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Economic policy.

The overall strategy

As set out initially in its November 1984 Agenda for Economic Renewal, the Government's medium-term policy strategy has two dimensions: one is to create a stable and predictable domestic macroeconomic environment for the private sector; the other is to promote potential growth through the implementation of structural policies. Only such a comprehensive approach that follows consistent medium-term objectives and integrates both macroeconomic and microeconomic instruments is considered to be able to improve the performance of the Canadian economy in the long run. While the first leg of the strategy has focused on restoring macroeconomic balance by reducing fiscal deficits and lowering inflation, microeconomic policies have concentrated on improving productivity performance by reforming the tax system, securing and opening trading relationships and encouraging competition through deregulation and privatisation. Budgets since 1984 have cut the growth of spending and raised the revenue share of GDP to more traditional levels. The numerous structural reforms implemented since 1984 include the deregulation of the energy and transportation sectors, the Free Trade Agreement with the United States, the reform of income taxation and introduction of the Goods and Services Tax, and the reform of the unemployment-insurance system.

Progress in achieving the strategy's objectives has been mixed, reflecting in part the time required for the private sector to adjust to the sweeping policy changes put in place gradually in the second half of the 1980s but also, more recently, the poor international economic situation. As noted in Part I, there has been a breakthrough in the inflation area, and the introduction of legislated spending limits (see below) has further improved the fiscal structure. Also, there is evidence of fundamental restructuring by Canadian business to take advantage of structural reforms. Nevertheless, as discussed in more detail in Part III of the Survey, productivity and competitiveness have remained problem areas. The absence of any apparent rebound in total factor productivity contrasts with model-based estimates of substantial efficiency gains resulting from tax reforms and the Free Trade Agreement with the United States. It would, however, be unrealistic to expect these reforms to turn around economic performance in a short period of time. In view of this slow progress, the authorities have launched the Prosperity Initiative, a consultation process to help identify, and build a consensus around, further structural reforms needed to improve the competitiveness of the economy (see Part III).

At the same time, reducing budget deficits continues to be of prime importance in view of the rising public debt, the loss in fiscal flexibility, and the adverse effect of government dissaving on the external balance. Fiscal restraint and strong economic expansion led to a rapid decline in budget deficits in the second half of the 1980s. However, the fiscal correction has not been sufficient to reduce the debt burden and, with the economic upswing coming to an end, budget consolidation has suffered a setback in recent years. As a result, the public debt/GDP ratio has reached a new high - reflecting the significant slowdown in nominal GDP growth in recent years - and the large public-sector deficits have had a counterpart in the substantial widening of the current-account deficit.

Moreover, tighter monetary conditions proved necessary to reduce inflation given the firmly-entrenched inflation expectations. In February 1991, the Bank of Canada and the Department of Finance jointly announced a set of inflation-reduction targets, according to which the annual increase in the Consumer Price Index (CPI) should fall to 3 per cent by December 1992 and to 2 per cent by December 1995. This step did not represent a change in monetary policy as such but rather an explicit commitment to a clearly defined medium-term anchor for monetary policy and to an objective against which the public can assess the Bank's performance. Overall, the achievement of these targets is expected to result in greater credibility of monetary policy.

The paragraphs below discuss in some detail the way the strategy has been implemented since the beginning of 1991. Fiscal-policy developments and the budget outlook are first discussed; the conduct of monetary policy is then examined, followed by a review of the progress in structural policies.

Fiscal-policy developments and the budget outlook

The source of Canada's persistent fiscal problem is the emergence of a structural imbalance between government spending and revenues - mainly stemming from sharply rising expenditure - in the decade following the first oil-price shock. In combination with rising interest rates, this led to explosive growth in the public debt in the first half of the 1980s. Given soaring debt servicing costs, such fiscal imbalances have taken time to correct, and progress in budget consolidation has been fragile. In the three years to 1988, fiscal restraint and strong economic growth brought down the general-government deficit as a share of GDP by over 4 percentage points to 2 1/2 per cent. At the same time, non-interest ("programme") expenditure was reduced relative to GDP, and efforts were made to restore the revenue yield. From 1988 to 1991, sharply-rising interest payments followed by weakening economic activity led to a widening of the deficit to 6 per cent of GDP, despite a further increase in the tax burden and continued action to restrain non-interest spending. As a result, the net public debt/GDP ratio, whose rise had been temporarily contained, has approached 50 per cent, compared with around 10 per cent in the early 1980s.

