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Macro and financial-sector policies to sustain the recovery.

Canada benefited from many strengths such as a less-leveraged financial sector, few subprime mortgages and sound corporate balance sheets as it weathered the global economic crisis of 2007-09. Actions by the monetary and fiscal authorities have stabilised financial markets and provided substantial support to the economy. With upturns in global trade and in commodity prices, the recovery is now well under way, but the pace of expansion is projected to slow later in 2010 and in 2011 as policy stimulus is withdrawn, inventory rebuilding runs its course and households reduce their spending growth in reaction to high indebtedness. In the longer term, Canada faces the same reform challenges that other OECD countries face to allow credible exit paths for big banks and to increase competition, contestability and shareholder oversight in this sector. International efforts to strengthen financial-system resilience should take inspiration from Canada's own model of risk-based prudential regulation, which successfully held banking risks in check. Reforms that imply large increases in bank capital should be accompanied by greater market discipline to contain moral hazard and spur efficiency. Securities markets should be better regulated in order to attract foreign capital, encourage competitive impulses and improve macro-prudential regulation.

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The global economic story that led to the first significant Canadian recession since the early 1990s is by now familiar. The failure and near failure of major financial institutions in the United States and Europe, notably Lehman Brothers in September 2008, resulted in sharply rising credit spreads and a freeze in some credit markets. Growth in international trade fell dramatically toward the end of 2008, and the world economy experienced the first synchronised global recession in over 60 years.

Several factors played in Canada's favour as it weathered this global recession. Its banks and other financial institutions were less leveraged and harboured fewer toxic assets than many of their international peers. Thanks in part to better regulation and supervision, major Canadian banks had an average asset-to-capital ratio of 18, compared with more than 25 in the United States, over 30 for European banks and over 40 for some big global banks. In the corporate sector, debt-to-equity ratios were relatively low going into the recession and increased far less than in other countries. Finally, the total government net debt-to-GDP ratio was under 25% at the start of the crisis, well below most other OECD countries. Governments generally had the fiscal space to support the economy, and indeed they implemented stimulus measures worth more than the OECD average; Still; none of these economic strengths could totally shelter Canada from the global downturn and particularly from the US recession, given the high degree of economic integration between the two countries.

The economy is recovering from a mainly externally driven recession

Economic softness started to show up in late 2007 through slowing exports. The decline turned into a full-fledged recession in the fourth quarter of 2008 as weakness spread and deepened in all sectors of the economy (Table 1.1). By early 2009, output, employment and inflation were all falling sharply. The global economic slowdown, and more particularly the very weak US auto and housing sectors, led to a collapse in Canadian real exports of close to 20% over a one-year period. At the same time, the very large reversal in the terms of trade, which by early 2009 had fallen by some 14% since mid-2008, turned around a key source of previous domestic income growth. Declining consumer confidence, falling asset values and accelerating job losses undermined consumer spending, which fell but to a much lesser degree than exports. Uncertainty about the economic outlook, deteriorating profitability, tighter lending conditions and rising unused capacity depressed business investment. Residential construction also contracted sharply. Initially, goods producers were slow to adjust their production, and inventory-to-sales ratios shot up to decade highs. The subsequent inventory correction put downward pressure on output growth in early 2009. Overall, the defining characteristic of this recession compared to the last two substantial downturns, those of the early 1980s and 1990s, is that it was mainly externally driven (Box 1.1).
Box 1.1. Comparing the last recession to its predecessors

Compared to the two previous significant Canadian recessions in
recent history, the 1981 and 1991 recessions, real output dropped
more sharply at the beginning of the recent downturn but also
tapered off and began growing again more quickly, so that four
quarters after the start of the recession, the level of real output
stood at exactly the same point relative to its peak as in the two
previous recessions (Figure 1.1, Panel A). Unlike previous
recessions, the recent one was clearly mostly externally driven,
however. Real private consumption was remarkably resilient and had
returned to its pre-recession level in 2009Q3, only four quarters
after the beginning of the recession (Panel B). Real business
investment fell a bit more sharply initially and remains well below
its pre-recession level (Panel C). Government consumption and
public investment supported the economy during the downturn (Panel
D). Export volumes, however, took a substantial tumble and have
remained extremely depressed relative to the two previous
recessions, though they have been bouncing back (Panel E). Import
volumes also declined faster than in the previous two recessions,
but thanks to private consumption strength and a relatively strong
Canadian currency, had bounced back somewhat after five quarters
and were higher relative to their pre-recession peak than in the
1981 recession (Panel F).


[FIGURE 1.1 OMITTED]

Aggressive co-ordinated action helped stabilise financial-market conditions

While the financial-market reaction was milder in Canada than in many other countries, the immediate effects of the crisis were most acute in the market for short-term debt of banks and other corporations. The market for asset-backed commercial paper froze and other short-term credit markets--those for regular commercial paper, bankers' acceptances and interbank lending--experienced significant stress. The Bank of Canada had responded rapidly to the onset of stress in 2007 with its traditional liquidity tools and with a series of term purchase and resale agreements (PRA) against an expanded set of eligible securities and longer maturities than usual. As the situation deteriorated in the fall of 2008, the Bank again expanded its provision of liquidity to financial institutions by transacting more frequently with a broader range of counterparties, for still longer terms and against an even wider range of eligible securities. It also took a number of other measures to improve liquidity conditions, such as providing liquidity in US dollars through swap agreements with the Federal Reserve. (1) From the summer of 2007 to April 2009, the Bank lowered its policy rate from 4.5% all the way to the effective lower bound (0.25%). Furthermore, to influence market expectations and shape the yield curve at slightly longer maturities, the Bank committed to keeping its policy rate at 0.25% until the end of June 2010, conditional on the inflation outlook, though in the end it raised the rate by 25 basis points on 1 June and again by the same amount in late July. As conditions normalised in money markets, the Bank let two of its three emergency liquidity programmes--the private-sector term PRA programme and the term loan facility--expire at the end of October 2009. The regular term PRA facility conducted operations until April 2010.

While the Bank of Canada focused on alleviating stress in short-term funding markets for financial institutions, the federal government, for its part, focused on providing longer-term liquidity to financial-sector actors through a number of programmes under an umbrella initiative called the Extraordinary Financing Framework (EFF). One programme, the Insured Mortgage Purchase Program (IMPP), allowed banks to sell National Housing Act Mortgage Backed Securities to the Canada Mortgage and Housing Corporation (CMHC), a Crown corporation. A new programme, the Canadian Lenders Assurance Facility (CLAF), would have insured the wholesale borrowing of federally regulated deposit-taking institutions that demanded it, though none did. A third, the Canadian Secured Credit Facility (CSCF), supported sales of vehicles and equipment in Canada through government purchase of term asset-backed securities backed by loans and leases on such assets. Certain measures under the EFF, including the CLAF, expired at the end of December 2009. The IMPP and the CSCF ended as planned at the end of March 2010.

Given a structurally healthier banking sector and the measures taken by the Bank of Canada and the government, financial conditions were less affected by the global financial crisis in Canada than in most other countries. Wholesale bank-borrowing costs rose much less and improved faster than in other countries, while corporate bond rate spreads remained below those in the United States and Europe. All the major banks remained profitable through the crisis. As a result, credit growth remained solid, mainly due to continued strong household borrowing (Figure 1.2, Panel A). Business credit growth decelerated more significantly through 2008 and 2009 due to the greater impact of the recession on the demand for such credit, as well as tighter lending standards, but now appears to be stabilising. Overall, financial conditions have recovered and, despite some retightening following the outbreak of the European sovereign debt crisis at end-2009, are now comparable to the pre-crisis period (Figure 1.2, Panel B).

Local and global fiscal stimulus has also boosted the economy

Canada's fiscal stimulus package, most of it announced in the spring 2009 round of federal and provincial budgets, is estimated to amount to 4.1% of 2008 GDP, higher than the average OECD package (OECD, 2009a). It consists, in large part, of special federal funds for infrastructure investments in collaboration with the provinces. Real government investment rose from 2.7% of real GDP in 20080.3 to 3.4% at the end of 2009, and it remains relatively high in 2010. The Bank of Canada ensured that monetary conditions remained accommodative, and it seems likely that the fiscal multiplier was stronger than it would have been in normal times.

[FIGURE 1.2 OMITTED]

The recovery is taking hold but will be moderate too

With a gradual normalisation of financial-market conditions and fiscal and monetary impetus gathering pace, activity strengthened in the last half of 2009 and into 2010. Private domestic spending, supported by significant policy stimulus and a well-functioning financial system, contributed significantly to growth. Housing investment was particularly strong, helped by low mortgage rates and the temporary federal tax credit for home renovations of 15% of eligible expenses between CAD i 000 and CAD 10 000. After outsized leaps in the last quarter of 2009 and the first quarter of 2010, GDP growth now seems to be moderating. The expansion is projected to continue over the rest of 2010 and in 2011, but only at a moderate pace of around 3.0-3.5% per year (Table 1.1).

Household spending will keep contributing to growth, but there are vulnerabilities related to high debt

Private consumption will continue to grow on the back of an improvement in labour markets and high consumer confidence, though it will slow relative to recent quarters because households now exhibit record-high debt-to-disposable income and debt-to-assets ratios and need to reduce their spending growth (Figure 1.3, Panels A and B). Household debt as a proportion of disposable income was near the OECD average in 2008 after rising significantly over the last decade (Figure 1.3, Panel C). Household indebtedness continued to rise through the 2008-09 recession, however, the first on record to show an overall expansion in real household credit. Most of the increase has been in mortgage debt due to a strong revival in housing activity. Of course, healthy credit expansion was a goal of policy action, and, despite increased debt levels, historically low interest rates have lowered the proportion of disposable income devoted to servicing debt. That being said, the upward trend in the debt ratios implies that households have a growing vulnerability to additional adverse shocks. For example, if households continue to borrow at the same pace as they did recently and interest rates increase as expected, by mid-2012 about 7.5% of Canadian households could have so much debt that they would be "financially vulnerable", up from 6.1% in 2009 (Bank of Canada, 2010). This group is likely to include many young, first-time home buyers that have been profiting from low mortgage rates. A significant amount of support to the economy was indeed coming from private residential investment toward the end of 2009 and early 2010, but the housing sector has now begun to show signs of cooling and is expected to continue doing so (see the housing discussion below).

[FIGURE 1.3 OMITTED]

Business investment should pick up

Private non-residential fixed investment remained weak through the downturn because of the large and growing amount of excess capacity but should recover as needed investments that have been postponed during the contraction are undertaken. Given healthy corporate balance sheets, good profitability, low leverage ratios, high liquidity levels, low absolute borrowing costs and the lower price of imported machinery and equipment because of the strong Canadian dollar and the elimination of all remaining trade tariffs on production inputs, there should be little to hold back firms, particularly in non-tradables sectors, from modernising their capital stock. Stiffer non-price terms for borrowing have been a restraining factor, but a recent survey indicates that they are beginning to ease as the recovery takes hold. Still, low capacity utilisation and uncertainty about the shape of the recovery may make the investment revival lacklustre initially. Stockbuilding should contribute strongly to GDP growth in 2010 as a pickup in sales has brought inventory-to-sales ratios back to their long-term averages, and inventory investment will need to keep up with rising sales.

The contribution of exports will moderate

The export sector benefited from a sharp rebound in US GDP in the second half of 2009. The bounce back in exports, though muted compared to the preceding large drop, was especially welcome, given that, aside from commodities, Canadian exports tend to be concentrated in the auto and construction-materials sectors, both of which were severely affected by the crisis. The initial rebound appears to have been driven by temporary factors such as US investment in inventories and that country's fiscal stimulus programme, however. The more moderate US growth rates projected for 2010 and 2011 and the strong Canadian dollar will temper the contribution of exports to Canadian growth.

Government spending will drag down growth as stimulus measures are withdrawn

The positive impact of government stimulus spending will fade in the quarters to come. The remaining federal and provincial stimulus measures for 2010 and 2011 are estimated to amount to roughly 1.6% of GDP, and there is little appetite for fiscal support beyond what has already been announced. The focus both in Canada and in other G20 countries is now turning to fiscal consolidation (see Chapter 2 for an analysis of fiscal-consolidation strategies in Canada). The contribution of fiscal policy to growth is projected to fade in the second half of 2010 and to turn negative in 2011 as infrastructure projects are completed and other stimulus measures expire. Together with the high currency, fiscal consolidation will provide de facto tightening of economic policy conditions, irrespective of any Bank of Canada moves.

