 7 percent rate. The new tax measure also has a component that makes advance quarterly payments to low income families to ameliorate the impact of the GST. This is the beginning of a guaranteed annual income system. Not unexpectedly, the introduction of this new tax system added substantially to consumer uncertainty. THE PATH INTO THE RECESSION

Canada entered into recession in the second quarter of 1990, and the United States followed in the fourth quarter. At first glance, the causes of the current recessions in Canada and the United States appear to be similar to those that precipitated the 1981-82 recession: tight monetary policy and high interest rates implemented to fight inflation. There are, however, some important differences. The rate of inflation in Canada prior to the current recession averaged only between 4 and 5 percent. This contrasts sharply with inflation rates twice as high prior to the 1981-82 recession.

In 1981 the United States Federal Reserve led the fight against inflation and the Bank of Canada followed the lead of interest rate increases in the United States. Indeed, there were brief periods leading to the previous recession when the Bank of Canada did not follow quickly enough in raising interest rates, with the result that the external value of the Canadian dollar fell temporarily until the Canadian central bank caught up with Federal Reserve interest rate policy.

Although both central banks have been fighting inflation during the past four years, the Bank of Canada has felt it necessary to fight much harder than the Federal Reserve. The Federal Reserve eased in late 1989 and in 1990, but Bank of Canada policy remained firm except for a brief, aborted easing in January 1990. The results were markedly higher short-term interest rates in Canada than in the United States, very high short-term interest rate spreads for an extended period of time, and an overvalued Canadian dollar. In comparing events during 1990 with the 1981-82 period, nominal interest rates did not rise nearly as much in 1990, real interest rates (Government of Canada three-month Treasury bill rates minus year-over-year percentage change in the consumer price index) rose roughly 50 basis points higher, and the Canadian dollar reached a level about two cents higher. The higher real rates and higher dollar that persisted since 1989 finally had the predictable effect and drove the Canadian economy into recession in early 1990, a half year ahead of the United States.

In spite of the easier monetary policy followed by the Federal Reserve since 1989, the United States economy entered what is expected to be a brief (two quarter) recession in the fourth quarter of 1990. That recession was brought on by a spurt in oil prices, the uncertainties over the Middle East crises and financial institution difficulties. This will make the Canadian recession a little worse than it otherwise would have been, but the recession in Canada was well established before one began in the United States.

The adverse effects of high interest rates were felt in Canada as early as the second quarter of 1989, when both real expenditures on housing and pretax corporate profits began to decline. Those and other indicators continued to point the way to recession, and evidence of the recession became much more widespread in April 1990. Although there were examples of contractions prior to this time, declines in indicators such as motor vehicle sales, housing starts and employment in April marked the beginning of a series of monthly declines throughout the rest of 1990. Available data have confirmed that total Canadian GDP declined in the second and third quarters and further declines in the fourth quarter of 1990 and the first and second quarters of 1991 are forecast.


The Canadian economy is currently in a recession that appears to be the second deepest recession since quarterly national accounts began in 1947 and will be much more severe than most analysts had anticipated. Real GDP in the fourth quarter of 1990 is expected to fall by 0.9 percent, resulting in a fall in GDP from year-ago levels of 0.9 percent as well. The first two quarters of 1991 are forecast to experience continued declines in real GDP of 1.0 percent and 0.2 percent, respectively. These declines will mean that the recession will last five quarters, producing a cumulative decline of 2.7 percent in total real GDP.

The recession was precipitated by federal government policies, implemented by the Bank of Canada, that were meant to reduce inflation. The main instrument used to achieve that objective was high short-term interest rates. A consequence of the Bank of Canada's initiatives has been that real short-term interest rates reached historic highs, causing the real cost of borrowing to exceed levels that can be tolerated by households and businesses. As a result of that policy, chartered banks prime lending rates averaged well over 14 percent during the second and third quarters of 1990, and in early 1991 prime rates were only slightly below those at the start of 1990. Monetary policy has acted to influence the price of credit, but no evidence of restricted availability or a "credit crunch" has been observed in Canada. High interest rates and their effects, however, have stifled the demand for credit. As long as borrowing costs remain high, the outlook for business investment and consumer spending is pessimistic.

Real business investment in machinery and equipment continued to decline in the third quarter of 1990. The decline was not unexpected as businesses became more pessimistic in reaction to sharply lower corporate profits, high real interest rates and the expectation that sales would stay weak well into 1991. Falling capacity utilization rates, combined with low corporate profits, will result in a further 3.8 percent decrease in the level of business investment in 1991, following a 3.0 percent decline in 1990.

