Proceedings of the Standing Senate Committee on
Banking, Trade and Commerce
Issue 9 - Evidence - Meeting of October 25, 2006
OTTAWA, Wednesday, October 25, 2006
The Standing Senate Committee on Banking, Trade and Commerce met this day at 4:05 p.m. to examine and report upon the present state of the domestic and international financial system.
Senator Jerahmiel S. Grafstein (Chairman) in the chair.
[English]
The Chairman: Welcome, ladies and gentlemen. We are delighted to recommence our hearings of the Standing Senate Committee on Banking, Trade and Commerce. We are delighted as well to have as our distinguished guests, David A. Dodge, Governor of the Bank of Canada, and Paul Jenkins, Senior Deputy Governor. Welcome to both of you.
The Senate Banking Committee, governor, as you and honourable senators know, is the oldest and longest-running committee of Parliament. It was established shortly after Confederation in 1867 to examine and have oversight, from the Senate's perspective, of the economy as a whole. Banking, trade and commerce are our terms, but our general frame of reference is to look at the economy as a whole.
We are delighted once again, governor, to invite you here to examine and report on the present state of the domestic and international financial system. We have had very interesting discussions with you in the past and we wait with great anticipation to listen to your evidence today. We want the public to understand as best they can what is happening in our economy. Governor, the floor is yours.
David A. Dodge, Governor of the Bank of Canada, Bank of Canada: I want to start by saying we appreciate the opportunity to meet with this committee twice a year following the release of our Monetary Policy Report. These meetings, I hope, keep you, and through you all Canadians, informed about the bank's views on the economy, our objectives in terms of monetary policy and the steps we are taking to achieve those objectives.
[Translation]
When Paul and I appeared before this Committee last May, shortly after the release of our spring Monetory Policy Report, we noted that the global economy had shown a little more momentum than had been anticipated: oil prices at that time were higher than previously assumed and metal prices had risen significantly. At that point, we were anticipating economic growth of about 3.1 per cent this year, 3.0 per cent in 2007, and 2.9 per cent in 2008.
[English]
Things have changed since then, six months ago. While global growth is expected to be higher than we were anticipating last spring, a weaker near-term outlook for the U.S. economy has curbed near-term prospects for Canadian exports and growth. The bank's outlook for growth in the Canadian economy has been revised down slightly from our reports in April and July. The base-case projection of the bank now calls for an average annual GDP growth of 2.8 per cent this year, 2.5 per cent next year and a return to 2.8 per cent in 2008.
I know productivity has been a concern of this committee, and weakness in labour productivity growth has led the bank to lower its assumption for potential growth for the 2006-08 period from 3 per cent to 2.8 per cent. Together, these factors imply that the small amount of excess demand now in the economy will be eliminated by mid-2007.
[Translation]
Core inflation is expected to remain a bit above 2 per cent in the coming months, but return to the 2 per cent target by the middle of 2007 and remain there through to the end of 2008.
Lower energy prices have led to a downward revision of the near-term projection for total CPI inflation. Total inflation, which includes the temporary impact of the GST reduction, will likely average 1.5 per cent through the second quarter of 2007 before returning to the 2 per cent target and remaining there through to the end of 2008.
[English]
Senators, as we noted at the time of our interest rate announcement on September 6, the risks around this base-case projection are judged to be a little greater than at the time of the July update, and certainly greater than they were last spring. The main upside risk relates to the momentum in household spending and housing prices, while the main downside risk is that the U.S. economy could slow more sharply than expected, and that would lead to lower growth in Canadian exports. What is very important is that at this time we judge these risks to our inflation projection to be roughly balanced.
In conclusion, last week we left our key policy rate unchanged at 4.25 per cent. This current level is judged at this time to be consistent with achieving our inflation target over the medium term. We at the bank will continue to pay close attention to the evolution of risks as well as to the economic and financial developments in the Canadian and global economies.
Mr. Chairman, Mr. Jenkins and I look forward to our discussion today.
The Chairman: Thank you very much for that presentation and for appearing before the committee.
Senator Angus: Welcome, governor and deputy governor. I always look forward to your visit here, and I know all my colleagues feel the same way. We are somewhat humbled by the fact that you are getting into the habit of going to the other place before you come here. We might have a little discussion off-line about that.
We received a press release yesterday saying that there was going to be a lock-up this morning at nine o'clock and that you would be giving a big speech in Niagara-on-the-Lake, Ontario. We wondered what it could be and why you were going to do something in Niagara-on-the-Lake and scoop the Senate Banking Committee. Since you were coming here today, we wondered why you did not do what you had planned. We tuned in this morning and took careful note of what you said. Now we understand that it was a particular economic conference that was focusing on economic growth and matters related in Ontario.
