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Country Report Canada

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Economic growth in Canada is expected to slow somewhat, as the oil price plunge will negatively impact investment but boost consumption somewhat. A new trade agreement between the EU and Canada may boost exports going forward. The housing market is Canada’s main domestic risk, as high house prices and high levels of debt make households vulnerable to a rate hike. 

Strengths (+) and weaknesses (-)

(+) Strong (public) institutions

Canada has very strong institutions, which contribute to a good investment climate.

(+) Solid banking sector

Relatively stringent regulation means the banking sector is well capitalized, profitable and has low non-performing loans.

(-) High dependence on US economy

Canadian exports are highly concentrated as around 75% of its goods exports are destined for the US.

(-) Housing market fundamentals

Although some macroprudential measures have been taken, houses are estimated to be still 7% - 20% overvalued. This leaves households vulnerable to changes in interest rates. 

Key developments

1. Growth likely to slow somewhat

The Canadian economy grew by a solid 2.5% in 2014, but growth is expected to slow to around 2% in 2015 (figure 1). This growth is likely to be driven by external demand and private consumption. As the Canadian dollar has depreciated against the US dollar amidst a fall in oil prices (figure 2), the competitiveness of the non-oil sector has improved. The lower oil prices will boost consumption and also push down headline consumer price inflation in 2015, but with a small output and unemployment gap, core inflation is expected to stay close to the Bank of Canada’s target rate of 2 percent. Gross fixed investment will turn negative as particularly oil companies cut their investment (see below). Lower oil prices are also likely to adversely affect the current account deficit, which is projected to increase slightly to -2.3% of GDP.

Figure 1: GDP growth in components
Figure 1: GDP growth in componentsSource: EIU
Figure 2: Canadian dollar depreciating in 2014
Figure 2: Canadian dollar depreciating in 2014Source: Macrobond

2. EU Canadian free trade agreement awaits implementation

Last year, Canada and the EU finalized the negotiations about the Comprehensive and Economic Trade Agreement (CETA), a free trade agreement (FTA) that will take away 98% of all tariff lines. The agreement still awaits ratification on both sides of the Atlantic. Recently the controversy over the Investors State Dispute Settlement (ISDS) in the EU’s FTA negotiations with the US seems to have spread to the CETA agreement. There are signals the EU is currently trying to renegotiate the CETA to make it more palatable for the European public. Once an agreement is finally implemented, it could boost trade between Canada and the EU by 23% and increase worker mobility and harmonize professional qualifications.

3. Housing market remains risk, particularly in light of the pending US rate hike

The housing market is the main domestic risk for the Canadian economy. Both the IMF and the OECD have estimated that there is considerable overvaluation of house prices. A correction in house prices could have adverse effects on the financial position of households, as these tend to have relatively high levels of debt. This would also have an effect on domestic demand and negatively affect growth. A correction is unlikely to have a great impact on financial stability as the financial sector is generally well capitalised. Moreover, the Canadian government has issued guarantees on 42.7% of the mortgage stock. At the same time, a sharp correction may thus entail costs for the Canadian government, as the IMF has recently once again warned. The current overvaluation, estimated by the IMF at 7% - 20%, is likely to be to a large extent the result of multiple years of very low (global) interest rates. A normalisation of monetary policy, especially in the US, could therefore create risks for the housing market. Given that US inflation has been low or even negative recently, the long-expected FED rate hike is likely to be delayed further until the end of 2015, leaving some time for measures taken by the Canadian policymakers to take effect.

Figure 3: Housing price overvaluation
Figure 3: Housing price overvaluationSource: Macrobond, OECD
Figure 4: Oil price decline
Figure 4: Oil price declineSource: Macrobond

4. Oil Prices stimulate consumption but pressure fiscal position

Canada is a large energy exporter. Despite a decent level of economic diversification, the energy sector accounts for around 10 percent of GDP, a quarter of exports, and a quarter of non-housing private investment. While the recent drop in oil prices is boosting consumption and economic growth in most developed countries, in Canada its effect on growth is ambiguous. Consumption is likely to be boosted but oil producer may cut investment. Energy investment is likely to fall less dramatically than in the US. In the US, the shale oil sector, which typically has a three to four year horizon, is very important, while Canada’s oil reserves are mainly in oil sands, which have an investment horizon exceeding a decade. Nevertheless, the Canadian Association of Petroleum Producers has indicated that oil companies are planning to decrease their investment by 33% in 2015, a sizeable decline. What is more, a protracted decline oil prices will negatively affect the public finances of the energy producing states. Particularly in Alberta, where oil revenues account for 20% of provincial government revenues, this effect could be substantial.

Factsheet of Canada
Factsheet of CanadaSource: EIU, CIA World Factbook, UN, World Economic Forum, Transparency International, Reporters Without Borders, World Bank.

Background information

Canada has one of the most developed economies of the world, with the fifteenth highest per capita income globally, and the 8th highest ranking in the Human Development Index. It ranks among the highest in international measurements of education, government transparency, civil liberties, quality of life, and economic freedom. Its economic growth has been primarily driven by domestic demand during the last decades, with a on average slightly negative contribution of international net trade.

Although also Canada suffered from the Great Recession, its recovery was faster and more sustained than in most other industrialised countries. This was mainly due to domestic demand, driven by soaring house prices. In normal times, economic prospects are highly intertwined with those of its neighbour, the US. More than three quarters of exports flow to the US and half of imports come from the US.

Energy exports account for a quarter of all exports and have grown considerably the last few years thanks to the rapid development of unconventional oil extraction (oil sands). Prospects for further growth are a little bleak as production in the US has grown while oil prices have fallen sharply.

The fiscal stance of the Canadian government is solid, although gross government debt is rather high at about 95% of GDP. A main fiscal sustainability issue is the expected increase of health expenditure.

The financial sector is well capitalized, profitable and has relatively low non-performing loans. Compared to other Western countries, it fared relatively well during the financial crisis.

Economic indicators of Canada
Economic indicators of CanadaSource: EIU
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Author(s)
Jurriaan Kalf
RaboResearch Netherlands Rabobank KEO
+31 (0)30 21 62666

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