CANADIAN ECONOMIC FORECAST: NORTHERN TIGER

UNCLAS SECTION 01 OF 07 OTTAWA 000160 SIPDIS SENSITIVE DEPT FOR EB/IFD, WHA/CAN AND WHA/EPSC STATE PASS CEA FOR Randy Kroszner, FRB FOR C. BERTAUT STATE PASS USTR FOR RYCKMAN TREASURY FOR OASIA/IMI - HARLOW, MATHIEU USDOC FOR 4320/MAC/ON/OIA/JBENDER PARIS ALSO FOR USOECD CALGARY PASS TO WINNIPEG E.O. 12958: N/A TAGS: EFIN ECON ETRD CA SUBJECT: CANADIAN ECONOMIC FORECAST: NORTHERN TIGER SHOULD CONTINUE TO ROAR THIS YEAR AND NEXT! REF: (A) TREAS 041955Z DECEMBER 2002 (B) OTTAWA 3113 (C) OTTAWA 2578 ¶1. Sensitive but unclassified, please protect accordingly. Not for Internet distribution. Summary -------------- ¶2. (SBU) Canada's economy is like the "Energizer Bunny" - it just keeps going and going. Canada should post a solid 3.3 percent annual increase in real GDP in 2002, which is more than double the 1.5 percent gain recorded in 2001. All components of real GDP contributed to the increase with the exception of business investment in plant and equipment. Positive business sentiment and an economy moving toward full capacity should reverse the trend in plant and equipment investment this year and next. Other contributors to future growth include new spending by the government on health, the environment and defense - fueled by stronger tax revenues, and a recovery in the U.S. resulting in Canadian exports to more than double this year and continue to grow in 2004. More balanced increases in investment, plus ongoing gains in consumer spending, round out the picture for why Canada's real economic growth should improve to 3.5 percent in 2003 -- with the outlook for 2004 now estimated at 4.3 percent. End Summary. Introduction -------------- ¶2. (SBU) Canada's economy grew at an annualized rate of 3.1 percent in the third quarter of 2002, a sharp drop from the robust growth of 5.7 and 4.4 percent recorded in the first two quarters, respectively. Exports contributed strongly to growth in IIIQ 2002, as did business investment in residential construction and in capital equipment. However, growth was dampened by a slowdown in consumer spending (primarily in autos) and in the pace of inventory accumulation. Following the anticipated 3.3 percent growth in 2002, we expect the Canadian economy to grow by 3.5 percent in 2003, and 4.3 percent in 2004. Domestic demand should stay strong over the forecast period, and solid growth estimates for the U.S. economy bode well for Canada's external sector. We anticipate a tighter monetary policy beginning in late 2003 and early 2004 as the Canadian economy reaches full capacity, which should slow quarterly growth rates in all sectors of the economy in the second half of 2004. Canada's inflation rate should remain in the upper end of the Bank of Canada's 1-3 percent target band, and the unemployment rate should stay at around 7.6 percent. Assumptions -------------- ¶4. (SBU) We assume the following: -- Real U.S. growth rates of 2.3 percent in 2002, 2.8 percent in 2003, and 3.4 percert in 2004 (ref A). -- Real G-7 growth rates of 2.2 percent this year and 2.7 percent next year (ref A). -- No major shocks in the oil and gas sector. We assume that a `war premium' has already been built in. -- The GOC will introduce a stimulative budget in February 2003, implementing many of the recommendations of the November, 2002 Romanow Report on reforming Canada's health care system, providing incentives to meet the targets of the Kyoto Accord, and