Recent developments and the short-term outlook.
Over the past year or so, the Canadian economy has been in a difficult transition from recession to recovery. Following a marked rise in the second quarter of 1991, activity virtually stagnated through the rest of the year, and showed only moderate growth in the first quarter of 1992. While in all previous business cycles since the 1950s output had returned to its pre-recession level within three quarters, in early 1992 real GDP was still about 2 per cent below the peak registered in early 1990.
One element holding back expansion was the weakening of demand abroad -- especially in the United States, Canada's main export market. In addition, exchange-rate appreciation up to November 1991 adversely affected export performance while boosting import demand. At the same time, falling commodity prices led to declines in Canada's terms of trade and reduced activity and profits in the resource sector. On the domestic side, confidence appears to have been undermined by labour-market uncertainties associated with economic restructuring and record debt-servicing burdens in the corporate sector. Moreover -- as in most other countries -- real long-term interest rates have remained relatively high despite the substantial easing in monetary conditions, possibly also reflecting uncertainties generated by the constitutional debate as well as about the exchange rate and future inflation performance. Finally, contrary to past experience, fiscal policy has moved towards restraint during the recent recession, as rapid debt accumulation over the 1980s had deprived the authorities of any fiscal room for manoeuvre.
Sluggish activity has led to a reversal of temporary increases in capacity utilisation and declines in unemployment. With substantial slack in goods and labour markets, underlying inflation has fallen significantly. Progress on inflation, which had been firmly entrenched during the 1980s, reflected both an easing of cost pressures and a deep erosion of profit margins. On the other hand, the sizeable current-account deficit, which had emerged during the recovery of the 1980s, has widened further despite subsiding demand pressures. The continued deterioration in the external balance had its counterpart in stronger public-sector dissaving, which has been only partly offset by an improvement in the private sector's financial position. This improvement has been modest, however, as -- over 1990-91 -- the personal saving ratio remained relatively stable while, at the same time, the low profitability depressed corporate savings. By comparison, in the recession of the early 1980s, the widening in the government deficit was more pronounced, but this was outweighed by sharply-rising personal savings, so that the current external account moved into surplus.
Widening output gap
In the twelve months to the first quarter of 1991, economic activity dropped by more than 3 1/2 per cent in real terms and, since then, only about one-half of this output loss has been recovered. Given estimates for the growth of potential output -- 3 to 3 1/2 per cent per annum -- this implies the opening of a substantial output gap of almost 7 per cent of GDP, roughly the same as had emerged in the 1981-82 recession. Measures based on the technical concept of capacity utilisation indicate that the rate of capacity use for non-farm goods-producing industries dropped by 11 points from its 1988 peak to 77 1/2 per cent in early 1991, as compared with a long-term average of 84 per cent. At 15 points, the drop in capacity utilisation was particularly pronounced in the manufacturing sector, where output losses have been concentrated; following temporary improvements during 1991, the capacity-utilisation rate in manufacturing fell towards the end of the year, although it remained well above the first-quarter through of 71 per cent. While activity has held up better in the service sector, the latter has been more affected by the recession than usual, with weakness concentrated in wholesale and retail trade.
The modest increase in real GDP since the first quarter of 1991 has been more than accounted for by a recovery of final domestic demand, and in particular spending on its most interest-sensitive components such as residential construction. TABULAR DATA OMITTED As a considerable part of this rise in demand -- most of which took place in the second quarter of 1991 -- was initially satisfied by drawing down inventories, those were rebuilt during the rest of the year before declining again in early 1992. On the other hand, while a marked deterioration in the real foreign balance acted as a brake on activity through the second half of 1991, real net exports have posted a strong recovery thereafter (see below).
In stark contrast to the 1981-82 recession, consumer retrenchment in 1990-91 largely followed income developments, with the household saving ratio changing little. The continued weakening in households' real disposable income reflects falling employment, declining investment income, marked increases in unemployment-insurance contributions, the introduction of the GST and indirect-tax increases. Apart from the overall price-level effect, uncertainty among consumers concerning the impact of this new tax on prices and adverse effects on consumer sentiment may have depressed private consumption in the first quarter of 1991, thereby leading to a rebound in the second quarter. The net impact of the change in relative prices associated with the federal sales tax reform on the time pattern of demand is, however, unclear: while there is evidence that expenditure on some semi-durables and services was brought forward to 1990, it also appears that spending on durables, in particular motor vehicles, was delayed until 1991.
