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Annex 2
Canada's Recent Economic Developments and Outlook^[1]

Highlights

• The global economic recovery has been uneven in 2003 but is expected to accelerate through the remainder of this year and next year, with the U.S. economy leading the way.
• Canadian growth has been dampened this year by severe acute respiratory syndrome (SARS), a single case of mad cow disease, the Ontario electricity blackout, massive forest fires in B.C. and the rapid appreciation of the dollar.
• The Canadian labour market has not been immune to these shocks. After a very strong performance in 2002, employment growth slowed in 2003. Nonetheless, a total of 98,200 new jobs have been created since the beginning of this year.
• Private sector economists expect stronger U.S. growth and low Canadian interest rates to support a recovery in Canadian growth over the balance of this year and into 2004. For 2003 they now expect real gross domestic product (GDP) growth of 1.9 per cent, down sharply from the 3.2 per cent they forecast at the time of the 2003 budget. They forecast 3-per-cent real growth in 2004, down from the 3.5 per cent forecast in the 2003 budget.
• Private sector economists believe that the extent and the speed of the appreciation of the Canadian dollar, as well as the uncertainty about future levels of the dollar, represent downside risks to their short-term Canadian growth forecast.

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The global economic recovery has been uneven but is expected to pick up speed in the second half of this year and next year.

• Following the global economic slowdown in 2001, the recovery in the world economy has been relatively modest and uneven. The International Monetary Fund (IMF) is projecting an upturn in global activity in the second half of this year, with real GDP growth for the year averaging 3.2 per cent.
• With reduced geopolitical uncertainties, monetary and fiscal policy stimulus in several countries, and a projected decline in oil prices, global growth is projected to strengthen to 4.1 per cent in 2004, led by the United States and developing and transition economies. The IMF forecasts that euro area growth will be only 1.9 per cent in 2004 and Japanese growth will be even weaker. Indeed, while recent data suggesting a stronger performance have led to a more optimistic outlook for growth in Japan in 2003, ongoing deflation and structural problems, including banking and corporate sector weakness, will continue to constrain domestic demand and real GDP growth in 2004.

.with the U.S. economy leading the way

• Following the recession in 2001 U.S. real GDP growth has been uneven. This reflects geopolitical uncertainties preceding the war in Iraq, accounting scandals and the lingering effects of the bursting of the stock market bubble.
• However, monetary and fiscal stimulus and a weaker U.S. dollar have contributed to a strengthening U.S. recovery. The U.S. economy grew a solid 3.3 per cent in the second quarter of 2003 and is estimated to have accelerated much further in the third quarter, aided by a pickup in consumer spending and business investment in equipment and software.
• Accommodative monetary and fiscal policies are expected to continue to support economic activity next year. Private sector forecasters expect growth to average about 4 per cent in 2004.
• The sustainability of the U.S. recovery depends on the economy delivering sustained job growth and a rebound in business investment. If not, consumer demand could weaken and investment could slow as companies lose faith in the durability of the recovery.
• Over the medium term the main risk is the large U.S. fiscal deficit, which, if not corrected, could put upward pressure on interest rates.

But the U.S. economy has been running large current account deficits, which have recently led to a realignment of world currencies

• The United States has been running current account deficits for over a decade. Since 2000 the current account deficit has averaged more than 4 per cent of GDP per year.
• This has led to a steady increase in U.S. net foreign debt as a share of GDP, rising from about 5 per cent in 1993 to about 23 per cent in 2002.
• The depreciation of the U.S. dollar against a broad array of currencies in 2002 and 2003 is a key factor in the adjustment process required to correct global imbalances. Since the beginning of 2002 the U.S. dollar has fallen by more than 10 per cent against a broad basket of currencies. In particular, it has fallen by about 24 per cent against the euro, 27 per cent against the Australian dollar, 17 per cent against the yen and 18 per cent against the Canadian dollar.

