The Canadian economy remains heavily dependent on debt-fuelled increases in household and government spending for growth, writes Senior Fellow Philip Cross in the Financial Post.
Philip Cross, Mar. 27, 2018.
The marked slowdown in Canada’s economic growth reflects the economy’s failure to make the transition from household and government spending to exports and business investment that the Bank of Canada has tried to engineer for years.
The Bank of Canada wants to make this transition because household and government spending growth has been partly sustained by more borrowing, leaving it vulnerable to higher interest rates when the bank begins to normalize interest rates. As well, exports and business investment are more sustainable sources of long-term growth, with the added bonus that more investment would raise Canada’s long-term potential.
However, the reality is the economy has failed to shift from household and government spending to exports and business investment. The implication is that for exports and business investment to replace all the dollars generated by household and government spending, they would have to grow much faster than the latter.
Instead of rising faster, the growth of exports and business investment has not even kept pace with household and government spending, never mind replace it dollar for dollar. Since the end of 2014, household and government spending combined has risen by nearly $120 billion. Over the same time period, exports have increased by only $20 billion, while business investment fell by $40 billion. In terms of growth rates, household and government spending rose by 8.6 per cent, more than double the 3.9 per cent gain in exports, while business investment fell by 15.7 per cent.
Weak exports and business investment reflects disenchantment with government policies
The Canadian economy remains heavily dependent on debt-fuelled increases in household and government spending for growth. In fact, its dependence on these sectors has increased over the past year, with their combined growth accelerating from 3.5 per cent in the first six quarters after the oil price shock to 4.9 per cent in the last six quarters. Meanwhile, export volumes have fallen slightly since early in 2015, while business investment has levelled off at 20 per cent below its 2014 peak.
The continued dependence on household and government spending to sustain growth is one reason the Bank of Canada is reluctant to follow the U.S. Federal Reserve Board in raising interest rates. Higher interest rates not only would hinder domestic spending but also would put upward pressure on the exchange rate, even as exports are struggling to grow at all.
More generally, the continued reliance on household and government spending poses a conundrum for policymakers. Much of the growth of household and government spending is being fuelled by debt, one reason Canada’s high overall debt-to-GDP ratio has drawn a red flag from the Bank for International Settlements. This inhibits the Bank of Canada from raising interest rates, which would curtail growth by forcing households and governments to spend more on servicing their debt. However, the longer it waits to increase interest rates, the more households and governments continue to take on more debt, increasing the risks to growth over the long term.
For the moment, the federal government is relying on tighter regulation of lending and not higher interest rates to rein in mortgage borrowing, apparently with some initial success as home sales retreated in January. However, it remains to be seen if a slowdown in housing demand and prices will be sustained and whether less mortgage borrowing will translate into a broader slowdown in total household demand for credit and less government borrowing. Curbing government borrowing seems particularly problematic, given that the federal budget tabled in February called for net borrowing to rise from $23.5 billion in fiscal 2017-18 to $34.8 billion in 2018-19 and stay above $30 billion for the next four years.
Exports should have benefited from the 20 per cent devaluation of the exchange rate since the 2014 oil price crash, but instead exports have stagnated despite a strengthening global economy. While exports of resource-based products recovered, exports of manufactured goods slumped when they are usually the main beneficiaries of a lower dollar. Business investment should have benefited from higher profits earned from exports as the dollar devalued as well as the passing of the worst of the cuts in the oilpatch. Instead, firms project investment will continue to slump for a fourth straight year in 2018. Weakness in investment helps explain the ongoing slump in exports, as firms do not upgrade their competitiveness, or add to their capacity to export.
The continued lethargy in exports and business investment reflects disenchantment with a wide range of government policies perceived as anti-business. These include sharply higher minimum wages in Ontario and Alberta, a nation-wide carbon tax, the continued obstruction of new pipeline construction, and new regulations for labour in Ontario and for the federal government’s environmental review process.
The continuing indifference of governments in Canada to the cumulative impact of these policies on business sentiment stands in stark contrast with developments in the United States, where tax reform lowered corporate taxes enough to erase Canada’s long-standing advantage, compounded by accelerated write-offs of U.S. capital spending and a declining regulatory burden.
Philip Cross is a Senior Munk Fellow at the Macdonald-Laurier Institute.