In any case, both the index of consumer confidence and consumer expenditure, which had risen in the second quarter of 1991, declined again during the second half of the year. Increased uncertainty about future employment conditions appears to have been the major factor behind this development. Persistently high indebtedness may have been another. Households had run up their debts to record levels through the second half of the 1980s, and, contrary to developments in the early 1980s, debt/income ratios have kept rising so far. However, adjusted for the increase in mortgage debt due to the rising rate of home ownership associated with the ageing of the baby boom generation, the personal debt ratio now would be about the same as it was in the early 1970s. The net asset position of the household sector has actually improved over the last decade, as rising mortgage debt has been more than matched by increasing asset values. Nonetheless, many households may find themselves short of liquidity or ready cash and cut back on all but essential consumer spending.
Housing investment -- an area that is particularly sensitive to reductions in interest rates -- has recovered strongly, following the steep fall of about 27 per cent between late 1989 and early 1991. From the first quarter of 1991 to the first quarter of 1992 residential investment rose by almost 13 per cent, although in 1991 as a whole it still declined substantially. Housing starts have recovered from a low of about 100 000 to around 170 000 units at an annual rate more recently, which compares with estimated new requirements, based on demographic trends and estimates of replacement requirements, of over 200 000 units per year. The recovery in residential investment was accompanied by record sales of existing houses as a flood of first-time buyers took advantage of lower house prices and mortgage rates. Over the past two years, housing affordability (payments on a mortgage as a share of disposable income) has improved by about 30 per cent, largely reflecting a significant decline in mortgage rates.
Despite historically low profit margins and record debt-servicing burdens in the corporate sector, business fixed investment has shown surprising strength. This performance appears all the more remarkable in that business capital spending usually lags behind other demand components. While business investment as a share of real GDP dropped by 3 percentage points in the first half of the 1980s -- well into the economic recovery -- it fell by only 1 point during the recent downturn before increasing a little through 1991. Investment has been supported by several special factors. Strength in machinery and equipment investment in 1991 was concentrated in office machines (up by one-third) and automobiles, partially reflecting delayed purchases from 1990 in anticipation of GST-related price reductions. Moreover, a transitional credit was given to small businesses to cover the administrative costs of switching to the GST: firms purchased new cash registers and some used the opportunity to install inventory-monitoring technology. Energy investment also played an important role, rising by 16 1/2 per cent in nominal terms in 1991 (according to the Private and Public Investment Intentions Survey) due to a number of on-going large-scale projects. The Free Trade Agreement with the United States is another reason for the untypical strength of investment in the recent downturn, as firms have been expanding to exploit their comparative advantage now that access to the American market is assured. On the other hand, investment was sharply reduced in commercial real estate, where rapid growth in recent years had produced a sizeable surplus that has not yet been absorbed.
Rising unemployment and falling labour-force participation
Weak economic activity has been reflected in substantial labour-market slack. After rising rapidly during the economic downturn from the first quarter of 1990 to the first quarter of 1991, the unemployment rate stabilised at about 10 1/2 per cent as output growth resumed. Given the slow pace of the recovery and substantial productivity gains, it has edged up again and exceeded 11 per cent in recent months, well above estimates of the "natural rate" of unemployment (which range from 7 1/2 to 8 1/2 per cent, see last year's OECD Survey) and almost 4 points above the cyclical low recorded in early 1990. Unemployment would be even higher, had it not been for an unusually pronounced fall in labour-force participation. On the other hand, the speed of the rise in unemployment reflected the continuing trend towards closer synchronisation of both the timing and magnitude between changes in employment and output. It appears that firms have learned from past experience and kept labour hoarding to a minimum in the face of extremely low profit margins and a longer-than-expected slump. In addition, industrial restructuring associated with increasing internationalisation of business and the implementation of the Free Trade Agreement with the United States seem to have affected employment developments.