Job losses have been significant, but the labour market has turned around

Although employment rose until October 2008, the unemployment rate then increased sharply to 8.6% in July 2009. This increase was larger than the fall in output would have suggested. Over the 1961-to-2009 period, a 2.6% increase in output was typically associated with a one-percentage-point fall in the unemployment rate (Beaton, 2010). In the recent recession, a one-percentage-point increase in the unemployment rate was coupled with a fall of only 1.6% in output. The stronger observed co-movement between unemployment and output is consistent with evidence of asymmetric behaviour in Okun's law over the business cycle: (2) the unemployment rate typically increases by more during recessions than it falls during expansions.

Employment losses were not distributed equally among sectors and regions. They were largely concentrated in the construction and manufacturing sectors (Figure 1.4, Panel A). Regionally, the province of Ontario, which has a large auto manufacturing sector, absorbed a disproportionate share of the losses. It is clear that manufacturing employment had been on a downward trend for years even before the recession, and this trend will likely continue, so manufacturing employment may get back to the pre-crisis trend but not its pre-crisis level (Figure 1.4, Panel B). The employment shift out of manufacturing is consistent with trend real exchange rate appreciation and will eventually have to be compensated by jobs in other sectors if the economy is to get back to full employment. This shift indeed seems to be happening.

[FIGURE 1.4 OMITTED]

The federal government took some exceptional policy measures to offset the economic and social consequences of rapid job dislocation. One such measure was to extend the length of work-sharing agreements, first by 14 weeks, to a maximum of 52 weeks, and subsequently by a further 26 weeks to a maximum of 78 weeks. Work-sharing avoids layoffs by offering Employment Insurance income benefits to qualifying workers willing to work a reduced work week while their employer recovers. Another measure was to increase the maximum number of weeks a claimant can receive Employment Insurance benefits, a change designed to keep individuals active in the labour market to alleviate the discouraged-worker effect and raise the participation rate (Johansson, 2002). The risk is that the longer benefit period will encourage some to stay unemployed longer than otherwise, which can lead to a deterioration of skills and higher long-term unemployment. While five weeks is a not a huge change, there is likely to be political pressures to extend the eligibility period or to make the new parameters permanent. Since the labour market has been recovering at a good pace, the federal government should resist such political pressures and let these exceptional measures expire as planned in September 2010.

Employment has been on an upward trend since July 2009, adding 403 000 jobs between then and June 2010. This gain offsets nearly all the sharp cumulative drop of 417 000 jobs from peak to trough. However, due to a large increase in the labour force, the unemployment rate only inched down to just below 8% (see Figure 1.10, Panel B below). Even if the economy keeps adding jobs at a pace of around 25 000 a month, which is the average rate of job gains during the 2003-to-2008 jobs boom, continued growth of the labour force means that it will take some more time for the unemployment rate to return to pre-crisis levels. In fact, the unemployment rate is projected to keep falling at a modest pace and reach 7% by the end of 2011, still much higher than the 6.2% rate of October 2008, though the rate is estimated to have been modestly below its sustainable level at that point. In any case, wage inflation is projected to remain subdued for the foreseeable future.

The housing market has re-inflated but is expected to cool down soon

The cycle in Canada's housing market is different from its US counterpart, and the downturn following the crisis was short lived and not severe. Prices soon resumed their upward trend and topped their pre-crisis peak (Figure 1.5). The main reasons why Canadian households have been able to bid up the price of existing homes even in this depressed economic environment are fourfold. First, Canadian households entered the recession relatively less indebted than their US counterparts. Many households were thus still in a position to take on additional debt. Second, they had access to a relatively healthy banking sector still willing to extend credit and at very favourable mortgage rates (see below). Household credit growth remained above its historical rate of growth through the worst of the recession (see Figure 1.2, Panel A above). And though long-term rates decreased far less than their short-term counterparts as the Bank of Canada eased monetary policy, they still dropped significantly, taking mortgage rates down as well (Figure 1.6, Panel A). Third, as part of its fiscal stimulus measures, the federal government gave a tax credit to first-time home buyers and purchased mortgages from banks to encourage new lending. And fourth, subprime mortgages never made up more than 5% of new issuance, compared with 33% in the United States at the peak. As a result, mortgage delinquencies have picked up only slightly compared to the sharp increase in the United States (Figure 1.6, Panel B).

The V-shaped pattern of real house prices during the economic crisis happened at a historically high price level (Figure 1.5). Real house prices had generally been increasing along with the price-to-income ratio since the late 1990s until June 2008 when the average resale home price started falling year over year for the first time in more than nine years, but only for a brief period. The result of these trends is that Canadian house prices, or at least some regional or local housing markets, notably those of Toronto and Vancouver, may still reflect excess-demand conditions. The price of an average home recently reached five times average household after-tax income, which is 35% higher than the long-term average of 3.7 (Sauve, 2010). One factor that may have fuelled the sustained appreciation is relatively loose monetary policy over the 2000s, though this hypothesis is controversial (Box 1.2). On the other hand, some studies suggest that the sustained house-price appreciation represented a catching up of prices with their long-term determinants and that they are now broadly in line with fundamentals (Tsounta, 2009).

[FIGURE 1.5 OMITTED]

[FIGURE 1.6 OMITTED]
Box 1.2. The Taylor rule and house prices

A Taylor-rule calculation begs the question as to whether the long
period of relatively loose monetary policy over the 2000s may have
contributed to the long sustained increase in house prices during
this decade. OECD research has found that conventional monetary
easing, when interest rates are brought well below Taylor rates and
are maintained there for an extended period of time, is frequently
followed by the build-up of financial imbalances in housing markets
(Ahrend, Cournede and Price, 2008). Had monetary policy reaction
functions followed a traditional Taylor rule based on the output
gap and inflation with standard weights, short-term interest rates
would indeed have been kept higher through most of the 2000s in
both the United States and Canada (Sutherland et al., 2010). To
illustrate for the case of Canada, Figure 1.7 compares the actual
Bank of Canada policy interest rate at a monthly frequency with the
rate determined by the following Taylor rule:

[sub.i]Taylor = 2.5 + [[pi].sup.[epsilon]] + 0.5 x GAP + 2 x ([pi]
- 2)

where 2.5 is assumed to be the real neutral interest rate, *
[[pi].sup.[epsilon]] is expected long-term inflation calculated as
the ratio between the long-term Government of Canada benchmark bond
yield and the yield on the long-term real return bond, GAP is the
estimated output gap in the latest OECD Economic Outlook
interpolated to a monthly frequency, and [pi] is the 12-month
change in the core consumer price index, the term in parentheses
representing the deviation between observed core inflation and the
mid-point of the Bank of Canada's inflation control range (2%). At
a zero output gap and with current inflation and long-term
inflation expectations stabilised at 2%, the neutral policy
interest rate given by this Taylor rule is 4.5%, consistent with
that used in the OECD Economic Outlook. The reaction function's
sensitivity parameters with respect to deviations in inflation (2)
and to the output gap (0.5) are standard in the economic literature
and reflect the relatively high weight that an inflation-targeting
central bank like the Bank of Canada would put on inflation, but
using other common values would not affect the qualitative results.

[FIGURE 1.7 OMITTED]

While the correlation is only suggestive, the time during which the
Bank of Canada maintained its policy rate significantly below the
Taylor-rule rate for an extended period lines up perfectly with the
period of sustained real house price appreciation over the last
decade (see Figure 1.5 above for house prices). It must however be
noted that from 2002 to 2008, monetary conditions were tightening
due to the sustained Canadian-dollar appreciation.

* For comparison, the Bank of Canada's latest quarterly projection
model (Terms-of-Trade Economic Model or ToTEM) uses a higher real
neutral interest rate of 3.2%(Murchison and Rennison, 2006).


Whatever the causes of the appreciation in house prices, in view of recent trends and the factors underlying them, it is reasonable to expect that house prices will come under downward pressure in the near future. First, mortgage rates are likely to rise as the policy rate is normalised. Canadian mortgage rates are typically reset every few years, so people who bought houses after short-term interest rates came down in response to the economic crisis will soon see rate increases. Second, like other OECD countries, Canada is probably entering a fairly long period of relatively slow household income growth, which will curtail housing investment. And, third, the supply of new housing appears to be catching up to demand, which should eventually slow or even depress prices for existing homes. Canadian housing starts were very strong through the second half of 2009 and early 2010, though the construction and renovation market is now cooling down. The market has almost certainly been boosted by the rush to beat the new harmonised sales taxes in Ontario and British Columbia, which came into effect on 1 July 2010, raising the price of new homes as well as that of resale transactions in these two provinces. Adjustments to the mortgage insurance guarantee framework that came into force in April 2010 are also likely to have boosted the housing market as home buyers pushed to beat them before they took effect.

Policy measures were taken to slow the mortgage market

Indeed, policy measures have appropriately been taken to cool down the mortgage market, and more measures could still be taken if these do not turn out to be sufficient. In Canada, the federal government provides financial guarantees for the provision of default insurance on high-leverage mortgages, that is, mortgage loans at 80% or greater of the value of the property. The insurance is provided by the Canadian Mortgage and Housing Corporation (CMHC), which has a 100% guarantee from the federal government on the insured mortgages, or by private insurers, which have a 90% guarantee from the federal government (see further below). These guarantees come with certain conditions, which can be changed over time. (3) In February 2010, the federal government adjusted the rules to qualify for government-backed insured mortgages as follows:

* Require that all borrowers meet the standards for a five-year fixed-rate mortgage even if they choose a mortgage with a lower interest rate and shorter term. This initiative will help home buyers prepare for higher interest rates in the future.

* Lower the maximum amount Canadians can withdraw in refinancing their mortgages to 90% from 95% of the value of their homes. This will help ensure home ownership is a more effective way to save.

* Require a minimum down payment of 20% for government-backed mortgage insurance on non-owner-occupied properties.

The government could require banks to show the sensitivity of mortgage payments to interest-rate increases; some banks have already started to provide information along these lines. It could also require larger down payments for all federally insured mortgages, not only those for non-owner-occupied properties. The recent global crisis has shown the importance of housing-market bubbles and busts for broader economic activity. Lending standards and the framework for mortgage insurance are the right tools to contain this cycle.

The Canada-US exchange rate has fluctuated a great deal

Given the Canadian economy's large exposure to the United States--about three quarters of Canadian exports go to the United States--bilateral movements in the exchange rate can have substantial impacts. The exchange rate has fluctuated significantly in recent times, practically in tandem with commodity prices (Figure 1.8). Relative public debt-to-GDP ratios also affect the Canada-US real exchange rate, with a fall in the Canadian ratio relative to the US driving up the exchange rate. Commodity prices and relative debt-to-GDP ratios together explain about 46% of the long-run variance in the Canada-US real exchange rate, with Canada-specific factors accounting for the remaining 54% and interest-rate differentials being important in the short run (Cayen et al., 2010). As regards the long period of general appreciation between 2002 and 2007, these two factors together explain more than 60% of the increase in the Canada-US real exchange rate, each with an equal share. Since 2007, the Canadian currency has reached and then breached parity with the US dollar for the first time since 1976, then depreciated by about 20%, and then strengthened all the way back to US-dollar parity again, hovering near this level since April 2010. It is clear, therefore, that Canada's flexible-exchange-rate regime acts as an important shock absorber for the country's economy, though exchange-rate volatility does create uncertainty for trade-intensive industries and regions. However, the exchange rate in itself is, rightly, not a focus of monetary policy. The Bank of Canada keeps a close eye on exchange-rate gyrations, and, consistent with its mandate, focuses on them only to the extent they affect the outlook for consumer price inflation.

[FIGURE 1.8 OMITTED]

Canada is not a significant contributor to global saving-investment imbalances

Throughout the last 30 years, Canada's overall net borrowing or net lending from the rest of the world has never been extreme, and as such the country has never been an important contributor to the much-discussed global imbalances that played a role in the economic crisis (e.g. Obstfeld and Rogoff, 2009). In terms of saving, up until the start of the recession the government and corporate sectors' net saving more than compensated for personal sector net borrowing, and the country had moved from a small net borrowing position relative to the rest of the world in most of the 1980s and early 1990s to a small net lending position (Figure 1.9). Recently, however, the situation has turned around. With the government's fiscal position rapidly deteriorating in 2008 and 2009, the government sector has become a net borrower again for the first time in more than a decade, bringing the domestic sector as a whole into a small net borrowing position. In terms of stocks, total public- and private-sector debt as a proportion of GDP was lower in Canada before the crisis and in early 2009 than in any other G7 country (McKinsey Global Institute, 2010). Since the early 1990s and leading up to the financial crisis, this proportion had been stable in Canada at roughly 220% of GDP, unlike for all other G7 countries where it had generally been rising, reaching over 400% of GDP in the United Kingdom and Japan. The foreign-owned share of total debt was also lower in Canada (14%) than in every other G7 country, except Japan (7%). Overall, this saving-investment-balance analysis reveals no serious vulnerability, though, as pointed out earlier, a non-negligible share of households will be vulnerable to rising interest rates, given their high indebtedness.

