INDU Committee Report

Since the turn of the second millennium, two very powerful external shocks have, one after the other, hit the Canadian economy. First, a worldwide “commodities boom” took hold in 2003 that sent many commodities prices and the Canadian dollar soaring to record levels and forced a restructuring of the Canadian economy away from manufacturing and towards primary commodities. The second external shock, a worldwide economic recession that began in late 2008, put an end to the first shock only by broadening the existing dampening effect on demand — both domestic and foreign — from Canadian manufactured products to include all Canadian goods and services. Matters, nevertheless, did get worse for the Canadian manufacturing sector, particularly specific industries focused on export markets such as forestry products, minerals and metal products, segments of the energy sector, motor vehicle manufacturers, automotive parts manufacturers,[1] aerospace, and high-tech manufacturing. Both of these economic events, as they have affected the Canadian economy and credit markets, are the topic of this section.

The “Commodities Boom” and the Rise of the Canadian Dollar

Beginning in 2003, rapid world economic expansion,[2] led largely by China, India and Southeast Asia, fuelled the demand for primary commodities, most notably energy and base metals, and led to rapidly rising commodity prices.[3] These price increases were also accompanied by a large and rapid appreciation of the Canadian dollar, particularly against the U.S. dollar. These more or less simultaneous events were not unrelated. Canada is rich in energy and minerals both in absolute terms and, more importantly, on a per capita basis relative to other countries, a circumstance that has allowed and even encouraged Canada to develop along commodity export lines. For a commodity exporting country like Canada, rising commodity prices mean higher export prices, while an appreciating home currency means lower import prices in Canadian dollar terms. Hence, Canada enjoyed a much improved terms of trade performance (i.e., the ratio of Canadian export to import prices) in the wake of the “commodities boom”,[4] and hand-in-hand with foreigners wanting more Canadian commodities and willing to pay more for them came both increased domestic production and a general rise in economic welfare across the country. Canada’s much improved terms of trade appears to have also sparked international investors’ interest in Canada. Net foreign direct investment (FDI) flows, which had been mostly outbound rather than inbound to Canada in the last two decades of the 20^th century, reversed course. Dominated by large foreign acquisitions of Canadian natural resource companies beginning in 2006, Canada recorded a net FDI inflow of $27.0 and $62.3 billion in 2006 and 2007, respectively. This positive capital inflow bolstered the terms of trade inspired rise in the Canadian dollar… until the global recession struck.

Figure 1

Source: Bank of Canada, http://www.bankofcanada.ca/en/rates/can_us_lookup.html.

A further outcome of Canada’s terms of trade spike has been a rapid and substantial appreciation of the Canadian dollar against the U.S. dollar and, indeed, against many other currencies.[5] The Canadian dollar had surged 78.5% in value relative to the U.S. dollar in just five and three-quarter years before resting in the vicinity of parity with the U.S. dollar throughout the first half of 2008 and then resettling in the 79¢ to 85¢ US range since October 2008 and the beginning of the global recession (see Figure 1).[6]^,[7] Of course, this currency performance is not uniquely a Canadian story. Another contributing factor has been currency traders’ concerns over both the large U.S. current account deficit and the U.S. government’s growing tendency to borrow in foreign markets to finance its budget deficit.

A Global Recession and a Credit Crunch

In autumn 2008, the U.S. economy began a slowdown that, by the end of the year, accelerated to a pace unprecedented since the Great Depression of the 1930s; it also encompassed a greater breadth of the economy than most recessions. At its origin was the unexpected and huge losses incurred on U.S. subprime mortgages or asset-backed commercial paper (ABCP) that had sparked a financial crisis in the summer of 2007 and would eventually set in motion a string of failures of several prominent global financial institutions. These most recent high profile corporate collapses then led many observers to suspect the liquidity crisis had grown into a solvency crisis. Declining confidence in financial markets next spilled over into housing markets, consumer products markets and, through trade markets, channelled the recession from the United States to all other major advanced economies of the world, including Canada. The fourth quarter of 2008 marked the beginning of a rather abrupt and deep global recession that is expected to further deteriorate throughout the first three-quarters of 2009, if not the entire year.

Figure 2

Source: Bank of Canada, Monetary Policy Report, October 2008 and April 2009.

Canadian exports of manufactured goods to the United States and elsewhere that had already been weak and declining (due to the rapid appreciation in the value of the Canadian dollar) began to plunge further in response to the global economic downturn. Indeed, in December 2008, Canada recorded its first merchandise trade deficit since March 1976. The contraction in demand did not stop at Canadian borders, however. Reductions in real income related to the sudden decline in commodity prices, the reduction in household net worth, and lost consumer and investor confidence also contributed to a decline in domestic demand. With falling demand for Canadian goods and services came a retrenchment in supply: Canadian GDP declined by a startling 3.4% annual rate in the fourth quarter of 2008 (see Figure 2).