The dynamics of deficits and debt have been particularly evident at the federal level, where -- contrary to the public sector as a whole -- the operating balance had moved into deficit in the mid-1970s. While by the mid-1980s around one-eighth of provincial revenue went to service debt, the corresponding federal-government ratio was just under 30 per cent and has kept growing. Although there has been a substantial improvement in the federal operating balance -- two-thirds of which has been attributable to programme spending restraint -- this has been offset to a significant extent by growing debt interest payments, as the stock of debt has risen.

To contain slippage in the original deficit targets and provide greater assurance that the medium-term objective of balancing the federal budget by the mid-1990s would be realised, the Government took action in the February 1991 Budget to partially offset the effects of weak economic activity on tax bases and social-security payments and to fund additional costs arising from the sales tax reform(1), agricultural assistance and the Gulf War. The Expenditure Control Plan, introduced in the 1990 Budget, was extended and broadened, and excise levies and unemployment-insurance premiums were raised. These measures, which totalled C$ 4.5 billion (0.7 per cent of GDP), were expected to keep the federal deficit in the fiscal year 1991/92 (starting in April 1991) stable at CS 30.5 billion (4.5 per cent of GDP).

As the economy turned out to be weaker than expected, leading to substantial shortfalls in tax receipts, further action was taken in the course of the fiscal year. This included a legislated freeze in civil-servant salaries, an additional increase in unemployment-insurance premiums, the introduction of legislation to provide for the full funding of public-service pensions(2), and a freeze on discretionary spending and new hiring (from late January 1992). With supplementary assistance to agriculture funded by cuts in defence spending and reduced debt service due to lower interest rates than projected, according to the 1992 Budget estimates it was expected that total expenditure growth would be kept below that of revenues and the overshooting of the budgeted deficit limited to C$ 1 billion.

The February 1992 Budget projections are based on the assumption of a continued decline in interest rates and a rebound in economic growth in the second quarter. With lower debt service payments reducing expenditure growth by 2 percentage points and the recovery bolstering tax receipts, the upward trend in deficits since the late 1980s is expected to be reversed. The Budget envisages the federal deficit (Public Accounts basis) falling from C$ 31.4 billion (4.6 per cent of GDP) in the fiscal year 1991/92 to C$ 27.5 billion (3.8 per cent) in 1992/93, which is C$ 3 1/2 billion and C$ 6 1/2 billion, respectively, higher than projected one and two years earlier. This further slippage reflects the effects of the delay in economic recovery: tax reductions - partly aimed at bolstering recovery - will be fully financed by spending cuts in the current fiscal year. Such expenditure reductions are widespread, affecting defence in particular. The tax measures, which will be gradually phased in over the next two years, include: lowering the tax rates and increasing the capital cost allowance for manufacturing and processing; reducing the personal income surtax which, originally labelled "temporary", had taken on a permanent look in response to unforeseen upward pressure on the budget deficit; and restructuring and enriching of child support by the introduction of a unified child tax benefit. Moreover, the Budget aims at stimulating residential construction by allowing home buyers to withdraw funds temporarily from registered retirement saving plans without having to pay tax.

TABULAR DATA OMITTED

With real GDP projected in the Budget to grow by 4 1/2 per cent per annum from 1993 and the lagged impact of lower interest rates, the revised medium-term fiscal plan for the next four years envisages a sharp fall in the federal deficit. However, the fiscal consolidation targets set out in the 1991 Budget have been delayed by one year: the budget deficit is now not expected to disappear before 1997. This reflects the adverse impact on government finances of weaker-than-expected economic activity in the past two years. The fall in revenue associated with the tax measures announced in the latest Budget will be to a large extent offset by spending cuts. Expenditure/GDP ratios are projected broadly to follow the downward track set out previously, with non-interest spending growing at an average annual rate of 3 per cent as foreshadowed in the 1991 Budget. Indeed, the Spending Control Act, which pulls together a variety of control mechanisms of the Expenditure Control Plan, ensures that non-interest spending cannot exceed the projections in the 1991 Budget, except in a limited set of prescribed circumstances. In principle, if expenditure on a programme rises above the projection for economic or policy reasons, this has to be offset by reductions elsewhere. Any overspending that occurred notwithstanding these arrangements would have to be recovered within the two following fiscal years.

