Financial crisis in Canada

Financial Crisis in Canada

Canada is the world's 9th largest economy according to the World Bank

The economy is diverse, encompassing a highly-developed service sector, strong technology, abundant natural resources and a well-developed manufacturing sector. Due to the importance of energy exports to the economy, the Canadian dollar is sometimes considered to be a petrocurrency and trade in the C$ is highly correlated with the price of crude oil and natural gas

Canada went into the financial crisis with an eleven-year string of balanced budgets to its credit. However, at the outset of the financial crisis the economy began to weaken

That said, the impacts of the crisis have been different for Canada than for the United States, in part due to its position as an energy exporter. The responses to the crisis have been different, too, a combination of the different impacts, different ideologies and a different governmental structure. This paper will examine the impacts of the global financial crisis on Canada, and outline the Canadian government's response to the crisis.

Affects of the Global Financial Crisis

In general, the financial crisis has not had as significant an impact on Canada as it has on most other industrialized nations. To illustrate, one needs only to look at the country's financial sector. The Canadian banking business has traditionally been structured quite differently from that of the United States. While the American banking system was deliberately set up to be decentralized, while Canada's highly-centralized banking system has traditionally worked in partnership with the federal government to stimulate economic growth. The protected market has allowed Canada's banks to grow -- they now occupy four of the top ten spots on the list of largest North American banks

As American and European banks were collapsing and/or receiving bailouts last fall, Canada's banking system was ranked as the most sound in the world, completely solvent with health balance sheets

. The Canadian banking systems received government not because they needed it to maintain liquidity, but to level the playing field against foreign banks that were essentially backed by the fiscal strength of their governments

Canadian banks were well-insulated from the credit crunch for a number of reasons. For one, they are better capitalized. Canada's banks have an average capitalization ratio of 9.8% (much higher than the 7% mandated by law). This compares with 4% for American investment banks and 3.3% for European commercial banks

. As a result, Canadian banks have been able to withstand losses on mortgage-backed securities without compromising their solvency. The structure of the industry has protected investment banks as well. Whereas U.S. investment banks operate with little supervision, many of Canada's investment banks are owned by the big commercial banks, meaning that they come under the tight regulatory control of the Bank Act.

These regulations include a variety of provisions that have resulted in a stable financial system. Regulations have not been loosened in Canada to the same degree that they have been in the U.S. And Europe. As a result, Canadian banks are not as highly leveraged as banks elsewhere. Other regulations limit unbridled expansion as well. In the U.S., mortgage interest is tax deductible, which encourages overconsumption of housing stock

. In Canada, mortgage interest is not tax deductible, thus the housing bubble was not as severe.

The strength of the financial sector should not be taken as a rousing applause of Canada's ability to weather the economic storm. It does, however, provide a measure of stability in the economy. This is essential, because Canada's economy has always been heavily dependent on exports. Today, the majority of these exports go to the United States. In 2008, Canada sent $335 billion worth of goods and services to the U.S.

Major exports include energy (oil, natural gas, hydroelectric power) and manufactured goods. Ontario, for example, is the largest producer of automobiles in North America, with most of that production heading back south of the border.

Therefore, any downturn in the United States economy will inevitably have an impact on the Canadian economy. In the past year, the Canadian GDP has dropped 2.4%

. The American GDP actually improved 1.1% for 2008

. Exports in the previous year for Canada dropped 16.8%. This drop in exports relates directly to the weakness in the U.S. economy. This has led to a significant downturn in Canada's manufacturing sector, which dropped 14.5% in the last year. Unfilled orders increased 14.2%, indicating that customers were not following through on the purchases they had tentatively made. This drives up inventory levels, and spurs a reduction in production.

As a result of loss of production, the manufacturing sector has seen significant job loss. In January of 2009, the sector lost 101,000 jobs, out of a total of 129,000 lost in the Canadian economy overall. This monthly total was larger than any monthly total in the previous two recessions

. The national unemployment rate has thus increased to 7.2%, compared with 7.6% in the United States at the time. The deterioration of jobs in manufacturing was not offset by increases in other parts of the economy. Including the January figures, the Canadian economy had lost 213,000 jobs since October. Note that the Canadian economy gained 107,000 jobs in September

Canada's housing sector was one of the main economic drivers during the 2000s, much as it was in the United States. The perception is that some parts of the country experienced a housing bubble, particularly British Columbia and Alberta, and to a lesser extent Toronto. Housing and other construction spurred economic growth but the bubble was not believed to be as substantial in Canada for a couple of reasons. One is that because mortgage interest is not deductible, demand for housing was limited, particularly speculative demand. Another reason is that Canada's mortgage market remains backed by the major banks, and they did not increase subprime lending to the extent that U.S. lenders did. Moreover, Canada does not have the same type of strong, liquid secondary market for mortgages as was facilitated in the U.S. By Fannie Mae and Freddie Mac.

