Proceedings of the Standing Senate Committee on
Banking, Trade and Commerce
Issue 27 - Evidence
OTTAWA, Thursday, October 23, 2003
The Standing Senate Committee on Banking, Trade and Commerce met this day at 11:05 a.m. to examine and report upon the present state of the domestic and international financial system.
Senator Richard H. Kroft (Chairman) in the Chair.
[English]
The Chairman: I would like to welcome our guests, Mr.David Dodge, Governor of the Bank of Canada and Mr.Paul Jenkins, the Senior Deputy Governor of the Bank of Canada.
This is our opportunity, which we have a couple of times a year, to visit with you at the time that you are providing insight into the country's affairs. I am always of mixed emotions. We are sort of last in your run of appearances over a couple of days and Ithink that cuts both ways. From our point of view, we have been able to watch and see and find out what you are saying and see what openings you may have given us. I am sure that our witnesses have saved things especially for us that they have not told anyone else.
It is a sincere pleasure to have you both with us here. As usual, we will begin with an opening statement in whatever way you wish to provide that. Then, as you are quite accustomed, we will go to the senators on the committee for questioning.
Governor, please proceed.
Mr. David Dodge, Governor, Bank of Canada: Honourable senators, it certainly is our pleasure to be here a couple of times a year to have a discussion with you and indeed, through you, with Canadians about monetary policy at the Bank of Canada.
I am pleased that this year, for the first time, I have with me Paul Jenkins in his new role as Senior Deputy Governor. We at the bank are extraordinarily pleased that our board appointed Mr. Jenkins to this job.
As you indicated, Mr.Chairman, you have our report before you. It is probably most useful if I keep my opening remarks very brief to allow as much time as possible for questions.
The last time that I appeared here was after the release of our April report.
[Translation]
Since April, our economy has been hit by a number of unusual shocks. Because of these shocks and other factors, growth has been weaker that projected when we were last here in April.
We now estimate that there is more slack in the economy than we had projected in April. On the positive side, the prospects for near-term growth in the global economy have improved since April, and geopolitical uncertainty has continued to decrease.
[English]
We expect that growth in the Canadian economy will strengthen during the fourth quarter of this year and through 2004. On balance, the expansion should be above the rate of potential growth, supported primarily by solid household spending and increased business investment.
Stronger growth abroad should boost foreign demand for Canadian products, but this will be dampened by the higher value of the Canadian dollar. Our base projection is that growth should average a little over 3percent in the second half of 2003 and about 3.75percent in 2004. With growth above potential, the slack in the economy should be absorbed by early 2005.
We expect core inflation to average just over 1.5percent for the remainder of this year, to fall to just above 1percent in early 2004 as the effects of earlier increases in auto insurance premiums dissipate, and then return to 2percent by about mid-2005 as the economic slack is taken up.
Honourable senators, I do want to emphasize that there are significant risks to this economic outlook. These risks relate to the timing and magnitude of adjustments to global economic imbalances. In particular, there is uncertainty about both the likely changes in key global exchange rates and their effect on the Canadian economy. There is also uncertainty about the sustainability of U.S. growth beyond mid-2004.
I should like to conclude by stressing that we are assessing — and will continue to assess — the implication of all these developments, both those that have occurred so far this year and those that will occur as we go forward, for output and inflation in Canada. We will continue to assess what this means for monetary policy going forward.
Senator Angus: Congratulations toyou, Mr.Jenkins. We are also very pleased to see you here in this new capacity. Mr.Governor, we were delighted to hear in the press this morning and at the committee yesterday that you intend to serve out your full term. I believe all of us here are reassured by this continuity and stability at the bank. You might note some changes here at this committee. I know some of them are people well known to you, and this is a good thing.
Mr. Dodge: There is still stability in your seat, senator.
Senator Angus: There is a lot of continuity, but not on our side.
As you know from past appearances here, I have had an ongoing preoccupation with both the level of the Canadian dollar vis-à-vis the U.S. dollar, and also with the nature and extent of the spread between U.S. and Canadian interest rates. You will probably see a bit of a smile on my face in both accounts at the moment.
I should like to focus on the Canadian dollar in this first round, chairman. As we all know, just a few minutes ago it was around 76.5 cents — far up from where it was. I believe there has been roughly a 21percent increase since July in the level of the Canadian dollar. I will bundle the question in three parts that you can deal with.
First, everyone is talking about the rate of the Canadian dollar, some people are happy, but the headline in The Globe and Mail would suggest that Bay Street is not. There are various suggestions as to what the causes are for the rapid increase in the rate. You have indicated that you personally are not preoccupied with the level, but maybe possibly a little bit preoccupied by the rate of increase in the rate, but I am not certain where you stand.
The other issue is what is the outlook. Is the higher level of the Canadian dollar a good thing or a bad thing for Canada's economy? What are the causes of it and what is the outlook for the short term?
Mr. Dodge: I should like to first speak to the evolution that has taken place. The evolution has really taken place since April. When we were here in April, it was 69cents, or thereabouts. We are up 10percent or 11percent since that time.
Why have we moved over that period? Fundamentally, we have a weakness in the U.S. dollar — not just against Canadian currency but also against most major currencies of the world, leaving aside the currencies of non-Japan Asia. Primarily, we are seeing a desire to reduce exposure to the U.S. dollar and then looking elsewhere to go. If you had to pick a single factor, the biggest factor is not that everyone loves Canada but that people really do want to get out of the U.S. at those levels, which were prevailing in 2002 and continue to do so.