Governor Dodge, in your last three appearances here you have expressed that your greatest concern from a macroeconomic point of view has been with global imbalances. I scrutinized your report given in Ontario this morning and, sure enough, you said:
Let me make one more point about the global economy before turning to the domestic outlook. For some time now, policy-makers have been worried about global imbalances; that is, the very large current account deficit in the United States, which is mirrored by current account surpluses in Asia and major oil-exporting countries.
Those are the OPEC countries.
I asked my research staff to help me understand what global imbalances mean in layperson's terms. All Canadians are interested in what you have to say. I gather you are still concerned about global imbalances. Could you tell us to what degree you are concerned and at the same time try to simplify, for the layperson, what global imbalances are? As well, when they begin to unravel, to use your language, if they do so suddenly and abruptly, what are the potential consequences?
Mr. Dodge: You described it very well, senator. The imbalances are the very large current account surpluses that are being run by China; to a lesser extent, but very important, Japan; and a couple of other Asian countries like Taiwan. They are taking in much more from their exports than they are paying for their imports, while at the same time, particularly in China, there have been large capital inflows as well.
In the OPEC countries the situation is exactly the same. The price of oil has gone way up and their trade balances have improved, and that has been matched by deterioration in the U.S. Essentially, the U.S. has been the residual source of demand for the whole world. Consumer demand has been very strong; more recently investment demand has been strong, and governments have been running deficits. When you add all of that up, the Americans demand more than they are supplying and other countries supply more than they are demanding.
We know that over a longer period of time countries cannot go on running deficits of the magnitude that the Americans are running and that at some point American demand will have to grow less rapidly in order for them to shrink their deficit with the rest of the world.
If at the same time there is no pick-up in domestic demand in other countries, world growth will slow way down. There is also a big worry, of course, that the Americans will take steps to correct this through trade restrictions, which would be very unhelpful for the world.
Finally, there is a worry that investors will lose confidence that the Americans are finally going to get their act together and they will cease to be willing to buy these pieces of paper, these IOUs, that the Americans are issuing to pay for all this.
That is the problem, very simply. Normally, of course, you would expect that adjustment would take place around the world. Rising incomes in China would lead to increased demand in China; the Americans would cease to build up debt and there would be falling demand in the United States. Everything would be rosy in the garden. Normally we have price mechanisms to allow that to happen. A price mechanism could be depreciation of the U.S. dollar on the one hand and a revaluation of the Chinese RMB on the other. There could be a lot of inflation in China. A number of things could happen. The problem has been that those price adjustments have not been coming through either exchange rates or differential rates of inflation.
The pressures kept building. In the last year we have seen some beginning of a recalibration. U.S. demand is slower. We have demand pick-up in Japan; we have seen some pick-up in demand in Europe. We have still not seen pick-up in household demand in China, but at least things have been moving a little bit in the right direction.
We remain very concerned, but at least the movement over the last 12 months has been in the right direction. In Canada we feel the pain of that because it has come from a reduction in housing and automobile demand in the United States, and that particularly hits us here in Canada.
Senator Angus: In Niagara-on-the-Lake today you used the words, ``the risk of an abrupt, disorderly resolution,'' and that is not what we are getting, obviously. It looks optimistic from your response, but what would a worst case scenario be and how would it affect us?
Paul Jenkins, Senior Deputy Governor, Bank of Canada: A worst case scenario can come from two different channels. One would be an abrupt slowing in the U.S. economy, to which the governor referred, without any offsetting growth of demand in the rest of the world. Therefore, you have overall global demand slowing, which would affect us as well as others, including some of our other trading partners.
The other channel through which this could come, and to which the governor also alluded, would be the financial markets. The large current account deficit in the United States is being financed by investors elsewhere in the world, and they may very well say enough is enough. If they were to say that, there would be two effects: a sharp depreciation of the U.S. dollar and higher interest rates, both of which would have ramifications for the global economy.
It can come at us from those two channels, but we are encouraged by what we call the rotation of demand. Fundamentally, for these imbalances to be resolved you must have stronger demand elsewhere than in the United States and some increase in U.S. savings or some slower growth in their consumption, and there are signs that that is beginning to happen.
Senator Angus: I would like to turning to the domestic scene, just for a moment, and the same area of imbalances; it is not the same, but perhaps there is an analogy. Some economists are saying that the rate of growth of the Alberta economy at the moment is in the range of 18 per cent or more, and we know that in some provinces the rate of growth is stagnant or less, and in others, somewhere in between.
Your October report and your opening statement today contain precise numbers — 2.8 this year, 2.5 next year; that is pretty precise reckoning. I am wondering how you calibrate the imbalances, if you will, in growth within the Canadian federation.
Mr. Dodge: You are right. Those sound very precise. It is always important to recognize that there is a fairly wide confidence band around those numbers. We will know only five years from now when Statistics Canada gets its final revisions what growth actually has been to the nearest decimal point.
We give it to the nearest decimal point because that is the centre of a band. Do not think that we are so bright that somehow we can get it to the nearest decimal point. It is a good indication of at least the centre of a band, and, as we have said, we think the risk is reasonably evenly balanced around that band.
