Causes and effects of Canada’s lower growth

June 5, 2018 | Last updated on June 5, 2018
4 min read

Canada’s growth in 2018 likely won’t surprise to the upside—and that will potentially affect the pace of rate hikes as well as where the loonie lands, says CIBC deputy chief economist Benjamin Tal.

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Domestic GDP growth for the first quarter was a disappointing annualized rate of 1.3%. That compares to 1.7% in the first quarter last year, and 2.2% for the U.S. in Q1 2018. For last year as a whole, Canada’s GDP growth was a stellar 3%.

“If you look at the overall situation when it comes to the Canadian economy, clearly 2018 will not be 2017,” says Tal, adding that 2017 GDP surprised to the upside by 1.2%. “This is not going to repeat itself in 2018.”

Read: Canada’s Q1 GDP growth lowest in almost two years

In fact, GDP numbers will likely languish below 2% this year, he says. One reason is consumers are starting to slow down, Tal says, and that will continue as interest rates rise.

Another problem is any positive economic impact from rising oil prices has been impeded by pipeline problems. “Canadian producers don’t get the same price as global producers or even American producers,” says Tal. “The discount is significant due to the inability to ship that oil.”

To address pipeline expansion, the feds announced last week that they would purchase the Trans Mountain pipeline and Kinder Morgan Canada’s core assets for $4.5 billion.

Read: How to invest amid Canada’s pipeline problems

Competitive disadvantage

Another indicator of lower GDP this year is a lack of business investment, says Tal. “You cannot blame CEOs for not investing, given the uncertainty regarding NAFTA and the negative impact of the tax changes in the U.S. on the ability of corporate Canada to compete. There are many headwinds facing corporate Canada, and that’s why we don’t see investment.”

The Bank of Canada’s latest Business Outlook Survey, conducted between Feb. 12 and Mar. 9, found firms’ overall sentiment was positive but that plans to boost investment had edged down.

Tal describes U.S. tax reform as a “significant force” that impacts Canadian business. “Overnight, we lost our ability to compete,” he says, as the U.S. slashed its federal corporate tax rate to 21%, making net effective rates similar in both countries. Another result of U.S. tax reform: “Many companies can write off immediately any new investment on new or used equipment—something that we cannot do in Canada,” says Tal.

Recent studies suggest business executives are split on the potential effect of U.S. tax changes, but they are cautious overall. A survey commissioned by the Institute of Corporate Directors in Q2 2018 found only 34% of respondents are optimistic about the domestic economy, down from 52% in fall 2017. What they’re most worried about is political instability for the next two to five years—34% say homegrown political strife will worsen in that period, and only 24% worry about U.S. taxes.

Meanwhile, an EY survey from spring 2018 found 61% of business leader respondents are worried about U.S. tax changes having a negative impact on business. Also, 51% said U.S.-based competitors may now have an edge when it comes to competing.

Read: Corporations cautious on Canadian economy: surveys

Canada could respond with fiscal policy to address a lack of economic competitiveness, says Tal. One option is to introduce an accelerated depreciation schedule, which would “basically allow Canadian companies to write off their investment immediately, the way the American companies do now,” says Tal. “That would be a good start to at least try to even the playing field.”

Going forward, Canada will likely rely on a cheaper loonie over the longer term in response to competition concerns, he says, explaining that “if you cannot compete, your currency should be going down.”

A late May report from TD said that the positive correlation between oil prices and the exchange rate had not been as strong as it usually is due to U.S. production increases and uncertainty over domestic pipelines, leading to a weaker loonie.

The loonie was valued at US$0.77 on June 1, compared to its six-month average of approximately US$0.79 and high of US$0.81. CIBC forecasts the loonie hitting US$0.76 in September.

Read:

Overall, Tal expects the 2018 Canadian economy to be “nothing more than OK.” As of May 28, CIBC forecasts GDP rates of 1.6% to 2.2% for the remaining three quarters of 2018.

Muted moves by the BoC

Along with subdued growth in 2018, Tal says rising inflation might rear its head this year. That combination is “one of the reasons why the Bank of Canada will be very muted,” he said, speaking ahead of the central bank’s May 30 decision to hold the key rate.

Read: BoC holds key rate at 1.25%, but hints at hikes to come

The central bank will put a greater focus on Canada’s economic growth, not on inflation, says Tal. “That’s why we believe that the Bank of Canada will be very slow in raising interest rates—much slower than what you see south of the border.”

Another reason for the Bank of Canada to act slowly relative to the Federal Reserve is Canadians’ sensitivity to rising interest rates because of higher debt levels, he adds.

As the Bank of Canada acts more slowly than the Fed, the loonie will weaken, he says, which, “at the margin, should help exports and companies to compete.”

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