Canadian domestic demand growth has remained healthy; however, a series of shocks contributed to the stalling of GDP growth in the second quarter

• Although Canadian real GDP growth slowed through 2002 and into 2003, final domestic demand growth remained robust.
• Solid consumer spending and residential investment growth have been important contributing factors to continued domestic demand growth.
• Notwithstanding solid domestic demand, the combined impact of SARS, bovine spongiform encephalopathy (BSE or mad cow disease) and the rapid appreciation of the Canadian dollar contributed to the stalling of real GDP growth in the second quarter of 2003.

The Canadian economy was hit by a number of shocks in the second and third quarters of 2003

• SARS hit travel-related industries, including accommodation and air transportation services. Real exports of travel services dropped almost 14 per cent (quarterly rate) in the second quarter of 2003 as SARS led to a sharp decline in foreign visitors to Canada.
• The export ban imposed as a result of a single case of BSE led to a 10-per-cent drop in the output of the slaughtering and meat processing industries between April and June.
• The electricity blackout in August in Ontario crippled much of the province's manufacturing sector for several days. The blackout and its lingering impact were significant factors behind a 4.5-per-cent decline in manufacturing shipments and a 5-per-cent decline in real exports in August.
• Massive forest fires in British Columbia affected the lumber industry in the interior of B.C., and Nova Scotia was recently battered by Hurricane Juan.

The Canadian dollar appreciated rapidly this year

• Another factor impacting growth in the Canadian economy this year and next is the rapid appreciation of the Canadian dollar vis-à-vis the U.S. dollar. The 17-per-cent appreciation of the Canadian dollar in the first half of this year is the largest on record over a six-month period. The Canadian dollar has continued to appreciate and is now about 21 per cent above its level at the beginning of the year.
• The rapid appreciation of the Canadian dollar reflects the general weakness of the U.S. dollar against all major currencies as well as increases in some commodity prices.
• A significant rise in the value of our currency reduces the profits of exporters and lowers foreign demand for Canadian goods and services. It also leads Canadians to substitute cheaper imported goods for domestically produced goods. This means there will be trade balance adjustments in response to this significant appreciation of the Canadian dollar.

Monetary and fiscal policy credibility has enabled the Bank of Canada to respond to shocks as needed

• In the first half of 2003, in response to above-target inflation and concerns about rising inflation expectations, the Bank of Canada increased its key policy rate (the target for the overnight rate) on two occasions by a total of 50 basis points to 3.25 per cent.
• In July and then again in September, the Bank of Canada subsequently lowered its key policy rate back to 2.75 per cent, citing faster-than-expected declines in inflation and inflation expectations, as well as negative effects from SARS, BSE and the appreciation of the Canadian dollar.
• Low interest rates should help offset the impact of recent shocks.

Low interest rates have supported household spending, which has been the main contributor to GDP growth

• Supported by historically low interest rates and high consumer confidence, household spending has been the main contributor to GDP growth since the beginning of 2002.
• Over this period real household spending has grown 4.2 per cent on average, reflecting increases in all categories of consumer spending, particularly those that are more sensitive to interest rates.

In particular, housing activity has been a major driver of Canadian domestic demand growth

• A key element of healthy household spending growth has been sustained growth in residential investment.
• Residential investment in the second quarter of 2003 was 8 per cent higher than a year earlier. Housing starts and renovation expenditures have both contributed to the strength in residential investment. At the current pace of 219,000 new units for 2003, housing starts are at their highest level since 1988.
• Improved housing affordability, reflecting low mortgage rates and rising incomes, has contributed to strong housing demand.

Business investment is gradually recovering

• Business investment declined in 2002. After this negative growth last year, both machinery and equipment and non-residential construction showed positive growth in the first half of 2003.
• Healthy corporate profits, low interest rates, a strengthening external environment and sustained gains in the stock market should support healthy investment growth in the coming quarters.
• Indeed, according to the revised 2003 survey of private and public investment intentions released by Statistics Canada in July, total investment is expected to increase by 4 per cent in 2003.

Stronger U.S. growth is supporting Canadian exports in the face of the dampening effect of the Canadian dollar appreciation

• Real exports fell in the fourth quarter of 2002 and first quarter of 2003, reflecting weaker U.S. demand, partly driven by Iraq-related uncertainties that led U.S. businesses to adopt a wait-and-see approach to the potential conflict.
• Although a stronger U.S. economy boosted exports in the second quarter, merchandise exports weakened over the summer. The strong appreciation of the Canadian dollar and the blackout in August were likely key factors.
• Since the beginning of 2003 real import growth has averaged 4.7 per cent, reflecting strong domestic demand in Canada and a possible shift from domestically produced goods to imported goods in response to a stronger dollar.