In previous downturns, labour productivity declined because firms were reluctant to reduce employment in step with output -- although in the 1981-82 TABULAR DATA OMITTED recession this phenomenon was already less pronounced. During the downturn ending in the first quarter of 1991, productivity performance was much better than in the early 1980s in manufacturing but not in the economy as a whole. If the recent period -- when activity has grown moderately and employment fallen further -- is added, the decline in employment since the cyclical peak has exceeded that of output in both manufacturing and the overall economy. However, even if recent productivity performance compares favourably with previous cyclical experience, it still has fallen short of trend productivity growth. Although it is difficult to disentangle cyclical and structural factors, the strong pick-up in productivity during the temporary burst of activity growth in mid-1991 suggests that labour hoarding has been reduced but not eliminated. It also implies that part of the favourable productivity performance in recent years reflects the fact that structural changes are occurring at a faster pace than usual.
Labour-supply growth has been strongly influenced by a decline in labour-force participation. Since the beginning of 1990, the labour-force participation rate has dropped by more than 3 percentage points, which is much more pronounced than during the severe 1981-82 recession when it fell by a little more than 1 point and recovered before the end of the downturn. Previous studies suggest that for a 1 per cent decline in the employment/population ratio (representing employment opportunities), the participation rate decreases by about 1/2 per cent. By this rule of thumb, cyclical factors would explain about two-thirds of the recent drop in the participation rate. Unusual weakness in industries where female employment is prominent, such as retail trade, has been associated with a marked drop in the labour-force participation rate of women, which has tended to be very sensitive to changes in employment conditions.
Structural factors, which also help explain the unusually pronounced recent decline in participation, include changes in the generosity of the unemployment-insurance system, an associated shift of funding to training, and possibly an increase in the importance youths attach to education and skills. The reduction in the generosity of unemployment insurance from 1990 has limited participation of people who include unemployment benefits in their marginal decision to work. With savings from reduced generosity being directed towards more training for the unemployed, an increasing number of people have opted to take training rather than stay in the labour force and search for work. The causes of a substantial increase in school and university attendance are more difficult to disentangle. While attendance typically rises during periods of labour-market weakness, an upward trend had already emerged well before the recent recession. The fact that virtually all job losses between 1990 and 1991 were accounted for by people with less than secondary school education may have underpinned this trend.
Despite the rapid rise in unemployment, wage pressures began to subside only during the course of 1991, more than one year after the economy had entered recession. This was in line with the response seen in the past. At the beginning of the downturn, the unemployment rate was significantly below all estimates of the "natural rate", and hence, allowing for the usual lags, upward pressure on wages persisted for some time into the recession. Moreover, the prospect of higher inflation due to increasing energy prices and the introduction of the GST appears to have stiffened wage demands. The downward adjustment of wage increases under major collective agreements -- reversing the upward trend from a low of 3 per cent in 1986 to over 6 per cent -- was hastened by restraint programmes introduced by the federal government and most provinces that have kept public-sector wage settlements within the 2 to 3 per cent range since mid-1991. Negotiated wage agreements in the private sector have fallen more gradually, dropping to below 3 1/2 per cent in late 1991 and towards 2 1/2 per cent in early 1992. Lower wage settlements have progressively shown up in effective earnings: in early 1992, the twelve-month increase in the fixed-weighted measure of hourly earnings fell below 4 per cent, down 2 1/2 percentage points from its peak a year before.
The decline in wage increases, reinforced by rising labour productivity, led to a marked deceleration in the growth of unit labour costs in 1991. This represented a sharp change from 1990, when labour-cost pressures were still rising and arithmetically more than accounted for domestically-generated inflation. Even with the adjustment of wage growth that was taking place during 1991, profits were severely squeezed, as demand weakness and international competition -- intensified by exchange-rate appreciation -- forced companies to keep price increases low. Profit margins of non-financial corporations fell to 2 1/2 per cent in late 1991, compared with a low of 6 per cent in the 1981-82 recession. The pronounced narrowing of profit margins contributed nearly as much to disinflation in 1991 as slowing growth in unit labour costs.