Let me answer your main question. Obviously demand in Alberta, especially investment demand, has been very strong, as it has been in the Lower Mainland of British Columbia and in Newfoundland and Labrador; those are the three places of very strong investment demand. Certainly the economy of Alberta and the economy of the Lower Mainland are running over capacity. What we are seeing is an escalation of prices and wages as a reflection of that very strong demand.
That is not inappropriate. Let me make that point. It is not inappropriate because in order for the real resources to move into those places of excess demand, the price mechanism works; so higher wages and higher prices there do encourage resources to move in. Those higher wages and prices are relative to what is going on in Ontario.
The question is this: How adaptable and how flexible are our markets to actually respond to that? As we have said several times, and certainly compared to the experience you will well remember in the 1970s, our labour markets and our capital markets do seem to be much more adaptable than they were then. Nevertheless, as we pointed out in our report, there is a risk that they are not sufficiently adaptable and that the wage and price pressures clearly evident in Alberta could spread back east. That is one of the worries we have, obviously.
Senator Angus: We have been looking at interprovincial trade barriers, as you know, and from one of your earlier reports I cannot help but think of the analogy of Lord Durham when he reported back to head office that he had found two nations warring in the bosom of a single state. I am wondering if we have 10 economies competing within the structure of a single economy. That is what I was getting at with my question.
Mr. Dodge: Of course we do. We also have reasonably flexible wages and prices and we have labour markets that, while never as flexible as one would like to see, in fact are reasonably flexible, certainly compared to earlier periods in our history.
We are seeing the adaptation take place, but clearly that adaptation would be faster and smoother if we could get rid of the barriers between provinces. If everybody had the same licensing arrangements for trades and professions, people could move easily, and obviously the adjustment would be better.
The Chairman: On that front we have heard good news from British Columbia and Alberta about mobility pacts; the same with Ontario and Quebec. In our continuing study of interprovincial barriers, this committee will be pushing that item, which we think is a clog and a barrier to productivity.
Senator Moore: Having read through your report and having read your speech this morning, governor, I was in interested in the currency markets. Your report states:
It would appear that the impact on the Canadian dollar from the decline in energy prices since July has been partly offset by an increase in currency flows related to cross-border mergers and acquisitions in Canada.
Can you explain that to me and the Canadian public who may be watching this session?
Mr. Dodge: We are a large net exporter of commodities, so when we have high commodity prices, that increases the foreign demand for Canadian dollars to pay Canadian suppliers and it puts an upward pressure on the dollar. We have discussed that over the last three years in front of this committee.
At the same time, when foreigners want to invest in Canada they also require Canadian dollars. We have seen that recently these flows have been larger than they were over the last two or three years, considerably larger. Indeed, our folks back at the bank are trying to manage a big flow going through right now from the CVRD deal.
Senator Moore: What is that?
Mr. Dodge: That is the CVRD purchase of Inco, and it is going through markets as we sit here this afternoon. CVRD is the Brazilian mining company, Companhia Vale do Rio Doce.
Senator Moore: When you say there is a larger demand for Canadian dollars to finance these acquisitions of Canadian companies by outside parties, how much is the increase in demand? Are we talking historical numbers? Is it 5 per cent, 10 per cent?
Mr. Dodge: Senator, we will never be able to figure that out exactly because the flows on any day are very large compared to the margin that even a very large deal like CVRD, which is $12 billion, would add. It is the margin, of course, that really counts in terms of moving currency around. We will never know exactly a priori because Canadians may turn around and invest that abroad.
Senator Moore: The money they receive from the purchasers?
Mr. Jenkins: It goes in both directions.
Mr. Dodge: As we observe currency markets and try to infer what is going on, it is fairly clear that the direction of this has been upwards on the Canadian dollar, because we have had a lot of them recently. So there have been upward pressures, which have offset what we would have thought would have been downward pressures coming from the fall in energy prices, in particular the fall in natural gas and oil prices.
Senator Moore: In the section ``Risk to the outlook'' on page 32 of your report, you state:
The main upside risk to the Canadian economy continues to relate to the momentum in household spending and housing prices. This momentum is linked to strong consumer credit growth.... There is a risk that these linkages could be stronger than assumed or that house prices could continue to grow more rapidly than expected, resulting in higher-than-projected household spending and, hence, greater upward pressures on inflation.
You must be recording something significant to cause you to put this in your report. Are house prices being hyper- inflated? Are people financing or borrowing against the equity they have in those houses based on those new, not paid for, but market prices for their homes?
Mr. Dodge: There are real issues and financial issues.