It has been very volatile, as you indicated. We expect that volatility to continue. Beyond that, are there domestic reasons? Canada looks like a pretty good place to put your money, or to place your bets. We are the only G7 country that has a balanced budget, we now, as a country, have one of the lowest debt-to-GDP ratios, and so the fiscal side is solid. We have a long and solid track record on monetary policy and, indeed, we have outgrown most of the other countries in the G7 pretty solidly for the last three years, so Canada is quite an attractive place to go when you do not want to be in the U.S. dollar.
In respect of interest rates, we are clearly higher at the very short end than the United States. Our spreads at the long end are pretty normal in terms of the differential with the Americans; they are certainly in the middle of a fairly wide normal range. Perhaps they are just a titch wider at the short end, but compared with other countries whose currencies are also appreciating, we are kind of in the middle of the pack. Some — Australia for example — have considerably higher spreads against the U.S. than we do. Others such as Japan clearly have much lower spreads. Fundamentally, in terms of causes, you have to look beyond the border.
That is the history. Looking forward, there are some things that also look fairly favourable for this country. With stronger world growth, what we have seen is U.S. dollar commodities priced in U.S. dollars. Those prices have been improving — in particular base metals — and there is clearly some improvement in the pulp and paper side and in other commodities. That is also favourable and particularly favourable to Canada and Australia if you look at the larger currencies that have appreciated against the U.S.
In respect of the outlook, there is some reason to think that Canada will continue to look like a pretty favourable place to go. There is a bigger question in terms of just how anxious people will be to move out of the U.S. dollar, and that almost varies from day to day and week to week. Much of that is sentiment and it is extraordinarily difficult to predict.
That is a broad answer to your broad question.
Senator Angus: Is the current level of 76 to 80 cents a good or bad thing for Canadians? You have not pronounced on that. Is it something you would prefer not to comment on because of the delicacy?
Mr. Dodge: No. ``Good'' or ``bad'' are not adjectives that I would use. The exchange rate is a price, like any other price, that will equilibrate supply and demand, and whether that price is high or low, a price is the price.
It is better viewed from the point of view that we have had a quite a sharp adjustment since April in a limited period of time. The issue is when rates move that fast, how quickly the economy— business and everyone else— actually adjusts and can adjust to those price changes.
It is fair to say, therefore, that it is always easier, whether the rate is moving up or down, to make the adjustments if that movement takes place smoothly rather than quickly.
Senator Angus: You indicated — I believe yesterday, or in the monetary policy report — that there are global forces at work that are quite beyond the control of our own policy-makers in this country. I would be interested to know maybe one or two of what those are, particularly in light of the fact that in the past we have discussed here, and even debated about, whether Canada is a commodity-based economy and whether our dollar is a direct function of commodity prices. We have in fact seen a sharp rise in base metal prices since the spring, and in the dollar as well. It makes me think that maybe we are still pretty much tied to the commodity prices.
Mr. Dodge: Let me go back to the first part of your question. I will start and then ask Mr.Jenkins to pick up on it.
First, you have to look at the state of global demand. As I indicated in my remarks, and as we go through the report, in fact global demand seems to be growing a bit faster as we near the end of 2003 than we might have anticipated. We have had quite a sharp recovery in demand in the United States, in the second and, we think, especially the third quarter of the year. We have got very strong performance in China and India. We have better-than-expected performance in Japan— not really robust but better than expected. Europe is bad, but no worse than had been anticipated.
Therefore, we do have a stronger world economy, and a stronger world economy is just plain ordinary good for Canada.
Senator Angus: What about the level of the dollar?
Mr. Dodge: The dollar will equilibrate supply and demand. When you get strong world demand, there is a strong demand for Canadian products and hence a strong demand for Canadian dollars to pay for them. That is number one.
Number two is that we have had upward movement — not only in the quantity of commodities demanded but also in the price — so our terms of trade, as a country, have actually been improving a little bit. That also is clearly good for Canada. That also is relatively favourable for the Canadian dollar.
We have to look at the other side. Number three is that there is growing concern about how the U.S. will resolve its twin imbalances, on the fiscal side and its current account imbalance. That is undoubtedly putting some downward pressure on the U.S. currency vis-à-vis everyone else.
Finally, of course, is what I said before: Our performance record has actually been pretty good. We are not operating as far away from full potential as is, for example, the United States.
There are a number of these factors. They all interact and so on. It might be useful, honourable senators, if we just gave you the on-average rule of thumb orders of magnitude of how these works.
Mr. Paul Jenkins, Senior Deputy Governor, Bank of Canada: The exchange rate is obviously a key issue for us all right now. In our monetary policy report and in our discussions with various groups yesterday, we have tried to provide some focus on the relationships through which the exchange rate has its impact on the Canadian economy. As the Governor suggests, we also look at some of the other factors that are at play internationally.
Just to give some order of magnitude, I will pick up on the 10percent or so appreciation of the Canadian dollar since April. Economists, of course, like to use the phrase ``all else being equal.'' I will use that phrase to start with, but all else being equal, 10percent appreciation of the Canadian dollar would have an impact on the Canadian economy stretched out over about a two-year period in the order of 2percent to 3percent. It is a significant price, obviously.