House prices in the U.S. have declined on average 25% during the financial crisis. In Canada, they have only declined 12.5%

. In part, this is because prices had not become so inflated in the first place. Another contributing factor is that because Canadian banks are much more solvent than U.S. banks, the credit crunch does not exist in Canada to the same degree as it does in the United States. A final factor is that consumer confidence in Canada is higher. The latest consumer confidence figures in Canada are 67.0

, versus 26.0 in the United States.

Another economic impact of the financial crisis is with respect to the currency exchange. As a net exporter, Canada relies on a low currency exchange rate as a source of competitive advantage for its exports, in particular with respect to the U.S. dollar. At the outset of the financial crisis in early 2008, the Canadian dollar was trading at or above the U.S. dollar as a result of it being a petrocurrency. However, as the global financial crisis began to weaken the world's economies, crude prices dropped, taking the Canadian dollar with them. The result of this is that the global financial crisis has restored Canada's competitive advantage in terms of currency exchange. However, this has not stunted the damage to the manufacturing base. It will set the country up well, though, for a recovery once the U.S. economy begins to pick up.

In terms of politics, the economic crisis has been less a political issue than it was in the United States. Canada held a federal election last fall, with the Conservative Party returning to a minority government. The election was significant because Canada was the first major country to hold an election since the global financial crisis broke open

. While the economy was an important issue, it did not dominate the campaign the way that it did during the U.S. election campaign. Instead, issues such as the war in Afghanistan were at the top of the agenda.

The formation of a minority government put the Harper government in an awkward position with regards to the financial crisis. The United States and other nations began passing stimulus packages and bailouts in the fall of 2008, but the Harper government deferred on the issue until the new year. The government needed help from another party to gain a majority of votes in Parliament, and therefore wanted to couple a stimulus package with its budget. The budget eventually passed with the help of the Liberal Party. There was nothing unusual in the political machinations required to pass the stimulus package -- the Harper minority has been forced to take such measures for the past several years.

In that way, the political situation has not changed much in Canada as a result of the financial crisis. The economy is increasing in importance as an issue. Rather than divide the nation, however, it has essentially forced the Liberal Party to cooperate with the Conservatives on stimulus, lest they damage their own chance in the next election. The partisan politics seen south of the border would be impossible, because the resulting inaction would be viewed unfavorably by Canadians.

The financial crisis has damaged Canada economically, but it has also highlighted the value of financial conservatism. Canada's handling of the crisis has improved its standing in the world. The Canadian banking system has been lauded for its conservative nature. Further esteem has been brought to the government for its role in building a strong, stable banking system. Many economic observers have taken notice of Canada's successes and prescribed some of Canada's regulations as a future path for their own banking systems.

Aside from banking, Canada is now showing some signs of economic weakness. The country's relatively strength, however, has caused the government to take relatively little action on the crisis. This has not enhanced Canada's international standing, but it has not hurt it either. Canada has not needed to take on a leadership role, and the government remains committed to sorting out the nation's position in Afghanistan above sorting out difficulties in the economy.

How Has the Canadian Government Handled the Crisis?

The late onset of the financial crisis in Canada, combined with an election where the crisis was not the primary focus, resulted in a delayed reaction on the part of politicians to the crisis. In the United States, the first step was a bailout of the banking sector in the wake of high profile bank failures. Canada's protected and highly-regulated banks had no need of a bailout. The second step in the U.S. was discussion of an automaker bailout, followed by the stimulus package and Fed response. In Canada, there is no Fed and the Bank of Canada does not have the same powers. There was, however, talk of an automaker bailout and in January a stimulus package was passed in the federal budget.

By late November, the Canadian government had still not made a strong move towards providing economic stimulus. Indeed, the economic statistics for October, heralding the beginning of recession in Canada, had barely been released. Thus, it was only in late November that the government first became subject to any palpable sense of urgency. The Finance Minister, Jim Flaherty, indicated in a traditional post-election economic update that a budget surplus was unlikely. The ever-opportunistic opposition parties pushed at that time for a stimulus package, but Flaherty deferred to the budget, due in late January

. This was necessary gamesmanship for a minority government. If the opposition parties were so intent on stimulus, they would need to cooperate with the Conservatives in the form of supporting the budget.