replacing outdated military equipment. -- The GOC will uphold its promises to the Canadian oil and gas sector made in exchange for their grudging support for Kyoto Accord ratification. -- Ontario, Canada's largest province demographically, will maintain its cap on residential electricity prices. (After the cap on electricity prices was lifted, residential electricity bills soared by 50 percent and more. Ontario's Premier quickly reinstated the price cap late last year, and Ontarians have received C$75 per household rebate checks, which we assume were spent in December 2002 and are included in our IVQ 2002 forecast.) Risks -------------- ¶5. (SBU) Risks to the forecast include: -- Sluggish growth in the U.S. economy (with special concern about flat employment growth); -- A longer-than-anticipated war with Iraq. Domestic Demand: Full Steam Ahead! -------------- ¶6. (SBU) We forecast annualized quarterly growth rates between 2.8 and 4 percent in both private consumption and government spending over most of the forecast period. Domestic demand will be fuelled by the record 560,000 net new jobs in 2002. Corporate profits and business investment intentions suggest aggregate employment should continue to grow this year and next (albeit not at the same rate as in 2002). This translates into sizeable increases in consumer spending and a hefty boost for government tax revenues. Business investment in non- residential construction and machinery/equipment is forecast to rise, while investment in residential construction should moderate after rising by over 15 percent in 2002, the highest annual growth rate in 15 years. Pent-up demand and high vacancy rates accounted for the steep increase in residential construction in ¶2002. New Spending On Health, Environment, Military Equipment -------------- -------------- ¶7. (SBU) In FY2001-2002, Canada's net federal debt was C$536.5 billion, for a debt-to-GDP ratio of just over 49 percent (down from almost 71 percent six years earlier). The debt reduction saves the GOC C$3 billion annually in interest payments, and provides increased fiscal flexibility. In addition, strong employment growth points to larger-than-expected surpluses. The Conference Board of Canada predicts possible GOC fiscal surpluses of almost C$20 billion in FY2002-2003 and FY2003-04, almost double the C$11 billion that Finance Minister Manley predicted in his fiscal update in October (ref B). However, we expect the GOC to respond to political pressure to spend part of the surplus on health care, the environment, and military equipment, with the remainder dedicated to further debt reduction, producing a balanced budget for FY2003-2004. Manley has made it quite clear that the GOC will cut spending rather than risk a budget deficit. ¶8. (SBU) Incremental spending increases introduced in FY2000 (on health care, defense spending, infrastructure, innovation, the environment, cities and aboriginal affairs) will continue this fiscal year and next. However, increased spending on health care and the environment seem likely in the upcoming federal budget. The GOC-commissioned Romanow Report recommends a C$15 billion increase in health care spending over the next three fiscal years (in increments of C$3.5 billion, C$5 billion, and C$6.5 billion). Costs of ratification and implementation of the Kyoto Accord are unclear, but the GOC, to placate Canada's oil and gas sector, has promised that the sector's contribution