At the same time, we also know that as world markets — including the U.S. market — expand what we call ``volume effects'' are also very important. In fact, our research suggests that a 1percent increase in the U.S. economy translates through to output in Canada in the order of 0.7percent or 0.8percent, and over a very short period of time. Therefore, when we think about the implications of the higher Canadian dollar, we also have to look at it in the context of what else is going on. If world markets are expanding, as the Governor suggested — not just the U.S. economy, but also in Asia, which is an important market vis-à-vis commodity prices — we have to factor that into our analysis as well.
Indeed, in terms of commodity prices — the basket we produce in Canada — the average U.S. dollar price, has gone up something like 15 per cent in the past year. Base metal prices, as the honourable senator noted, have actually gone up even more than that.
Over the span of about a year or so, a 15percent increase in commodity prices would have an impact of about 1.5percent on Canadian GDP. There is the impact of the dollar but there are also other factors at play. Part of what we have tried to do in the monetary policy report is to give some attention to all these factors and the importance of working through these in terms of their net effect on the Canadian economy, particularly in terms of output and inflation, and then the implications of that for Canadian monetary policy. These are the issues that we have been looking at and have tried to address in the report itself.
[Translation]
Senator Massicotte: On reading the monetary policy report and your inflation forecast of 1 per cent for this year and for next year, it is apparent that inflation is not a critical issue at this point in time. Inflation becomes a consideration only when we measure the NAIRU in monetary policy. Quite frankly, the exchange rate is not a priority. It is a very secondary consequence of inflation.
The NAIRU stems from a projected inflation rate of 1 per cent. If all other factors remain constant, we can expect interest rates to fall. Would you agree with that statement?
Mr. Dodge: As always, there are special factors to consider. For example, at the beginning of next year, core inflation in Canada will be very low, since the effects of automobile insurance premium increases that took effect in early 2003 will abate. Thismeans that for a period of time, core inflation will be lowerthan usual, so to speak. However, we expect that by mid2005, that is 18 to 24 months from now, core inflation should return to 2 per cent. That is our goal. Naturally, as you know, other factors could come into play during this time. However, that is our best projection at this time.
[English]
Senator Massicotte: Governor, when you appeared before the House of Commons Finance Committee yesterday, questions were raised about events that occurred during your time as Deputy Minister of Health and whether they cast doubt or credibility as Governor of the Bank of Canada on monetary policy. I understand the chairman of that committee ruled those questions out of order. You do not need to respond here, but if you had any comments to add we would probably appreciate them.
Mr. Dodge: I certainly do not want to run away from those questions, senator. As senators will know, there are some limitations on what I can say at this point, because charges of criminal conduct have been laid and that is now before the courts. I must be very careful not to prejudice the judicial proceedings. I can say that no one was more upset and remains more upset and concerned that these events occurred and that we have serious charges of fraud and breach of trust against public servants, some of whom were under my jurisdiction.
It is important to say that this in no way should diminish Canadians' confidence in the abilities of the public service to carry out fairly and honestly the tasks with which they are charged. In fact, there is absolutely no system that one can put in place that will guard and guarantee 100percent that there will never be an issue of fraud or breach of trust. My experience in the public service certainly has been that 99.9percent of those public servants work very hard to do their very best job and to do it honestly for the people of Canada.
The issue is: How could such fraud occur? Even with the unbelievably best systems, there is always a chance of fraud occurring. What is important is that it is picked up in audit. That is the purpose of audit and in this case, it was. As soon as there were allegations of criminal conduct, I referred — absolutely appropriately, I believe— the matter to the police who carried out an investigation. As far as I know, that investigation is ongoing and serious charges have emerged from that.
The other question is: Leaving that aside, were there issues of straightforward ordinary management lapses in the department? Not related to criminal activity, which is quite different. No department is ever perfect. No organization is ever perfect in its management. As those issues were brought to my attention, or as I discovered them, then we moved to address them. We were in the process of addressing a number of issues in the old medical services branch in the fall of 2000, when this particular incident came to light.
Indeed, we had decided in the spring to change the way that branch was oriented. We informed Mr.Cochrane that he would have to find another job — not because we suspected fraud at the time; we had no knowledge of any fraud— but simply because we wanted to change the way the branch was operating and delivering services to Canadians. Indeed, we were making changes right through the department at that point in time.
That is all I can sort say at this point in time. I think I did my job; that is not to say that all management practices were perfect. They were not, but they were not perfect when I arrived and we were in the process of improving them. That is an important issue, because Canadians need to have confidence in their public servants and they need to have confidence in me. Frankly, all I can do is conclude by saying that I think you can continue to have confidence in me and you can certainly continue to have confidence in the way that my colleagues and I manage this great institution.
The Chairman: Thank you. I appreciate the question and the response. I would like to limit any exchanges on this subject to that question and that answer because we are here to deal with the matters of the bank. I would ask all of my colleagues to return to subjects relating to the governor in his role as governor.
Senator Tkachuk: I am sure that Senator Massicotte was making sure that I would not ask that question. He wanted to get it out of the way.