A falling trade surplus and weakening commodity markets throughout the recession led the current account balance to turn negative in 2009 for the first time in 11 years. Commodity prices have now reversed some of their decline, and global demand is recovering, helping to bring about a reduction of the deficit in 2010, but the current account balance is projected to remain in deficit in the short term. The strong currency (relative to the US dollar) will make exports less competitive, boost foreign tourism by Canadians and discourage foreign travellers from visiting Canada. Despite the recovery, demand from the United States will also remain relatively weak in level terms. The aging of the population will put further downward pressure on personal saving rates, as pensioners draw down assets to pay for current consumption rather than save out of current income. Nonetheless, over the long term, Canada is not expected to remain a net borrower from the rest of the world. If governments can gradually return to balanced budgets, and with many countries such as China expected to become increasingly important buyers of Canadian natural resources, Canada is expected to return to being a net exporter and a net lender to the rest of the world.

[FIGURE 1.9 OMITTED]

Monetary policy needs to withdraw extraordinary stimulus

Headline inflation has been muted, but core measures have been surprisingly strong

Headline inflation has been quite muted against the backdrop of substantial slack in the economy (Figure 1.10, Panel A). Consumer prices fell in year-on-year terms between June and September 2009, but this was largely attributable to fluctuations in world energy prices. Prices started to rise again late in 2009 as the base effect from high commodity prices in 2008 started to fade. Core inflation has surprised on the upside through the recession, however, in part the result of a slower-than-anticipated deceleration in wages despite the large amount of excess supply. It remains to be seen whether this is due to firm anchoring of inflation expectations or to stronger price and/or wage rigidities at very low inflation rates.

The high unemployment rate will largely contain wage pressures, and producer pricing power should remain weak for a while (Figure 1.10, Panel B). The renewed strength of the Canadian dollar will also dampen inflation. As a result, core inflation is projected to remain muted for some time. Headline inflation will pick up temporarily in the middle of 2010 and again in early 2011 due to sales tax changes. Ontario and British Columbia are introducing their Harmonised Sales Taxes (HSTs) on 1 July 2010--switching to such a tax increases the price of many services by including them in the tax base--and Nova Scotia is raising its HST rate on the same date. Quebec is raising its sales tax rate on 1 January 2011. Nevertheless, both headline and core inflation are projected to remain comfortably below 2% over the course of 2011, taking into account a gradual, steady tightening of monetary policy by the Bank of Canada from the middle of 2010.

[FIGURE 1.10 OMITTED]

The Bank of Canada's exit strategy is relatively straightforward

The impact of unprecedented monetary policy measures on the size of the Bank of Canada's balance sheet was relatively small compared to actions in other countries. During the global financial crisis, the extraordinary liquidity provided by the Bank peaked at roughly CAD 40 billion in December 2008, or about 80% of the average size of its balance sheet over the pre-crisis period. By December 2009, the size of the monetary base in Canada was roughly 25% larger than it was in the pre-crisis period. The comparable figure was 150% in the United States and over 200% in the United Kingdom (Minegishi and Cournede, 2010). That is partly because the Bank of Canada took fewer and smaller exceptional steps than many other central banks--for instance, it did not purchase long-term assets outright from the private sector--and partly because it sterilised most of the expansionary effect of extra liquidity provision on the monetary base through an increase in government deposits and through the sale of Treasury bills. As a result, the Bank's strategy to withdraw excess liquidity from the money market has been relatively straightforward. It has relied on automatic reductions of its balance sheet by letting previously accumulated positions mature.

The Bank's current monetary stance is still extremely expansionary. Thanks to the Bank's history of focusing on the inflation target, expectations for inflation have remained within the 1-3% control range throughout the financial crisis, so the real Treasury bill rate has averaged around -1.75% over the past year. By any standard, this is an enormous amount of monetary stimulus. In addition, low interest rates have been effective at stimulating credit growth because of a relatively healthy banking system. If the economy continues to recover along the path currently projected, then the output gap will shrink to the point where such an exceptionally accommodative monetary policy is no longer appropriate. The latest OECD Economic Outlook estimates that the (negative) output gap is in the 3-3.5% range as of mid-2010 and projects that it will narrow to the 1-1.5% range at the end of 2011. Based on these figures, on projections of trend growth over the medium term, and on a scenario of continued moderate expansion after 2011, the output gap would be expected to close around the last quarter of 2012. Accordingly, gradual normalisation of the policy rate, following the first rate increase in June 2010, would be desirable. Of course, this assessment will be revised in the light of incoming economic data. The Bank could pause the tightening cycle at any time if the projected strength of the recovery does not materialise and inflation sags, or accelerate it in the opposite scenario.

Several factors militate for a moderate normalisation pace. First, the confidence bands around the economic projection are unusually large, and the sustainability of the recovery is still in some doubt. Indeed, the Bank has warned that risks to the global recovery and financial markets have intensified since end-2009, reflecting factors such as the European sovereign debt crisis and persisting global imbalances (Bank of Canada, 2010). In this context of uncertainty, it makes more sense to err on the side of caution and risk a little more inflation than to tighten too soon and risk taking momentum out of the recovery. Second, the expiration of temporary stimulus measures in late 2010 and through 2011 and the beginning of fiscal consolidation at both the federal and provincial levels will already take some of the steam out of the recovery and reduce inflation pressures in industries (such as construction) that benefited from stimulus spending. Moreover, the speed of monetary tightening must take into account the synchronicity of exit measures, both fiscal and monetary, around the world. Third, given weak consumer fundamentals--a record-high household debt ratio, a loss of net worth and relatively soft income growth--and the likely fall of house prices ahead, even a moderate monetary squeeze should be sufficient to drive a material deceleration in consumer spending. And, fourth, the strength of the Canadian dollar already provides some considerable effective tightening to financial conditions.

The current inflation-targeting agreement should be renewed without change

In November 2006, the Bank of Canada and the federal government renewed their joint inflation-targeting agreement for another five years. At the same time, the Bank launched a concerted research programme regarding the costs and benefits of an inflation target lower than 2%, and the costs and benefits of replacing the current inflation target with a longer-term price-level target. The Bank has been carrying out internal research and encouraging external research on these questions to prepare for the next renewal of the inflation-targeting agreement at the end of 2011. The 2008 OECD Economic Survey of Canada argued on the basis of research available at the time that the current regime had yielded significant benefits to the Canadian economy, and that no compelling argument supported the view that changes to the current inflation-targeting regime would generate benefits that would outweigh the possible costs of getting the new policy wrong, or undermining the credibility that the Bank has accumulated over the past two decades under the current regime. It also argued that further research was necessary to make an informed decision in 2011.

Reviewing existing research with the benefit of one more year of studies, (4) Amano, Carter and Coletti (2009) conclude that an inflation target below 2% is likely preferable to the status quo, though it is unclear how much lower policy makers should aim nor how much Canadians would benefit from a shift. Their evidence suggests that lowering the mid-point of the inflation target range, say from 2% to 1%, would be unlikely to do much damage, and might offer some economic benefits, while at the same time strengthening the Bank's commitment to price stability. With regard to the price-level target, they find that the evidence is more mixed, with a need for further study concerning: i) the target's influence on contracting behaviour and inflation expectations; ii) strategies for ensuring credibility in the commitment to price-level targeting; and iii) the Canadian economy's vulnerability to shocks that the literature identifies as particularly detrimental to the target's performance. Reviewing the same evidence, former Bank of Canada governor David Dodge concludes that "... there is still no clear evidence that a lower inflation target would yield economic performance significantly better than that achieved with the 2% target, although there are some indications that it might do so" (Dodge, 2010). If these two reviews can agree on anything, it is for the need to continue the research programme and attempt to answer the remaining questions before the inflation-targeting agreement has to be renewed. Given that conclusions so far are still tentative, however, it seems unlikely that uncertainty will dissipate and that an evidence base solid enough to convince the authorities to modify the current agreement will be available by mid-2011 when the renewal decision will have to be made. In its absence, the government should probably err on the side of caution and stick with a tried-and-trusted regime to which both central bankers and market participants have adapted well. With governments taking on large amounts of debt, 2011/12 would be a particularly bad time for a significant change in the inflation regime that may upset market expectations.

While the economic crisis has brought back to the fore arguments for a generally higher average rate of inflation, these arguments are not persuasive. One such argument is that higher inflation reduces the risk of hitting the zero lower bound if highly stimulative monetary policy becomes needed. In many countries higher inflation and thus higher nominal interest rates at the beginning of the financial crisis would have made it possible to cut interest rates more, thereby probably reducing the drop in output and the deterioration of fiscal positions, or helping to bring output, employment and inflation more quickly back to steady-state values (Blanchard, Dell'Ariccia and Mauro, 2010). But as noted above, now is not an auspicious time to be destabilising inflation expectations. Moreover, this argument ignores the significant costs that inflation imposes, often on the most vulnerable members of society. Another argument is that high inflation facilitates adjustments in the labour market by making real wages more flexible. With low inflation, getting relative wages right would require that a significant number of workers take wage cuts, an unlikely occurrence given well-documented nominal wage rigidity. In this case, a somewhat higher inflation rate would lead to lower unemployment, not just temporarily, but on a sustained basis (Akerlof, Dickens and Perry, 2000). However, the available evidence suggests that this is not the case for Canada.

The global financial crisis has also raised a number of questions about the conduct of monetary policy with regards to financial-market developments. For instance, the crisis has reopened the debate on what to do in the presence of asset-price booms and increases in leverage. Co-ordinating the actions of the central bank and of the regulator is another matter for reflexion. The crisis has provided examples from many countries of the difficult co-ordination between separate agencies, which has led to a debate about the pre-crisis trend toward separation of monetary and regulatory authorities. No consensus seems to have emerged in either of these debates. Regarding the second one, in Canada's case, the absence of co-ordination failures between different agencies and the seemingly good processes in place for sharing information argue once again against trying to fix what does not appear to be broken.

In the medium term, trend output growth will slow

Recent empirical work suggests that economic downturns tend to result in sizeable and permanent output losses, and that such losses generally increase when they are associated with financial crises. Furceri and Mourougane (2009) estimate that financial crises permanently lower the level of potential output by 1.5% to 2.4% on average for OECD countries, and by up to 4% for severe crises, and some other studies estimate even larger effects. (5) Forward-looking OECD work estimates that the level of potential output in Canada as a whole may be 3.5% lower than it would have been over the medium term without the recent economic crisis, with most of the decline due to a higher cost of capital (OECD, 2010c). The second-largest adjustment to potential stems from the discouraged-worker effect on the participation rate. Severe downturns--where the change in the output gap is at least six percentage points from peak to trough--have statistically and economically significant adverse effects on labour-force participation that more moderate downturns do not. Canada is estimated to have had just such a downturn, from a peak output gap of 1.2% in 2007Q2 to a trough of -5.9% in 2009Q3, for a total change of seven percentage points (OECD, 2010a). A severe downturn typically reduces the aggregate labour-force participation rate by about 1.5 percentage points five years after the preceding cyclical high, with the effect concentrated on younger and older age groups.

The OECD Economic Outlook 87 medium-term baseline projects that Canada-wide potential real GDP will grow at a 1.6% average annual rate from 2010 to 2017, more than a full percentage point less than over the 1998-to-2008 decade (OECD, 2010a). (6) This projection takes into account the estimated likely effects of the crisis on the level of potential output, but it reflects primarily a slowdown in the growth of the working-age population that was projected to occur even without the crisis. Using an approach similar to that used in the OECD Economic Outlook to project potential output growth by province in a way consistent with the Outlook's country-wide projection reveals that potential output growth is expected to slow in every province (Table 1.2). (7) And since the just-mentioned demographic trend is more pronounced in Quebec and in eastern provinces than in the west, trend GDP growth rates are expected to slow more significantly east of Ontario. Projected differences between the levels of potential GDP in 2017 relative to their pre-crisis trends again take into account both the level effect of the crisis on potential output and the growth effect of demographic trends. In the two largest provinces (Ontario and Quebec) and all the eastern provinces the level of potential GDP in 2017 is projected to be 10% or more below its pre-crisis trend.