to meeting emission targets in the first commitment period of the Accord will be limited to C$15 per tonne. And Don't Rule Out The External Sector! -------------- ¶9. (SBU) Canada's global merchandise trade surplus dropped by an estimated C$10 billion in 2002, to C$54 billion (US$34.4 billion) from the previous year, as demand softened from Canada's major trading partners, in particular, the United States. This resulted in a S$9.6B (US$6.1B) drop in Canada's global current account balance. However, given U.S. and G-7 growth projections for the forecast period, Canadian exports should grow at a respectable rate, outpacing increases in investment- related imports. In particular, energy exports should remain strong and so should exports of consumer durables and office machinery and equipment. We forecast that Canada's global merchandise trade surplus will rise only slightly in 2003, to C$54.5B (US$34.7B),before climbing to C$66.9B (US$42.6B) in 2004. The improvement is in line with the ongoing strength in the global and U.S. economies. Inflation -------------- ¶10. (SBU) Canada's inflation rate, as measured by the year-over-year percent change in the All-Items Consumer Price Index, jumped to 4.3 percent in November 2002. However, Statistics Canada attributes the large increase to a sharp decline in the base used for comparison. For example, the All-Items CPI fell by an unusually steep monthly 0.9 percent between October and November 2001, so without a similar drop in the index in 2002, the year- over-year percent change is exaggerated. (Note: The monthly decline in November 2001 was attributed to a steep drop in energy prices and traveler accommodation. The same factors caused the All-Items CPI to drop by 0.5 percent in October 2001 from the previous month.) We expect Canada's inflation rate to remain at the upper end of the Bank of Canada's 1-3 percent target band. However, there is a risk of higher inflation in the second half of 2003 as the Canadian economy reaches full capacity. Monetary Policy -------------- ¶11. (SBU) The Bank of Canada (BOC) is still looking for an opportunity to take back some of the low-interest stimulus that it pumped into the Canadian economy last year. While the BOC continues a "made in Canada" monetary policy, i.e., not following the Fed in lockstep, we believe that monetary policy will tighten later this year once the Canadian economy reaches full capacity. We expect the spread between U.S. and Canadian short-term interest rates to remain at roughly 175 basis points in favor of Canada. While we do not forecast exchange rates, we believe the Canadian dollar will continue trading in the upper-63 cents range vis--vis the U.S. dollar. Any appreciation linked to tighter monetary policy will be erased as the Fed increases U.S. interest rates. While the weaker dollar is a boon for Canadian exporters, it makes investment-related imports and consumer durables much more expensive. TABLE 1. REAL GROSS DOMESTIC PRODUCT SEASONALLY ADJUSTED AT ANNUAL RATES (MILLIONS OF 1997 CANADIAN DOLLARS) LINE 1 = LEVEL LINE 2 = QTR-OVER-QTR PERCENT CHANGE LINE 3 = YR-OVER-YR PERCENT CHANGE FRCAST FRCAST 2002 2002 COMPONENT IVQ ANNUAL -------------- -------------- -------------- CONSUMPTION 598240 594525 0.4% 2.3% 2.5% INVESTMENT 190644 187021 5.9% 2.1% -- RESID. 56864 55278 1.5% 13.1% 15.2% -- NON-RESID. 