I was looking at the monetary policy report. The bank spends a lot of time talking about exports and a tremendous amount of time talking about inflation. Has the bank has conducted a review of the positive effects of a rising dollar? For western Canadians at least— but I think it is true for the agriculture sector clear across Canada— the cost of equipment such as combines and tractors will drop significantly for us. Those are mostly imported products. Half-ton trucks and equipment for manufacturing for improving productivity are mostly foreign-made.
There is very little information on those effects and I was wondering if you could comment on those and whether there is any work being done on that?
Mr. Dodge: That is an extraordinarily good question and a good observation. The answer is yes, there is. We have been doing a fair bit of work trying to look at how this works sector-by-sector.
First, let us go to the simplest point. Since machinery and equipment is largely priced in foreign currency — though not exclusively U.S. dollars — when the Canadian dollar appreciates, means that the Canadian dollar price of that machinery and equipment falls relative to the price of labour in Canada, which is priced in Canadian dollars. Hence, there is the normal market incentive to make greater investments in machinery and equipment because it is relatively cheaper to produce using more machinery and equipment than it was when the price of machinery and equipment was higher.
There is a very much an advantage in that over time, it should produce higher rates of productivity growth as we get the investment. That is the sort of economics 101 part of it.
Now, I will address the more complicated part of it. The effects are very different as you go across different sectors of the economy. The effects depend, first, on the capital intensity of the sector itself. Second, the effects depend on the amount of intermediate inputs that are required to produce the final good or service here in Canada — that is, the amount of intermediate inputs that are imported relative to those that are produced domestically.
Finally, of course, the effect depends on the pricing of the output of that sector, whether it is one that is normally priced, let us say, in U.S. dollars, or whether there is a margin of manoeuvre.
Mr. Jenkins: There is a technical box in our report. I will not take you through that right now, but it does try to gauge the impact across different industries of movements in the exchange rate. Several factors play into this. One is the extent to which industries use imports in their production process. Those with a significant degree of imports into their production process are less affected than those sectors with very little import content. We have been looking at this factor across industries and across regions.
Considering your question from a macro-economic perspective, it might be worthwhile to reflect on the conditions in Canada today compared with those in the mid-1990s. In that time, the Canadian economy went through a very difficult period of adjustment. There were the implications of the Asian crisis on world commodity prices; there was the fiscal adjustment that was taking place. The movement of the exchange rate through that period did provide some offset for commodity producers; commodity prices declined something in the order of 20percent to 25 percent.
The exchange rate movement also facilitated an adjustment of the Canadian economy to provide more Canadian producers to feed into what, at that time, was a very strong U.S. economy. This is what we call the ``shock absorber'' role of the exchange rate at the macro level. That movement of the exchange rate played an extremely important role in supporting the economy overall.
Today we have a different set of circumstances. We have a very robust domestic economy. We have a world economy that we think is looking better going forward, but it has been on the soft side. Moreover, you have this global adjustment that we have been talking about where things must happen to work towards reducing the U.S. current- account deficit. Ideally, one would like to see that corrected through strong global growth, but some of it will occur, and has occurred, through some exchange rate adjustments.
Now we are seeing a set of circumstances where the exchange rate is adjusting in part to help us preserve overall balance in the Canadian economy. Behind that, in a sense, is a very strong domestic economy. That macro-economic perspective is important to bear in mind here as well.
Senator Tkachuk: I hope the Canadian dollar holds or even goes up a couple of cents. If it does, it seems to me that imports will be less expensive.
Mr. Jenkins: Are you referring to machinery and equipment?
Senator Tkachuk: I mean things like TV sets, all the things that consumers buy. What happens to that cash? Is it like a tax break? Will people spend more and therefore the economy will be stronger from higher consumer spending? Do people put the extra cash into savings or will they just buy more stuff?
Mr. Dodge: First, we are going through the experience of a 20percent appreciation. That is a bit unusual by itself. We cannot be definitive about that. Your fundamental point here is very important: Real incomes of Canadians have gone up because our terms of trade have actually improved through this period.
Canadians as a whole are indeed better off. Some proportion of that will be spent because goods prices, relative to service prices, will not be quite as high. There is probably a bit more bias towards the purchase of goods prices. Some may get saved. As I said, we cannot give you a definitive split between what happens to goods purchases, what happens to services purchases, and what happens to savings.
To go back to your first question, though, this is undoubtedly this positive for investment in machinery and equipment.
Senator Moore: Mr.Governor, you said in your remarks that growth is expected to average a little over 3percent in the second half of 2003. We went through SARS. We thought we had it beaten and it came back. We had BSE and, in August, the tremendous fires in British Columbia. Had we not had those things, what do you think the growth would have been in the first half and in the second half?
Mr. Dodge: There is a box in our report on this. I will ask Mr.Jenkins to take you through that.
Mr. Jenkins: I will turn to that, technical box 1 on page 11 in the English version of the report.
In this box, we try to break out the effects of some of these temporary factors to which you have referred, senator— SARS, BSE and, more recently, the Ontario power outage. These are not the only things that were going on during these quarters. There were other factors at play. For example, in the second quarter, there was a very large inventory de-accumulation that was part of that very weak no-growth scenario that we went through. However, in looking at these factors, our staff indicates that, on the basis of those few components at play — although all of them are significant — annual growth rate in the second quarter was about 0.7percent less than it would have otherwise been had these factors not occurred.