Despite global weakness, Canada's current account remains in surplus and its net foreign debt has declined

• Despite weakness in external demand over the past two years, Canada's current account balance has remained positive.
• In fact, Canada's current account has now been in surplus for 16 consecutive quarters, averaging over 2 per cent of GDP.
• As a result, Canada's net foreign debt as a share of GDP has continued to decline in recent years. Indeed, Canada's foreign debt ratio was 19 per cent in the first half of this year, close to its lowest level in 50 years.
• The decline in net foreign debt means that more of the income that Canadians earn is staying in Canada.
• These developments stand in sharp contrast to the U.S., whose current account and net foreign debt positions have both deteriorated.

After a very strong performance in 2002, employment growth in Canada slowed this year as shocks hit the economy

• In 2002 the Canadian economy created 560,200 jobs. This strong labour market performance was an important contributor to domestic demand.
• However, the Canadian labour market has not been immune to recent shocks to the Canadian economy. As a result, job gains have been uneven so far in 2003. A total of 98,200 new jobs have been created since the beginning of the year.
• Slower job creation, combined with participation rates that have remained at record high levels, has caused the unemployment rate to rise to 8 per cent in recent months.
• Although less robust than in 2002, the Canadian labour market continues to show strength relative to the U.S. labour market. In contrast with Canada's job gains, the U.S. economy has lost 336,000 jobs since the beginning of this year.

Employment gains have been reflected in the continued growth of real disposable income of Canadians

• Since 1996 real personal disposable income per capita has increased 13 per cent.
• This progress has continued since the beginning of 2001 despite a U.S. recession and subsequent uneven recovery, and shocks to the Canadian economy. The positive performance of recent years in the midst of global economic uncertainty reflects the resilience of the Canadian economy.

In spite of a recent series of shocks, consumer confidence remains historically high

• Strong economic and policy fundamentals and low interest rates, which have helped to keep employment levels high and incomes rising, contributed to keeping consumer confidence relatively steady despite recent shocks to the Canadian economy.
• Consumer confidence in Canada, although lower than its very robust values in the summer of 2002, remains high by historical standards. This should help to underpin the expected strengthening in economic activity in the remainder of this year and into next year.

Corporate profits also remain at a historically high level, boding well for investment

• Despite a slight decline in the second quarter of 2003, corporate profit levels remain quite healthy in Canada. Combined with economic recoveries in both Canada and the U.S., the current level of corporate profits bodes well for future investment growth in Canada.
• Reflecting this, the Conference Board of Canada's Index of Business Confidence rebounded strongly in the third quarter of 2003, with a large increase in the proportion of firms expecting economic conditions to improve in the next six months.
• The latest survey by the Canadian Federation of Independent Business also found that confidence among its members has recovered most of the ground lost earlier this year in the wake of the multiple shocks that hit the Canadian economy. Furthermore, the survey indicated that its members were more positive than a few months ago about what they expected over the next 12 months.

Low borrowing costs should continue to support economic activity in Canada

One-Year Mortgage Rate and Prime Business Rate

Savings on interest payments since January 2001 on a one-year $100,000 mortgage and a $250,000 business loan

	One-year mortgage rate	Prime business rate
Rate-January 2001	7.70	7.50
Rate-October 22, 2003	4.55	4.50
Change in rate	-3.15	-3.00
Monthly payment-January 2001	$744.16	$1,562.50
Monthly payment-October 22, 2003	$556.26	$937.50
Change in monthly payment	-$187.90	-$625.00
Change in annual payment	-$2,254.80	-$7,500.00

• Interest rates remain near historically low levels, providing strong support for household spending and business investment.
• The one-year mortgage rate and prime business rate are currently 4.55 per cent and 4.50 per cent. These rates are 315 basis points and 300 basis points lower than their levels at the beginning of 2001.
• Households now save about $2,250 per year on a new or renegotiated one-year mortgage of $100,000 relative to what they would have paid at the beginning of 2001.
• For their part, businesses now save $7,500 per year on a $250,000 business loan relative to what they would have paid at the beginning of 2001.

