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Chapter 3
Economic Climate

Highlights

• The global financial crisis has triggered the deepest and most widespread global recession since World War II.
• Economic activity contracted sharply in all Group of Seven (G7) countries in the fourth quarter of 2008 and the first quarter of 2009, reflecting the impact of financial market dislocations and a sharp decline in consumer and business confidence.
• As a trading nation, Canada has been affected by the global recession.
• But Canada has been less affected than all other G7 countries.
  • Canada was the last G7 country to enter recession in 2008.
  • Canada has had the smallest decline in output since the second quarter of 2008.
  • Canadian labour markets have fared much better than in the U.S., where job losses have been proportionally twice as large.
• Looking ahead, most private sector forecasters continue to expect a return to growth in the second half of 2009 and gaining momentum in 2010.
• The weaker economy will result in more support being provided through higher Employment Insurance (EI) benefits and lower tax collections.
• In addition, as part of the Government's response to the weaker economy, significant additional support has been provided to support the automotive sector in partnership with the United States.
• Taken together, the weaker economy and actions taken in support of the economy have led to a deterioration in the Government's projected budgetary balance.
• The Government is now projecting deficits of $3.9 billion in 2008–09 and $50.2 billion in 2009–10. More than half of the 2009–10 deficit is the result of temporary measures under Canada's Economic Action Plan, less taxes collected, higher EI benefits, and the decision to freeze EI premium rates.
• Canada's fiscal situation remains strong relative to other nations, with the smallest deficit and the lowest debt burden in the G7.

Introduction

The global economy has been in a deep and widespread recession since the middle of 2008. The pace of contraction accelerated sharply in late 2008 and in the first months of 2009. In recent months, there have been encouraging signs that the global economy and world financial markets are beginning to stabilize. However, the economic situation remains uncertain.

As a trading nation, Canada has been hit by the global recession although we have fared much better than most other major advanced economies.

Looking ahead, most private sector forecasts continue to point to a sustained economic recovery beginning in the second half of 2009 and gaining momentum in 2010.

The recovery in Canada will be hastened by this country's strong economic, fiscal and financial position together with the positive support provided by extraordinary policy actions, including those taken in Canada's Economic Action Plan.

The Government will continue to monitor closely economic developments over the summer with a view to providing an update to Canadians in the fall.

Global Economic Developments
and Outlook

Economic activity contracted sharply in all G7 countries in the fourth quarter of 2008 and the first quarter of 2009, reflecting the impact of financial market dislocations and a sharp decline in consumer and business confidence. The financial market turmoil has also caused hardship in emerging and developing countries, which have been hit hard by the disruption of global trade and credit flows. The global financial crisis has now resulted in the deepest and most widespread global recession since World War II.

In the Euro area, real gross domestic product (GDP) fell by 9.7 per cent in the first quarter of 2009 after a 6.8-per-cent decline in the fourth quarter of 2008, the fourth consecutive quarterly drop and reflecting declines in most member countries, including Germany, Italy and France. In the United Kingdom, real GDP fell by 7.3 per cent in the first quarter, following a 6.1-per-cent decline in the fourth quarter. In Japan, real GDP fell by a record 15.2 per cent in the first quarter after a 14.4-per-cent plunge in the fourth quarter.

The contraction in output in Canada since the second quarter of 2008 has been significant, but less than in all other G7 countries. Canada was the last G7 country to enter recession in 2008 and has had the smallest decline in output over the last three quarters. While real output has declined by 2.2 per cent in Canada since the second quarter of 2008, it has declined significantly more in most other major economies, ranging from 2.8 per cent in France to 8.3 per cent in Japan (Chart 3.1).

The scope and severity of the global crisis has resulted in a steady downgrading of the global economic outlook for 2009 (Chart 3.2). According to the International Monetary Fund (IMF), the global economy is in a severe recession inflicted by a massive financial crisis and an acute loss of confidence," while "advanced economies are projected to suffer deep recessions."¹

 

The IMF now expects that global economic activity will slow sharply from growth of 3.2 per cent in 2008 to a contraction of 1.3 per cent in 2009, the first decline in 60 years. This is down from the IMF's forecast of 0.5 per cent growth in January 2009² and well below its outlook of 3.8 per cent growth just over a year ago in April 2008. All of the major advanced economies are expected to suffer sharp contractions in real economic activity this year. Growth is also expected to remain very weak in developing countries, reflecting the disruption of global trade and credit flows.