The rest of the table demonstrates that because these are largely temporary — not all of these factors are behind us — as they dissipate growth would actually be a bit larger. As we go through to the fourth quarter, we are seeing largely a reversal of these temporary factors with these factors contributing to growth in the order of about 0.75percent.
We think that the effects on the level of activity will have netted out by the end of the year. You can clearly see that there were short-term effects as we went through each quarter. There is some recovery in the fourth quarter as these effects worked themselves out.
Senator Moore: When you looked at the fourth quarter, did you take into consideration the fires in B.C. or Hurricane Juan? Are those included in the basis of the calculation?
Mr. Jenkins: Yes. Our staff has worked through, to within best estimates, the implications of all those things. We are looking to give you a precise number in the fourth quarter of this year and it is implicit in our monetary policy report. For the fourth-quarter growth rate, we are looking at close to 4percent at an annual rate. That is how we typically present rates. In the absence of those factors, growth would have been closer to 3percent or 3.25percent.
Senator Moore: On the second page of your comments, you mention that there are significant risks to the economic outlook relating to timing and magnitude of adjustments to global economic imbalances.
We have had quite a discussion about currency rates. What other economic imbalances are causing you concern in terms of forecasting?
Mr. Dodge: I mentioned two in response to an earlier question. First, the fiscal imbalance in the United States over 50 years will have to be rectified in some way or another. Second, the U.S. current account deficit, which is currently running at about 5percent of GDP, for the richest and largest country in the world, cannot continue ad infinitum and some degree of correction will be required there. Those really affect us.
One would hope that the U.S. will find ways to reduce expenditures and increase revenues to deal with its fiscal situation over time. Furthermore, it is hoped that demand abroad for U.S. products will be strong so that as they are squeezing their economy as they fix their deficit, some of that gets taken up in terms of external demand outside of North America. That is precisely what we in Canada went through after about 1993.
That is the hopeful side. The real uncertainty is if that does not materialize, if the world does not grow as fast, if the U.S. current account stays wide and all of it has to come through a downward adjustment in the U.S. dollar rather than in strength abroad and demand for U.S. products, then it could be fairly rocky.
We do not know exactly how that will play out. At the moment, it is playing out in terms of currency adjustment of the U.S. against everyone except non-Japan Asia. It is non-Japan Asia that is accounting for an ever-larger fraction of the overall U.S. imports, first, but also an increasing fraction of the U.S. trade deficit.
Senator Moore: With regard to the non-Japan Far East, we have read comments recently about the Chinese currency being kept down artificially. Is that another one of the influences that factor into your considerations when you talk about these imbalances?
Mr. Dodge: I do not want to pin this so specifically on China, but to look at non-Japan.
Senator Moore: I am not suggesting that. Is it another one of the main factors?
Mr. Dodge: They will have to make an adjustment there. As I say, that will come through very strong demand in those countries. We would hope that they will follow policies that will allow for that very strong demand to take place, first, and second, to actually spread itself out across the world.
Senator Prud'homme: I refer to your monetary policy report on page 16. If this question is totally unrelated, I do not mind if you defer this to another debate. You say that ``the financial situations and profitability of banks in Canada have improved, a positive sign for future credit conditions.''
I was here when we talked about the merger. I opposed the merger, but the report went to the Senate. I did not make a scene by saying that I objected to the possibility when we studied the bill. I said at the time that I agreed with the banker, Mr.Clark, who said if we had clearer rules, a merger might occur — not under this government, but under the next. That means I am getting closer to my prediction when I said last year that there would be an election in April.
Would you be in a position to write the same thing if there was to be a merger? Could this affect our collective judgment and could it affect the way this is well written there, that the profitability of banks in Canada has improved and positive signs for future credit conditions?
I am afraid for credit conditions in smaller places. I will try to speak for the smaller people in the smaller places. They are people who may have other views. Could this affect all your good predictions?
Mr. Dodge: That is very hard to answer. I am not going to try to answer it definitively.
In Canada and other countries, we observe that when one has a healthy and profitable banking system, that system is actually in a position to make loans to businesses so that businesses can grow and, indeed, make those loans on relatively favourable terms. Generally speaking, a healthy and profitable banking system is really quite positive for growth. The banking system in Japan is in trouble. Japan has had trouble growing because there has not been appropriate credit available, especially to smaller enterprises.
You ask whether, indeed, if we had fewer chartered banks in Canada, there would be any difference in the profitability and any difference in credit conditions. That is extraordinarily difficult to answer. The presumption going in would be, not very much difference, because the retail side of banking in this country — as in the United States and the United Kingdom — is actually reasonably profitable at the moment, regardless of the structure. The U.S. has many institutions; Britain has fewer; we have fewer still. Profitability rates are not terribly different for the retail structure.
Senator Prud'homme: That is good food for thought for me. I am very conservative, which might please you. I like our banking system as it is and I am very skeptical about the future. You comfort me by putting more doubts in my mind.
The Chairman: I would like to turn to the question of housing. We have had extraordinary housing markets both in new construction and in values of existing housing stock, which has had an enormous impact on the economy — both directly in terms of what is generated from that construction and also because of the low interest rates, the freeing up of consumable capital through refinancing or new financing at low rates.
Could you give a general sense of how important this has been to the economy in the period that we have just gone through and how sustainable this might be? I wonder about it. Is this kind of a finite thing? Is there a point at which those anywhere near a position to make a significant change in their housing, either first time housing or upgrading, will find the situation is beginning to run down? Even though low interest rates may continue, will we lose this thrust to the economy that we have been getting from this direction?