The impact of fiscal action at the federal level can be amplified or offset by developments at other levels of government. In terms of expenditure, the provincial, local and hospital (PLH) sector is larger than the federal government. But, because of concerns over bond ratings, which raise the cost of access to capital markets, deficits of PLH borrowers have typically been relatively modest. As, in addition, the Canada and Quebec Pension Plans have recorded relatively stable surpluses since their creation in 1966, the evolution of the general-government deficit has therefore been largely determined by developments at the federal level. This has not excluded, at times, substantial deteriorations in the PLH fiscal balance - reflecting provincial developments - but those have in the past been corrected relatively quickly.

By contrast to this pattern, the marked increase in the general-government deficit in 1991 -- from 4 per cent to 6 per cent of GDP -- was to a large extent accounted for by the PLH sector, although an improvement in local governments' financial position partly offset the sharp rise in the provincial-government deficit. The pronounced deterioration in the PLH fiscal balance resulted from a marked deceleration in revenue growth, with expenditure increases not out of line with those at the federal level. Provincial spending growth was, however, substantially higher, and revenue growth lower, than the PLH average. Moreover, the aggregate conceals considerable differences among provinces. Whereas, in parallel to the federal government, most provinces implemented spending cuts, the largest province, Ontario, introduced some stimulative TABULAR DATA OMITTED measures. Given the rapid increase in indebtedness in some jurisdictions and associated financial market pressure - as evidenced by the downgrading of bonds by rating agencies - almost all provinces have now adopted restrictive fiscal policies. There are, however, a number of structural features suggesting that this time it might take longer for them to rebalance their budgets.

The PLH sector's difficult fiscal situation reflects in part the fact that the rate of growth of federal transfers to other levels of government has been constrained. Provincial governments have complained that the federal government is shifting its budget problem to them and suggested that "federal offloading" over the past decade accounts for most of their deficit(3). Efforts to curb federal transfers (see Annex I) have, however, to be put into perspective. As can be seen from Diagram 8, federal transfers to the PLH sector had tended to expand strongly: by the mid-1980s, they were twice as high as in the 1950s and 1960s as a share of GDP. At the same time, provincial spending rose sharply as a proportion of GDP.

With very rapid expenditure growth in areas financed by transfers, the federal government needed to confront this serious structural element in its own deficit. Measures taken during the 1980s(4) to delink federal transfers from the evolution of provincial programme costs broadly stabilised the PLH transfers' share of federal non-interest spending at a high level. This alone put some pressure on provincial finances, as federal spending expanded less than inflation during the second half of the 1980s. The situation became even more severe with the introduction of the Expenditure Control Plan in 1990, which freezes some federal transfers to provinces in per capita terms and constrains the expansion of others. As a result, growth in federal transfers to provinces in the form of cash payments - but not including the transfer of tax points(5) -- has fallen below that of total federal programme spending. The provinces' fiscal problem is compounded by the fact that public spending pressures are most intense and particularly difficult to compress in areas of provincial responsibility such as health, education and social services. Some provinces have responded to this situation by tax increases, but room for manoeuvre in this respect is limited by voter resistance and competition considerations, which require that tax systems not be dramatically out of line with those in other provinces and the United States.

Monetary policy

Inflation-reduction targets

As indicated above, since early 1991 monetary policy in Canada has focused on the achievement of announced inflation-reduction targets. These targets are formulated in terms of a downward trajectory for inflation steep enough to indicate a strong commitment to price stability, within a sufficiently broad range to make them appear achievable. The targets are framed in terms of the CPI, although for operational reasons the focus is on the CPI excluding food and energy. An option to temporarily adjust the targets for the impact of large changes in indirect taxes has been left open. The entire target path can be reconsidered only under specific and unusual circumstances; it is not adjustable solely because one of the targets along the path is missed(6).