Table 1 Global Economic Growth Projection

Country or Region	Share of Real Global GDP (%)	Projected Growth (per cent)
		2008	2009	2010	2011
United States European Union Japan China and Asian NIEs Others	22  20  7  14  37	1.1  0.7 -0.7  7.1  4.9	-2.4 -3.6 -6.2  3.5  1.0	1.2 -0.2  1.0  6.0  3.0	2.9 1.8 2.5 7.3 4.0
World	100	3.2	-0.8	2.2	3.7

Source: Bank of Canada, Monetary Policy Report, April 2009.

Many forecasters predict the global recession to persist and even deepen throughout the course of 2009. A global economic recovery is not expected until either the fourth quarter of 2009 or sometime in 2010 — or not until 2011 in the case of the European Union (see Table 1). The decline in economic activity in Canada is also forecast by many to continue throughout 2009, with the Bank of Canada projecting an acceleration in the decline to -7.3% in the first quarter of 2009 and the trough in the economic cycle not to be reached until the third quarter of 2009. Put in annual terms, the Bank of Canada forecasts a decline of 3.0% in economic activity in 2009, followed by growth of 2.5% in 2010.[8]

Of course, not all forecasting outfits share this projection. For example, The Conference Board of Canada forecasts a decline in GDP of about 6.4% in the first quarter of 2009 and the trough to be reached in the following quarter. In annual terms, the Conference Board of Canada forecasts a drop in GDP of 1.7% in 2009, followed by growth of 2.5% in 2010.[9] TD Economics, on the other hand, forecasts a decline in GDP of 5.8% in the first quarter of 2009 and the trough to be reached in the third quarter of 2009. In annual terms, TD Economics forecasts a drop in GDP of 2.4% in 2009, followed by growth of 1.3% in 2010.[10] In summary, the Bank of Canada holds the view that the recession in Canada will be deep and long, but the recovery will be brisk. TD Economics, on the other hand, believes the recession in Canada will be deep by historical standards (but shallow compared to the Bank of Canada and The Conference Board), followed by a slow and tepid recovery. The Conference Board’s forecasts are found in the middle of these two projections.

Despite these differing views of the near future, all forecasts of economic recovery are predicated on the stabilization of the global financial system, and in the latter lies the greatest source of uncertainty to any economic projection at this time. Moreover, the resolution of this uncertainty and the emergence of an economic recovery in Canada will mostly be found in the actions taken by others — in the fiscal and monetary actions of international and foreign country institutions. The Canadian economy is, therefore, largely hostage to the economic and financial acumen of decision-makers in other countries.

It is important to note that Canada benefits from an exceptionally robust financial sector, the linchpin being its banking industry. Indeed, in October 2008, the World Economic Forum declared that Canada has the soundest financial system in the world. There are a number of reasons for this status and why Canada finds itself in a more favourable financial condition than most other advanced countries. First and foremost, Canadian banks have a history of adopting conservative lending practices compared to other banks, and this conservatism showed up in its relative insignificant involvement in the U.S. subprime market and thus modest exposure to the ABCP market meltdown.[11] A second source of mortgage delinquency in the United States appears related to its adjustable rate mortgages, whereby in the early years of the mortgage the interest rates are discounted from market rates and gradually rise above them in later years. It is generally believed that loan delinquencies (and their frequency) will rise with the upward adjustments in the contracted interest rate. Canadian banks never introduced these types of loan products into their domestic mortgage market. Finally, U.S. investment banks were lightly regulated and had low capital ratios that averaged 4% on the eve of the financial crisis, whereas, in the 1980s, Canadian commercial banks acquired most large investment dealers until only the small were left, and they were folded into larger diversified lending institutions that were considerably more regulated and had Tier 1 capital ratios averaging 9.6% in December 2007.[12]

With all recessions, there will be a contraction in both the demand for, and the availability of, credit. Referring to the Bank of Canada’s most recent Business Outlook Survey, the balance of opinion on credit conditions — that is, the percentage of people who reported a tightening minus the percentage of people who reported an easing of credit conditions — reached a record high in the fourth quarter of 2008 (see Figure 3).

Most firms reported that the tightening came in the form of higher borrowing costs. So it seems that, in Canada as elsewhere, the supply of credit has contracted more than the demand for credit since the third quarter of 2007 and before the beginning of the recession.

However, the first sign of a turnaround in credit conditions appeared in the first quarter of 2009. The overall balance of opinion on lending conditions fell from 76% in the fourth quarter of 2008 to 60% in the first quarter of 2009. The source of this decline was reported to be based on more favourable non-pricing conditions (i.e., not on the interest rate charged). Improvements in the terms of borrowing (most likely with respect to capital availability and collateral requested) suggest that financial institutions — mostly banks — are moderating the demands they place on borrowers.[13] Although credit conditions remain very tight, perhaps the Bank of Canada’s recent decision to hold its target for the overnight rate at 0.25% over the next year and to focus on a combination of quantitative easing and credit easing in the months ahead will further unclog Canada’s credit markets.[14]

Figure 3

Source: Bank of Canada, Business Outlook Survey, Vol. 6.1, April 13, 2009.

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