The long period over which the possible negative effect of the crisis on labour-force participation would occur means that there is still time for policy to at least partly offset it. The size of the effect indeed depends on institutional factors that affect the degree of labour-market flexibility, such as the structure of benefit replacement when workers lose their jobs. In this regard, the long-standing OECD recommendation that the federal government reform the Employment Insurance programme to eliminate automatic variations in eligibility and benefits according to labour-market conditions appears especially timely as these features reduce labour mobility across regions. More generally, the projected slowdown in the trend rate of growth in most provinces underlines the importance of carrying on with structural policy reforms that can boost the economy's potential rate of growth. To their credit, even during the crisis, Canadian governments carried through with structural reforms. Important recent pro-growth reforms include tax reductions (continued gradual elimination of federal and provincial capital taxes), the relaxing of restrictions on foreign ownership (on Canadian broadcasting satellites), the harmonisation of some provincial retail sales taxes with the federal value-added tax (Ontario and British Columbia), the introduction of a new tax-free savings account, and the elimination of all remaining tariffs on imported capital goods. The latter initiative is particularly noteworthy in light of the feared resurgence of protectionist instincts during the crisis. Annex 1.A1 reviews recent progress in implementing structural policy recommendations from past Surveys. The OECD places a high priority as well on the quality of growth, particularly in the dimensions of environmental cleanliness ("green growth") and social fairness, to make it strong on a sustainable, long-run basis. Box 1.3 discusses progress in the critical area of policies to address climate change.
Box 1.3. Canada's climate-change policy

A greenhouse-gas (GHG) emissions-intensive economy. Canada is among
the most resource-rich countries of the OECD, particularly in
energy raw materials such as crude oil, bitumen, natural gas, coal
and uranium. It is also the OECD's largest energy exporter, with
the United States its main foreign market. The extraction
industries are relatively more carbon intensive than in competitor
countries, in part reflecting the rising weight of Alberta's
northern oil-sands fields, estimated to be the second largest
petroleum reserves in the world. The current processes by which
bitumen (tar) is extracted from the sand or clay and then processed
into synthetic crude is exceptionally intensive in the use of gas
and water. High oil prices have made the development of oil sands
extremely profitable. The sector has been growing rapidly and is an
important source of income and employment generation for Canada,
but at a high environmental cost. By 2008, GHG emissions were 24%
above 1990 levels, compared with Canada's Kyoto commitment to cut
them by 6%, although less than 10% of the increase is attributable
to oil-sands development.

Energy is used primarily for transport, electricity generation and
heating (residential, commercial and industrial processes).
Moderate fuel excise taxes, though not as low as in the United
States, make transport carbon intensive relative to OECD countries
in Europe. A significant share of manufacturing industries is
resource based and energy intensive (e.g. aluminium smelting and
cement) and therefore carbon intensive in international comparative
terms. Electricity generation is relatively "clean" on the other
hand, with 75% produced from non-emitting sources, notably hydro
and nuclear energy. As a consequence the household sector exhibits
relatively low emission intensity despite the severe climate. In
summary, most Canadian industries are slightly less carbon
intensive than their international counterparts, but the
energy-intensive industries are more so, and they have a relatively
high economic weight, rendering the Canadian economy the most
carbon intensive in the OECD apart from Australia and New Zealand
(Figure 1.11), and Canada is the fourth-largest emitter of GHGs in
the OECD, after the United States, Japan and Germany.

Political economy. The federal and provincial governments are fully
cognisant of the need to develop resources in an environmentally
responsible manner. In its 2007 environmental strategy document,
Turning the Comer, the federal government put forward the objective
of cutting 2006-level emissions by 20% by 2020 and 50% by 2050,
moving away from the (unrealistic) commitment made by a previous
government in Kyoto. Public opinion supports green growth in
principle, though its willingness to pay has wavered in the wake of
the economic downturn and in reaction to doubts aired by
climate-change sceptics. In the federal and provincial elections in
late 2008, the parties that had the most ambitious climate-change
policies invariably lost. In 2009, the changed economic environment
and increased likelihood of comprehensive climate change policy in
the United States, combined with the recognition of the
inextricable linkages between the Canadian and US economies, led
the federal government to harmonise policy with the United States.
The new US administration is committed to passing climate-change
legislation, though it faces major hurdles in Congress. Some
sector-specific regulations, e.g. car emissions standards, will in
the meantime be jointly implemented by the two governments. At the
Copenhagen climate-change conference, Canada aligned its commitment
with the United States, i.e. to reduce GHG emissions by 17% below
2005 levels by 2020, but has yet to lay out a plan on how this will
be achieved. While the reasoning underlying the Government of
Canada's policy shift to harmonise with the United States has been
generally understood and accepted by many Canadians, it sends a
confusing and perhaps negative signal to Canada's other
industrialised partners (IEA, 2010). US environmental groups have
called for sanctions on oil-sands ("dirty oil") imports from
Canada.

Federalism issues. According to the Constitution, provinces own the
resources on their land and have a major say in resource
management, though federal powers are granted with respect to
international agreements and national strategic interests.
Provinces differ greatly in GHG-emissions intensities, with
energy-rich Alberta and Saskatchewan being among the most
intensive, and Quebec the least. Given their constitutional role in
resource management and electricity generation and partly in
response to a perceived lack of leadership from the federal
government, a number of provinces are implementing noteworthy and
progressive policies, e.g.: Ontario's feed-in tariffs for renewable
electricity; British Columbia's and Quebec's (initially modest)
carbon taxes; Alberta's CAD 2 billion carbon capture and storage
(CCS) fund; and the Western Climate Initiative, a collaboration of
seven US states and four Canadian provinces (though not including
fossil-fuel-dependent Alberta and Saskatchewan) working to develop
an integrated emissions-trading scheme. In 2009, Alberta
substantially raised its resource royalties to reduce the net
subsidisation of fossil fuels (as recommended in OECD, 2008,
Chapter 4), although more recently, in response to competitive
pressure from neighbouring provinces, it sharply cut royalty rates
for costly non-conventional gas extraction and development, and
significantly reduced maximum rates for conventional oil and gas as
well. It will be important that the federal government regain the
initiative in matters related to climate change (IEA, 2010). It
should provide leadership and facilitate dialogue with provinces
and territories to achieve a clear, harmonised Canadian
climate-change policy.

Innovation. Federal and provincial policies to cut GHG emissions
still rest heavily on regulation and incentives to support
technological innovation in the fields of renewable energy, energy
efficiency and carbon storage. The federal government has set an
objective that 90 per cent of Canada's electricity needs be
provided by non-emitting sources such as hydro, nuclear, clean coal
or wind power by 2020 and provinces have followed suit with
supporting policies. The federal government has proposed regulation
that will require five per cent renewable content of gasoline
(biofuels) by 2010. Since 2006, the Government of Canada has
invested more than CAD 10 billion to reduce greenhouse gas
emissions and build a more sustainable environment through
investments in green infrastructure, energy efficiency and
clean-energy technologies. Some CAD 2.3 billion of this spending
supports biofuels where the returns in terms of GHG-emissions
reductions are low relative to energy-efficiency measures or other
renewable-energy generation, especially once account is taken of
the GHG impacts of land clearing and the use of nitrous fertilisers
for crops (nitrous oxide is 300 times more harmful to the
environment than C[O.sub.2]). Upward pressure on food prices is yet
another hidden cost. Conversely, in areas where the potential for
emissions reductions is high and cost effective, e.g. solar, wind
or biomass, incentives have generally been more modest. One study
concludes that the cost per tonne of GHG emissions saved is CAD
300-450 for ethanol, versus CAD 20-50 for retrofits and renewable
energies (Samson and Stamler, 2009). This suggests huge waste in
the form of a new type of agricultural support. It would be much
more efficient to give a fixed bounty for each tonne of GHG
emissions saved, allowing producers to find the least-cost
solution. Better yet would be to eliminate such subsidies and
rather price emissions (see below). Governments are also investing
heavily in CCS technology to reduce GHG emissions. While
commendable, capturing and storing carbon does not mitigate
behaviours at the source of emissions; rather it only attempts to
control damage. It will be important to diversify funding, given
high uncertainty around the success and the commercial viability of
any given technology. Finally, there should be a focus on
translating substantial R&D funding and support into commercial
applications (and productivity growth).

The need for market instruments to price carbon. Numerous studies
have shown that by far the most efficient way to achieve
GHG-emissions reductions, i.e. at least cost to the economy, is to
set a price on carbon by means of market instruments, either a
carbon tax or trading in emissions permits, supplemented by a cap
on emissions, price floors and ceilings, and banking (trading
through time). About 80% of the Canadian economy is sufficiently
price sensitive to be amenable to permit trading. The remaining 20%
would continue to reach objectives via regulation. One study (by
M.K. Jaccard and Associates for the Pembina Institute and David
Suzuki Foundation, 2009) has assumed that in order to meet its
(former) target of reducing emissions by 20% from 2006 levels by
2020, the government implements a trading scheme immediately (by
2011) and lets the effective carbon price rise to CAD 100 per tonne
of C[O.sub.2]-equivalent by 2020 (to CAD 200 in order to reach the
more ambitious target of a 25% cut from 1990 levels as advocated by
environmental groups). Revenues from carbon trading and taxes would
reach CAD 46 (71) billion per year by 2020, of which around CAD 3
(6) billion would be needed to buy offsets abroad to reach domestic
targets. The remaining revenues would be split about evenly between
reduction of income taxes and a broad range of public policies.
Economic growth would suffer but job losses in carbon-intensive
sectors would be more than compensated by new jobs elsewhere, and a
large transfer of wealth from Alberta and Saskatchewan to the other
provinces would occur--wherein lies the crux of the political
challenge. OECD (2009b) analysis, using a dynamic global model,
finds substantially lower carbon prices for such policies, however:
33 USD/tC[O.sub.2]-equivalent to meet the target of -20% from 2006.
The OECD analysis also notes the challenge Canada faces as one of
the five countries or regions worldwide with the highest cost per
tonne of reducing emissions. In any case, without a broadly-based
carbon tax or cap-and-trade system, it will prove difficult for
Canada to achieve its 2020 target, and even if it does, this will
in all likelihood come at a higher--albeit perhaps less
visible--economic cost.

Competitiveness concerns. Market-based carbon policies put an
effective price on carbon emissions by business that if
unilaterally applied might severely cut into Canada's international
competitiveness given its high degree of economic integration with
the United States. Bataille, Dachis and Rivers (2009) find that
Canada would experience some output losses from moving in isolation
(i.e. GDP is forecast to fall by 1.5% in 2020 relative to a
business-as-usual scenario), with impacts concentrated in
energy-intensive sectors, while harmonisation within the OECD would
halve the most severe losses, i.e. those incurred by industrial
minerals (notably cement and lime production); competitiveness
mechanisms like border adjustments and free permits to vulnerable
industries would be largely ineffective and inefficient. The
federal government's intention to link its climate policy with the
possible cap-and-trade system in the United States is
understandable and sensible. However, acting unilaterally would
result in domestic and international credibility gains. In fact,
uncertainty as to future regulation is becoming a major barrier to
investment in nonconventional oil and natural gas industries (IEA,
2010). Canada should thus remain vigilant and not import avoidable
climate-policy uncertainty from its neighbour. Over the medium
term, it should strive to meet efficiency levels comparable to
international best practices.

[FIGURE 1.11 OMITTED]


Financial-market reform is appropriately on the agenda

In the wake of the global financial crisis OECD and other market economies are entering a learning and re-adaptation process, whose point of departure is that current macro policy tools, i.e. conventional monetary and fiscal policies, while highly successful in anchoring inflation and exchange-rate expectations, have not been sufficient to guarantee financial and hence ultimately macroeconomic stability. Notwithstanding the good performance of its banking sector in the crisis, the inter-connectedness of banking systems means that Canada has a stake in developing tools to better target financial stability in a world of intense banking moral hazard. Furthermore, it must avoid the risk that an excessive focus on stability might impair the efficiency and adaptability of the financial system as a driver of productivity growth, and so should continue to encourage contestability in banking and proceed with seeking more efficient public policies in securities markets.

The banking system withstood global shocks remarkably well

Canada's banks emerged from the global financial crisis in relatively good shape. Unlike troubled US and European banks, they did not require injections of public capital, expansions of deposit-insurance limits, or wholesale-funding guarantees. They were able to raise capital from the markets even in the depths of the crisis, which reflected a high degree of market confidence (as well as a need for even more capital to maintain it). More modest losses than incurred by many of the top global banks have pushed Canada's five main banks into the top 15 in North America. As a result of their demonstrated resilience, Canadian banks have earned high regard worldwide, and the Canadian regulatory and supervisory framework is increasingly looked to for good practices in the world's search for a better banking model. For example, a recent IMF (2008) assessment concluded that financial stability in Canada is underpinned by sound macroeconomic policies and strong prudential regulation and supervision, with well-designed arrangements for crisis management and failure resolution. Indeed, a recent survey of enterprise chiefs carried out by the World Economic Forum voted Canadian banks as the most stable in the world.