Real residential construction, one of the hardest hit areas of the economy, fell for the third consecutive quarter in the July-September period. The number of new housing starts plunged to an annualized rate of 164,000 units during the third quarter, 25 percent lower than the same period in 1989. Housing starts are forecast to total 150,000 units in 1991, compared with 182,000 units in 1990. The resulting reduction in real residential construction expenditures in 1991 is projected at 7.1 percent, following a 6.0 percent drop in 1990.

Rising unemployment and personal and corporate bankruptcies along with the weakening housing market suggest declining consumer expenditures in all categories in the fourth quarter of 1990 and the first half of 1991. Real consumer spending on goods and services is expected to fall by 1.0 percent in 1991, with most of this decrease occurring in spending on durables and services. Expenditures on services will experience sharp declines in 1991, as purchases of some discretionary services will be adversely affected by the new Goods and Services Tax.

Both imports and exports fell in the third quarter as domestic demand weakened in Canada and in its major export market, the United States. This trend is likely to continue into 1991 until the two economies strengthen. An earlier recovery (and a shorter and shallower recession) in the United States along with productivity gains in Canada will boost Canadian exports in the second half of 1991 and cause a small improvement in the merchandise trade surplus in 1991. Some deterioration in other major components of Canada's international current account, namely services and net investment income, will leave the current account deficit largely unchanged at around $16 billion in 1991.

The Canadian economy is expected to begin its recovery in the third quarter of 1991. Lower interest rates should set the stage for a rebound in consumer spending and business investment, while recovery in the United States should increase net exports. Consumer confidence should also improve as both consumers and businesses adapt to the Goods and Services Tax.

The projected pickup in Canadian domestic demand, along with stronger export growth to the United States and possibly other areas such as Eastern Europe, will lead to substantially stronger growth in real GDP of 3.0 percent in 1992.


As indicated above, there are three key ingredients to the forecast of the Canadian economy coming out of recession beginning in the summer of 1991. These are a recovery from recession in the United States, a decline in interest rates in Canada and the familiarization with - and acceptance of - the Goods and Services Tax by Canadian consumers. Such a forecast would also presume that the Gulf War is not prolonged. An alternative scenario, dealing with the consequences of a prolonged war is dealt with in the section "Risks to the Forecast."


The U.S. recession is expected by most forecasters to last for only two quarters, with recovery also beginning in the second quarter of 1991. The recovery is expected to be quite broadly based, with both personal consumption expenditures and business investment benefitting from the easier monetary policy that the Federal Reserve made evident in late January. Exports from the United States will be stimulated by the depreciation of the United States dollar against the Japanese yen and, especially, against the German mark in recent months.

These developments in the United States, providing no prolonged Gulf war or other major difficulty, should increase demand for a wide variety of goods and services from Canada, which remains the United States' largest trading partner.


In early 1991 the Bank of Canada signalled that it would continue on the path of easing monetary policy and lowering interest rates, a trend which had begun in late 1990. The decline in real GDP in the second and third quarters of 1990, the sharp increase in the unemployment rate and the deterioration in most other economic variables, all indicated the need for a reversal of restrictive economic policies.

If the federal government wished to ease economic policies, the large federal budget deficit would hamper any expansionary fiscal policy. Thus, an easier monetary policy seems to be the only way that the federal government can stimulate the economy. Some provincial governments, most notably Ontario, may expand government spending to stimulate economic recovery, although most provinces are also hampered by large deficits.

The speed and extent of the decline in Canadian interest rates in the first half of 1991 will be partly influenced by how much additional inflation is generated by the implementation of the GST. The Consumer Price Index is forecast to rise at year-over-year rates of 5.0 to 5.7 percent during the January to August period of 1991. This represents a sharp increase over the 4.2 to 5.2 percent year-over-year percentage increases experienced during the last several months of 1990. But the 7 percent GST was expected to have an even greater impact and the central bank had stated that it would "look through" the immediate inflationary effects of the changing tax system.

The central bank, the Bank of Canada, is expected to allow short-term interest rates to fall substantially in the first half of 1991. From early observations, it appears that the very weak economy will prevent the temporary burst of inflation from the GST from becoming entrenched in the economy. But in allowing such an interest rate decline, the central bank may remain cautious about inflation. The reduction in interest rates would still leave Canada-United States short-term interest rate spreads at substantial levels and extremely large by historical standards. It should be remembered that short-term interest rates in Canada and the United States would normally be at the same level providing the exchange rate was not expected to change.

