Macdonald-Laurier InstituteDespite rosy reports of a hot economy, Canada is still struggling economically, writes Philip Cross. Importantly, the long-hoped-for shift to business investment and manufactured exports has failed to materialize.

By Philip Cross, September 19, 2017

As anyone who’s followed the news in the last couple of weeks knows, Canada’s economy continued to surpass expectations in the first half of 2017. But things are not as rosy as the headlines suggest. Several factors explain why the first-half upsurge of growth does not represent a break from Canada’s chronic slow growth of about two per cent. Transitory factors temporarily boosted growth. More fundamentally, the long-hoped-for shift to business investment and manufactured exports has not taken hold. Already exports fell a total of 10 per cent in June and July, reversing all of the gains earlier in the year.

Growth was buttressed by inventory building in the auto industry on top of relief from cost-cutting in the oil industry. Broadly speaking, the upturn of growth in the first half of 2017 was the mirror image of the near-recession in the first half of 2015. At that time, the shutdown of auto plants in Canada for extensive retooling compounded the deepening slump in the oil industry. The lesson of both 2015 and 2017 is that Canada’s $2-trillion economy is still small enough to be significantly affected by the actions of one or two of its leading industries, which may not reflect the underlying course of the total economy.

The Macdonald-Laurier Institute’s leading indicator clearly points to the unsustainability of the upturn of growth. After a peak rate of increase of 0.8 per cent, the index has slowed to 0.2 per cent or less in the last three months. Most of the slowdown originated in the housing and manufacturing sectors, which had led growth in the first half of the year. Housing already is reeling from measures taken to cool the market. Meanwhile the auto industry implemented long-planned shutdowns starting in July.

Housing already is reeling from measures taken to cool the market. Meanwhile the auto industry implemented long-planned shutdowns starting in July.

It is worth reflecting on why the Bank of Canada began to raise interest rates for the first time in seven years. Publicly, Governor Stephen Poloz said that rates were hiked because lower rates had “done their job.” However, recall that the bank for years had said that low interest rates were intended to encourage an upturn in exports and business investment that would lay the groundwork for more sustainable growth. While the surprise cut in interest rates early in 2015 had the desired effect of lowering the exchange rate, the expected rebound in exports and business investment remains elusive.

Manufacturing exports continued to struggle in the first half of 2017. Virtually all of the increase in exports originated in energy and autos, the latter driven by inventory-building in the U.S. before production is cut. Exports of non-auto manufacturing goods continued to weaken. Declines were posted for all other exports except industrial materials. Bank of Canada Deputy Governor Carolyn Wilkins offered no explanation of this weakness, saying in mid-June that “We have been working hard to understand the forces behind the data” on exports.

The apparent recovery of business investment is even more shallow than for exports. Investment gains in the first half of the year were concentrated in oil and gas after two years of severe cuts. As well, investment was artificially inflated in the third quarter of 2016 by the arrival of the main drilling platform for the Hebron offshore project. With the passing of this one-time event, investment spending plunged in the fourth quarter. As a result, much of the apparent gain in 2017 simply represented a return to more normal levels of investment. Business investment remains quite weak by historical standards, little changed from the level of a year ago and well below its level before the boom in the oil and gas sector ended late in 2014.

The housing-market bubble began to unwind in the second quarter after the average price of a house reached nearly $1 million in both Vancouver and Toronto. House prices in Vancouver and Toronto took off early in 2015 due to the confluence of three factors interrelated with falling oil prices. The first was the drop in interest rates engineered by the Bank of Canada to boost demand and lower the dollar. The second was the boost this devaluation gave to foreign homebuyers, since their currency now bought 20- to 25-per-cent more Canadian dollars. Finally, the end of the boom in Alberta meant that the flow of population from Vancouver and Toronto to Alberta came to a halt and even was partly reversed.

The housing-market bubble began to unwind in the second quarter after the average price of a house reached nearly $1 million in both Vancouver and Toronto.

Governments have introduced a number of measures to cool their housing markets, with an immediate impact of lowering national house prices. B.C.’s experience over the past year suggests that this leads to a one-time drop in demand as a segment of foreign buyers moves elsewhere, but does little to alter the fundamentals of the housing market. The Bank of Canada will need to raise interest rates to curb demand on an ongoing basis.

Besides industry-specific anomalies behind the first-half surge in growth, higher spending continues to be financed by debt, for both households and governments. The July increase in interest rates is a belated move to curb the overheated housing markets in Toronto and Vancouver.

There is widely-held skepticism about the endurance of the first-half growth surge. Despite the better than expected start to 2017, the consensus growth forecast for the next two years is a return to the two per cent or less that has gripped Canada’s economy most of the time since 2009. Examining the sources of growth in the first half of 2017 reinforces this skepticism. Sustaining higher growth in Canada is nearly impossible without an acceleration in the U.S., and there are few signs that is occurring. With incomes weakened by a drop in export prices and a reversal in housing, Canadians sustained higher spending by continuing to borrow more. This is an unsustainable path in a world of rising interest rates.

Philip Cross is a Munk senior fellow at the Macdonald-Laurier Institute.