May 21, 2019

Context

1. Over the past five years, Canada has employed a judicious mix of policies to support inclusive growth and reduce vulnerabilities in the financial system. The use of fiscal space combined with accommodative monetary policy at the onset of the 2014 oil price shock was effective in overcoming the recession in 2015. The economy posted the strongest growth rate among G7 economies in 2017 and the unemployment rate fell to its lowest level in forty years. The positive momentum in the economy carried through to 2018 and the government took the opportunity to push through several important reforms to boost productivity growth. A deal to overhaul NAFTA was signed, the Canada Infrastructure Bank opened for business, and tax allowances for business investment were expanded to help preserve Canada’s tax competitiveness following the 2018 U.S. Tax Cuts and Jobs Act. With the policy rate kept low amid a booming housing market, macroprudential policy was tightened to slow the rise in household debt and to enhance the resilience of the financial system.

2. Risks are evolving as federal elections approach. Growth has slowed to a more sustainable level following the stellar pace set in 2017. The global economy is slowing, low oil prices, aggravated by domestic pipeline constraints, have dampened exports and business investment, while private consumption and residential investment—important contributors of Canada’s recent rapid growth—have decelerated in line with the slowdown in the housing market, rising interest rates, and slower real income growth. While the deal to overhaul NAFTA was signed, the new USMCA awaits legislative approval and trade tensions between the U.S. and its major trading partners continue to cast a shadow over the economic outlook.

3. Canada should continue to preserve financial stability and focus policies on supporting long-term growth. Several rounds of macroprudential measures, provincial and municipal tax measures, and tighter monetary policy have contributed to a reduction in housing-related financial stability risks. The government is under pressure to ease macroprudential policy or introduce new initiatives that buttress housing activity. This would be ill-advised, as household debt remains high and a gradual slowdown in the housing market is desirable to reduce vulnerabilities. Looking ahead, policy priorities should focus on ensuring that the financial system remains sound and resilient, cooperation between federal and provincial governments is enhanced, and structural reforms target productivity growth. This year’s Staff Report incorporates findings from the 2019 Financial Sector Assessment Program (FSAP), which is conducted every five years for G-20 countries. The FSAP is a comprehensive and in-depth analysis of a country’s financial sector stability and soundness.

Outlook and Risks

4. Growth is projected to slow in the near term. Real GDP growth is projected to decline to 1.5 percent in 2019 , partly reflecting a disappointing first quarter and more subdued global growth. Growth is expected to pick up in 2020 as the effects of last year’s slowdown in oil-related activity wane . Demand for exports will continue to be supported by a robust U.S. economy with the Federal Reserve expected to deliver more accommodation than previously assumed, and the ratification of USMCA, which will reduce trade uncertainty. Business investment is expected to be supported by new tax changes that allow for immediate and accelerated expensing, although pipeline constraints will limit investment in the energy sector. With the output gap becoming more negative in 2019, monetary policy is expected to remain on hold in the near term, and the fiscal stance is expected to be broadly neutral. Over the medium term, low productivity growth and population aging will limit potential growth to around 1.7 percent .

5. Risks are tilted to the downside. A key domestic risk is a sharp correction in the housing market. If a house price correction is accompanied by a rise in unemployment and a collapse in private consumption, additional risks to financial stability and growth could emerge. External risks include a larger-than-expected global growth slowdown, a sharp tightening of global financial conditions, or an escalation of trade tensions between the U.S. and its major trading partners, which could include the failure to ratify USMCA and the break-up of NAFTA. This would impact global value chains, weaken Canadian exports, and lower business confidence and investment. Stronger-than-expected U.S. growth and an increase in oil prices would provide upside risks.

6. The core financial system is resilient to a materialization of these downside risks, but households and mortgage insurers would be vulnerable, as evidenced by FSAP stress tests. The adverse scenario in the FSAP stress tests assumes a severe recession would occur concurrently with significant financial market stress, a large exchange rate depreciation, and a sharp housing market correction. Domestic systemically important banks would remain resilient, helped by strong revenue-generating capacity and existing capital buffers. Corporates would also be able to withstand sizable income and funding cost shocks. However, household mortgage defaults would rise significantly, with larger effects where household debt is high. In this severe scenario, CMHC and private insurers would need a capital injection totaling $15-23 billion (around 1 percent of GDP) to meet the supervisory target ratio.

Key Policy Messages

7. With growth moderating to a more sustainable level, fiscal consolidation should be gradual. Rebuilding fiscal buffers and reducing debt faster would provide more options to handle future challenges. In this context, the planned fiscal adjustment is appropriate at the federal level, but provinces need to increase the size of their adjustment to achieve overall balance for the general government by 2024. Any unexpected fiscal savings should target deficit and debt reduction. If downside risks materialize and growth underperforms, automatic stabilizers should be allowed to operate fully. Discretionary measures could be used, depending on the severity of the downturn.

8. To enhance its commitment to well-managed public finances, the federal government could explicitly incorporate a fiscal rule. The rule would be most effective if it includes a debt anchor and an operational rule that strikes the right balance between enforcement, flexibility, and simplicity. Regularly scheduled reviews assessing whether the fiscal framework achieves its objectives should be an integral part of the system. The PBO is well placed to monitor compliance and ensure that rules are not circumvented.

9. At the provincial level, fiscal rules should strengthen the link with debt while protecting public investment. Rules can be quite different across provinces. Sources of fiscal imbalance should be identified (e.g. excessive current spending or under-taxation) and longer-term challenges related to demographic changes should be considered. Transparency and accountability are crucial elements to ensure fiscal sustainability over the long term.