A turnaround in private-sector expectations as a result of such an inflation-targeting approach to monetary policy would reduce the cost of eliminating inflation. So far, Canada's experience in this regard has been mixed. Survey data compiled by the Conference Board suggest that short-term expectations concerning inflation have fallen considerably, in line with the sharp domestic deceleration in price increases as emphasised in Part I. Between the fourth quarter of 1991 and the first quarter of 1992 the number of business leaders who expected prices to increase at a rate of 2 per cent or less in the next six months jumped from 31.7 per cent to 67 per cent. Similarly, the percentage of respondents who expected an inflation rate of 3 per cent or less increased from 69.8 per cent to 94.8 per cent. This represents a dramatic change compared with the third quarter of 1991 when only 37.3 per cent of the respondents to the survey expected prices to increase by 3 per cent or less.

While these survey results may indicate a gain in near-term credibility, however, they do not reveal the extent to which economic agents expect lastingly lower inflation. In this regard, the sticky behaviour of long-term interest rates (see below) suggests that expectations of future inflation remain relatively high. Furthermore, there is no evidence as yet of any credibility effects in labour markets that might reduce the short-term cost of disinflation: as noted in Part I, the wage response to changes in employment conditions has remained in line with previous experience. This is not entirely surprising, however, as it could take some time before the credibility attached to the achievement of the inflation-reduction targets influences the private sector's behaviour.

Given the fact that the monetary authorities have increasingly stressed price stability as their primary objective, it also comes as no surprise that financial markets have been paying careful attention to the CPI release as a relevant source of news. Although the authorities have made it clear that they are concerned about the underlying trend in inflation rather than month-to-month fluctuations, since the late 1980s, short-term Canadian interest rates are found to react to monthly CPI announcements. This suggests that market participants were closely following CPI releases well before the announcement of the inflation-reduction targets in 1991 (see Annex II). This result supports the observation made earlier that the formulation of such targets did not represent a new goal for monetary policy, but rather a clarification and formalisation of the existing price stability objectives. Moreover, the observation that CPI reactions to interest rate changes are asymmetric, i.e. interest rates react only to greater-than-expected CPI increases, implies that previously market participants recognised that actual inflation performance exceeded the implicit long-term goal of the Bank of Canada.

Implementation of policy

Since mid-1990, the Bank of Canada has permitted monetary conditions to ease in response to the weakening of economic activity and decline in inflation, although only gradually so as not to add to volatility in financial markets. The easing is essentially reflected in the behaviour of short-term interest rates which have fallen from a peak of 14 per cent to below 6 per cent -- a development only temporarily interrupted in early 1992, when the Canadian dollar came under downward pressure(7). The pace of the monetary relaxation has been measured, however. Indeed, the call loan rate has tended to be above the three-month Treasury bill rate, and, after dropping significantly until mid-1991, the short-term interest-rate differential between Canadian and U.S. rates remained at around 3 per cent before falling to below 2 per cent in mid-1992.

Long-term interest rates, which had peaked at 11 1/2 per cent, have eased less. Canadian long-term government bond yields declined markedly in the six months to January 1992, to just under 9 per cent. After firming temporarily in line with U.S. rates, they returned to that level in mid-1992. Despite Canadian inflation (measured by the GDP deflator) being lower than that in the United States since the fourth quarter of 1989, the long-term interest rate differential between the two countries has narrowed slowly. This seems to suggest that Canadian bonds still carry a risk premium either because the relatively good inflation performance is not yet recognised as being permanent (see above) or, alternatively, because the Canadian dollar is viewed as likely to depreciate in real terms before it reaches a sustainable level.

Despite the fall in interest rates, money and credit expansion has slowed markedly(8). High levels of existing debt and increased uncertainty about future income growth help explain the moderation of household credit growth. TABULAR DATA OMITTED Businesses have attempted to improve their balance sheets by shifting towards equity and longer-term bond financing. The decline in bank lending does seem to be attributable to weak credit demand rather than to credit supply rationing by the banking system. Earnings and capital positions of Canadian banks are strong, and they appear capable of withstanding possible loan losses associated with the recent difficulties of Olympia & York. Their willingness to cut prime lending rates to narrow spreads over rates on short-term paper, which is in stark contrast to developments in the United States, suggests in fact that they have been actively seeking new lending opportunities.