Will the interest rate reductions expected during 1991 be sufficient to pull the Canadian economy out of this serious recession? The expected decline in real interest rates in 1991 is only slightly smaller than the decline after the 1981-82 recession. As this recession is less severe than 1981-82 recession, such a decline in interest rates seems a reasonable prerequisite to an economic recovery. Of the particularly interest-sensitive sectors, personal consumption on durable goods, residential construction and business investment are each forecast to experience about half the percentage decline in the current recession than they did in the 1981-82 recession. It seems likely, therefore, that, if the Bank of Canada does drop interest rates as forecast, such a decline will be enough to stimulate a recovery.


The war in the Middle East contributed some strength to the foreign exchange value of the Canadian dollar in early 1991 because many investors view Canada as a "safe haven" for their funds far away from the hostilities. But Canada-United States short-term interest rate spreads together with trade flows remain the major factors determining the Canadian dollar's external value. Spreads of several hundred basis points seem likely to continue in 1991 even as the Bank of Canada lowers domestic rates. Those spreads will provide some cushion to any decline in the external value of the Canadian dollar but a somewhat lower dollar will improve Canada's competitiveness in the United States and overseas markets.


With interest rates declining throughout 199293, the momentum of Canada's economic recovery is expected to be substantial. Rapid growth will be registered across all sectors of the economy, but most importantly in consumer spending, which accounts for about 60 percent of Canadian economic activity. Individuals should react positively to rapid employment growth, higher personal incomes, and a less inflationary environment. Growing domestic demand and lower interest rates will provide firms with an opportunity to increase capital spending steadily, although this growth will not be as strong as it was in 1986-88. During 1992-93, the Canadian dollar is expected to fall to around the 82 U. S. cent mark, as Canada-United States short-term interest rate spreads narrow appreciably. The effect of this depreciation in the Canadian dollar will be a period of strong growth in Canada's merchandise exports and a steady improvement in the current account deficit.

The major risk beyond the recession is the effects of monetary and fiscal policy on economic activity. A rational federal fiscal policy, at a time of fairly rapid real economic growth, would center on deficit reduction through specific program reductions, although there is unlikely to be much of this prior to the next federal election, which will probably be in 1992 or 1993. Some deficit reduction will take place automatically as a result of lower short-term interest rates. On balance, there may be few changes in fiscal policy or in the deficit.


A major risk to the forecast is that the war in the Middle East will be prolonged. One result of a prolonged war would be to increase the volatility of international oil prices. It would probably not raise them for any protracted length of time, however, unless there was an extraordinary development such as a successful Iraqi invasion of Saudi Arabia.

Currently, the materials being used in the war are coming from the huge inventory of supplies, largely that of the United States armed forces. A second result of a prolonged war would be the need to increase the production of war-related items as these inventories ran down. Such increases would be most noticeable in the United States but would also affect Canada, both directly through the needs of Canadian armed forces and, more importantly, indirectly through additional demand from the United States. A prolonged war would likely keep consumer and business confidence depressed in both the United States and Canada. This, in turn, would tend to prolong the recession. Additional war-related production could offset the effects of depressed confidence and pull the United States economy out of recession, although the recovery would be delayed.

A third effect would be that of an increased United States federal budget deficit to pay for the additional war-related production. The Canadian federal budget deficit would probably be adversely affected as well. The higher United States budget deficit and additional financing needs would probably lead to a fourth effect - an increase in long-term interest rates. A fifth effect would be an increase in the foreign exchange value of the Canadian dollar, partly because Canada is a net oil exporter but mainly because a long war would focus attention on Canada as a "safe haven" for overseas investors.


Quebec's future role in the Canadian Confederation is uncertain. Recent public discussion seems to indicate a growing view in Quebec favoring some form of independence, or at least more independence than it has presently. Even if this trend continues, it seems unlikely that major political changes would take place during the next two or three years. Nevertheless, discussion about Quebec's future could result in increased volatility in the external value of the Canadian dollar and a lower value for the Canadian dollar. If these movements were large, short-term interest rates in Canada might be moved up by the Bank of Canada as a stabilizing measure. Long-term interest rates could also rise in reaction to concerns and uncertainties about future government financing arrangements.


With some good fortune, Canada could see the recession end by midyear and resume strong economic growth in 1992. The FTA will still cause some structural changes, and Canada's new value-added GST will become a firm part of the tax system. It has always been a standard admonishment to Canadian business forecasters and planners that they should not underestimate the resilience of Canada's economy. Perhaps one would do well, in the midst of recession and readjustment, to remember that saying. Figuration Omitted.
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Author:Peters, Douglas D.
Publication:Business Economics
Date:Apr 1, 1991
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