In the United States, the economic slowdown intensified over the second half of 2008. In particular, the consumer sector in the U.S. was hit hard by deteriorating financial and labour market conditions, plunging consumer confidence and a sharp decline in equity wealth. Employment, which had started to decline modestly in January 2008, weakened at a much faster pace in the second half of the year, with monthly losses exceeding the 500,000 mark by November 2008. Business activity was also disrupted as firms cut back capital expenditures and began to slash inventories in response to the collapse in demand.

As a result, U.S. real GDP plunged 6.3 per cent in the final quarter of 2008 (Chart 3.3), the sharpest decline since 1982. The contraction reflected broad-based weakness, including a significant drop in consumer spending (the sharpest in 28 years), as well as sharp declines in residential and business investment and exports. The U.S. contraction continued in the first quarter of 2009, with real GDP falling 5.7 per cent due to further declines in business and residential investment, a decrease in government spending and a sharp inventory correction.

The U.S. has officially been in recession since January 2008, making this recession already the longest and one of the deepest downturns since World War II. Since January 2008, employment has fallen by a record 6.0 million jobs, while the unemployment rate, at 9.4 per cent, has reached a 25-year high.

The sharper-than-expected contraction in the U.S. in late 2008 and the first half of 2009 has resulted in a significantly weaker outlook for 2009. Private sector forecasters now expect that U.S. real GDP will contract by 3.0 per cent in 2009, 1.2 percentage points lower than expected at the time of Budget 2009. Even so, private sector forecasters still expect the U.S. economy to begin to recover in the second half of 2009 and through 2010, supported by significant monetary and fiscal stimulus as financial market stresses abate.

Recent Signs of Stabilization in the Global Economy

A sustained and strong recovery in the Canadian economy will require a sustained recovery in the global economy and financial markets. Several encouraging signs in recent months suggest the global economy and world financial markets are beginning to stabilize.

First, although financial markets remain disrupted, fears of a systemic collapse of the financial system have eased considerably and financial conditions are improving. World equity markets have improved significantly in recent months, with most major benchmark indices posting gains of between 25 per cent and 40 per cent from lows hit in early March (Chart 3.4). Rebounds in the share prices of financial corporations have been a major factor behind these gains. Moreover, although financing costs for businesses around the world remain elevated, they have retreated towards their historical averages in recent months, owing to accommodative monetary policy and specific measures to address financial market dislocations. In Canada, these costs remain below those of other countries, reflecting the soundness of Canada's financial sector.

Moreover, yields on short-term government securities have declined significantly since Budget 2009 and are currently around record lows of 0.2 per cent, reflecting very accommodative monetary policy in Canada. Yields on long-term government bonds are currently around 3.1 per cent, broadly in line with levels at the time of the budget.

A second encouraging sign is the recent increase in the world prices for many commodities. Between July 2008 and early 2009, prices for many key Canadian commodities collapsed, reflecting sharply lower global demand. The decline was most pronounced for energy prices, with crude oil prices declining by 70 per cent from peak levels (Chart 3.5) as significant reductions in crude oil supply could not keep pace with rapidly falling oil consumption. This unprecedented fall in commodity prices reduced export incomes and put significant downward pressure on the Canadian dollar, which fell by almost 20 cents relative to the U.S. dollar over this period.

Since the time of the budget, commodity prices have remained weak relative to a year ago, but have improved. However, prices remain volatile, reflecting uncertainty over future global economic conditions and continued excess supply for many commodities, both of which mean that the recovery in commodity prices will likely be gradual. Current crude oil futures contracts suggest prices will continue to rise modestly in coming months, averaging US$60 per barrel in 2009 and US$74 per barrel in 2010, above expectations in Budget 2009.

Third, there have been tentative signs that the rate of contraction in U.S. and global production is slowing. Particularly in the U.S, where the current crisis originated, the most recent data support the view that the rate of contraction in U.S. economic activity may be slowing and the U.S. housing sector stabilizing. Monthly existing home sales have settled around 4.6 million units over the six months to April and inventories of existing homes for sale (in months' supply) have declined to 10.2 months from their peak of 11.3 months. As well, consumer confidence has improved, and new orders in the manufacturing sector increased for the first time in a year and a half, suggesting U.S. manufacturing activity is stabilizing (Chart 3.6).

