Canada may A be able to resist being sucked into a U.S. slump by relying on its own real strengths
For one nerve-jangling day, it looked as though the Canadian economy was about to be put to its toughest test since struggling back from the 1990-1991 recession. On Jan. 2, stock traders booted up their computers for 2001 s first trading session to be confronted with news that a key barometer of U.S. manufacturing, the National Association of Purchasing Managements main index, had dropped to an alarmingly low level. Investors already unnerved by bad tidings that piled up late last year—from layoffs in the auto industry to a spate of profit warnings in the once-sizzling high-technology sector—were in no mood to face down adversity. They sold. The techladen Nasdaq stock market was hammered, and so was the Toronto Stock Exchange.
Many Canadian economists, who for months have been forecasting that Canada’s economy would outpace U.S. growth in 2001, spent the day pleading for calm. They told anyone who would listen that even if the market carnage made it look like the inevitable cooling of the overheated U.S. economy was turning out to be more dramatic than expected, the Canadian economy still had its own strengths to fall back on. Taxes are coming down. Productivity is going up. It seemed Canadians were about to find out if the country’s hard-earned new economic virtues—government surpluses, tamed inflation and companies converted to the gospel of globalization—would pay off in the face of a real U.S. slump. But, then, the clouds to the south lifted. Or, rather, they were parted by Alan Greenspan, the U.S. Federal Reserve Board’s resident deity, who bestowed a surprise Jan. 3 cut of one-half per cent in interest rates. Thankful markets dutifully rallied, but then tumbled again two days later.
The uneven response to the Fed chairman’s intervention left some fearing a hard landing is in store for the U.S. economy. But the stakes for Canada even in the so-called soft-landing scenario are huge. Most forecasts suggest the only way Canada's economy can avoid meltdown and meet expectations this year is by drawing on internal resources—no longer relying on being pulled along in the powerful slipstream of the United States. “The slowing U.S. economy is going to affect us negatively in Canada, there’s no getting away from that,” says Bank of Montreal chief economist Tim O’Neill. “But the fact is that we’ve got some domestic momentum— employment growth, real income growth and business investment spending that has tended to be somewhat stronger than in the U.S.”
What happened to the doctrine that borders wouldn’t matter much anymore in the North American economy of the free-trade era? It turns out that despite bigger and tighter trade bonds than ever, the Canadian and U.S. economies have moved out of sync in the past decade. Emerging from the recession of the early 1990s, the U.S. economy surged into the world-wowing expansion that carried on majestically through President Bill Clinton’s two terms in office. Canada’s recovery was, at first, unsteady. Canadian government debt and deficits were that much worse. Inflation fears, a weak Canadian dollar and periodic scares over Quebec’s future kept interest rates higher than in the United States. But sustained federal and provincial assaults on deficits and an unflinching Bank of Canada anti-inflation stance, along with booming trade to the United States, finally began to translate into climbing disposable incomes—the bottom line of prosperity—about three years ago. “It was really not until 1997 that we started to track close to where the U.S. was,” says O’Neill. “That’s unusual. Historically, the Canadian and U.S. economies tended to track closer together.”
Having arrived late at North America’s economic party, Canadians are hardly ready for the bash to end. “In the U.S., housing sales peaked early last year,” notes David Rosenberg, chief Canadian economist and strategist for international investment house Merrill Lynch. “In Canada, the housing cycle has only gotten going in the past 12 months.” The same lag factor applies to cars. Americans have replaced their old vehicles in record numbers in recent years, but in Canada about 45 per cent of the cars and trucks on the road are at least nine years old. So while new car sales are expected to fall off in the United States this year, a recent Bank of Nova Scotia report projects vehicle sales in Canada will edge up to 1.56 million from the record 1.55 million sold in 2000.
Still, with 85 per cent of the cars and trucks built in Canada exported to the United States, sustained domestic demand does little to offset the continental sales slide. Last week, General Motors Corp. shifted the already crawling auto industry into an even slower gear by announcing it will idle 11 North American plants with more than 32,000 employees, including one in Ste-Thérèse, Que. The move followed cuts to overtime and worker layoffs by Ford Motor Co. and DaimlerChrysler AG in Canada, as well as in the United States.
A slump in the auto sector, though, no longer delivers the body blow to the Canadian economy it once did. “Cars aren’t everything anymore,” says Stephen Poloz, chief economist at the federal Export Development Corp., pointing to a trend of export diversification. Poloz expects farm and food sector exports to grow by 11 per cent, aerospace by 25 per cent and telecommunications equipment by 14 per cent. And even though the sagging United States remains by far Canada’s biggest customer, growth in other foreign markets is picking up at least some of the slack. Sales to Asia and Latin America sank by 30 per cent in the late 1990s after those developing economies hit a financial crisis, but since then the regions, and Canadian exports to them, have bounced back to former levels—and then some.