The delay was exacerbated by the fact that the House of Commons was scheduled to go on Christmas break from December 12 to January 26. Given that Prime Minister Harper had announced in a speech in Peru in November that the crisis was moving so quickly that governments did not have time to set out policy, the impending two-month delay on the part of his party was not met favorably

. The U.S. had already announced an $800 billion stimulus package and other industrialized nations were following suit, prompting criticism from the opposition

As early as November, the Canadian government had begun discussing the idea of an automaker bailout. The initial discussions surrounded the possibility of a joint Canada-U.S. bailout. As one of Canada's major export industries, automobile manufacturing accounts for some 400,000 jobs, mainly in Ontario. After the Bush administration offered a bailout to the automakers, both Canada and Ontario followed suit, in order to defend their jobs in the face of impending auto industry restructuring. The Canadian bailout accounted for roughly $4.27 billion

After the automaker bailout, the House of Commons adjourned for the holidays, picking up at the end of January with the passage of the budget, with the stimulus plan embedded. Harper's Conservatives are a right-wing party whose platform is built around economic and social conservatism. The centrist Liberal party also helped pass the budget, and they are built around economic conservatism and social liberalism. Thus, the budget contains strong elements of economic conservatism. Not only was the stimulus package relatively small, but it was based largely on supply-side initiatives, in stark contrast to the largely Keynesian stimulus package of the Obama administration.

Jim Flaherty's economic statement in late November had already indicated there would not be a major government spending spree, as he hoped that the budget would be balanced. While this would ultimately not come to pass, the stimulus package was widely criticized as being insufficient

. When the budget finally arrived, the minimalist nature of the stimulus package was evident. The total stimulus provided was $40 billion over five years.

The stimulus package/budget contained a wide variety of initiatives. These include tax relief, public works, housing projects, unemployment insurance, skills development and transitional support for struggling industries. The bulk of the stimulus, however, comes in the form of tax relief.

The tax relief component is estimated to be worth $20 billion over five years, the largest component of the stimulus package. Included is an increase in the basic personal amount and a raise in the ceiling of the bottom tax brackets. This provides a direct reduction in personal taxes for Canadians. This stimulus, however, does not take effect for the 2008 taxes, thus the effect of this stimulus will not be fully felt until the spring of 2010. Because the tax relief is spread over five years, it is estimated to contribute $4 billion per year, or approximately $125 per person per year

The tax program also contains other initiatives target at certain groups, some of whom are politically desirable demographics. Seniors for example receive a reduction in their taxes, which given that they are likely to spend the extra money can hardly be considered stimulus. But for a government that may be facing another election soon the move is certainly pragmatic. There will also be an increase to the child tax benefit, and to the working income tax benefit, targeted at workers transitioning into the workforce

In addition to the tax relief, some $12 billion was set aside for public works projects. This will include the following: $4 billion over two years in an Infrastructure Stimulus Fund. This will be portioned out to the provinces and used for a range of projects, including public transport, sewers, and neighborhood regeneration projects. There will be a $1 billion investment in a Green Infrastructure Fund over five years. For recreation facilities, $500 million will be provided

Housing projects will receive $1 billion over two years for energy retrofits of social housing; $400 for new social housing construction for seniors; $75 million for social housing for persons with disabilities; $400 million for social housing for First Nations; $200 million for social housing in the north

Employment insurance recipients will eligible to receive an extra five weeks' worth of benefits. Beyond that, the stimulus package will add $1 billion in training for EI recipients. Another $500 million will be provided to a Strategic Training Fund. A variety of minor training programs will receive amounts $100 million and below

The bulk of the response to the economic crisis does not come in the form of a stimulus package, however. An estimated $200 billion has been earmarked to support credit markets. This includes $50 billion to the Insured Mortgage Purchase Program, the Canadian corollary to Fannie Mae and Freddie Mac that purchases pools of mortgages

. This move was intended to short up liquidity, ensuring that credit remains available. The move also helps to insulate Canadian banks against the competitive advantage that foreign banks gain from being backed by their governments. Such backing -- as many major U.S. banks now have de facto -- lowers the cost of capital for those banks because it all but eliminates their default risk. Thus, Canadian banks required similar backing or otherwise would have had a higher cost of capital than foreign banks, reducing their competitiveness in the international market.

Two other programs received substantial funds under this initiative. $13 billion has been made available for loans via a variety of crown corporations. In addition, another $12 billion has been set aside to create the Canadian Secured Credit Facility, which will support the financing of vehicles for consumers and businesses

In addition to the financial initiatives, the Canadian government has responded to the crisis with a range of non-financial initiatives. These have generally taken the form of increased regulation. The Minister of Finance has been given additional authority to "promote financial stability and maintain efficient and well-functioning markets." The Canadian Deposit Insurance Corporation (CDIC) has been granted "greater flexibility to enhance its ability to safeguard financial stability." A "standby authority" has been created to allow the government to inject capital into the banking system. Furthermore, a new securities regulator will be created, essentially replacing the old system wherein every province had its own regulator

On other fronts, the government has created a task force to devise ways to improve financial literacy. This is a lesson taken directly from the American experience, where the subprime crisis was exacerbated by poor financial literacy and consumers literally not understanding the risks they faced. Further disclosure stipulations and regulations have been imposed on both credit card issuer and mortgage insurers. There are also regulatory improvements being made to federally-regulated pension plans, in addition to solvency relief financing being made available.