These recent developments raise the prospect of stabilization in global financial markets and in global economic activity more generally. At issue is whether these improvements will be sustained and to what extent they will translate into a recovery in the global economy.

Strengths of the Canadian Economy

The Canadian economy has fared better than those of the other major industrialized countries owing in part to Canada's strong economic and financial fundamentals. Indeed, Canadian households, businesses and governments have entered this period of economic and financial turbulence from a position of strength. Importantly, the imbalances that were present in other countries did not exist in Canada. As a result, while Canadian exports and production have been affected by developments abroad, the impact on the domestic economy has been far less than in other countries.

A major reason is the soundness of the Canadian banking system, which is characterized by high capital adequacy ratios, low leverage ratios and strong prudential regulation. While Canadian banks and other financial institutions have been affected by the global financial crisis, the position of strength from which Canada entered the recession has helped Canadian financial market conditions and kept financing costs for businesses significantly below those of other countries even through this period of financial turbulence. Indeed, the World Economic Forum has recognized Canada's banks as the soundest in the world and the IMF has noted that our banking system has shown "remarkable stability amid the global turbulence, thanks in good part to strong supervision and regulation"³ (Chart 3.7).

The Canadian housing market also remains sound. Importantly, the current cyclical adjustment in prices and activity is fundamentally different than the correction that is occurring in the United States. In particular, Canada's housing market growth was not fuelled by aggressive marketing of high-risk, sub-prime mortgage products that led to unsustainable growth in demand and prices in the United States. However, the recent declines in housing starts and existing home sales in Canada have been accompanied by modest declines in average house prices in Canada as well (Chart 3.8). Prices have fallen the most in Western Canada where prices had increased sharply in recent years. The smaller deterioration of the Canadian housing market has meant that the net worth position of Canadian households has fallen by far less than in the U.S., which will help support consumer expenditures going forward.

Finally, Canada entered this recession in a better fiscal position than any G7 country. In 2007, at the onset of the crisis, Canada had the lowest debt-to-GDP ratio of all G7 countries. Also, the Organisation for Economic Co-operation and Development and the IMF expect Canada to maintain this position among the G7 in the years ahead. This strong fiscal position, together with solid economic and financial fundamentals, is supporting consumer and business confidence in Canada.

Canada's strong fiscal position has also lowered our reliance on foreign funding, leading to significant reductions in net foreign debt (Chart 3.9). Net foreign debt is the difference between liabilities owed by Canadian households, businesses and governments to the rest of the world and the foreign assets that they own. Canada was in a net international asset position for the first time in 80 years in the fourth quarter of 2008. The sharp reduction in Canada's net foreign debt benefits Canada through lower net income flows abroad, and has significantly lowered our exposure to global financial market shocks.

Canadian Economic Developments and Outlook

The global recession has negatively affected the Canadian economy. Real GDP fell 3.7 per cent in the fourth quarter of 2008—officially marking the beginning of the recession in Canada—as weak foreign demand continued to lower Canadian exports and deteriorating financial conditions and confidence led to an outright decline in consumer spending and business investment. Real GDP declined further by 5.4 per cent in the first quarter of 2009 as a result of a continued deterioration in exports and domestic demand. Recent economic indicators are pointing to another contraction in output in the second quarter, but at a much slower pace.

In addition to the significant contraction in real economic activity, rapid and sharp declines in world energy and non-energy commodity prices reduced the average price of production in Canada as measured by the GDP price deflator, which declined by 11.0 per cent in the fourth quarter of 2008 and an additional 6.5 per cent in the first quarter of 2009. As a result of sharply lower GDP inflation, together with the significant decline in real GDP over the past two quarters, nominal GDP dropped by an unprecedented 14.4 per cent in the fourth quarter of 2008 and a further 11.5 per cent in the first quarter of 2009.

The weakness in the domestic economy has spread to labour markets in Canada. Employment has fallen by over 360,000, or 2.1 per cent, since the recession in Canada began. However, the Canadian labour market has fared much better than that of the U.S, which has lost a record 6.0 million jobs—a 4.3-per-cent decline—since the beginning of the U.S. recession in January 2008 (Chart 3.10).