Traditional banking activities

A conservative banking culture based on more traditional concepts of what banks should do turned out to be a key source of stability in the crisis. A strong retail-deposit base and greater reliance on traditional and well-diversified lending, as opposed to participating heavily in markets for high-return new exotic instruments, limited the banks' exposure to roll-over and market risks and therefore to capital-base erosion in the crisis (Box 1.4). Nevertheless, they still depended heavily (as do banks everywhere) on wholesale funding, for which international markets seized up, and were to that extent vulnerable to cross-border contagion. This in turn necessitated sizeable government intervention in the form of asset purchases, facilities and guarantees to provide term funding, liquidity and improved market access (see above). In particular, the government purchased CAD 69 billion of Canadian government-insured mortgages--a huge support given that the top five Canadian banks have less than CAD 200 billion in equity capital. Following changes to the US GAAP, Canadian authorities also made beneficial changes to the treatment of debt securities in Canadian accounting standards. Continuing strong deposit inflows in the crisis also helped with funding, while a shift of credit demand from businesses toward households further boosted bank capital ratios (given lower risk weights applied to residential mortgages than to corporate loans under the Basel II rules). Though losses from both recession-hit domestic loans and still-deteriorating US-asset holdings may be in the pipeline, robust bank capital positions have lessened the need for deleveraging in Canada, helping to cushion the recession and support the recovery. The banks are now awash in capital, and bank profitability (as elsewhere) is again booming in response to extraordinary macro-policy ease, so that they would seem well poised to meet an expansion of business credit demand when it comes--so long as financial-market uncertainty has diminished sufficiently to justify lower capital buffers.
Box 1.4. Bank balance sheets and riskiness

The composition of bank (consolidated group) balance sheets, as
well as their less transparent off-budget exposures, was a key
factor in determining which banks succumbed to the worst effects of
the 2007-09 financial crisis. Ratnovski and Huang (2009) point to
ample retail depository funding as the key factor behind the
relative resilience of Canadian banks. Based on end-2006 balance
sheets, they measure deposits (including both retail and wholesale)
for the five largest Canadian banks at the internationally high end
of 6S-70% of total assets. However, according to a more refined
breakdown by Northcott, Paulin and White (2009), wholesale funding,
retail deposits and securitisations/repos respectively accounted
for 50%, 30% and 20% of total funding of the major Canadian banks
by end2008. Canadian bank assets were more weighted in stable loans
and less so in securities and derivatives than US and European
banks, though the advantage of Australia's banks in this respect
was greater (Figure 1.12). Canadian authorities adopted a
conservative position on securitisations and did not allow capital
relief on bank purchases of credit default swaps.

Interestingly, Citibank had a very stable funding base as well (50%
deposits, 20% long-term wholesale borrowing and 20%
securitisations/repos), and (unlike European banks) was endowed
with apparently high capital and liquidity ratios. Yet, it suffered
crippling losses in the crisis because the asset side of its
balance sheet was heavily overweight in high-risk
structured-investment vehicles based on non-prime US mortgages
(Blundell-Wignall, Wehinger and Slovik, 2009). Falsely favourable
ratings were given to these assets due to the skewed incentives
faced by rating agencies as clients of the big banks, which
artificially held down their capital requirements and permitted de
facto leverage ratios far in excess of regulatory standards.
Markets vastly underpriced the risks of these products, partly in
anticipation of taxpayer bail-outs in case of trouble, and partly
due to the use of inadequate risk-assessment tools by institutions.
Thus, the big banks could "hedge" these unacknowledged risks quite
cheaply and without much concern for counterparty risk, via
derivatives contracts (e.g. credit default swaps) which, according
to accounting rules, had to be put back on the balance sheet only
in case of losses. Such moral hazard reflected repeated
US-government salvaging actions in the wake of earlier mini-crises,
plus the simple fact that the banking system is essential to the
good functioning and health of the economy (Goodhart, 2010). The
same factors suggest that markets are also the solution to the
problem, as they, unlike regulators, have the resources and
first-hand expertise to find and assess information. All that needs
to change are their incentives, though regulators also will have to
do a better job in eliciting information to help re-establish
confidence in the system. More rigorous accounting with derivatives
exchanges, central counterparties, and/or trade repositories, are
essential components of an enhanced regulatory approach to clarify
how much risk is being transferred and to increase certainty. This
is all the more critical as massive bank bail-outs by a number of
OECD governments have greatly increased moral hazard and therefore
sown the seeds of a potential future crisis.

[FIGURE 1.12 OMITTED]


Rigorous supervision

Conservative risk appetites are to a large extent the product of the prevailing regulatory and structural incentives. A rigorous and credible regulatory and supervisory regime is a very important feature of the Canadian system. This regime is principles rather than rules based (the US system is rules based) and therefore harder to circumvent via accounting or other loophole-seeking strategies. There is a clear demarcation of objectives across the various financial-system regulators to ensure single-minded focus, and minimal compromises with competing objectives, in the pursuit of each target. The Department of Finance is responsible for overall federal financial policy; the Bank of Canada for inflation; the Office of the Superintendent of Financial Institutions (OSFI) for prudential regulation of banks and other financial institutions such as federally regulated insurance companies; the Canada Deposit Insurance Corporation for deposit insurance in federal financial institutions; and the Financial Consumer Agency of Canada for protecting and educating financial consumers by focusing on market-conduct issues (e.g. mortgage and consumer loans).

At the same time, close collaboration among regulators was assured through various collaborative fora at the federal level, notably the Financial Institution Supervisory Committee (FISC). During the crisis, meetings of the FISC were held far more frequently and essentially embodied a macro-prudential approach taking into account systemic risks and regulatory spillovers. Thirteen provincial and territorial securities commissions regulate capital markets, though they do not participate in the FISC. Frequent review of regulatory legislation is intended to make the financial system nimble in adapting to rapidly changing technology and global context. According to recent OECD analysis, the quality of Canadian bank regulation compares favourably with that found in the OECD at large in three key areas: strength of supervisor, depositor protection and liquidity and diversification (Figure 1.13).

Risk-based prudential supervision is conducted by OSFI in an effective way. Canadian bank capital-adequacy requirements are well in excess of the Basel II Tier 1 and 2 standards: 7% and 10%, versus Basel minima of 4% and 8%. The quality of Tier 1 capital is enforced by a 75% minimum common equity (core capital) requirement (though this was reduced to 60% in the crisis). As an effective check on banks' self-assessed (model-based) asset risk weights for purposes of capital adequacy, there is a supplementary ceiling of normally 20 on total leverage. The latter is defined as the ratio of unweighted assets (including some off-balance-sheet items though not derivatives contracts and the like) to total (Tier 1 + Tier 2) capital. There are also limits on concentrated bank exposures. Principles and reliance (trust) seem to have encouraged good risk management as a way of doing business, not as a compliance exercise (Northcott, Paulin and White, 2009). Banks demonstrating sound risk management may be temporarily allowed higher leverage ratios of up to 23. Where the quality of risk management is in question, however, prompt corrective action backed up by sanctions indicates a pro-active approach. Once regulatory limits are breached, sharp penalties are imposed, typically a lower leverage ceiling or higher minimum capital ratio for a number of years. (8) The desire to avoid ever getting into such a position has led the major Canadian banks to hold ample buffers so as to be able to withstand unforeseen shocks. The regulator also promotes a forward-looking approach to loan-loss provisioning, rather than the usual (pro-cyclical) static accounting approach, on a voluntary basis. Significantly, these very methods are being discussed in the G20 reform process as forming part of the new regulatory architecture.

[FIGURE 1.13 OMITTED]

Wider scope of regulation

Another advantage, which in hindsight seems particularly critical, has been a relatively broad scope of regulation. Large Canadian investment dealers have been bank-owned since the early 1990s, and so are subject to prudential regulation as applied to the bank group on a consolidated basis, including all bank subsidiaries in Canada and abroad. There are alternative ways of achieving broad-based supervision, nevertheless. Australian bank groups, for example, are subject to "Chinese walls" between commercial and investment banking activities, allowing for separate regulation tailored to businesses with distinct risk profiles within the group. Both the Canadian and Australian models contrast with those in countries where large "shadow banking systems" were created by highly non-transparent corporate structures, e.g. US bank holding companies that enabled commercial banks to leverage far beyond regulatory limits via off-balance-sheet transactions with unregulated investment-banking arms (so-called double gearing). When the highly leveraged and unstable shadow banking system suffered a run, and material risks transferred back onto commercial-bank balance sheets, the entire bank group ultimately benefited from public guarantees.

Heavy government intervention and efficient tax policy in the mortgage market

Substantial public protections and efficient policies underpin the stability of the mortgage market and hence of the entire financial system. Mortgage debt is not tax deductible (though capital gains on principal homes are exempted from tax) and mortgagors are personally liable for loans, while mortgages with insufficient (normally less than 20%) equity backing must be insured. Mortgage insurance is available from Canada Mortgage and Housing Corporation (CMHC), a Crown corporation, and from private mortgage insurers. (9) Such standards have recently been tightened to forestall housing-market overheating under prolonged monetary-policy ease (see above). Thanks to these policies, households in Canada have smaller mortgages relative to the value of their homes, and the sub-prime loan market is much smaller than in the United States, with rarer housing bubbles, yet the rate of home ownership in the two countries is similar (around 70%). Bank securitisation of mortgage assets is normally undertaken for liquidity rather than risk-transfer purposes (Northcott, Paulin and White, 2009), and such securities are fully guaranteed by the CMHC. Nevertheless, as with any government intervention, there may be distortions. While CMHC, as a government-owned-and-controlled corporation, avoids the exploitation of the government guarantee for private profits that ultimately bankrupted the US mortgage giants Fannie Mae and Freddie Mac (government-sponsored enterprises, or GSEs), the result of public guarantees on a large portion of bank assets (mortgages) is a lower bank risk premium and hence cost of capital--an implicit subsidy to mortgages. A potential downside is contingent liabilities of government through the CMHC, although according to the Canadian government, house prices would have to fall drastically in order for such risks to materialise. The CMHC has recently doubled its reserves (to CAD 1.3 billion), apparently in order to provision for potential losses linked to forthcoming Bank of Canada interest-rate normalisation.

Post-crisis challenges loom large

Macro-prudential (counter-cyclical) regulation

Given the unprecedented magnitude and public costs of the 2007-09 financial crisis, the moral hazards these imply and the increasingly global dimension of bank activity, the Canadian authorities are working closely with the international community (Basel Committee on Banking Supervision of the BIS, Financial Stability Board of the G20, surveillance by the IMF) to reduce interconnected banking-system fragility and therefore systemic national and global risks arising from modern banking activity. They, as others, are also hoping to influence the direction of reform in ways consistent with particular national banking situations and interests.

A principal common objective in the G20/BIS discussions will be to design and implement a "macro-prudential" regulatory approach. Close collaboration among regulators both within and across national borders by means of harmonised policies, information sharing and strategic co-ordination is a vital component of this approach. It would take into account systemic risks posed by banks in the setting of their capital adequacy and other standards, i.e. not just idiosyncratic bank risks as under micro-prudential supervision. This leads naturally to a focus on procyclical bank behaviour under present regulatory settings, i.e. where internal models or ratings used to set risk weights for minimum capital holdings under Basel II are overly influenced by the macro environment, exacerbating the credit cycle. Key proposals would apply to all banking systems, including Canada's, in order to discourage regulatory arbitrage. These are to: raise the quality of Tier 1 capital; expand the risk coverage of capital to trading-book and counterparty-risk exposures; promote the buildup of counter-cyclical capital buffers that can be drawn down in an economic downturn; and introduce harmonised leverage ratios, a global minimum liquidity standard for international banks, and possibly systemic-risk-adjusted capital or liquidity ratios for systemically important banks, prefunded levies on riskier portfolios and penalties on short-term (under 2 years) wholesale funding. (10) Anticipatory (dynamic) provisioning is also being considered, so as to smooth out provisioning, hence capital, over the cycle, as are qualitative standards on liquidity.