Canada's response has been largely in the form of protecting credit markets and financial solvency. The bulk of this response is based around increasing regulation, with the desired effect of protecting citizens. Canada's successful navigation of the financial crisis thus far has been attributed to its strict regulatory environment, and the response has been geared to making improvements to this environment. While increasing regulation may reduce opportunity for profit in boom times, it also provides greater protection in times of economic distress.

The stimulus package itself is a relatively minor package in financial terms. The small size of the package has been criticized by many groups who feel that a much larger package is needed. However, the stimulus package is consistent with not only the relative lack of economic damage that has occurred in Canada as a result of the crisis, but of the government's conservative approach to fiscal policy. As a right-wing government, Harper's Conservatives are inclined to approach the issue from the supply side, as has been the case. The regulatory side of the response is against core conservative policies, but is consistent with longstanding Canadian policy with respect to the financial sector.

Assessment of Canada's Response

Assessment of Canada's response to the economic crisis is difficult at this point, since the crisis continues to deepen. However, what we have seen thus far is probably an insufficient response. The first component of the response was the delay in responding. Whereas both the outgoing Bush administration and the incoming Obama administration were aggressive in their stimulus and bailout plans, Canada preferred to delay response. In some ways, this is more prudent (no AIG-like scandals, for example), but in other ways the response appears to be too little, too late. The delay in responding certainly did not help stem the flow of job losses.

However, it could be argued that the bulk of the job losses were inevitable. The massive January job losses were 78% in the manufacturing, a sector that only accounts for 28.4% of the GDP

. These jobs losses are directly tied to the decline in the U.S. economy, given that a significant portion of Canada's manufacturing output is destined for the United States. Short of paying people to not work, there is probably little the Canadian government could do under those circumstances, especially given the scope of the job losses. As it is, the government chose to address the issue of paying people to not work by extending EI benefits; they have however coupled this with added EI-based training programs, to ensure that those manufacturing workers who find themselves permanently displaced are able to progress with their careers in other, meaningful ways.

The Canadian government's response with respect to the financial markets is interesting. They have enjoyed success that is the envy of the developed world as a result of the high degree of regulation in the financial sector. Yet, the government has taken steps to increase regulation, even though it is apparently not needed. This proactive measure has been taken to ensure that the system remains strong, although it may come at the expense of competitiveness. The direct financial stimulus to the sector was initiated not because of the need to avoid a credit crunch, but to maintain the competitiveness of Canadian banks on the global stage.

While the effect of increased regulations is subject to debate, the stimulus package tabled is decidedly weak. The tax stimulus of $20 billion is spread out over five years, meaning that it averages just $125 per person per year. Worse, the impact of that stimulus will trickle through the economy very gradually. As a result, the taxation component of the stimulus plan is weak, and unlikely to have any discernable impact. An increase in the basic personal amount will be reflected on paychecks, so the result will be a few more dollars on each paycheck, a benefit that will go entirely unnoticed and have little impact on the economy. Even if $20 billion was pumped directly into the economy, that amounts to just 1.5% of the annual GDP, thus the impact would be minimal even under the best of conditions. The stimulus package as presently constituted is not the best of conditions. Thus, the supply side, free-market component of the stimulus package is unlikely to have any particular benefit to the Canadian economy.

The other elements of the stimulus package are more Keynesian in nature. However, these benefits too are spread out over a period of years. The underlying theory seems to be that the infrastructure investments today will have benefits in the future. This, however, does not address the need for stimulus today. The bulk of the benefits will go to the construction and government sector, rather than the ailing manufacturing sector. Thus, the stimulus represents a significant infrastructure investment, but is unlikely to play a major role in economic recovery.

It is reasonable to conclude that the reason the Canadian government has not expended much effort or expense to deal with the financial crisis is because Canada has been well-insulated from the crisis. The one area of the economy that is suffering, manufacturing, is one that the government has limited control over anyway. Most commentators are reserving judgment, except those who are disappointed with the size and timing of the stimulus package. However, there is little evidence at this point to affirm or refute the critic's claim of inadequate response. Some observers have pegged the needed stimulus as low as $13-15 billion

. Other groups have declared the package not enough, though one prominent group has based this on the theory that Canada needs to use stimulus to replace job-for-job and dollar-for-dollar what has been lost, which is out of step with the Conservative government's economic philosophies