In Canada, job losses in the manufacturing sector have accelerated since the recession began, with significant losses in autos and auto parts manufacturing as a result of a number of plant closures owing to weak U.S. demand. Moreover, lower residential and non-residential investment has led to a major slowdown in the construction sector. As a result, the unemployment rate rose to 8.4 per cent in May, its highest level in eleven years. Nevertheless, the Canadian unemployment rate remains significantly below that of the U.S., currently at 9.4 per cent, and the increase in the unemployment rate in Canada has been about half of that in the U.S. since early 2008.

These recent developments have led private sector forecasters to revise down their forecasts for real and nominal GDP in 2009. They currently expect that Canadian real GDP will contract by 2.5 per cent in 2009, compared to a contraction of 0.8 per cent at the time of Budget 2009 (Table 3.1). Private sector forecasters have also revised down their expectations for nominal GDP this year from a decline of 1.2 per cent to a decline of 4.3 per cent.

Private sector forecasters expect that the weaker outlook this year will translate into an increase in the unemployment rate to 8.6 per cent in 2009, up significantly from 7.5 per cent at the time of the budget. Private sector forecasters expect Canadian short-term interest rates to average 0.3 per cent in 2009, lower than the 0.8 per cent expected at the time of the budget. Expectations for long-term interest rates this year are largely unchanged.

Table 3.1
Average Private Sector Economic Forecast for 2009

	January 2009 Private Sector Forecast	May 2009 Private Sector Forecast
	(per cent)
Real GDP growth	-0.8	-2.5
GDP inflation	-0.4	-1.9
Nominal GDP growth	-1.2	-4.3
3-month treasury bill rate	0.8	0.3
10-year government bond rate	2.8	2.9
Unemployment rate	7.5	8.6
U.S. real GDP growth	-1.8	-3.0
Source: Department of Finance Canada survey of private sector forecasters.

In Budget 2009, the Government anticipated that global and domestic economic conditions could turn out to be weaker than suggested by the average of private sector forecasters. Nominal GDP growth for 2009 was adjusted significantly downward to -2.7 per cent for budget-planning purposes (Table 3.2). This means that about half of the downward adjustments to the economic outlook of the private sector forecasters since January has already been accounted for in budget-planning assumptions.

The Department of Finance regularly surveys private sector economists on their views of the economy. Private sector forecasters included in the May 2009 survey are Bank of America Merrill Lynch, BMO Capital Markets, Caisse de dépôt et de placement du Québec, The Centre for Spatial Economics, CIBC World Markets, Desjardins, Deutsche Bank of Canada, Laurentian Bank Securities, Global Insight, National Bank Financial, Royal Bank of Canada, Scotiabank, TD Bank Financial Group, UBS Warburg, University of Toronto (Policy and Economic Analysis Program).

The IMF expects that Canada will experience the smallest contraction of all G7 countries in 2009 and the strongest recovery going into 2010 (Chart 3.11). This reflects Canada's core strong economic, financial and fiscal fundamentals as well as Canada's Economic Action Plan.

Table 3.2
Canadian Economic Outlook for 2009

	January 2009 Private Sector Forecast	January 2009 Budget Fiscal Planning	May 2009 Private Sector Forecast
Nominal GDP growth (per cent)	-1.2	-2.7	-4.3
Nominal GDP level (billions of dollars)	1,590	1,560	1,533

As with the global economy, there are also encouraging signs that the pace of decline is slowing in Canada and that the Canadian economy could begin to recover in the second half of 2009:

• The Conference Board of Canada's Index of Consumer Attitudes increased in four of the past five months, which suggests that household confidence is improving and bodes well for personal consumption going forward. This has already been reflected in retail sales, which increased for a third consecutive month in March.
• Residential building permits, which led the upturn in residential construction in the past two recessions, increased in March and April. As well, existing home sales registered a third consecutive monthly increase in April.

Downward revisions to real and nominal GDP in 2009 largely reflect a more severe contraction in economic activity at the end of 2008 and in the first half of 2009. Looking ahead, most private sector forecasters have not changed their view since January—they continue to point to a sustained economic recovery beginning in the second half of 2009 and gaining momentum in 2010 (Chart 3.12).