While capital and liquidity requirements surely need to better reflect banking risks, potentially large increases in capital requirements could harm bank productivity if they lead to excessive focus on high-quality assets, notably government bonds and mortgages, and end up shutting out credit to smaller and innovative firms that are critical to growth. Moreover, countercyclical capital buffers--built up in the upswing to be drawn down in the ensuing slump--may, on their own, fail to curb the deterioration of loan quality during bubbles and not work well in a future crisis, when markets are likely to demand that more, not less, capital be held. (11) Indeed, an ample capital buffer was by itself not a very good predictor of country vulnerability in the last crisis: a perverse correlation between crisis-induced write-downs and pre-crisis regulatory-capital ratios can be observed (Figure 1.14). By contrast, the leverage ratio (total assets to core capital, a more restrictive definition than used in Canada) was a much better predictor of vulnerability (even though US commercial banks, not shown in the Figure, are likewise subject to leverage ceilings). It may be inferred that the quality of bank capital and of banks' self assessments of asset-risk weights for purposes of the Basel II capital requirements may have been particularly deficient in the case of weak banks and ultimately did not provide much protection under duress, rendering the rules useless.

[FIGURE 1.14 OMITTED]

As Canadian banks held fewer exotic instruments, they were less prone to distortions on the asset side. However, the quality of capital may have been watered down even in Canada. This is suggested by the fact that the draft revised capital-adequacy rules (Basel Committee on Banking Supervision, 2009) would cut Canadian banks' Tier 1 capital ratios nearly in half due to stricter requirements for core capital. This would force the banks to raise much more capital, cutting severely into their profitability if the recommendations were to be adopted. Canada's banks find this result particularly unfair, given that they were neither the instigators nor the perpetrators of the crisis, and they have warned of harmful effects on the economy as well. (12) High uncertainty while the proposals are merely being discussed could also cause banks to hold excessive buffers, "just in case", putting a brake on the strength of the recovery, in particular of business investment. Because of such concerns, the G20 has moved toward granting banks longer transitions to the new rules, with greater national flexibility and somewhat less onerous requirements than earlier envisaged. (13)

Market mechanisms to impose discipline on banks

A promising alternative, or at least an important counterweight, to heavy regulation is to rely on market incentives to discipline banks more effectively. As such an approach would harness the knowledge and resources of markets in assessing risks (which, according to its proponents, no government regulator could hope to match), it may be more efficient. A further argument is that regulation is static, whereas markets are dynamic, so that by the time a regulation is developed it may be out of date, or the market will have found ways to circumvent it, e.g. by shifting activity to less-regulated institutions or geographical areas. At its core, the market approach seeks to revert to the classic banking principle, whereby the authorities act as lenders of last resort to illiquid banks, but insolvent banks must be allowed to fail, no matter their size; hence, market mechanisms to encourage banks to self-insure are imperative. By contrast, the regulatory approach accepts the new (post-Lehman) reality that authorities must act as insurers of large insolvent and illiquid banks, but uses regulations to try to stop them from ever becoming insolvent (Goodhart, 2010). (14)

A relatively simple example of the market approach is the issuance of bank insurance bonds. The above-mentioned proposal by international partners to levy a tax on banks in order to pre-fund safety nets has been opposed by the Canadian authorities on the grounds that their banks did not need bail outs. Canada has instead come out in support of the market-based idea of contingent capitals. This is a kind of insurance mechanism whereby banks are required to issue debt which under crisis conditions automatically converts into equity, even in the absence of government intervention. This would give both holders of such debt and shareholders (whose stakes would be diluted under such a conversion) strong incentives to monitor the bank for excessive risk exposure and to provide other observers with a transparent reading on how it is doing in that regard. The main sticking point for such a plan seems to be what the threshold for crisis conditions should be, and who would decide when it is reached without fear of provoking market mayhem.

Another critical aspect of self-insurance is good governance, whereby directors have the motivation and expertise to take into account the long-term health of the bank in their actions, as a check on short-termist executive incentives embedded in compensation structures. In this respect, Canada's bank supervisor has stated that Canada's governance model could be improved by allowing more bankers with experience of real-life banking problems to sit on bank boards, (16) which accords with OECD best practices. The big banks might also be required to draw up living wills (blueprints for orderly wind-downs in case of failure), to make their exits credible. The market approach in other words should rest on a credible threat to make banks, their shareholders and creditors (rather than taxpayers) accountable for losses arising from their own highly profitable activities on the upside.

Research at the OECD has suggested that member countries adopt a non-operating holding company (NOHC) arrangement for their large financial conglomerates, similar to that found in Australia as discussed above: commercial and investment banking arms are strictly separated in their capital structures, with each subject to separate regulation and respective risks made transparent, while still being allowed to share technology, staff and cross-selling to boost the group's efficiency (Blundell-Wignall, Wehinger and Slovik, 2009). Such regulatory firewalling of activities would be an important complement to leverage-ratio restraints (since the same leverage can be respected with a variety of risk positions), by making very clear what capital is available for risky business, to which deposit insurance and other guarantees need not apply. It is in this sense a key, market-based structural reform to tackle "too big to fail" moral hazards in a fundamental way, making living wills and other voluntary solutions redundant. This is actually less radical than some US proposals to revert to Glass-Steagall-type strict separation between commercial and investment banking, as bank conglomerates would continue to exist and enjoy full economies of scale and scope. Nonetheless, banks (including Canadian ones) are expected to oppose such a solution as it cuts into their profitability by raising the cost of capital for high-risk activities.

Competition should be further encouraged

The above reforms to tackle big-bank moral hazard are an essential start to ensuring more vibrant bank contestability, efficiency and competition, so long as they avoid overly constraining banks' productive activities. Some remaining scope for structural improvement in the Canadian financial and capital markets will be considered in this section.

Competition versus stability--is there a trade-off?

The financial system plays a central role in economic growth, ensuring that firms have the financing to grow and innovate, and that capital is channelled to its most productive uses. A competitive banking environment promotes allocative efficiency by facilitating the greatest supply of credit at the lowest price (Northcott, 2004). Boosting sluggish national productivity growth is a major policy goal in Canada, making it important that bank stability does not come at the expense of bank competition and efficiency--as a trade-off is traditionally thought to exist. However, domestic and international evidence suggests that this is not necessarily so. In the banking sector, concentration is not a very good indicator of competition, which itself is very hard to measure. Economies of scale seem to be important in banking, so that concentration with good prudential regulation could be optimal. A degree of market power is furthermore conducive to relationship banking and gives banks incentives to monitor creditors, potentially improving the allocation of credit. Therefore, the goal may be not to eliminate market power but to facilitate an environment that promotes competitive behaviour (contestability) (Northcott, 2004).

The OECD (2010b) has found that strong regulation characterised by credible exit can go some way to ease the trade-off between banking-system stability and competition. This should hold for Canada, given the generally high quality of its regulation, though it is also true that very few Canadian banks have ever failed (compared with hundreds of mostly small bank failures in the United States). It may be that the cosy, if not oligopolistic nature of Canadian banking has enabled high franchise value and therefore profitability without the need for competition based on risky activities. While obviously stable, the contribution to economic efficiency of this banking model could be improved. Indeed, Canada stands out among OECD countries (along with the Czech Republic, Greece, Hungary, Korea, Mexico, Poland, Portugal and Turkey) as showing a clear above-average reliance on competition-adverse prudential regulation (Ahrend, Cournede and Price, 2009, Figure A12). Contestability, as defined by ease of entry and restrictions on ownership, is below the OECD average (Figure 1.13).

Banks and other financial intermediaries

Canada's banking system is highly concentrated: in all, there are 69 banks, of which the five largest own nearly 90% of banking system assets. In the United States, with an economy about 10 times the size of Canada's, there are around 8 000 banks, while the five largest owned only about 20% of total bank assets prior to the crisis. As noted, high concentration creates a suspicion that oligopoly has been the price of stability in Canada. However, empirical studies suggest that the five-bank-dominated system in Canada is monopolistically competitive, rather than collusively oligopolistic, although virtually all OECD banking systems fit this description (Allen and Engert, 2007). This reflects that contestability essentially substitutes for competition in the sector. In Canada, economies of scale and scope and ease of entry are attained by virtually unrestricted flow of investments across provincial borders, and by bank ownership of investment banks and insurance subsidiaries (following liberalisation in the 1990s). Having five national banks competing in any given town is certainly more competitive than having one dominant bank in each town or region. Being well diversified across geographical and product lines likewise provides some protection against economic shocks. The big banks face competition not only from the 64 other domestic and foreign banks but also from 30 independent trust companies and about 1 100 credit unions and caisses populaires (Laidler, 2006). Thus, competition tends to occur at the periphery, within markets and product lines rather than across institutions.

The insurance sector, which is about as concentrated and as large as the banking sector, is more insulated from competition by prohibition on bank sales of non-authorised insurance products (life, property and casualty insurance), recently extended to bank websites, on the argument that banks' superior information about, and close relationships with, their clients could pose unfair competition in the market. Disclosure and transparency can increase bank contestability, for example via credit bureaus, by reducing the information asymmetries that give relationship banking its advantage (Northcott, 2004). External auditing and disclosure, and to a lesser extent accounting and provisioning, are low in Canada (Figure 1.13), impeding this channel of contestability. Also, contestability by the securities market is weak. Indeed, Canada's branch-banking model traditionally had greater lending capacity than US banking, which long suffered from restrictions on branch banking across state lines; to compensate for this deficiency, the United States developed more open and deep capital markets (Bordo, Rockoff and Redish, 1993).

Despite elements of market contestability, the big banks engage in price discrimination which would not be possible without some degree of monopoly power--so that banks capture a share of consumers' surplus, lowering their welfare. Banks' hegemony in retail banking helps to explain higher bank profitability, despite lower asset riskiness, than in comparator countries, even prior to the crisis (at least, after around 2003 when individual price discrimination came into practice; Figure 1.15). Customers are loyal to their banks and tolerate the relatively high margins that banks impose on them. The same could be said for small and medium-sized firms, which depend on local banks for funding, though less so than their US counterparts as family financing is apparently significant in Canada. Big banks exercise much less pricing power with respect to large corporations who have access to international syndicated loans and capital markets, where they can often get better terms than available from domestic banks. The big banks also enjoy a capital-cost advantage vis-a-vis their smaller counterparts in terms of the implicit government guarantee ("too big to fail"). A US-Canada comparative study found that the Canadian reputation for stability confers on banks a cost-of-capital reduction (Bordo, Rockoff and Redish, 1993). High profitability could also reflect extra efficiency, resulting in part from heavy concentration and extensive branching as argued above. However, net interest margins, a common indicator of profitability, are not especially high because of a significant difference between actual and posted lending rates.

[FIGURE 1.15 OMITTED]

All that said, there exist some features of the policy landscape that may, at least potentially, run counter to bank contestability. Canadian banks have maintained in the past that they are prevented from growing to optimal size in order to face international competition, (17) but have been refused permission for proposed mergers. (18) The Minister of Finance makes the final decision on mergers and ensures that all relevant public policy considerations are taken into account and weighed accordingly, which include the views of the Competition Bureau and OSFI. The Minister must consider all matters relevant to the transaction, including the best interests of the financial system. Quite apart from the issue of whether more concentration is advisable on efficiency and/or macro-stability grounds (the latter is debatable in the aftermath of the crisis), this creates uncertainty, which discourages merger proposals from being formulated, much less submitted for approval, removing the discipline that might be imposed by the market for corporate control. Furthermore, despite significantly reduced barriers to foreign entry by the mid-2000s, notably permission of foreign branch banking, the foreign-bank share of deposit taking in Canada has barely grown and is still one of the smallest in the OECD. The remaining barrier seems to be a high minimum-deposit requirement on foreign branches that effectively excludes retail deposit banking. Another barrier to fuller contestability is the "widely-held rule", which prohibits any single entity from owning more than 20% (formerly 10%) of any large Canadian bank. This helps to insulate banks from the discipline that large shareholders are able to exert and from takeover by buyers who might be able to run them more efficiently. The widely-held rule may also discourage foreign entry insofar as likely bidders for Canadian banks may include large foreign (mainly US) financial-services' firms. However, the government's rationale for this rule is that it actually improves shareholder oversight by imposing a high degree of transparency, thereby facilitating market scrutiny of an institution. Information technology (e-banking) could be harnessed more effectively to improve information and contestability. Likewise, the use of external auditors should be increased and accounting rules strengthened, and this may be a likely result of ongoing international reform efforts.

Contestability and therefore efficiency in banking could be further enhanced by relaxing these remaining protective barriers. As in most countries (bar New Zealand), however, there is a potential conflict between the pursuit of domestic policy objectives in financial markets and substantial foreign entry into the banking system. That is, foreign-controlled banks might be less responsive to directives from the central bank to promote stability or transmit monetary policy actions. However, such fears are often overblown and may be not worth paying the price of lost bank efficiency and economic productivity.