The marked easing in inflationary pressures in 1991 is evidenced by the drop in the growth rate of the deflator for GDP at factor costs -- from 3 1/2 per cent to less than 2 per cent -- which excludes the substantial price-level effects of indirect-tax changes. Those were particularly large in the case of the consumer price index (CPI) -- the focus of public interest and target variable of monetary authorities -- which rose by more than 5 1/2 per cent as the switch from the Federal Sales Tax (FST) to the GST in January 1991 shifted taxation from investment and exports to consumption. Estimates based on input-output tables suggest that the short-run accounting impact of the introduction of the GST on the CPI was 1.4 per cent, assuming a full pass-through of cost savings due to the abolition of the FST. In addition to the GST, a number of indirect-tax increases implemented at the federal and provincial level during the first half of 1991 raised the CPI level by more than 1 percentage point during the year. Altogether these measures contributed 2 1/4 percentage points to consumer price inflation in 1991 as a whole. After dropping to below 4 per cent in late 1991, the annual TABULAR DATA OMITTED increase in the CPI fell sharply at the beginning of 1992 as the effect of the GST dropped out, and averaged 1 1/2 per cent in the first five months of the year.
Falling import prices, reflecting in part exchange-rate appreciation, damped the increase in the CPI in 1991. The decline in the nominal effective exchange rate by around 6 per cent since November 1991 would -- if sustained, and with a lag -- raise the CPI level by 1 1/2 per cent, assuming a full pass-through to domestic prices. However, although the three-month increase in the CPI has edged up in recent months, it seems that, given the current slack in goods markets, firms are absorbing some of the exchange-rate effect in profit margins in order to maintain market share. As current low profit margins are clearly not sustainable, recent CPI figures are probably overstating the progress that has been made in reducing inflation.
Large external deficit
Despite the weakness of domestic demand, the external current-account deficit has displayed an upward trend: averaging 4 1/4 per cent of GDP in 1991 -- slightly above the previous post-war highs registered in the late 1950s -- it approached 5 per cent in the final quarter of the year before dropping towards 4 per cent in the first quarter of 1992. One factor explaining the failure of the external balance to improve as in the 1981-82 recession is Canada's relative cyclical position: unlike in the first half of the 1980s, when the effects of a decline in domestic demand relative to major trading partners offset the deterioration in the terms of trade, the relative demand position has remained broadly stable since 1989. According to OECD estimates, following gains in volume market share in 1990, export performance deteriorated significantly last year for manufactures but only marginally for goods overall. Losses of export-market share have been limited by a fall in relative export prices since 1989, despite a further decline in cost competitiveness, implying sharp reductions in profit margins. Improved access to the U.S. market may also have played a role. Losses of market share appear, however, to have been substantial in the domestic market, reflecting the steep rise in domestic prices relative to import prices, in addition to the process of U.S./Canadian market integration.
The fall in the merchandise trade surplus in 1991 -- which followed upon a temporary widening in the year before -- was attributable both to a deterioration in the terms of trade and substantial rise in import penetration. Export developments can be traced largely to the course of foreign demand: following a recovery in mid-1991, merchandise export volumes fell back again and rose only little in the year as a whole. The increase in import volumes, which exceeded that of exports, came as a surprise -- even taking account of exchange-rate appreciation -- given the decline in domestic demand in 1991 as a whole. The removal of the import bias, which had been associated with the old Federal Sales Tax, should have moderated the growth rate of imports. In many cases (e.g. consumer electronics), however, there appear to be no Canadian producers who would be able to supply the relevant goods. Moreover, as noted above, the sales tax reform led to some deferral of purchases from 1990 to 1991 and increased demand for office machinery, which may help explain the strong rise in imports TABULAR DATA OMITTED of machinery and equipment. But imports of consumer goods also expanded strongly. The merchandise trade surplus widened considerably in the first quarter of 1992, as import demand expanded little and exports picked up markedly due to the revival of the U.S. economy.
The rising trend in the deficit on international travel continued in 1991. Increased cross-border shopping, which got a boost from the appreciation of the Canadian dollar until late 1991, accounts for part of this. The sizeable deficit on investment income, resulting from the high net foreign liability position of Canada, dropped for the first time in eight years: low profit levels of Canadian corporations led to a marked decline in dividend payments abroad while falling interest rates curbed the rise in interest payments. Net transfer payments, though remaining limited, have tended to grow, reflecting inter alia decreasing inflows of funds of immigrants.