This being said, there continues to be a large degree of uncertainty surrounding the global economic outlook. While there is some upside risk to the outlook this year and next, significant downside risks remain. As a trading economy, the expected recovery in Canada is highly dependent on a sustained recovery in the global economy, in particular in the United States. The global economic recovery, in turn, cannot fully materialize until dislocations in global financial markets are fully resolved and these markets are fully functioning.

Canada's Economic Action Plan Is Creating and Preserving Jobs

Preserving and creating jobs is the Government's top priority. Canada's Economic Action Plan will preserve or create 190,000 jobs. All elements of the Economic Action Plan contribute to this overall agenda.

The Plan has been designed to provide immediate support to the job market through lower taxes, a responsive and enhanced Employment Insurance system, and upgrading of Canadian infrastructure. The Plan is already having an impact on the job market:

• The number of Canadians benefiting from the enhanced work-sharing program, an innovative feature built into the Employment Insurance system, has increased fourfold since January—from about 27,000 in January 2009 to about 120,000 in May 2009.
• Sales in home centre, building, hardware and garden stores have posted the strongest gain among major retail store categories since January, supported by the Home Renovation Tax Credit, creating and preserving jobs in the construction industry and related sectors.
• Many infrastructure projects to upgrade and modernize federal infrastructure—from bridges and highways to buildings—are already underway, supporting employment in the construction and related industries.
• A number of framework agreements have been signed with provincial and territorial governments to identify specific infrastructure and social housing projects. For example, the Government of Canada and the Province of British Columbia have announced a new $123-million Seniors'Rental Housing Initiative to build up to 1,000 new housing units for seniors and people with disabilities. Construction of the first 218 units will start in 19 B.C. communities over the next few months. The project will create or preserve close to 800 jobs.

Canada's Economic Action Plan will build on these early impacts in coming months as further elements of the Plan, such as federal-provincial-territorial infrastructure and social housing projects and actions to support affected sectors and communities, are implemented.

The most effective means of raising employment through public expenditure is through infrastructure investment. One billion dollars in infrastructure investment generates $1.6 billion in economic activity and creates almost 10,000 jobs over time with significant impacts felt almost immediately. Similarly, the Federation of Canadian Municipalities estimates that each $1 billion invested in new infrastructure creates more than 11,000 jobs. For this reason, more that 40 per cent of the Plan's total stimulus funding is devoted to infrastructure investment.

Further, a modernized infrastructure contributes to the overall competitiveness of the economy, providing a permanent boost to incomes. Infrastructure spending also targets two of the sectors most affected by the current economic downturn—construction and manufacturing. Manufacturing employment has been declining since 2007, while employment in construction has fallen by 120,000 since September 2008. For every dollar spent on infrastructure, about 60 per cent of economic activity and jobs created are in the construction industry. The remaining 40 per cent of jobs created are in industries that support construction—notably manufacturing.

Fiscal Outlook

The weaker-than-expected economic performance in late 2008 and first half of 2009 will result in more support being provided through the automatic stabilizers in the federal budget, most notably lower corporate income tax revenues and higher Employment Insurance (EI) benefits.

In addition, as part of the Government's response to the weaker economy, significant additional support has been provided in partnership with the United States to position the automotive industry for long-term success.

Taken together, the weaker economic outlook and actions taken in support of the economy have led to a deterioration in the Government's projected budgetary balance.

The Government is now projecting deficits of $3.9 billion in 2008–09 and $50.2 billion in 2009–10. More than half of the 2009–10 deficit is the result of temporary measures under Canada's Economic Action Plan, less taxes collected, higher EI benefits, and the decision to freeze EI premium rates. The remaining deficit of $23.2 billion, or 1.5 per cent of GDP, is primarily a reflection of the weak economy and will be reversed as the economy recovers. The Government is committed to return to surplus in future years and to pay back the deficits that have been accumulated over this period. Canada's deficit is particularly modest compared to the fiscal situation of other countries. Further, Canada entered this recession with the lowest debt-to-GDP ratio of all G7 countries.