Mr. Jenkins: With regard to the risks, as you indicated from our report, there are two aspects. Higher house prices feed directly into the consumer price index, and we are seeing evidence of that. Therefore, that is one area that we have been watching closely and will continue to watch closely. The other aspect on the real side is very much the phenomenon that you are describing. With increases in house prices, higher equity, higher net worth from the point of view of the household sector, they can borrow against that, and that in turn would feed into their consumption of other types of goods and services. Again, we have seen very strong growth of household credit, and certainly some of that is financing the consumption of durables and other consumption goods. We see that in the data. On the risk side, we felt that was important enough to highlight in terms of how this might continue to feed into the economy, both of those channels having a potential increased impact on inflation.
Senator Moore: In the long term, is there any fear that people would not have the resources to pay back the credit they have gained from the current market prices for their residences?
Mr. Dodge: We think the risks to future financial stability are pretty low. We report on that in our financial system review and will be reporting again in December this year, but certainly our review to date would say that the risk is indeed fairly low that we could have any systemic problems.
Senator Moore: Are these borrowings against equity being secured by mortgages against real estate, or are they also credit card borrowings and collateral mortgages which may be at higher interest rates and more risky?
Mr. Dodge: With the development of personal lines of credit that are secured not in the conventional mortgage way but by equity in houses, consumers are able to borrow more cheaply than they could by borrowing on credit cards or whatever. The cheaper borrowing has helped consumers to borrow more at lower rates.
Senator Tkachuk: Welcome, governor. After years of concentrating on the dollar, and at the last meeting on interest rates, I have turned into a bit of a gadfly and will turn to a new topic. I want to talk about productivity. The Minister of Finance has identified productivity as the focus of his next budget. One of the main themes is productivity and labour supply and potential output research from 2006. On the website, you have a question: What factors explain the historical behaviour of Canadian labour productivity, including differences between Canadian and U.S. productivity experiences? That question is almost virtually the same as the one you had last year. I was wondering if you could perhaps update us on the results of that. What new information you can give us today?
Mr. Dodge: I am afraid it will be there next year as well.
The Chairman: It would be helpful, governor, to explain for our audience what productivity means in layman's terms. It is very important for the public to understand what we are talking about.
Senator Tkachuk: We will all find it helpful.
Mr. Dodge: Senator, there are many different measures. The one that is most commonly used, because I think we can all relate to it the best, is labour productivity. It is simply the amount of output that we get for an hour's worth of labour input. That is not the only measure, obviously, because it is very important that capital be productive, and there is a more sophisticated measure called total factor productivity, but let us stick with the one that is commonly used, and that is labour productivity.
First, labour productivity in Canada, as we have noted before, and as you have noted in your own work, has not been growing as rapidly as it has been south of the border. Second, it has not been growing as rapidly as our longer- term view that it should grow at about 1.75 per cent per year.
There are reasons to think that over time we should begin to see the investments in technology and in particular information communications technology start to pay off in terms of higher productivity. Despite the lower productivity numbers in 2001, 2002 and 2003, we had thought that we would begin to see this uptake. Indeed, last October, when we were here, we thought we could see it coming and we intended to go back and plug in our longer- term assumption of 1.75 per cent, which would give us capacity growth when you add in labour force growth of 3 per cent.
Unfortunately, as the numbers have kept coming in, we have not seen that improved performance. This year, in our October report, we said that maybe we jumped the gun, so we have gone back and assumed roughly 1.5 per cent, which gives us a total capacity growth of 2.8 per cent.
As far as the influence on monetary policy, it is very important for us to get this more or less right. If we judge it to be far higher than it actually is, we end up with a whole pile of inflation in the economy. If we judge it to be too low, we have excess supply in the economy and we could have grown faster. It is a judgment call, and it is very hard to know exactly what that number is.
There is then the question of what will allow us collectively to work smarter, if you will, so that we get more output per hour of labour input. Obviously it is, as I said, investment in new and more productive machinery and equipment, and, particularly for information technology, it is investment in training, so that workers have the right and better skills to be able to be more productive. Also, very important, it is having resources move out of low-productivity parts of the economy into higher-productivity parts of the economy.
That movement or process of making that adjustment, though, is, in the short run, costly. That may well be the reason we are not seeing a more immediate payoff from the investment that has taken place.
Senator Tkachuk: You did not explain the historical differences between Canada and the United States. Perhaps you could go back to that. Over the last number of years, was it the high dollar that made them more efficient or that drove them to be more efficient? Was it education and skills development? What was it about the American economy that increased their productivity while we lagged behind?
Mr. Dodge: We know that the big difference is in the service sector. In the goods producing sector, the differences have not been very large between Canada and the U.S. in terms of productivity growth output per man hour in manufacturing. The difference happens in the service sector. The U.S. stands out across the world as having faster service sector productivity growth. One small part of the difference might be the use of a different system of measurement. Certainly, in terms of direction, some conceptual differences in measurement would narrow the gap a bit. However, fundamentally it appears to be that the service sector in the United States has taken advantage of information and communications technology much more rapidly than we have in Canada.