10. The authorities should continue to monitor and evaluate the effectiveness and efficiency of the tax system. Recent tax changes that allow for immediate and accelerated expensing are a step in the right direction. Further steps toward a cash-flow based system could include permanently allowing immediate expensing of all capital investments and removing interest deductibility.

11. Monetary policy should remain on hold in the near term. Further monetary tightening will be warranted as the output gap closes, but this should be implemented at a gradual pace. Gradualism is appropriate given the balance of risks around the outlook and uncertainty about the level of the output gap and the neutral rate. If downside risks materialize and the outlook deteriorates, the Bank of Canada should be prepared to cut the policy rate.

12. Macroprudential policy has been effective in containing financial stability risks and the current stance is appropriate. With the measures working well, their effectiveness should not be diluted by home buyer initiatives that inadvertently increase household debt. In the event of a sharper than expected contraction in credit growth, adjustments to macroprudential tools could be considered. Provincial and municipal tax measures should also be harmonized into broad-based tax measures targeted at speculative activity more generally. To alleviate vulnerabilities in the housing market on a more durable basis, macroprudential policy should be complemented with a broad set of supply-side policies. As noted in last year’s Staff Report, municipal, provincial and federal authorities need to work together to develop and implement a comprehensive housing supply strategy to increase density and alleviate construction bottlenecks. The recent establishment of an Expert Panel on the Future of Housing Supply and Affordability is a step in the right direction.

13. The framework for systemic risk surveillance and crisis management has worked well, but there is a case for modernizing the arrangement. The responsibilities for systemic risk oversight are dispersed over multiple agencies. This has prevented the development of a Canada-wide framework for systemic risk surveillance and oversight. A revamped Heads of Agencies Committee that includes all relevant agencies could be one way of carrying out economy-wide systemic risk analysis, with the objective of increasing transparency and cooperation around policy decisions and providing a broader, more inclusive dialogue on macroprudential policy. The envisaged Capital Markets Stability Act can further strengthen systemic risk surveillance and management in capital markets. The Senior Advisory Committee should assume the role of overseeing Canada-wide crisis preparedness, in collaboration with key provincial authorities.

14. Macroprudential oversight should be complemented with stronger microprudential supervision and safety nets. Gaps should be addressed in bank resolution (e.g. compensation to support bail-in), liquidity support (e.g. testing contingency plans), and monitoring of risk-taking by pension funds (e.g. disclosure requirements). OSFI should have the authority to issue its own legally enforceable regulations. Memorandums of understanding still do not exist between OSFI and provincial authorities, constraining the exchange of information and policy coordination. There is scope for further harmonization of the provincial regulatory frameworks, and the Cooperative Capital Markets Regulatory System initiative can help overcome risks from dispersed oversight of securities markets. Additional capital buffers for mortgage exposures, along with measures to increase risk-based differentiation in mortgage pricing, are desirable.

15. Current levels of productivity growth are insufficient to sustain long-term growth. Canada faces the challenge of attracting productivity-enhancing investment that both diversifies the economy beyond traditional sectors and takes full advantage of opportunities provided by new trade agreements. Beyond international trade and other structural reforms, there are significant opportunities for productivity gains from reducing domestic barriers to inter-provincial trade. Barriers to domestic trade is a longstanding issue and nothing short of a sustained and concerted collective effort is needed to break down barriers that are impeding Canadian businesses from competing on a level playing field and scaling-up. A “coalition of the willing” could be one way to accelerate progress.

• The Canadian Free Trade Agreement signed in 2017 provides a platform for cooperation in reducing internal trade barriers, but several problematic aspects need to be resolved, including setting clear targets for reducing the number of exemptions and strengthening the process of regulatory reconciliation. The potential gains are sizable and could increase real GDP by almost 4 percent—a much larger gain than expected from recently-signed international trade agreements. Finance, business services, and insurance is by far the most important sector to benefit, reinforcing the value of efforts to unify securities regulations across provinces and enhance labor mobility.

• Structural reforms should remain a key objective of the government’s growth agenda. There is still a need to remove restrictive regulations of product markets and foreign-direct investment. Efforts to encourage infrastructure investment are welcome, including progress in fully operationalizing the Canada Infrastructure Bank. However, challenges in project selection, execution and coordination—especially at the provincial and municipal levels—must be overcome to avoid delays in infrastructure investment. A more detailed strategic plan is needed to prioritize infrastructure projects that most serve the long-term national interest. Federal and provincial authorities should continue to improve financial reporting and cost-tracking to better facilitate the flow of federal infrastructure funds.

• The reduction in trade uncertainty that came with the new USMCA is welcome, and the benefits of the agreement are enhanced with the elimination of U.S. tariffs on steel and aluminum imports and Canada’s retaliatory measures. Canada should also be commended for its rapid ratification of CPTPP and greater opportunities for diversification that it brings, and for its leadership in efforts to reaffirm the importance of a multilateral trading system.

16. Canada volunteered to be assessed under the IMF’s Enhanced Governance Framework on the supply and facilitation of corruption. In this regard, the authorities are encouraged to continue enforcement actions against foreign bribery, and enhancing the effectiveness of AML/CFT frameworks to tackle the proceeds of crime, including foreign corruption.

The IMF team would like to thank Canada for its warm hospitality and constructive dialogue.