The bounce in overseas markets helps, but it is the buoyant domestic scene that is giving the most cause for hope. One big reason is that 2001 is the year Canadian taxpayers will finally turn over substantially less of what they earn to governments. “Tax cuts are coming at an almost ideal time as the economy is slowing, and they will bolster consumer spending,” says Josh Mendelsohn, chief economist at the Canadian Imperial Bank of Commerce. As of Jan. 1, federal income tax rates dropped across the board, to 16 per cent from 17 per cent for income below $30,754; to 22 per cent from 26 per cent for income from $30,754 to $61,509; and to 26 from 29 per cent for income from $61,509 to $100,000. And even though the basic rate for those earning six-figure salaries and higher remains the same (29 per cent), those well-off taxpayers benefit from the removal of a five-percent surtax on income over $85,000. Most provinces are also cutting their tax takes. The Canadian Tax Foundation estimates that a two-income family with children in Ontario making $100,000 will see its total federal and provincial tax bill fall by $2,126 this year, and a similar Alberta family will save $2,448.
The easing tax burden comes as most Canadians were finally seeing their incomes grow after the discouraging stagnation in living standards during the first half of the 1990s. After 1996, disposable income has grown almost eight per cent, and hourly wages rose 6.5 per cent over the same period. And there are signs better days are coming not only to the better-off. The National Council of Welfare reported late last month that the number of Canadians living below Statistics Canada's low-income cutoff, widely viewed as a poverty line, dropped in 1998 to the lowest level in six years, to 16.4 per cent from 17.8 per cent in 1997. It’s not just that working Canadians are earning more, it’s that more Canadians are working. Unemployment sank to an estimated 6.8 per cent in 2000 from 9.5 per cent five years earlier.
But could the good times stop rolling in 2001 ? None of the most influential forecasters are anticipating a full-blown recession, defined as two consecutive quarters in which the economy shrinks. A sharp slowdown from last year’s pace of growth, though, appears inevitable. In pockets of the economy, notably the beleaguered auto industry, it will be painful. Still, CIBC’s Mendelsohn, in a forecast released last week, projected a respectable 3.3-per-cent growth in gross domestic product this year, down from a muscular five per cent he estimates for 2000. In the same CIBC forecast, corporate profits are pegged to rise by nine per cent this year after soaring 23.2 per cent in 2000. And as companies see profits increasing by less than last year, they are expected to curb growth in spending on machinery and equipment—a key to both driving current economic activity and creating the conditions for future competitiveness—to 8.6 per cent this year after pumping it up by 21.3 per cent in 2000.
Yet economists view the pace of business investment in machinery and equipment as a positive part of the Canadian outlook, especially spending on new information technology. “Our real lag with the U.S. was investment in IT,” says Bank of Montreal’s O’Neill. “But for the past 18 months or so, investment in this area has been running substantially faster in Canada than in the U.S.” The jump in business spending on computers and telecommunications gear is a theme that Finance Minister Paul Martin hit hard in his pre-election fall mini-budget, emphasizing that Canadian companies’ rapid machinery and equipment spending has been driven largely by purchases of information and communications technology.
That trend is at the core of the Liberal government’s boast that Canada is no longer a poor second cousin when it comes to the New Economy. Martin plans to take his message of a more wired, e-savvy, productivity-driven Canadian economy to New York City later this month, to deliver a speech aimed at catching the attention of American investors. He will also meet with business leaders, including directors of the New York Stock Exchange, to tout Canada as a too-often-overlooked alternative to investing in the United States.
By the time Martin hits Manhattan, the fallout from Greenspan’s bold rate cut should be clearer. The key question in Canada: should the Bank of Canada follow suit? Many economists suspect the bank will ease Canadian rates somewhat in the first half of this year, but not in lockstep with the Fed. After all, the growing Canadian economy may not need the added fuel of lower borrowing costs as soon or as much. “Essentially, domestic demand in this country, most economists predict, is going to be strong enough to take us through the needed slowdown in the United States,” said Martin in his last public pronouncement on the state of the economy, back on Dec. 19. That suggests a faith in the economy’s momentum without an added push from easing monetary policy.
And the situation at the Bank of Canada is complicated by change at the top. Martin’s old partner in deficit fighting, former deputy minister of finance David Dodge, 57, takes over as the central bank’s governor from retiring Gordon Thiessen on Feb. 1. But Thiessen is scheduled to preside over his last meeting of the bank’s governing council on Jan. 23. That leaves him in a delicate situation. Does he shave interest rates as his last move, or stand pat and leave it to Dodge to put his stamp on the bank’s 2001 policy direction? Dodge is already committed to maintaining the bank’s low-inflation policy. Merrill Lynch’s Rosenberg suspects the bank will resist the urge to follow the Fed, at least for now. With U.S. rates falling, merely holding the line on Canadian rates should help attract the foreign investment some economists have long looked for to bolster the Canadian dollar. “What a glorious opportunity,” says Rosenberg, “for the Bank of Canada to see our currency finally begin to move towards its fair value of about 70 cents (U.S.) without having to do a thing.”
Closing the gap with the mighty U.S. dollar, catching up to U.S. productivity and, ultimately, chasing enviable American levels of personal income: economists see the coming slowdown as a chance for Canada to make up lost ground in all those areas this year—if their projections come to pass. But there are other economic divides Canadians may not be so eager to narrow. According to a recent Organization for Economic Co-operation and Development report, equities made up on average 18.6 per cent of the wealth of Canadian households in 1999, compared with 27.3 per cent in the United States. Back when stock indexes were soaring ever higher, that looked like another example of staid Canada being left behind. These days, as lurching markets signal less certain times ahead, it’s a piece of the national economic personality Canadians may be content to preserve. *
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