Canadian Economy to Outperform U.S. in Next Five Years

Includes: CEF, EWC
by: Research Recap

Despite challenges created by an exceptionally strong Canadian dollar, Canada has the lowest level of sovereign debt and the highest GDP growth rate in the G7 — a pattern that appears likely to persist for some time. Having avoided the worst of the global financial crisis, the country now enjoys a number of distinct competitive advantages, says Oxford Analytica in this guest post.

Fiscal prudence payoff. Canada has the potential to outperform the United States over the next few years, thanks principally to its prudent fiscal policies:

  1. Modest deficits. The United States will run a fiscal deficit of 10-11% of GDP this year, which may narrow to 5-6% in 2011, after the economy recovers. Canada had a deficit of 42 billion Canadian dollars (41 billion dollars) last year, or just 2.7% of GDP. Provincial shortfalls are also modest. They amounted to 8.9 billion Canadian dollars in 2009, or 0.5% of GDP, compared to an average of 0.6% of GDP during the previous three years.
  2. Relative tax burdens. As a result of these modest deficits, there is little danger of tax increases. Indeed, the minority Conservative government of Prime Minister Stephen Harper is committed to reducing the corporate tax rate to 15% during the next two years. The US corporate tax rate, by contrast, is 35%. US federal income and capital-gains taxes are much lower relative to other developed world countries. However, large US fiscal deficits greatly increase the risk of substantial tax hikes at some point during the next few years.
  3. Growth implications. The fiscal differences have two implications:
  • Canada is likely to outperform the United States over the next five years.
  • The greatest uncertainty confronting Canada will be the danger of a US consumer recession if Washington is forced to introduce a value-added tax, a carbon tax or large increases in marginal income tax rates in order to reduce the federal deficit.

Canadian GDP is likely to grow more quickly than that in the United States over the next five years, as a sounder fiscal environment will mean lower taxes — particularly on corporations.

Investment, trade strength. Canada now has 590 billion Canadian dollars of foreign direct investment (FDI), compared to 549 billion Canadian dollars of foreign investment within Canada. Canada has 342 billion Canadian dollars of FDI in the United States, whereas US firms have 292 billion Canadian dollars of investment in Canada. The other big investors in Canada are:

  • the United Kingdom (63 billion Canadian dollars);
  • Switzerland (21 billion);
  • France (18 billion);
  • Germany (14 billion);
  • Japan (13 billion); and
  • China (9 billion).

FDI in Canada is concentrated in three sectors: natural resources (particularly oil sands — 104 billion Canadian dollars), manufacturing (195 billion) and financial services including insurance (71 billion). Canada’s own outward FDI is equally diverse, but follows a similar pattern.

Downside risks. There are just two factors that appear capable of undermining this rosy scenario for the Canadian economy:

  • Household debt. The ratio of household debt to disposable personal income has risen to 146%, from 120% ten years ago. (The US ratio, by contrast, is 174%.) Most economists dismiss concerns about the debt because it has been matched by increases in the price of houses and other assets owned by the household sector. Mortgage debt accounts for approximately 62% of all household debt.
  • Strong loonie. The loonie is again hovering near parity with the US dollar, which reduces the competitiveness of Canada’s exports in its primary marketplace, the United.

Bank of Canada (BoC) Governor Mark Carney is well aware of these hazards, and has sought to allow the Federal Reserve to be the first mover, in beginning the process of tightening rates from record lows. However, this effort appears likely to fail, as the BoC is likely to be compelled to raise its benchmark rate in June. This could push the loonie up to 1.10 dollars by November, acting as a drag on trade and growth.