Capital markets

Securities. Securities markets are highly fragmented, with 13 provincial and territorial regulators responsible for only loosely co-ordinated supervision. The hodge-podge of regulations, along with serious failures in enforcement, severely limits the desirability of listing in Canada by foreign firms (Laidler, 2006). Domestic firms, by the same token, find it increasingly attractive to list abroad. A single national regulator and enforcement body would greatly increase the attractiveness of listing in Canada by both foreign and domestic firms, helping to deepen the capital market, which is an important source of investment-risk diffusion and financing for firm growth. On 26 May 2010, the Government of Canada released the proposed Canadian Securities Act, marking a key step towards a long-standing commitment to establish a Canadian securities regulator. There has been some difficulty in getting all of the provinces to sign up. This problem could be addressed by devising incentives to help the recalcitrant provinces to come on board along with careful institutional design to give every province an equal say. Once formed, it would be important that the single regulator fully participate in the macro-prudential process.

Small firms have increasingly turned to asset securitisation to raise short-term finance as a convenient alternative to bank loans. The asset-backed commercial-paper (ABCP) market in Canada grew exponentially over the decade to 2007. In late 2007, that market became severely destabilised as a breaking down of confidence in US sub-prime mortgage-backed securities was quickly transmitted across the border. That is, investors holding Canadian ABCP feared (usually erroneously) that they were somehow contaminated by the presence of US sub-prime mortgages in their underlying asset mix. This reaction reflected a lack of transparency and disclosure about the ultimate issuers, mix of assets and their riskiness. Notably, there were no prospectuses, and the ratings given to the paper were suspect: US rating agencies refused to rate Canadian ABCP because of restrictive provisions for liquidity support, so that only a single rating was provided by a Canadian rating agency. In the end, banks chose to provide liquidity to the bank-sponsored portion of the market in order to protect their own reputations. However, the non-bank sponsored portion suffered a CAD 32 billion restructuring, the largest in Canadian history (the Montreal Accord was a 10-year, largely industry-led, restructuring process). It will be important to improve transparency in this market by better disclosure requirements and framework conditions. These reforms have begun, but would doubtlessly gain considerable traction if a national securities regulator were in place, as envisaged under the proposed Canadian Securities Act.

Private equity (venture capital). Canada spends relatively large sums on public R&D support, either directly to universities and research institutions (hospitals) or indirectly to firms via tax credits. The standard of basic research generated by these institutions is world class. Yet, the translation of such funding and research into commercial applications and innovation is puzzlingly weak. One reason appears to be an underdeveloped venture-capital market. The US venture-capital industry is a major source of private-equity funding and associated human capital. It should be looking to invest in Canada due to the attractiveness of its bright ideas, abundant talent and public support. However, Canada's share in the North American venture-capital market--both fund-raising and investments--is far inferior to its economic weight. In the mean time, rising stars such as India, China and Israel are capturing a larger share of that same market. US firms often snap up promising young Canadian firms with bright ideas and strong public support quite cheaply, because for lack of funding the firm was never able to grow to the requisite size for market leadership. These firms often migrate to the United States altogether. Because US and Canadian firms compete with each other in an integrated market, the lack of capital for venture-backed Canadian companies is a serious handicap (Hurwitz and Marett, 2007).

Canada's cross-border tax laws have been cited in surveys as the main impediment to the cross-border flow of private-equity capital. Commentators have typically identified two aspects of Canada's tax system as creating impediments to private equity flows, in particular from the United States: i) the tax treatment of taxable Canadian property, which subjected foreign investors to an onerous administrative procedure in order to benefit from tax-treaty exemptions; and ii) the tax treatment of limited-liability corporations, which were not recognised as tax-paying entities and hence were unable to benefit from the provisions of the treaty at all. However, both these aspects have been addressed in recent policy changes. First, the Fifth Protocol to the Canada-US Tax Treaty, ratified in 2008, introduced rules designed to ensure that income that the residents of one country (the residence country) earn through a hybrid entity (such as a limited liability corporation) will, in certain cases, be treated by the other country (the source country) as having been earned by a resident of the residence country for purposes of the treaty, thereby ensuring that treaty benefits are granted in such cases. Second, Budget 2010 announced a narrowing of the definition of taxable Canadian property under the Income Tax Act, thereby eliminating the need for tax reporting of dispositions by non-residents of many equity investments and bringing Canada's domestic tax rules more in line with its tax treaties and the tax laws of its major trading partners. Stakeholders' reactions to the changes and their potential impact on venture capital flows have been positive.
Box 1.5. Recommendations for stabilisation policies and
financial-market reform

* Continue on the path of tightening, but proceed at a measured
pace, conditional on the effect on inflation of the likely domestic
and worldwide synchronicity in fiscal and monetary tightening
measures, and of persisting global financial risks.

* If it becomes necessary to further restrain the build-up of
mortgage debt, extend tightened access rules for mortgage insurance
to owner-occupied homes.

* Renew the current inflation-targeting agreement without change
when it expires at the end of 2011.

* Fully co-operate with international reforms to improve and
co-ordinate financial=market regulation.

* Balance strengthened bank regulation with market-based incentives
to signal true bank risks and to address the moral hazard of "too
big to fail" (e.g. well-designed contingent capital instruments,
strict capital separation between commercial banks and their
investment bank subsidiaries).

* Enhance banking contestability by considering opening further
avenues for entry, while ensuring that all changes are considered
in a macroprudential context.

* Establish a national securities regulator, as planned, with
strengthened efforts to get all provinces on board.


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Notes

(1.) See Zorn, Wilkins and Engert (2009) for more details on the Bank of Canada's liquidity actions in response to financial-market turmoil.

(2.) Okun's law describes a more or less stable relationship between output growth and unemployment growth over the business cycle.

(3.) Since 2008, amortisation periods have been limited to 35 years and loan insurance is offered only up to 95% of a loan's value. Before then, mortgage insurance was offered on loans worth as much as 100% of the purchase price and amortisation periods as long as 40 years.

(4.) For a summary of the research done until spring 2009 on the desirability of switching to a lower inflation target or to price-level targeting, see the special issue of the Bank of Canada Review at www.bankofcanada.ca/en/review/spring09/review_spring09.pdf.

(5.) See OECD (2010d) for other estimates and references therein.

(6.) Potential real GDP growth is a measure of the sustainable rate of growth of productive capacity. The growth rate of the economy over the long run is determined by its supply-side components, which include working-age population, labour force participation, structural unemployment, the length of the workweek, and labour productivity. Correspondingly, the level of potential GDP trends upward at a relatively steady rate. Real GDP fluctuates around this potential level.

(7.) See Annex 2.A1 in Chapter 2 for an overview of the methodology used to estimate and project potential output by province, and see Guillemette (2010) for more details.

(8.) One widely acknowledged defect of the Basel rules was that the international agreement lacked any system of sanctions to enforce capital rules.

(9.) Private mortgage insurance contracts are a small part of the market and are themselves 90% insured by the CMHC. To make it possible for private insurers to compete effectively with CMHC, the Government also backs private mortgage insurers' obligations to lenders through guarantee agreements that protect lenders in the event of default by the insurer. The Government's backing of private insurers' business that is eligible for the guarantee is subject to a deductible equal to 10% of the original principal amount of the mortgage loan.

(10.) New Zealand has imposed a restriction on the share of short term funding by its banks in wholesale markets. This has been costly for banks but deemed to be highly protective against liquidity risk in the next crisis (Reserve Bank of New Zealand, 2010).

(11.) In Spain, countercyclical buffering in the form of dynamic loan provisioning has been in place since 2000. Spanish banks appeared to have fared much better in the crisis than many of their European counterparts, as they were less exposed to the US subprime market. In part this may reflect that authorities have discouraged off-balance-sheet securitisations, as in Canada. However, dynamic provisioning failed to prevent a housing bubble in the run-up to the crisis (Caprio, 2009). Nonetheless, it is likely to have slowed excessive lending growth in the boom period, while also creating an additional buffer that provided some protection against deteriorating solvency ratios as the bubble unravelled.

(12.) See S.B. Pasternak, "Canada Banks May Be Weakened by Regulatory Reforms, Waugh Says", www.bloomberg.com, 8 April 2010.

(13.) See "Shares bounce as rules are softened", Financial Times, 28 July 2010.

(14.) European officials have tended to push counter-cyclical regulations, along with greater powers to be given to regulatory authorities. The United States has tended very much toward market-insurance mechanisms.

(15.) See J. Dickson, "Protecting banks is best done by market discipline", Financial Times, 9 April 2010.

(16.) See D. Alexander, "Boards Need More Bankers on Boards, Dickson Says", Bloomberg.com, 18 November 2009.

(17.) There is some evidence of economies of scale in Canadian banking that even the largest banks are too small to exploit (Allen and Liu, 2005), though this may be out of date.

(18.) This is the legacy of applications having been made in the 1990s by two pairs of the big banks who each wanted to merge. The banks mishandled the affair, and the Minister ultimately decided to reject the proposal.
ANNEX 1.A1

Progress in structural reform

This annex reviews action taken on recommendations from previous
Surveys. Recommendations that are new in this Survey are listed
in the relevant chapter.

Recommendations                      Action taken since the previous
                                     Survey (June 2008)
BUSINESS TAXATION

Abolish capital taxes as rapidly     The federal government abolished
as possible.                         its capital tax and introduced a
                                     financial incentive to encourage
                                     provinces to eliminate theirs.
                                     All provinces plan to eliminate
                                     their general capital taxes by
                                     2012.

Switch from provincial sales         Ontario and British Columbia are
taxes to value-added taxes (VAT).    eliminating their retail sales
Change tax mix to rely more on       taxes and adopting the federal
VAT and less on less-efficient       Harmonised Sales Tax framework as
income and profit taxes.             of 1 July 2010. As a result, the
                                     proportion of taxable commercial
                                     activity in Canada for which
                                     there is no sales tax on business
                                     inputs will increase to 94%, from
                                     approximately 40%.

Continue to rationalise the          Draft legislation has been
federal and provincial business      released to phase out the
tax preferences (special low         accelerated CCA for oil-sands
rates, accelerated Capital Cost      investment over the 2011-15
Allowances (CCA), deductibility      period. An accelerated CCA
of provincial royalty payments,      treatment will apply to computers
etc.) to sectors like                acquired after 27 January 2009
manufacturing and natural            and before February 2011, and to
resources, and to small-scale,       manufacturing and processing
Canadian-owned firms.                machinery and equipment acquired
                                     after 19 March 2007 and before
                                     2012. Cuts in the general
                                     corporate income tax rate between
                                     2000 and 2012 will result in a
                                     75% fall in the differential
                                     between the general corporate
                                     income tax rate and the small
                                     business rate at the federal
                                     level.

Continue the move toward the         Alberta undertook a natural gas
elimination of the preferential      and conventional oil
federal tax treatment for the        Competitiveness Review in 2009
mining sector. Re-examine the tax    and announced subsequent
treatment of exploration and         adjustments to its royalty system
development costs as well as         in March 2010, substantially
flow-through shares. Review          reducing top rates. Quebec
royalty regimes.                     undertook a review of its Mining
                                     Duties Act in March 2010, which
                                     involved removing some tax
                                     preferences (accelerated
                                     depreciation) and increasing tax
                                     rates.

PERSONAL TAXATION

Target in-work refundable credits    In order to harmonise benefits
on low-income earners while          where possible and to maximise
starting to phase them out           the effectiveness of the Working
earlier and more gradually to        Income Tax Benefit (WITB), a
reduce high Marginal Effective       refundable tax credit that
Tax Rates (METR) at low to middle    supplements the earnings of low-
incomes. Co-ordinate federal and     income workers, the federal
provincial benefit programmes to     government has entered into WITB
avoid excessive METR spiking.        reconfiguration agreements with
                                     four jurisdictions and continues
                                     to make this option available to
                                     all provinces and territories for
                                     2010. The 2009 federal budget
                                     enhanced the tax relief provided
                                     by the WITB. Other tax relief
                                     provided by the federal
                                     government also improved work
                                     incentives for low-income
                                     Canadians.