Forecasters expect economic growth in Canada to strengthen through the latter part of this year and into 2004

• The Department of Finance recently conducted its regular survey of 20 Canadian private sector economists, which is the basis for the five-year status quo fiscal projections provided in Annex 3.
• Taking into account the impacts of the stronger Canadian dollar, SARS, BSE, the blackout and forest fires, private sector economists expect modest GDP growth this year. They expect growth of 2 per cent in the third quarter and about 31?2 per cent in the fourth quarter of this year.
• For 2004 the private sector forecasters expect quarterly growth of slightly above 3 per cent. The private sector economists noted that their forecast pace and pattern of growth in 2004 could be impacted by adjustments resulting from the rapid appreciation of the dollar.
• The rebound in growth is supported by continued strong U.S. growth, recent interest rate reductions by the Bank of Canada and a return to more normal levels of output as the negative impacts of recent shocks unwind.

Reflecting recent shocks to the economy, growth in Canada this year and next is expected to be weaker than projected in the 2003 budget

• On an average annual basis, private sector economists expect real GDP growth of 1.9 per cent this year, down sharply from the 3.2-per-cent growth they forecast at the time of the 2003 budget. For 2004 they forecast 3-per-cent growth, again down from the 3.5 per cent forecast in the 2003 budget. With real GDP levels lower this year and beyond, this will have ongoing negative impacts on government revenues.
• Canada ranked first in real GDP growth among Group of Seven (G-7) countries in 2002, and the IMF expects Canada to rank third in 2003 and second to the U.S. in 2004. The IMF expects Canadian growth to be lower than in the U.S. in part because of the rapid appreciation of the Canadian dollar and the smaller degree of excess capacity in Canada than in the United States.
• Compared to the February 2003 budget, private sector forecasters expect higher GDP inflation in 2003, at 3.3 per cent. However, GDP inflation is projected to slow to below 2 per cent in 2004.
• Reflecting the slower forecast real GDP growth in 2003, private sector forecasters expect short- and long-term interest rates to be lower in both 2003 and 2004 than anticipated at the time of the February 2003 budget.
• The Canadian outlook has several risks. Principal among these is uncertainty about the outlook for growth in the U.S. and the extent of the adjustment from the appreciation of the Canadian dollar. Private sector economists view the risks to the U.S. outlook as balanced, meaning that growth in the U.S. could be higher or lower with similar probabilities. However, they believe that the extent and the speed of the appreciation of the Canadian dollar, as well as the uncertainty about future levels of the dollar, represent downside risks to their short-term Canadian outlook for growth.

Evolution of the Average Private Sector Forecast for Canada

	2003	2004
	(per cent, unless otherwise indicated)
Real GDP growth
February 2003 budget	3.2	3.5
November 2003 update	1.9	3.0
Difference (percentage points)	-1.3	-0.5
GDP inflation
February 2003 budget	2.2	1.9
November 2003 update	3.3	1.4
Difference (percentage points)	1.1	-0.5
Nominal GDP growth
February 2003 budget	5.4	5.4
November 2003 update	5.3	4.4
Difference (percentage points)	-0.1	-1.0
Employment growth
February 2003 budget	2.1	1.8
November 2003 update	1.9	1.3
Difference (percentage points)	-0.2	-0.5
Unemployment rate
February 2003 budget	7.3	7.0
November 2003 update	7.7	7.7
Difference (percentage points)	0.4	0.7
3-month Treasury bill rate
February 2003 budget	3.3	4.5
November 2003 update	2.9	2.9
Difference (percentage points)	-0.4	-1.6
10-year government bond rate
February 2003 budget	5.4	5.9
November 2003 update	4.8	5.0
Difference (percentage points)	-0.6	-0.9
Sources: December 2002 and September 2003 Department of Finance surveys of private sector forecasters.

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Note:

¹

Incorporates data available up to October 28, 2003. [Return]

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