by Wojciech Szadurski
The U.S. Bureau of Economic Analysis (BEA) released the first tally of second-quarter GDP on July 31 that showed a better-than-expected 2.4% annual growth rate. While Statistics Canada will report second-quarter GDP numbers late in the month, available information suggests the Canadian economy contracted at a 0.3% annual pace. This would mark only the fifth quarter since 1999 that the U.S. economy had outpaced Canada’s. Indeed, on average, Canadian growth exceeded U.S. growth between 1999 and 2002. Does the latest performance auger a new trend?
Consumer spending in Canada likely posted very little growth in the second quarter, when the labor market weakened and new motor vehicle sales fell despite the continuation of heavy price incentives. Meanwhile, after several years of significant tax cuts, Canadian governments became more focused on funneling cash to health care and infrastructure projects, while staying away from budgetary deficits, than on easing the tax burden. The estimated 1.0% growth in consumer spending compares to the 3.3% rise in the United States.
Low labor productivity growth in Canada compared with that in the United States also contributed to the relatively weak spending picture in the second quarter. Measured as real output per worker, labor productivity fell 0.5% year over year (y/y) in the first quarter in Canada, but rose 2.2% in the United States. Consequently, despite Canada’s relatively stronger labor market over the past year, real personal disposable income rose only 0.7% y/y, compared with a 2.3% gain south of the border.
Canadian government expenditures likely rose very strongly in the second quarter, particularly investment outlays, as all levels of government try to repair and update various infrastructure such as hospitals, schools, and roads after years of neglect. For example, double-cohort students entering Ontario post-secondary institutions in the fall have prompted heated investment spending at many colleges and universities. South of the 49th parallel, a spike in military expenditures related to the war in Iraq vaulted U.S. federal government spending to a 7.5% increase—a faster pace than in Canada. Excluding defense spending, however, U.S. government expenditures fell slightly; by itself, defense spending contributed 1.6 percentage points to the second-quarter growth rate.
Boosted by low interest rates, investment in residential construction probably continued to grow at a solid pace in Canada, although not at the first quarter’s breakneck speed of 12.7%. Likewise, low interest rates kept residential construction growing at a 6.1% annual pace south of the border.
We do not have a lot of information on Canadian business investment in the second quarter, but April-May data on capital imports and building permits suggest a 4% increase, which is smaller than the 6.9% gain in the United States. The large U.S. increase, though, follows a 4.4% contraction in the first quarter; in contrast, Canadian businesses raised investment spending 1.1% in the first. Higher energy prices boosted capital outlays in Canada’s oil patch. Improving profits on both sides of the border have contributed to the strengthening investment activity in both countries, with pre-tax earnings rising 26% y/y in Canada and 14% y/y in the United States during the first quarter. This marks a dramatic turnaround from the first quarter of last year, when profits fell 17% and 10%, respectively.
Exports dragged down Canada’s GDP growth rate in the second quarter. Services exports were depressed by the SARS outbreak in Toronto during April and May that kept international tourists and business visitors away, not only from the city, but also from other parts of Canada. In addition, a ban on Canadian beef imports by the United States, Mexico, Japan and several other countries—after a lone case of BSE, or mad-cow disease, was discovered in Alberta during May—depressed exports of agricultural products. Global Insight estimates that the SARS outbreak and the beef import ban shaved 1.2 percentage points from the annualized GDP growth rate in the second quarter. The rapid appreciation of the Canadian dollar also restrained exports in the quarter, although Global Insight expects the main impact to be felt next year. Combined with an uptick in imports, the external side of the economy clearly depressed output this spring. The situation was similar in the United States, where net exports subtracted 1.8 percentage points from the second-quarter GDP growth rate. There is one important difference, however. As the Canadian dollar appreciated, the U.S. dollar depreciated on a broad basis. This suggests that the currency supported U.S. exports in the second quarter and that this support will grow in the future.
Inventory investment is the last item on the GDP addup. Canadian business inventories rose an eye-popping C$18 billion in the first quarter, accounting for the entire output growth. Based on increased concern among manufacturers about overly high stocks, inventory investment likely moderated in the second quarter, possibly subtracting as much as 2 percentage points from the GDP growth rate. There is, however, no reason to be overly concerned about the accumulated inventories, as they equaled 15.3% of GDP in the first quarter, compared with the trend of 15.5% between 1995 and 2002. Business inventories also weighed on the U.S. GDP growth rate in the second quarter, to the tune of 0.9 percentage point. As in Canada, the stock of U.S. inventories is close to trend: the ratio of accumulated inventories to GDP stood at 14.1% in the second quarter, compared with the 1995–2002 average of 14.7%.
In summary, both Canadian and U.S. GDP were influenced by special factors that will likely not repeat themselves to the same extent in the third quarter: SARS and BSE in Canada, and defense spending in the United States. When their contribution is netted out, GDP in both countries grew at a similar pace of around 1%. Surely, the United States is set to outperform Canada in economic growth over the next few years, largely because its fiscal policy is looser and the U.S. dollar has been falling relative to a number of currencies, including the Canadian dollar. Moreover, Global Insight’s forecast of superior U.S. productivity growth ensures a better performance of the U.S. economy over the longer term. The gap between Canadian and U.S. growth, however, will be modest and nowhere near what developed in the second quarter.