That much seems to be reasonably clear. We the bank are supposed to know something about the financial services sector so we decided to investigate that activity because, on the face of it, the differences are huge. We are in the process of doing that extraordinarily difficult job. We are not sufficiently along in our investigation to provide the committee with those answers. This has been a highly incomplete answer to your question but ask us again next year, when we might be further along in our difficult work.
Senator Tkachuk: I have one more question on productivity. It stems from a CTV story, in which you are quoted you as saying that now is the right time to encourage partnerships between the Government of Ontario and private providers, given the climate of low nominal interest rates and the presence of large pension funds that are searching for these kinds of investment opportunities. Besides education and skills development, you talked about the public-private partnership. What do you mean by that and how far should it go?
Mr. Dodge: A number of other countries, in particular the U.K. and Australia, but also Scandinavia and Europe as well as a number of U.S. states, have made much greater use of having private firms take on both the financing and the development of public infrastructure than Canada has, whether building roads, water works or other things. Generally, though not always, the experience seems to be that this has led to more efficient operations and, because the private provider takes on some of the risk, it means that management is tighter and the financing is operated at very low spreads because of the demand of pension funds and investors globally for this kind of asset.
Why have we not made more use of that mechanism here? In part, we have not done as much work as other countries have done to set the legal framework for it, which is important. In part, we have not developed the expertise to write risk-sharing arrangements. As well, part of the opposition comes from the fact that a couple of projects have had bad risk-sharing arrangements. That does not mean that we should forget about this. Indeed, it would be incredibly important because our infrastructure demands in this country are extremely large.
Senator Tkachuk: What about hospitals?
Mr. Dodge: You have to be a little careful in what you mean by ``hospitals.'' One reference could be the provision of the building per se; another reference could be the operation of the hospital; and another reference could be the entire system. Therefore, one has to be careful with the use of such a word. However, yes, there are clear opportunities, but the contract has to be written carefully if it is to benefit both taxpayers and the people who need the service.
The Chairman: I have another question on productivity progress. As you know, the committee has done a landmark study on productivity based on your urgings and those of others. It has been well received. This committee feels it has a special responsibility to continue its oversight of that. Have you any suggestions on how the committee could proceed on that now — to prod sector by sector to increase their productivity progress? Mr. Dodge, you and I have discussed the fact that each sector has its specific problems with respect to productivity. There might be best cases that could be expanded between pillars. How do you think this committee, in a cost-effective and productive way, could assist in this national objective?
Mr. Dodge: Far be it from me to give advice to parliamentarians on how best to conduct their affairs. However, it would be incredibly useful for this committee to take one day per year as a productivity day and call in the folks at Statistics Canada to start with a report on what they have observed over the last year. You could call in various people working in this area to report on their work and on the trends. You would keep the issue and its importance in front of us all, whether employees, employers or governments. Fundamentally, as you pointed out in your paper on aging, if we do not increase productivity, we will not have any increase in real incomes, because our labour force will stop growing by the middle of the next decade.
The Chairman: Thank you. Your answer is a consensus of what our committee has reached but I wanted you to share your views with members of the committee and the public. That is our intention. We welcome that recommendation.
[Translation]
Senator Massicotte: Thank you for being here today. I would like to follow up on the notion of productivity, particularly in Quebec. Mr. Bouchard talked about the lack of productivity in Quebec, and the need to work more hours. Statistically, we see that the number of hours worked in Quebec is lower than in Ontario, and much lower than in the United States. He has stressed this point.
In Quebec, our demographic problem is more serious than it is in the rest of Canada, and certainly much more serious than it is in the United States. Given those two observations, would you make a specific recommendation for Quebec, particularly in answer to Mr. Bouchard's questions, and particularly in view of the fact that these significant challenges are coming ever closer?
Mr. Jenkins: As we discussed, the productivity issue is a very difficult one. That can be explained by a number of factors, though other factors explain productivity growth in the future.
Economic incentives are critical; these include training, education and ability to use human and financial resources to promote economic growth. For every sector and every province in Canada, we must find and apply the stages which are critical to the operations of capital markets, to promote investments in machinery, technology and equipment for the future.
Public policy is extremely important, as is market flexibility. We need the capacity to facilitate the movement of resources from one sector to another, and from one province to another. In my view, there is not one single factor involved. Governments, businesses and workers all play a role in helping productivity grow faster.
Senator Massicotte: I would like to move to another current issue in Canada: the very strong dollar. The Bank of Canada's priorities are inflation, economic growth and, indirectly, the well-being of Canadians. Like Ontario, we have a very broad economic sector. Recently, we heard Mr. Beaudoin — and a number of other Quebec economists — explain that we could accept a high dollar, but only for a very short period. It is very difficult for businesses to adjust. We are seeing it in Quebec every day — significant job losses in the forest industry, the manufacturing industry, and so on.