Growth of the broad monetary aggregates has declined considerably over the past two years. In recent months, the twelve-month increase in M2, M2+ and M3 has been within the 5 to 6 per cent range, which can be regarded as broadly consistent with the anti-inflation orientation of policy. Three main factors account for the slowing of broad money. First, the disinflation process has moderated the growth of demand for money. Second, the amount of funds placed in Canada Savings Bonds in 1991 was unusually large. Finally, because of weak demand, sluggish lending has dampened the funding requirements of the deposit-taking institutions, reducing their need to attract deposits, particularly wholesale funds. While this last factor would be consistent with the view that (at least in the case of M3) weak money growth is reflecting a hesitant recovery, the possibility of money demand instability implies that the current behaviour of broad monetary aggregates must be interpreted with caution(9).

By contrast, the pick-up of narrow monetary expansion in early 1992 would appear to be more clearly indicative of stronger economic activity. However, despite the sharp drop in short-term interest rates, the acceleration of M1 growth has fallen short of the rapid pick-up during the previous two recoveries. The slower rise in M1 than might have been expected on the basis of historical relationships seems to suggest that the demand for narrow money has become less interest sensitive.

Progress on structural policies

The Government's major initiatives on the structural front -- the Free Trade Agreement with the United States, the reform of the income and indirect-tax system, and the reform of the unemployment-insurance system -- were the topics of the special chapters of the last three Surveys. Among recent structural-policy developments, which are reviewed in this section, the most important is the reform of the financial-institution legislation. The scope for further supply-side initiatives -- notably in the areas of education and inter-provincial trade barriers -- with a view to enhancing productivity performance is examined in Part III of the Survey.

The overhaul of legislation governing financial institutions was launched in the mid-1980s when the Government issued discussion papers outlining a phased reform. This initiative responded to the federal government's commitment to non-bank financial institutions to modernise their legislation following the 1980 Bank Act revision. Other factors motivating the reform were the fact that institutions wanted to expand their activities because of changing customer preferences, as well as significant changes in the ownership of non-bank financial institutions, and pressures arising from increased internationalisation of financial markets. In 1988, in conjunction with changes at the provincial level, the federal government amended its legislation to permit federal institutions to own securities-dealers subsidiaries. The reform process gathered momentum during the course of the past year: legislation passed in December 1991 and effective from June 1992 breaks down many remaining barriers between banking, insurance, trust and loan companies and co-operative credit institutions. Federally-regulated financial institutions now are able to offer most financial services either directly or indirectly through subsidiaries or networking. There are, however, certain exceptions, such as the restrictions against selling most types of insurance through the branches of deposit-taking institutions.

These changes will result in increased competition, thereby offering households and firms a greater choice of suppliers of financial services and products. In addition, the legislation improves prudential safeguards, banning, for instance, with certain exemptions, transactions of regulated financial institutions with related parties to limit self-dealing. The reform process currently continues with an examination of the deposit-insurance system and of the regulatory and supervisory systems at the federal level; moreover, there are federal/provincial discussions aimed at harmonising and disentangling the federal and provincial legislation as it applies to non-bank financial institutions.

Another step towards creating a level playing field for financial institutions is the gradual elimination of reserve requirements for chartered banks(10). With the proclamation of the new Bank Act in June 1992, primary reserve requirements will be phased out over a two-year period, while secondary reserve requirements are removed immediately. This is intended to place banks in a comparable competitive position with other types of deposit-taking institutions. Under the new system, clearing institutions will continue to hold deposits at the Bank of Canada to settle their net positions after the daily clearing of cheques and other payment items.

The reform of the unemployment-insurance system has directed more funds towards training for the unemployed, while reducing the generosity of the system by reducing the maximum duration of benefits and increasing the minimum period of work required to qualify for benefits. Under the Labour Force Development Strategy, funding for training was raised from C$ 0.5 billion in 1990 to C$ 2 billion in 1992. In addition, the government plans to spend C$ 1.6 billion for skills training and employment assistance for people not receiving unemployment insurance. The reduction in the generosity of the unemployment-insurance system is estimated to lower the "natural rate" of unemployment by 1/2 percentage point by the mid-1990s. However, even after recent changes, the duration of unemployment benefits continues to be related to regional unemployment levels, thereby discouraging the mobility of labour across provinces.

