Canada: Policy Matters

Bank of Canada: A Series of Unfortunate Revisions

As Global Insight anticipated, the Bank of Canada lowered its short-term growth forecast for the Canadian economy on the back of a weaker projection for the United States. The bank expects Canadian GDP to slow from 2.8% in 2006 to 2.5% in 2007, before rebounding to 2.8% in 2008. A sharper slowdown is penciled in for U.S. growth: from 3.3% to 2.6%, before a ramp-up to 3.2% in 2008.

Alongside the growth haircut, however, the bank also acknowledged that its prior view on Canada's potential growth was too rosy. It scaled down its growth estimate from 2.9% for 2006 and 3.0% for 2007-08 to 2.8% for 2006-08. The lower estimate of potential implies that the weaker growth of the economy, rather than generating excess supply, will be just sufficient to work off the slight excess demand from the middle of 2006.

The evidence of the economy operating at above-capacity levels came loud and clear in the past few consumer price reports, with core inflation picking up from 1.7% in early 2006 to 2.3% in September. In addition, in the bank's autumn Business Outlook Survey, the percentage of firms reporting difficulties in meeting an unanticipated increase in demand remained above average. Judging from the jobless rate of 6.2% in October, which is just above the three-decade low of 6.1% in May and June, the labour market remains drum tight.

The bank's revised view of potential growth, as well as some recent economic data, took the edge off the urgency to lower interest rates. Consequently, Global Insight no longer expects overnight rate cuts in December and in 2007. The key lending rate is now forecasted to stay at 4.25% through the end of 2007. Market interest rates are also expected to be higher, which will dampen consumer spending and housing starts. Canada's GDP growth is projected to slide from 2.8% in 2006 to 2.4% in 2007. We look for a bounce back to 2.8% in 2008.

Federal Government: The Trust Massacre

It was a night of trick and treating on Halloween when the federal government unexpectedly announced plans to tax the distributions of income trusts, an increasingly popular investment vehicle for Canadians and foreigners. The government intends to impose a distribution tax on existing income trusts starting in 2011, at the combined federal-provincial rate of about 31.5%. For any new companies converting into trusts, the combined federal-provincial tax of about 34% will apply in 2007. Real estate income trusts will continue to be exempt from the distribution tax.

If implemented, the proposed taxation would directly lower the income received in tax-exempt registered savings plans by Canadians and the income received by foreigners. The taxation faced by foreigners would rise from 15.0% to 41.5%. The financial market judges the likelihood of the implementation to be fairly high and, accordingly, the stock value of affected trusts fell sharply the following day. The TSX income trust sub-index fell 12% on November 1 and was still 11% below the pre-announcement level one week later. The government expects to raise, on net, $400 million in revenue in 2011 from the proposed changes.

The treats in the proposed package raise the chances of the measures being implemented to above even, despite the tenuous hold on power by the minority Conservative government. Most importantly, many retired couples will be able to save money starting in 2007 by splitting their combined income. The package also includes a cut in the federal corporate income tax from 19.0% in 2010 to 18.5% in 2011. Finally, the age credit for seniors will increase from $4,066 to $5,066, effective with the 2006 tax year.

Dollar Implications

The Bank of Canada has managed a rare feat of being dovish on growth without sounding worried about undershooting its inflation target. Financial markets are still pricing in a small chance of a rate cut next year. If our call for steady monetary policy comes to pass, those expectations will unwind. Assuming the Fed will ease policy next year, we figure the steady Bank of Canada will lift the dollar up by half a U.S. cent by late 2007.

Most of the time, one needs a magnifying glass to spot the impact of fiscal policy changes on the Canadian dollar. It was different this time, as the Canada-U.S. dollar exchange rate fell about 3/4 of a U.S. cent in overnight trading after the trust-tax announcement. Although this negative impact will likely persist for a while, it should wear off over time. The tax measure reduces the attractiveness of Canadian trusts to foreign investors and, thus, lowers their demand for Canadian dollars. This will create an excess supply of dollars that the Bank of Canada will eliminate over time to prevent a decline in the overnight rate.

On net, we are slightly more pessimistic in the near term about the Canadian dollar than in October. The fallout from the trust-tax proposal will depress the currency to below 88 U.S. cents by early 2007. A narrowing of the negative Canada-U.S. interest rate spreads, however, will move the loonie to just above 89 U.S. cents by the end of 2007, which is the same forecast as in October.