I can predict what your answer will be, but what do we tell the unemployed when the dollar is very high and, as a result, we are faced with these serious consequences? Is this situation temporary? What should we do?
Mr. Dodge: There is a real problem in the forest industry. It is a long-term problem associated with demand. World demand for newsprint is low, and there is a fairly high competition, from Brazil and Indonesia among other countries. The cost of wood in Eastern Canada, Quebec and Ontario is higher. So there is a fairly specific problem in the forest industry, and we need to invest to renew the sawmills, even if some sawmills have to be shut down. We have to channel the skills of workers from mills that are to be shut down towards other industries. This is a difficult transformation, because sawmills are all geographically distant from the major markets in Montreal and Quebec City.
There is no miracle cure for this, because the problem is a structural one. In the furniture and textile industries, for example, the competition is from Asia. Canadian businesses cannot pay a Canadian worker 50¢ an hour — or a similar rate — to compete with those countries.
What is important is to find market niches with increased added value. We have noted that Quebec manufacturers are on the brink of making those adjustments, but the process is going fairly slowly.
In conclusion, what is very important is going through the transformation, making the adjustments, and not keeping workers in jobs that have no future. Employees must be helped to do what needs to be done. Subsidies should not just be provided to industries that do not have a realistic future.
Senator Massicotte: I agree with what you say, but the challenge lies in that the value of the dollar changed for a very short period. That leads to a loss of significant market share. Perhaps we should take corrective action. It is very difficult to manage a business when the dollar fluctuates so quickly. Situations like those cannot be easily understood. Hundreds of thousands of jobs might be lost because of temporary situations. Perhaps one and a half or two years from now, the dollar will be at 83¢ or 84¢, and business decisions will have to be different again. The Bank is aware of those fluctuations.
Mr. Dodge: Yes, prices do indeed fluctuate widely. The price of the barrel of crude oil has gone from $20 to $70, the price of aluminium has more than doubled while the price of nickel is four times what it was. The prices of goods and even services have fluctuated quickly. The fluctuation of the rate of the dollar is a result of those variations. Because of those variations, it is very difficult to make changes, but things will become even more difficult if needed changes are not made.
Senator Massicotte: I have noted that the Bank of Canada made a number of comments on Canadian income trusts two weeks ago. You observed that income trusts provide some benefits for the Canadian economy. Could you say a little bit about what those benefits are?
Mr. Dodge: I could certainly talk about them for a few minutes, because the article in The Globe and Mail —
[English]
The Chairman: This is a major topic for us, so please take your time because I am sure there will be follow-up supplemental questions on this.
Mr. Dodge: Let me start on this. The Globe and Mail article that you probably read last week on what we said at our press conference was not wrong, but, boy, it put a slant on things that we really did not intend.
Last June, in our financial system report, we published the results of the work we had done on this. To make it clear, I would like to recap what we said.
First, we said that income trusts exhibit characteristics different from those of common stocks. Limited evidence suggests that income trusts may enhance market completeness by providing diversification benefits to investors and a source of financing to firms that might not otherwise have access. That was number one.
We said that income trusts are more similar to stocks and bonds, but that they have a risk return characteristic sufficiently different from either equities or bonds to allow investors to achieve portfolio risk-return combinations not otherwise available. In our language, they made markets more complete and, hence, were a good additional instrument for markets to have.
We concluded that there are still areas where standards for trusts are not equivalent to those for corporations. We noted, in particular, two areas that need improvement — those related to accounting and those related to corporate governance.
That is what we said. It is a little different than the headline that was in the paper, which said, ``Dodge Touts Trusts' Benefit.'' That is the work we actually did.
We have not done work on how income trusts affect overall Canadian economic performance or productivity. We will not be doing that work. Indeed, that work is incredibly difficult to do. You can ask others to do it, but recognize that it is just very difficult to reach any firm conclusions.
Finally, none of the work we have done relates to the appropriateness of all of the tax system as it relates to the incentives to operate either in the form of an income trust or in the form of a corporation. We have done no work on that. None of what we have done should be taken to say that we think that the current tax system — taken in its entirety — is necessarily ideal.
The only principle here that you, as legislators, should bear in mind is that to the extent that the overall tax system provides a big incentive to use one form of organization as opposed to another, it may well be that businesses and their shareholders choose a form of organization that may not be absolutely ideal, and not the one that they would choose were there no total incentives in the tax system to choose that. However, we have done no work on that and we cannot aid you in any deliberations you may have on the matter.
The Chairman: I will allow other senators to ask supplemental questions on this topic of income trusts. Perhaps they could ask their questions and then you could respond to all of them before we move to another topic.
The reason for this is that the deputy chair and I have been discussing and will continue to discuss tomorrow what we intend to do on income trusts. We will decide tomorrow and then recommend to our committee what will be our follow-up.
Senator Goldstein: I have a number of questions, which I will come to in due course. What is your view of the effects of the pressure to distribute virtually all income out of the income trusts on research and development within the Canadian economy?