 

Changes in the Fiscal Outlook
Since Budget 2009

Based on economic developments since Budget 2009, the deficit before any actions has been revised up by $2.9 billion for 2008–09 and $8.1 billion for 2009–10, to $3.9 billion in 2008–09 and $41.7 billion in 2009–10 (Table 3.3). This deterioration reflects, in part, the impact of automatic stabilizers, such as EI, which provide support to the economy by automatically raising spending and lowering tax collections as the economy slows.

Table 3.3
Summary of Changes in the Fiscal Outlook Since the January 2009 Budget

	Projection
	2008–09	2009–10
	(billions of dollars)
January 2009 budgetary balance	-1.1	-33.7
Impact of economic and fiscal developments
Budgetary revenues
Less personal income tax	-0.4	-0.4
Less corporate income tax	-2.5	-2.3
Goods and Services Tax	0.0	0.6
Less other revenues	-0.1	-2.6
Total revenues	-3.0	-4.7
Program expenses1
Higher EI benefits	-0.6	-2.8
Other major transfers	-0.2	-0.3
Direct program expenses	1.2	-0.6
Total program expenses	0.4	-3.6
Public debt charges	-0.3	0.3
Total economic and fiscal developments	-2.9	-8.1
Revised status quo budgetary balance	-3.9	-41.7
Actions since Budget 2009
Loans to the auto industry		-8.0
Canada Health Transfer top-up		-0.5
Total		-8.5
Revised budgetary balance	-3.9	-50.2
Note: Totals may not add due to rounding. 1 A positive number implies a decrease in spending and an improvement in the budgetary balance. A negative number implies an increase in spending and a deterioration in the budgetary balance.

 

 

Updated Fiscal Outlook

Table 3.4
Summary Statement of Transactions

	Actual	Projection
	2007–08	2008–09	2009–10
	(billions of dollars)
Budgetary revenues
Personal income tax	113.1	116.7	109.8
Corporate income tax	40.6	29.2	24.1
Goods and Services Tax	29.9	26.4	26.4
Other revenues	58.8	61.1	59.9
Total revenues	242.4	233.3	220.2
Program expenses
Employment Insurance benefits	14.3	16.2	21.7
Other transfers to persons	43.8	45.3	47.4
Major transfers to other levels of government	46.2	46.5	50.9
Direct program expenses	95.2	98.4	121.2
Total program expenses	199.5	206.3	241.2
Public debt charges	33.3	31.0	29.2
Total expenses	232.8	237.3	270.4
Budgetary balance	9.6	-3.9	-50.2
Federal debt	457.6	461.5	511.7
Per cent of GDP
Budgetary revenues	15.8	14.6	14.4
Program expenses	13.0	12.9	15.7
Public debt charges	2.2	1.9	1.9
Total expenses	15.2	14.8	17.6
Budgetary balance	0.6	-0.2	-3.3
Federal debt	29.8	28.8	33.4
Note: Totals may not add due to rounding.

Relative to the size of the economy, the 2009–10 deficit is projected to be 3.3 per cent of GDP. This is smaller than the deficits recorded during much of the 1980s and early 1990s, which averaged nearly 6 per cent of GDP, as illustrated in Chart 3.16.

Risks to the Fiscal Projections

The updated fiscal projections are being prepared early in the fiscal year before final 2008–09 results are available and with very limited information on 2009–10 economic and fiscal results. As a result, there is significant uncertainty.

The risks to the projections come primarily from the uncertain global economic outlook as well as uncertainty as to how economic developments will translate into spending and tax revenues. For example, there is significant uncertainty as to how declining corporate profits and increased corporate losses in 2009 will affect corporate tax revenues this year, since it is not yet known the extent to which corporate losses will be used to claim refunds of past taxes paid.

Private sector and Government forecasts have changed significantly over the last year, due to these unique and uncertain times. The Government will continue to monitor economic developments over the summer with a view to providing an update to Canadians in the fall report.

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Note: This chapter incorporates economic data available up to June 5, 2009, unless otherwise indicated. Figures in this chapter are at annual rates unless otherwise noted.

¹ IMF, World Economic Outlook (April 2009).
² IMF, World Economic Outlook Update (January 2009).
³ IMF, Canada: 2009 Article IV Consultation (May 2009).
⁴ Council of Economic Advisers, Estimates of Job Creation from the Americal Recovery and Reinvestment Act of 2009 (May 2009).