Net long-term capital inflows grew strongly in 1991, as nonresidents invested a record amount in Canadian securities, which was to a large extent channelled into new bond issues of the provinces and their enterprises. Direct investment recorded a net inflow for the second year in a row, although Canadians increased their net direct investment abroad substantially. Foreign direct investment in Canada remained at a high level, with the United States accounting for the major part of the inflows. Net short-term capital inflows, which had been fuelled by increased foreign borrowing by Canadian banks in response to high interest-rate differentials, lessened in 1991. For the first time since 1985, official reserves decreased in 1991, partly reflecting a sharp fall towards the end of the year associated with downward pressure on the exchange-rate; with this pressure persisting, foreign-exchange reserves declined further in early 1992.
Given modest activity growth at the beginning of the year, real GDP is projected to increase by less than 2 1/2 per cent in 1992 before expanding by more than 4 per cent in 1993. By boosting Canadian exports, the revival of demand in the United States together with the lower exchange rate and improved domestic cost performance should provide the impetus for the recovery: merchandise export volumes are projected to expand in line with market growth even as depressed profit margins are partly restored. Lower interest rates and improving confidence should spur growth in domestic spending. Residential investment is expected to be the most dynamic component of domestic demand: requirements for new housing stemming from demographic developments -- due in part to immigration -- along with lower financing costs and actions in the latest Budget should provide a boost to this sector. As foreshadowed in intention surveys, the contribution of business investment to growth is projected to be modest in the near term; over time, however, improving profitability and TABULAR DATA OMITTED capacity utilisation, along with corporate tax reductions announced in the 1992 Budget, should stimulate investment activity. Private consumption is likely to be less buoyant than in previous recoveries, but should revive progressively as employment growth and tax and transfer adjustments underpin personal real disposable income and progressive improvement in households' balance-sheet positions leads to a decline in the saving ratio.
The projected upturn of activity is unlikely to lead to a substantial decline in unemployment over the next eighteen months, as the cyclical fall in labour-force participation may reverse. Downward pressure on wages -- resulting from unemployment well above its "natural rate" of 7 1/2 to 8 1/2 per cent, along with a cyclical rebound in productivity -- should ease growth in unit labour costs. Low capacity utilisation is expected to limit the price effects of the recent exchange-rate depreciation, so that CPI inflation should remain below the official target of 3 per cent by the end of 1992. With the excess-supply gap narrowing only slowly, disinflation is projected to resume in 1993 despite some recovery in profit margins. The current-account deficit is projected to change little: in the short run, improvements in the foreign balance in volume terms are expected to be to a large extent offset by further declines in the terms of trade; thereafter, with strengthening domestic demand, volume growth of imports is projected to catch up with that of exports. Given the marked improvement in the external balance in early 1992, the outcome may be more favourable than projected.
These projections are based on information available in May 1992 and the following assumptions:
- With above-average growth projected for the United States, Canada's markets for merchandise exports are expected to expand at a higher rate than world trade: over the next eighteen months, they may grow at an annual rate of around 7 1/2 per cent in real terms;
- Crude oil prices are assumed to rise slightly from US$17 to US$17 1/2 per barrel by end-1993;
- Under the assumption of constant nominal exchange rates from May 1992, Canadian import prices are expected to rise on average by 2 1/2 per cent over the next eighteen months;
- With tax reductions announced in the 1992 federal Budget financed by spending cuts, the move towards surplus in the cyclically-adjusted general-government budget balance is projected to exceed 1 per cent of GDP in the two years to 1993;
- Both short and long-term interest rates are assumed to continue to decline moderately from the levels recorded in early spring 1992, implying some further narrowing of the differentials between Canadian and U.S. rates.
The major risk attached to the projections would seem to be a less favourable external environment, as the expected rebound in real growth depends to a large extent on a sustained strengthening of demand in the United States. On the domestic side, uncertainty about consumer spending in the near term constitutes a risk to the outlook. Indeed, contrary to the business climate, which improved in the first quarter of 1992, consumer confidence has remained depressed, possibly reflecting labour-market uncertainties associated with economic restructuring. While the recent - more pronounced than assumed - easing in monetary conditions could lead to faster progress in closing the labour-market and output gaps, the constitutional debate adds to the risks, as related uncertainty could adversely affect exchange-market sentiment and interest-rate levels. On the other hand, the projected growth for 1992-93 is significantly below the norm of past recoveries which, when they finally took hold, usually exceeded expectations; this recovery may eventually do the same.