Eliminate GST zero rating for        No action taken.
basic groceries

Equalise tax across savings          A new Tax-Free Savings Account
instruments, i.e. eliminate          (TFSA) became available as of
targeted tax preferences to          January 2009. Contributions to
qualifying pension plans, and        the TFSA are made out of after-
capital-gains exclusions. Then       tax income, but investment income
tax all savings on an EET            earned in a TFSA is tax-free and
(exempt-exempt-tax) or TEE (tax-     withdrawals are tax-free (TEE
exempt-exempt) basis.                basis). The TFSA complements the
                                     Registered Retirement Savings
                                     Plan (RRSP) (EET basis) and other
                                     savings plans. As the TFSA
                                     programme matures, it is
                                     estimated that over 90% of
                                     Canadians will be able to hold
                                     all their financial assets in
                                     tax-efficient savings vehicles.

PRODUCT-MARKET COMPETITION

Lift restrictions on foreign         Consistent with the
direct investment in airlines,       recommendations of the
telecommunications and               Competition Policy Review Panel,
broadcasting.                        the 2010 federal budget announced
                                     the removal of existing
                                     restrictions on foreign ownership
                                     of Canadian communications
                                     satellites.

Minimise use of industrial           Support to industries adopted as
subsidies, and scale back            part of the Economic Action Plan
business-assistance programmes to    in the 2009 federal budget will
those that address a real market     be wound down as planned in March
failure, ensuring that they do so    2011. Other subsidies remain,
at minimum economic cost.            however.

INNOVATION

Examine whether the efficiency of    The 2010 federal budget announced
the scientific-research and          a comprehensive review of all
experimental-development tax         federal support for research and
credits might be improved.           development to improve its
                                     contribution to innovation.

Eliminate the federal and            Ontario proposed to complete the
provincial tax credits for           phase-out of its tax credit for
investments in Labour-Sponsored      Labour-Sponsored Investment Funds
Venture Capital Corporations.        by 2012.

FISCAL POLICY AND FISCAL FEDERALISM

Pursue efforts for provinces to      No action taken.
grant cities more autonomy to
raise revenue.

Make more use of property taxes      No significant action taken.
and user fees by municipalities,
while easing the property-tax
burden on business. As their tax
base becomes more sustainable,
reduce local authorities'
reliance on provincial transfers.

SOCIAL AND LABOUR-MARKET POLICIES

Ban contractual mandatory            No action taken. The federal
retirement.                          government and New Brunswick
                                     still have no legislation banning
                                     mandatory retirement.

Adopt a more rigorous system of      Summary evaluations of employment
evaluation of active labour-         benefits and support measures
market programmes. Make these        have been completed in all
programmes more effective.           provinces and territories with
                                     results available for 12 of them.
                                     Results for the last are expected
                                     to be available in summer 2010.

Continue developing better           Canada's 2009 Economic Action
procedures for assessing and         Plan provided CAD 50 million over
recognising foreign credentials      two years to support the work of
and tailor training programmes to    governments in addressing
improve immigrants' low levels of    barriers to credentials
literacy and fluency in Canada's     recognition. In November 2009,
official languages.                  the Pan-Canadian Framework for
                                     the Assessment and Recognition of
                                     Foreign Qualifications, a joint
                                     commitment by federal, provincial
                                     and territorial governments, was
                                     announced.

Remove the differential treatment    No known actions taken.
for public funding of for-profit
and non-profit childcare in
provinces where such
differentials still exist.

Make adjustments to Canada           In May 2009, joint stewards of
Pension Plan (CPP) pensions          the CPP unanimously agreed to the
actuarially neutral for workers      gradual restoration of actuarial
between 60 and 65, relax             neutrality to adjustments made to
restrictions on rights'              the CPP retirement benefit when
accumulation and eliminate the       taken early (ages 60-64) or late
stop-work clause.                    (ages 66-70). Other changes
                                     include: removing the work
                                     cessation test; expanding
                                     coverage to those otherwise
                                     eligible to receive retirement
                                     benefits who continue to work or
                                     return to work; and raising the
                                     number of low-earnings years that
                                     can be dropped from the
                                     calculation of the retirement-
                                     benefit amount.

Introduce employer experience        No action taken.
rating into unemployment
insurance, or scale back access
to it for seasonal and temporary
workers.

ENERGY AND ENVIRONMENTAL POLICIES

Consider introduction of a           The federal government currently
(federal) GHG-emissions tax as a     has no plans to introduce an
complement to the                    emissions tax. British Columbia
emissions-trading scheme. Lower      and Quebec have introduced levies
levels of government could also      on fossil fuels.
implement more environmental
excise taxes and congestion
charges.

Regularly review water pricing       Results from surveys and reports
and rights to ensure efficient       show that Canadian municipalities
use. Check that the Albertan         are providing more appropriate
water-allocation and                 market signals, resulting in
licence-transfer processes reach     conservation of water. Water use
conservation objectives while        in the oil-sands areas is
minimising effects on oil-sands      regulated through a system of
developments.                        licensing and monitoring. The
                                     interim Water Management
                                     Framework prescribes when, and
                                     how much, water can be withdrawn
                                     from the Lower Athabasca River
                                     for oil-sands mining. Oil-sands
                                     projects in northern Alberta
                                     recycle up to 90% of the water
                                     used in their operations.

Continue to make more use of         The federal government has
market instruments. Ensure           committed to work to develop and
compatibility of planned national    implement a North America-wide
emission-strading system with the    cap-and-trade system for
United States and/or the European    greenhouse gases. Harmonising
Union.                               Canada's domestic approach with
                                     that of the United States is an
                                     important objective for the
                                     federal government.

Monitor emissions in the             Both federal and provincial
transport sector. Introduce a        levels of government levy excise
(carbon) fuel tax in addition to     taxes on motor fuels. Certain
standards.                           provinces (Quebec and British
                                     Columbia) have also introduced
                                     carbon-related taxes/levies
                                     linked to their specific
                                     environmental objectives. The
                                     federal government recently
                                     announced regulations harmonised
                                     with the United States to reduce
                                     greenhouse-gas emissions from new
                                     vehicles.

Liberalise electricity markets in    The federal government continues
provinces where they are still       to actively engage with provinces
regulated. Liberalise trade in       and territories to liberalise and
energy goods and services among      enhance energy trade within
provinces by finalising the          Canada.
energy chapter of the Agreement
on Internal Trade.

Review the efficiency of the         The federal government continues
policy of promoting corn and         to consider the benefits and
cellulosic ethanol and other         costs of action on biofuels over
biofuels. Rather than mandate use,   time. It has provided CAD 500
offer increased research             million to Sustainable
subsidies or prizes for              Development Technology Canada to
technological breakthroughs if a     create the NextGen Biofuels Fund,
carbon tax or permit trading are     which will invest in innovative,
infeasible in agriculture.           large-scale demonstration
                                     projects of next-generation
                                     biofuel technologies.

Review the oil-sands tenure          No known action taken.
process regularly and remove the
exploration/production
requirement to make the system
consistent with Alberta's
sustainability objectives.

AGRICULTURAL POLICIES

Phase out the supply-management      No action taken.
regimes by progressive
introduction of market forces, in
particular, by shrinking single-
commodity transfers for milk and
eggs.

Consider the use of business         Federal, provincial and
risk-management tools to replace     territorial governments are
government safety-net programmes     currently undertaking a strategic
that serve to build up moral         review of business risk-
hazard and place a heavy burden      management programming to ensure
on the budget.                       that these programmes are meeting
                                     their objectives in helping
                                     producers manage risks to their
                                     business operations.

Implement a regular pesticide use    The Pest Management Regulatory
survey, in line with foreign         Agency (PMRA) of Health Canada
practices.                           has been collecting pesticide
                                     sales data annually from
                                     pesticide registrants since the
                                     2007 calendar year. The PMRA has
                                     also been collecting pesticide
                                     usage data from a variety of
                                     sources, both public and private,
                                     since 2002.

Table 1.1. Economic indicators

Annual percentage change, volume (chained 2002 Canadian dollars)

                                              2006     2007     2008

Demand and output

Private consumption                            4.1      4.6      3.0
Government consumption                         3.0      3.3      3.7
Gross fixed capital formation                  6.9      3.7      0.9
  Public                                       5.3      6.1     12.4
  Private residential                          2.1      2.8     -2.7
  Private non-residential                     10.0      3.7      0.2
Final domestic demand                          4.5      4.1      2.6
  Stockbuilding (1)                           -0.2      0.2     -0.2
Total domestic demand                          4.3      4.3      2.4
Export of goods and services                   0.8      1.1     -4.7
Imports of goods and services                  4.7      5.8      0.8
  Net exports (1)                             -1.3     -1.6     -1.9
Statistical discrepancy (1)                    0.0      0.0      0.0
GDP at market prices                           2.9      2.5      0.4

Prices and employment

GDP deflator                                   2.6      3.2      3.9
Consumer price index                           2.0      2.1      2.4
Underlying price index                         1.9      2.1      1.7
Total employment                               1.9      2.3      1.5
Unemployment rate                              6.3      6.0      6.2
Memorandum items
  General government financial balance (2)     1.6      1.6      0.1
  General government gross debt (2)           69.5     65.0     69.7
  General government net debt (2)             26.2     23.1     22.4
  Short-term interest rate                     4.1      4.6      3.5
  Current account balance (2)                  1.4      1.0      0.5
  Output gap (per cent of potential GDP)       0.9      1.0     -1.0

                                              2009     2010     2011

Demand and output

Private consumption                             0.2     3.3      3.2
Government consumption                          3.0     4.6      2.1
Gross fixed capital formation                 -10.1     4.7      3.7
  Public                                       13.0    10.5     -2.4
  Private residential                          -7.4    12.7      4.2
  Private non-residential                     -17.4    -2.2      5.8
Final domestic demand                          -1.7     3.8      3.0
  Stockbuilding (1)                            -1.1     1.0      0.3
Total domestic demand                          -2.8     4.9      3.3
Export of goods and services                  -14.0     7.6      6.1
Imports of goods and services                 -13.4    11.4      6.4
  Net exports (1)                              -0.4    -1.3     -0.1
Statistical discrepancy (1)                     0.3    -0.1      0.0
GDP at market prices                           -2.7     3.6      3.2

Prices and employment

GDP deflator                                   -1.9     3.5      1.8
Consumer price index                            0.3     1.6      1.7
Underlying price index                          1.8     1.7      1.5
Total employment                               -1.6     1.7      1.8
Unemployment rate                               8.3     7.9      7.2
Memorandum items
  General government financial balance (2)     -5.1    -3.4     -2.1
  General government gross debt (2)            82.5    81.7     80.7
  General government net debt (2)              28.9    30.3     31.0
  Short-term interest rate                      0.8     0.9      2.9
  Current account balance (2)                  -2.7    -1.6     -1.6
  Output gap (per cent of potential GDP)       -5.3    -3.4     -2.0

(1.) Contributions to changes in real GDP (percentage
of real GDP in previous year).

(2.) As a percentage of GDP.

Source: OECD, OECD Economic Outlook 87 Database.

Table 1.2. Estimates and projections of potential output growth

Per cent or percentage points

                                Average                      Average
                             1998-2008 (1)   2009   2010   2010-17 (2)

Newfoundland and Labrador         4.0        1.7    1.1        1.0
Prince Edward Island              2.2        1.1    0.8        0.8
Nova Scotia                       2.1        0.9    0.8        0.6
New Brunswick                     2.4        1.3    1.1        0.9
Quebec                            2.4        1.6    0.7        0.6
Ontario                           3.0        1.7    1.7        1.6
Manitoba                          2.4        2.4    1.4        1.3
Saskatchewan                      2.2        3.6    1.5        1.5
Alberta                           3.7        2.7    3.3        3.3
British Columbia                  2.9        2.0    1.3        1.1
Canada                            2.9        1.9    1.6        1.6
Memo.: Canada (Outlook 87)        2.9        1.8    1.6        1.6

                              Difference      2017 level versus
                                (2)-(1)      precrisis trend (1)

Newfoundland and Labrador        -3.0               -22.5
Prince Edward Island             -1.4               -11.7
Nova Scotia                      -1.6               -12.4
New Brunswick                    -1.5               -12.1
Quebec                           -1.8               -13.9
Ontario                          -1.3               -11.0
Manitoba                         -1.0                -7.7
Saskatchewan                     -0.7                -4.1
Alberta                          -0.4                -4.1
British Columbia                 -1.7               -13.1
Canada                           -1.3               -10.5
Memo.: Canada (Outlook 87)       -1.3               -10.4

(1.) Calculated as the per cent difference between the projected level
of potential output in 2017 and an alternative projection in which
potential keeps growing at its average 1998-2008 growth rate from 2008
on.
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Publication:OECD Economic Surveys - Canada
Geographic Code:1CANA
Date:Sep 1, 2010
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