Mr. Dodge: That is a very good question. We spend a lot of time considering that question, as you might imagine, as the housing sector is very important.
I will begin with a very general remark. The structure of the Canadian housing market is probably one of the healthiest — if not the healthiest — in the world. We do not have a number of the factors that tend to push toward bubbles. We did learn a bit of a lesson after 1989. Homeowners, homebuyers and lenders tend to be fairly conservative in trying to avoid the sorts of problems that they remember all too well back from 1989-1990. That distinguishes us from the Australians, the British or even some Americans. In the United Stated I think there are some indications that there is a bit of froth in the market.
That sector will not continue to grow. We are running at between 225 and 230 starts, which is well above the actual day-to-day, longer-term needs. Thus, it will not grow. Sustaining it at high levels will be an achievement. It will be fantastic in the sense that it will put more Canadians in their own homes and will take more pressure off rents in the country. Thus, what we ought to see is stability of price and, in fact, better and more housing for individual families.
I do not think we can expect very much in the way of further growth in the sector. However, maintaining the high level that we are at would be quite an achievement. It will have to come off a bit, over time. On the other hand, it is a sector in which we certainly have seen some price and cost pressures.
The third point I would like to make isthat, as Canadians have taken on a lot of debt to buy these homes over the last few years and mortgage debt and consumer debt as a share of household income has actually gone up, people often question whether that is sustainable. The fact that the share has gone up is undeniable. However, the monthly servicing cost has come down quite sharply as we have moved to a period of relatively low interest rates. Therefore, consumers and homeowners are not stressed at the moment. That is very healthy.
The question we have addressed is this: Suppose house prices were to fall off, would we see some difficulties? I think the answer to that is, no. There is not nearly the potential problem that we had in 1989-1990. Furthermore, the ratio of mortgages as a percentage of the value of homes is not actually terribly high at the moment. On that side, we do not see much risk.
On the side of some increase in interest rates, even were rates to be a couple of points higher than they currently are for a standard five-year mortgage, debt-servicing ratios would still remain certainly below their historic average, although they would start to move up toward their historic average.
Those are the general points. Mr.Jenkins, have I missed some of the important issues?
Mr. Jenkins: No, I think you have covered them well, Governor.
The numbers certainly indicate that the housing market, overall, is healthy in the sense that there are none of the speculative pressures that we saw in the late 1980s and early 1990s. Indeed, when you work through the balance sheet of the household sector, yes, debt ratios have gone up to some extent. However, looking at debt-service ratios, and working all of this through to the net worth of the household sector, the balance sheet of the household sector looks quite positive. Certainly, the sentiment you are hearing from the Governor and from me is supported by discussions we have with the industry itself in terms of how they see the situation both currently and into the future.
The Chairman: Where a homeowner takes advantage of low interest rates and refinance —, at whatever stage of the mortgage that is — and generates cash as a result, what do you know about where that money goes? Typically, does it stay in housing? Is it generally put toward housing improvements or new acquisition; or is that often a source of other consumption?
Mr. Dodge: It is important to distinguish between the Canadian and the U.S. markets. Typically, the U.S. housingmarket is financed on 25 or 30-year mortgages,with not only a 25-or 30-year amortization, but with a 25-or 30-year term. Thus, when rates fall what a homeowner can do is to hold his or her monthly payments the same, refinance a lot more of the value of the house and take a pile of cash out.
Generally speaking, we do not see that in Canada because, typically, Canadians finance on a mortgage term of five years. Some are more than five years but, generally, five years is the longest. There are many people who finance on one-year terms. The interest rate fluctuates.
When interest rates are low, people tend to think that they can buy a little bit more house. Additionally, Canadians are quite conservative in terms of their financial affairs and will tend to move to pay off their mortgage faster, which is tremendous advantage to a Canadian because he cannot deduct the mortgage interest whereas the American can. Paying it off is a really important proposition here in Canada.
Then, as Mr.Jenkins reminds me, there are all the other effects.
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Senator Biron: One way of ensuring a higher exchange rate is to peg our interest rate to the much higher U.S. rate. For example, during the 1990s, the spread between Canadian and U.S. rates was greater than three percentage points.
Of course, over the past ten years, Canadian interest rates have at times been lower than U.S. rates, which has resulted in lower demand for and a depreciation in the value of the Canadian dollar.
Today, the Canadian dollar is repositioning itself vis-à-vis the U.S. dollar, in large part because the Canadian economy is performing much better. The Canadian dollar has appreciated in value because of one factor. Its value has been increased artificially, which has led to upward pressure on demand and to much higher interest rates.
There is no question that as a result of the monetary policy embraced by Canada over the past several years, the Canadian dollar is today feeling the effects of more positive factors. Would that indeed be your assessment, at least in part, of the situation?
Mr. Dodge: First of all, the Canadian exchange rate is affected by a number of factors. While relative rates are important, there are a number of other, equally important factors to consider. At times when the Canadian dollar was weak or its value was depreciating, the difference in value between the Canadian and U.S. dollars was rather significant. At other times, when the Canadian dollar was relatively strong, the spread was fairly narrow. This is one factor that affects the exchange rate, but only one factor.
