Canada

OECD Economic Outlook, June, 1995

Recent developments

Real GDP expanded at an annual rate of 6 per cent in the second half of 1994, bettering the growth rate achieved in the preceding half-year. As has been the case [TABULAR DATA OMITTED] throughout the recovery, economic growth was fuelled by exports and - to a lesser extent - by business investment. Almost half of the extraordinarily high growth in merchandise exports resulted from gains in market share in response to the sharp decline in the real exchange rate since 1991 (by more than 20 per cent in terms of relative unit labour costs). Exports of machinery and equipment and automative products, in particular, have soared since mid-1994. High capacity utilisation rates in export-oriented industries and surging profits contributed to the strength of business investment. Growth in consumer spending continued to outstrip the moderate rise in disposable income. Apart from improved consumer confidence, this appears to reflect the fact that personal net wealth has increased significantly more than incomes. Consumer demand was led by spending on durables, despite higher interest rates. However, the marked rise in mortgage rates aborted the temporary revival of residential investment that emerged in the first half of 1994. Housing starts suggest that the weakness of residential investment has continued in early 1995, and there are also signs that higher interest rates have started to damp demand for consumer durables. Although exports and manufacturing shipments have remained buoyant, labour-market statistics and other leading indicators point to a marked deceleration in overall economic expansion in the first quarter of 1995.

[TABULAR DATA OMITTED]

No further inroads into unemployment have been made in recent months as job creation slowed. This follows a fall in the unemployment rate by 1 1/2 points to 9 1/2 per cent during 1994, associated with employment growth of around 3 per cent. The relatively rapid decline in unemployment reflects the fact that, in contrast to previous recoveries, the pick-up in employment has not yet induced large-scale re-entry into the labour market. Nonetheless, a shift from part-time to full-time employment suggests an improvement in job opportunities and helps explain rising consumer confidence and spending. While collective wage settlements have remained subdued, the annual increase in effective earnings has edged up somewhat, although continuing to fall short of productivity growth. The resulting decline in unit labour costs, along with substantial excess capacity outside the export sector, has kept inflation low, despite upward pressure on import and producer prices stemming from currency depreciation and higher commodity prices. Although underlying inflation has picked up a little, it has only reached the middle of the official target range of 1 to 3 per cent. "Headline" inflation has moved back towards the underlying rate, as last year's cut in tobacco taxes has ceased to affect the twelve-month increase in the consumer price index. With favourable cost and price performance reinforcing the competitiveness gains stemming from a lower exchange rate, export growth has increasingly outstripped that of imports. As a result, the current-account deficit narrowed by nearly 2 percentage points during 1994 to 2 3/4 per cent of GDP, despite a marked rise in the investment income deficit (due to foreign-debt servicing and higher profits of foreign companies in Canada).

Policies and other forces acting

Strong economic growth has been reflected in government finances. The general government deficit dropped from a peak of 7 3/4 per cent in the first half of 1993 to 4 1/2 per cent of GDP in the second half of 1994. The fiscal stance, which was broadly neutral in 1993, tightened in 1994, as evidenced by a decline in the cyclically-adjusted deficit from over 4 per cent to below 3 1/2 per cent of GDP. This move towards restriction largely reflected discretionary spending cuts. In its February 1995 Budget, the federal government adopted drastic further expenditure restraint in order to convince financial markets that deficit reduction targets will be met in spite of higher-than-expected hikes in short-term interest rates. Measures include major cuts in government employment, transfers to provinces, and subsidies to business and agriculture. Tax increases play a minimal role in fiscal action introduced in the Budget. Assuming that in their forthcoming budgets provinces adopt similar austerity measures in response to cutbacks in transfer payments, the general government deficit could narrow to 2 1/2 per cent of GDP by 1996. Although the fiscal tightening underlying this projection is substantial (1 1/2 per cent of GDP over 1995-96 in terms of the cyclically-adjusted balance), this would just suffice to put the excessively high net public debt-to-GDP ratio on a downward trend from a peak of 64 per cent. Moreover, the remaining structural deficit, estimated by the OECD Secretariat to be just under 2 per cent of GDP, would still leave government finances vulnerable to any pronounced cyclical downturn.