45727 45982 -0.2% -3.2% -4.5% -- MACH/EQUIP 88052 85761 1.5% 7.2% -1.6% GOVERNMENT 225775 223574 0.6% 2.8% 3.1% CHG/INVENTORIES 5000 2705 -NET X 52530 54680 EXPORTS(G+S) 448661 441094 0.6% 4.8% 1.5% IMPORTS(G+S) 396131 386415 0.9% 8.3% 1.1% STAT DISCREP 1000 -577 REAL GDP 1073189 1061929 0.6% 3.9% 3.3% TOTAL DD 1020659 1007249 0.6% 5.1% 3.1% GDP DEFLTR 106.8 106.5 0.8% 2.0% 0.1% NOM GDP 1146165 1130423 -0.5% 6.0% 3.5% TABLE 2. FRCAST FRCAST 2003 2003 COMPONENT IVQ ANNUAL -------------- -------------- -------------- CONSUMPTION 618838 610006 1.0% 3.4% 2.6% INVESTMENT 202591 197561 1.7% 6.3% 5.6% -- RESID. 58998 58213 0.9% 3.8% 5.3% -- NON-RESID. 47534 46569 1.5% 4.0% 1.3% -- MACH/EQUIP 96059 92778 2.4% 9.1% 8.2% GOVERNMENT 233781 230672 0.9% 3.5% 3.2% CHANGE IN INVENTORIES 5000 5000 -NET X 59409 54927 EXPORTS(G+S) 469181 459548 1.6% 4.6% 4.2% IMPORTS(G+S) 409772 404622 0.8% 3.4% 4.7% STAT DISCREP 1000 1000 REAL GDP 1120619 1099165 1.4% 4.4% 3.5% TOTAL DD 1061210 1044238 1.1% 4.0% 3.7% GDP DEFLTR 110.8 109.3 0.9% 3.7% 2.7% NOM GDP 1241646 1201387 2.4% 8.3% 6.3% TABLE 3. FRCAST FRCAST 2004 2004 COMPONENT IVQ ANNUAL -------------- -------------- -------------- CONSUMPTION 629417 624428 0.5% 1.7% 2.4% INVESTMENT 211063 208741 0.6% 4.2% 5.7% -- RESID. 60848 60231 0.6% 3.1% 3.5% -- NON-RESID. 49169 48755 0.5% 3.4% 4.7% -- MACH/EQUIP 101046 99754 0.7% 5.2% 7.5% GOVERNMENT 242311 239089 0.9% 3.6% 3.6% CHANGE IN INVENTORIES 4000 4500 -NET X 72198 68286 EXPORTS(G+S) 493564 485692 1.0% 5.2% 5.7% IMPORTS(G+S) 421366 417406 0.6% 2.8% 3.2% STAT DISCREP 1000 1000 REAL GDP 1159989 1146043 0.8% 3.5% 4.3% TOTAL DD 1087791 1077757 0.6% 2.5% 3.2% GDP DEFLTR 114.0 112.8 0.7% 2.9% 3.2% NOM GDP 1322387 1292736 1.5% 6.5% 7.6% TABLE 4: GLOBAL CURRENT ACCOUNT SUMMARY (BILLIONS OF C$ UNLESS OTHERWISE STATED) COMPONENT 2002F 2003F 2004F -------------- -------------- -------------- -------------- TRADE BALANCE 54.0 54.5 66.9 -- (US$) 34.4 34.7 42.6 -- (% GDP) 4.8% 4.5% 5.2% - CURR.ACCT.BAL: -- C$ 20.4 20.3 28.9 -- US$ 13.0 12.9 18.4 % OF GDP 1.8% 1.7% 2.2% MEMO ITEMS: CANADIAN $ 63.68 63.68 63.68 NOMINAL GDP: 1130.4 1201.4 1292.7 TABLE 5: CONSUMER PRICE INDEX, NSA, 1992=100 INDEX Q/Q YR/YR DATE NO. % CHG % CHG -------------- -------------- -------------- -------------- -- 1998 108.6 -- 0.9% 1999 110.5 -- 1.7% 2000 113.5 -- 2.7% 2001 116.4 -- 2.5% 2002 119.1 -- 2.3% 2003 122.4 -- 2.8% 2004 125.9 -- 2.9% TABLE 6: INDUSTRIAL PRODUCT PRICE INDEX NSA, 1997 = 100 INDEX Q/Q YR/YR DATE NO. % CHG % CHG -------------- -------------- -------------- -------------- - 1998 100.4 0.4% 1999 102.2 1.8% 2000 106.5 4.2% 2001 107.6 1.0% 2002 107.6 0.1% QUARTERLY: 00:Q1 105.1 1.5% 5.4% 00:Q2 106.3 1.1% 5.8% 00:Q3 106.6 0.3% 4.0% 00:Q4 108.1 1.2% 4.4% 01:01 108.0 -0.1% 2.7% 01:02 108.8 0.7% 2.3% 01:03 107.5 -1.2% 0.8% 01:04 106.0 -1.4% -1.9% 02:01 106.8 0.8% -1.1% 02:02 107.2 0.3% -1.5% 02:03 107.8 0.6% 0.3% 02:04 108.7 0.8% 2.5% TABLE 7: LABOR FORCE DATA EXPRESSED IN THOUSANDS UNEMPLOY LABOR % EMPLOY % MENT YEAR FORCE CHANGE MENT CHANGE RATE -------------- -------------- -------------- -------------- -------------- -------------- -- -------------- - --- - 1993 14505 12858 11.4% 1994 14627 0.8% 13112 2.0% 10.4% 1995 14750 0.8% 13357 1.9% 9.4% 1996 14900 1.0% 13463 0.8% 9.6% 1997 15153 1.7% 13774 2.3% 9.1% 1998 15418 1.7% 14140 2.7% 8.3% 1999 15721 2.0% 14531 2.8% 7.6% 2000A 15999 1.8% 14910 2.6% 6.8% 2001A 16253 1.6% 15086 1.2% 7.2% 2002A 16667 2.5% 15396 2.1% 7.6% 2003F 16993 2.0% 15709 2.0% 7.6% 2004F 17155 1.0% 15845 0.9% 7.6% Cellucci