In the spring, investors were looking to earn the best rate of return. During this time period, capital movement was affected by the spread between the U.S. interest rate, and Canadian, Australian, European and British interest rates. This was less apparent during the summer.
This is merely an observation, albeit an interesting one. There is not necessarily a cause-effect relationship here. However, in the summer, spreads were slightly wider than they now are and Canadians moved their capital into Canadian bonds.
These are complex considerations and major factors vary from time to time. It is very difficult to say.
Mr. Jenkins: To some extent, exchange rates are the most indigenous variables in an economy. Putting it another way, as the Governor said, exchange rate movement is determined by several factors. It is all relative and therefore, U.S. economic factors play a role in this, as do global and domestic factors. Obviously, it is important to look at all of these factors. The interest rate spread is merely one consideration.
Over the past two years, the interest-rate spread has averaged 110.35 basis points. However, over the past 30 years, the spread has been less than 20 basis points. As the Governor said, we are dealing with a complex situation. Exchange rate movement is influenced by both domestic and external factors.
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Senator Angus: The news you are putting out here — both verbally and in the written report — seems to be extremely positive. I have concluded early, from my preparation for today, that you definitely consider the fundamentals of our economy to be very good at the moment. I have just made a short list to be sure I have it right.
Inflation is low and within the bands of your policy. I believe that you said the interest rates are relatively low, notwithstanding the gap with our friends to the south. The dollar is strong and robust. There is good economic growth. You are anticipating 3.25percent going forward. There is low unemployment and a good climate for investment in Canada. There is political stability and good money supply. There is strong capital and stock markets.
Yet, in your opening statement you sounded a strong warning. In the headline of The Globe and Mail this morning was a plaintive cry, and in boardrooms around the country I am hearing people engaged in the business of selling goods and getting paid in U.S.dollars and having to convert them back to Canadian for purposes of reporting to their shareholders' tears.
Are these crocodile tears? Do we have some good news for those plaintive voices? How concerned are you really in terms of the warning?
Mr. Dodge: I am glad we have come back to this matter. We at the bank have to watch this issue carefully because adjusting to a movement in the exchange rate that has been as rapid as it has been since April poses real on-the-ground difficulties — not necessarily impossible to overcome — but difficulties nonetheless. For some firms, especially for those that buy most of their inputs — whether it is labour, materials or equipment — in Canadian dollars and sell a substantial fraction of their output in U.S.dollars, it can be a relatively difficult time.
We gave you the rough orders of magnitude about how fast the world has to grow to provide the demand to offset a rise in the Canadian dollar vis-à-vis the U.S.dollar. Of course, we are concerned and have sounded a note of caution because the rise that we have been getting over the last little while may not actually signal that we are going to get much stronger world demand. We have to watch this carefully.
Therefore you would have the one factor that will tend to dampen foreign demand— the rise in exchange rate— not being offset by the growth in demand. That is why we signal that while in the second and third quarter of this year, the U.S.has clearly done better than we anticipated last April when we expected roughly a 4percent growth rate from the fourth quarter of this year on in the United States for the next four or five quarters. We are not predicting any more than that, now. However, when we did our report last April we had a 69-cent dollarand the average when we did this report was a 72.5-cent dollar. We have to really balance this.
What it will mean, senator— and this is really important— is that, to the extent thatthere is weaker foreign demand because it is not foreign demand for Canadian goods and services and because aggregate demand abroad is not growing fast enough to offset the exchange rate effects for us, we are going to have to find a way to crowd in domestic demand in Canada, whether that be household demand, but in particular investment demand.
No one should leave this room thinking that, given these changes — and especially if they look like they will persist or if we see a weakening in world demand — that we would not take action to try to crowd in some more domestic demand. As we sit here today, I cannot tell you that we will do that. None of us can. We have to look at the situation as it evolves and as we better understand what has actually happened in Canada over the last couple of quarters. The statistics are distorted by these factors that Mr.Jenkins explained earlier.
There is always uncertainty going forward. However, there is some uncertainty about what has happened in the past. We should not be too fixated on any one of these numbers because, frankly, Statistics Canada, who have the best national account statisticians in the world, are having difficulty doing some of the accounting because of these changes and because of the rapid change in exchange rates. That makes it difficult to know what the real flows of goods and services are back and forth across the border.
I want to make it clear that no one should make an assumption that we will not have to alter monetary policy in order to crowd in domestic demand, if it is clear that foreign demand, after the exchange rate effects, will not grow as rapidly as we had anticipated.
Senator Angus: What would be the nature of such an alteration?
Mr. Dodge: Normally, to crowd in domestic demand we would do what we have been doing — which has been to reduce interest rates.
Senator Massicotte: I will first make a comment to SenatorAngus. When my honourable colleague enumerated all the good things that happened in our country, I was pleased that he was very complimentary of our Canadian government, as to what a good job we are doing.
I should like to talk about the industry perception and respond to SenatorBiron's points. There is certainly a Canadian impression that the currency— and I know you answered, but I want to be more specific— problem is strictly an industry problem. I am sure you are plagued by the hypothesis that if you put interest rates down the currency problem will be resolved.