Senator Massicotte: I refer to Jack Mintz, who is an expert on the taxation side. His summary article showed there is no tax difference on the individual side regarding the gain or benefit to the Canadian taxpayers. Where there is a significant difference is the pension funds' own trust units, as well as individuals who own it in RRSPs, for approximately $1.1 billion today.
Is there a public policy interest to tax or remove that incentive to those two players? Given that they already benefit from no capital tax and no income tax, should we go further to make sure everybody is on the same scale? Should we make it equal to all of them?
[Translation]
Senator Biron: To follow up on the question by Senator Goldstein, there will not only be a long- or medium-term reduction in profit distribution, but they will also have difficulty reinvesting in research and in improving productivity. They will also become vulnerable to competition from companies in the U.S. and other countries.
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Senator Moore: I am glad you raised that article, governor, because I happened to bring it with me. In it, you are quoted as saying,
The work we have done in terms of capital markets, per se, is that probably, on balance, income trusts make capital markets somewhat more complete and somewhat more efficient.
I would like you to explain how trusts make the markets more complete. I understand it is another vehicle for raising money, but beyond that, how do trusts make the market more efficient?
[Translation]
Senator Hervieux-Payette: As members of the committee, we are always particularly concerned about public interest, and I suppose the Governor of the Bank of Canada would have similar concerns.
Do you believe that the risk analysis on this vehicle, which is supposed to be complementary, is properly done? It would seem that titles, or unit investments of this nature would be more popular with retirees. If you cannot provide the yield sold at the time the unit is purchased, the cost or price paid will drop as well; at that time, the retiree loses his investment and his income drops. How can we as lawmakers protect the people who would invest a significant portion of their savings and who will have no opportunity to make losses up later? This vehicle is used particularly for retirees. I am not particularly worried about people who are younger and understand the risks they are taking, but I do wonder whether this kind of rush to invest in a cause like these will not increase the risk for our aging population.
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The Chairman: We will return to this subject. I hope that you can be cogent in your responses. You have been asked capacious questions. I thought they were short; they are not. Please do your best to sum up so that we can move to another topic. We will return to this, as obviously committee members are intensely interested in pursuing this topic.
Mr. Dodge: Let me turn first to the issue of completeness and investor protection. We will ensure that you all get copies of our brief. What we meant by ``completeness'' is that, for investors, an income trust is different in terms of its risk characteristics from either an equity or a bond. It may well be that for certain investors, the particular risk characteristic that surrounds an income trust is quite attractive. It can fill a niche to make markets more complete in that regard and it may allow some issuers who could not otherwise do so to tap the capital market. That is what we meant by ``completeness.'' I do, however, urge you to read the brief in its entirety.
In terms of protection of investors, we do worry on the accounting side. There are no standards for distributable cash. The accounting industry and IDA, the Investment Dealers Association of Canada, are working on this because it provides information on a comparable basis that the ordinary citizen managing his or her investments in an RRSP needs to have. That would go a long way.
Beyond that, the straight investor protection, in terms of representation, is a matter for securities commissions. Certainly the Ontario Securities Commission, and I think many others as well, are working very hard on this issue, so it would be worthwhile talking to them.
Turning to the two more difficult questions, the impact on research and development and the impact on machinery and equipment, we are not competent to talk about those, and in abstract, it is really not possible to talk about them. As I said earlier, an income trust is an appropriate vehicle in a number of circumstances, as long as the incentives to choose that vehicle are not so strong that an inappropriate vehicle gets chosen. That is the real issue here, and that is difficult for me to comment on.
However, it is true, as the senator has said, that tax exempts and foreigners face a rather different set of incentives or net returns than does the individual Canadian investing outside of his or her RRSP. That is an obvious fact, but I cannot comment on what one might do about it.
The Chairman: Governor, thank you very much. As I say, we will return to this topic. Senator Eyton has a brief comment about it, and then he will open up, I hope, another pillar of questions.
Senator Eyton: Governor, I thought I understood you perfectly well when you made your original comments on income trusts, but I am pleased to hear you repeat them today and elaborate a little to give us a better understanding.
I generally understand income trusts very well, but what I took away from your comments was that there were some concerns about accounting treatment and corporate governance. I only make the point that both of those are issues apply not only to income trusts but also to share companies.
Mr. Dodge: Absolutely.
Senator Eyton: There is a trend today, particularly in the U.S., to attempt to retreat a little from some standards that were imposed on stocks and which are proving to be either difficult to work with or impractical. That is my comment on income trusts, and I will leave that topic now.
I have a short question, which is a repetition of a question that I put during similar sessions with you recently. Are there limits to consumer credit? I think I have asked this question of you in three of these sessions.
Senator Massicotte: You do not like the answer?
Senator Eyton: No, it is a very intelligent answer.
The Chairman: If you at first don't succeed, try, try, try again.