In the area of trade policy Canada's main priority is a successful conclusion of the Uruguay Round (UR) of the Multilateral Trade Negotiations (MTN). Canada has much to gain from a successful UR outcome (e.g. in agriculture, market access, trade remedy rules) and has been an active participant in the negotiations. In parallel with the MTN, Canada has also been pursuing complementary regional trade liberalisation. Implementation of the Free Trade Agreement (FTA) between Canada and the United States, which provides for the phased elimination of tariffs between the two countries by 1999, has made further progress. In response to strong interest on the part of importers and endusers both in Canada and the United States, tariff reductions were accelerated in 1990 and 1991, and are likely to be so again this year. However, the scale of such reductions has tended to decline with each round. Although there have been many cases of trade friction (recent ones include Canadian exports of cars and softwood lumber), dispute settlement mechanisms under the FTA have improved Canada's ability to protect its trade interests. Canada has also entered negotiations with Mexico and the United States to establish a North American Free Trade Agreement (NAFTA). Participation in such a trilateral agreement would help Canada to compete with Mexico where it matters most - the U.S. markets -- and ensure that Canada stays as attractive as the United States as a place to invest for supplying the entire North American market.

The Government has also continued to reduce its role in the economy through deregulation and privatisation. In particular, draft legislation to establish a new telecommunications-policy framework has been submitted to Parliament. The aim of the proposed reform is to make regulation more flexible and encourage competition while favouring Canadian ownership and control of telecommunication infrastructures and guaranteeing Canadians access to reliable, affordable and high-quality telecommunications services. In addition, a review to assess the changes which have taken place in the transportation sector since its deregulation in 1987 is under way and may result in modifications to national transportation policy. More generally, the Government has launched a department-by-department review of existing regulations, with particular attention being paid to their effects on competitiveness.

Privatisations over the past year include those of Petro-Canada (in part) and Telesat Canada. Since 1984, the Government has privatised 23 Crown corporations (public enterprises) and other holdings and dissolved about half as many(11). A total of 46 government entities are affected by streamlining measures announced in the 1992 Budget. Twenty-one agencies or other government organisations will be wound up and others merged or consolidated. Two corporate holdings are being privatised and three other privatisations are under consideration, including that of the Royal Canadian Mint.

After declining gradually during the second half of the 1980s, general-government subsidies, as defined by the National Accounts, rose by 0.4 percentage points to 2.1 per cent of GDP in 1991, largely reflecting developments at the federal level. About one-third of this increase is accounted for by transitional subsidies to small businesses to alleviate the effect of the introduction of the GST, and about 40 per cent subsidies to the agricultural sector. Agricultural support is substantial and rising: according to Secretariat estimates, assistance to Canadian producers, as measured by the Producer Subsidy Equivalent (PSE)(12), increased from 36 per cent in 1989 to 45 per cent in 1991, catching up to to the OECD average; this compares with 30 per cent for the United States where PSEs grew little over that period.

In principle, the new agricultural income-support programme (see last year's Survey), which became effective in 1991, should be self-financing over time. However, as it turned out that the new system would have resulted in lower assistance in 1992, the formula to calculate support payments was adjusted(13). Moreover, the new income safety net has not led to the disappearance of ad-hoc measures, as intended: further additional assistance was given in 1991. Despite these measures, there has been a strong decline in net farm incomes, however. The authorities have emphasised that the new safety nets would only support orderly adjustment to lower income levels (and thus reduced government assistance). The purpose of measures taken in spring 1991 was to encourage participation in the new system. Extra support provided more recently reflected the unforeseen sharp deterioration in markets in 1990-91 and is thus seen as consistent with the long-term structural objective of adjustment to lower income and government assistance levels.
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Title Annotation:Canada
Publication:OECD Economic Surveys - Canada
Date:Sep 1, 1992
Words:4986
Previous Article:Recent developments and the short-term outlook.
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