Could you comment as to what would happen in your hypotheses using Mr.Jenkins' point of all else being equal? If interest rates dropped by 1percent, what would happen to the Canadian dollar? If you saw the The Globe and Mail this morning, one journalist commented that the reason the Canadian dollar is so high is that we have a high interest rate perception around the world, that we will always be higher than the Americans and that is why the Canadian dollar is higher. Can you respond to that, please?
Mr. Dodge: I cannot give you anumber. There are other elasticities that we know on average — not necessarily the margin —how it works. What you are talking about, though, always operates at the differential. I cannot tell you. It really does depend on where we are sitting. The direction ought to be to make it less advantageous to hold Canadian dollars. Hence, it ought to have some downward pressure on the exchange rate.
On the other hand, if you do the analysis and say, ``Gee, they have lowered rates, therefore they will get better growth in Canada, therefore, it is a better place to invest and in fact we should perhaps invest more and the capital will actually flow the other way.'' Mr.Jenkins has been at the game longer, but it is certainly not possible for me to give a definitive answer to that question.
Our interest rate policy is not targeted at the exchange rate. Our interest rate policy is targeted at trying to ensure that over a period of 18 to 24 months we try to take the economy back to full potential production. That is what we are aiming for. The inflation rate is a good measure of that. At full potential, we are targeting 2percent. However, we do not move rates around for exchange rate reasons. This goes back to my response to SenatorAngus: it is really a question of trying to see what happens to aggregate demand for Canadian products relative to our supply capacity. That is important. People often miss that fundamental point.
Senator Tkachuk: I wish to return to the same line of questioning perhaps from a different angle.
In your monetary report, in the second paragraph, you say that, ``Low inflation allows the economy to function more effectively. This contributes to better economic growth and works to moderate cyclical fluctuations in output and employment.'' The goal of the Bank of Canada, to check inflation and to keep inflation at a reasonable, targeted amount of 2percent or whatever the target is that the bank sets.
However, the dollar plays havoc with this when it fluctuates as quickly as it has been over the last while. This is not just a question of a slow increase in the dollar; as our economy gets better, our dollar gets stronger. Our interest rates may go up because of higher inflationary pressures and because of our strong economy and, therefore, our dollar gets stronger.
This seems to be haphazard. Is there anything that the bank can do? Do you even have a role to play? You have said in the past that you have nothing to do with the 65-cent dollar and that this was not part of the monetary policy of the government and Paul Martin to solve some of our economic problems. Is there any way that you can stabilize either the rate of increase or the fluctuation of the dollar?
Mr. Dodge: You have asked a series of questions, senator. I will leave the difficult ones for Mr.Jenkins.
Let me start with your very first statement, senator. You said that our goal is inflation control. Our goal is to maximize output and employment over time. The best contribution that monetary policy can make to that goal, which is our real goal— the welfare of Canadians— is to provide low, stable and predictable inflation from the bank side. That is how we get there. The real goal is to get the maximum sustainable growth and to not have fluctuations in the economy.
That is what we target. If we are to do that, that will mean that we have to accept whatever happens on the exchange rate side because it is the sort of balancing item.
The problem is that there are real things that drive that exchange rate. Mr.Jenkins will talk about those. There is also Keynes' famous ``animal spirit'' sentiment. Obviously, we cannot do anything about that other than to provide a good stable climate for business growth and employment in Canada.
Perhaps Mr.Jenkins can deal with some of those very difficult questions that the senator has just posed.
Mr. Jenkins: The first observation I would make, senator, is that there has been quite a bit of volatility in a number of financial markets recently. I would refer you to technical box two of our report, when you have time to reflect on it. It focuses not so much on exchange markets or the volatility that we have all seen recently in the Canadian dollar exchange rate, but on global fixed-income markets, bonds markets, which have shown quite a bit of volatility recently.
Some of this global volatility that we have seen in financial markets has reflected some of the uncertainties that we have experienced over the last couple of years, including, uncertainties around geo-political developments, uncertainties around corporate scandals, uncertainties about whether there is a risk of global deflation, for example. If there is one thing financial markets do not like, it is uncertainty. We have seen that volatility in a number of different markets, including our own markets. As we have been discussing, that poses certain issues.
Having said that, looking at the broad movements of the Canadian dollar over time, we feel that those movements follow the fundamental factors that drive exchange rates that we have been discussing — issues that relate to relative positions of one economy versus another, commodity price cycles, and differences in inflation rates. A number of factors determine the fundamental movements of exchange rates. When we look back over time we think the Canadian dollar has, by and large, played its appropriate role as part of our monetary policy framework.
Part of that appropriate role is reinforced by the importance of having a monetary policy anchored to inflation control, because that helps market participants, but economic agents more generally, to develop expectations about what monetary policy will deliver for your economy.
When you look at the research over a span of years, the Canadian dollar has been far less volatile than virtually all other major currencies. I would be happy to provide you with some of that research, if you would like to see it.
In terms of what can be done, as I mentioned, we place high importance on having firmly anchored expectations because that does condition markets and behaviour. As well, we are also concerned with the development and improvement of capital markets more generally. Here, you get into issues of markets that do provide corporate enterprises with the capacity to hedge, for example, going forward, certainly wanting to see your capital markets continue to develop to have instruments that enable people to manage their affairs from that point of view as well.
The Chairman: Thank you, gentlemen. Once again, I think we have had a useful and interesting session. Thank you for the time and for your work on behalf of Canadians. We look forward to the next occasion.
The committee adjourned.