Senator Eyton: On every successive occasion when I asked the question, consumer credit has increased, and I understand that consumer credit is now at record levels.
Whether out of experience or empirically or instinctively, can you imagine some limit, some level of debt generally that could pose a problem for Canada and, of course, for you in your role at the Bank of Canada?
Mr. Dodge: We have seen a levelling off of the rate of growth of household credit since 2005, and that is on the chart on page 22. It is still growing very fast, at about 10 per cent. Household debt relative to income is rising. Is there some limit to that? Part of the limit, of course, comes from what fraction of its income a household can devote to debt service. That debt now is about 125 per cent of household income.
At the same time, since 2000, the amount of household income that has gone to debt service has dropped from 8 per cent to about 6.5 per cent of household income. One cannot look at just the stock without looking at the ability to manage the flow.
One of the great advantages of our inflation targeting system is that it has given consumers and lenders the confidence that interest rates will stay within a reasonable bound as they look forward. The cost of servicing that debt is unlikely to go through the roof, unlike the situation, which you will well remember, in 1981 or in 1990. Quite rationally, households will take on board more debt in circumstances of low and relatively stable rates than they will in periods of high, and potentially explosively high, interest rates.
Our conclusion is that at the moment this is not, at least in aggregate, a worrisome situation for Canadian households or for lenders to Canadian households.
Mr. Jenkins: I will add a couple of additional thoughts. Another way of analyzing this is to think in terms of the household sector balance sheet, where you net off liabilities and assets to get down to a net worth for the household sector. In fact, the net worth of the household sector in Canada has been growing fairly steadily over a number of years now.
On your question, the issue really is the value of those assets against which you are holding those liabilities and whether there is anything you might see in the economy that would change that balance.
We do sensitivity analyses around this. For example, what would happen if interest rates went up in terms of the debt-service cost and the ability to finance those levels of debt? We have done quite a bit of analysis through that household sector balance sheet and concluded, as the Governor noted, that at the aggregate level we think the household sector is fairly secure from that perspective. However, we will continue to look at it, for the reasons you have cited.
Senator Eyton: I would like to hear your comments on globalization, particularly as it affects our financial world. I will point to two examples that can be found across our many sorts of financial institutions.
There is a trend for world exchanges to be merging or aggregating. If recent trends are an indication, I can foresee a time when there will be four or five major stock exchanges, and they will be located in New York, Tokyo, London and a couple other cities.
A second example is head offices of international companies that can readily locate in almost any part of the world. You mentioned earlier CVRD, a Brazilian company that has just completed a major transaction and acquired control of an old-time Canadian company. Xstrata recently acquired Falconbridge. I mention those examples as trends that I think impact many other institutions.
Does that international aspect of our financial world, taking all the trends together, constitute a problem for the role of the Bank of Canada?
Mr. Dodge: Those are extraordinarily good questions. With respect to the second example about head offices, we have no particular insight on that. With respect to the first example in terms of financial markets and the competition that Canadian financial markets have from New York, Chicago, London and Singapore, that is a very real issue for us because that competition is immense.
The question that comes back to you, as parliamentarians, is what governments can do in Canada through laws and regulations to create a comparative advantage here in Canada for our capital markets. We did that, as we have discussed before, after the Porter commission, and for a number of years we were ahead of the world. However, the world has moved very quickly over the last decade.
Your question is very important, and we need a rule-making mechanism that is relatively simple, uniform and appropriate for our needs to allow us to continue to compete in markets where we have very real expertise, such as the mining market. There is quite a bit that we can do, and we are on record in many places arguing for that. Those changes are not necessarily easy, but unless we move to gain a comparative advantage, the size of other markets will make it very difficult for us.
Your earlier comment on Sarbanes-Oxley, and particularly section 404, is very relevant. We did not write those complicated rules.
The Chairman: Governor, please tell the public what Sarbanes-Oxley is.
Mr. Dodge: I am speaking of the rules pursuant to the Sarbanes-Oxley Act on reporting and management of financial risk in corporations.
We were a little smarter, quite frankly, and that helped our markets. We must be equally smart in all areas of financial market regulation.
The Chairman: This committee shares your leadership in wanting to have at least one small comparative advantage in our country, and that is to have a single regulator. After all these years we still do not have a single regulator in this country, and we are the only modern democracy in the world that does not. This is one of our passions, which we share with you. We will exert our influence as best we can to achieve that goal. It is difficult, but we are working on it.
Senator Goldstein: I first have a supplementary question with respect to one of the answers that you gave, Mr. Jenkins, on net household equity. You indicated that equity on balance has gone up over the years to a level where you have no concern. If interest rates were to rise, that would be a problem because of the cost of servicing the debt, but would it not also be true that a substantial amount of the net household equity of which you speak is housing, and if that market bubble, as some call it, were to diminish, would that have a potentially disastrous effect on net household equity?
Mr. Jenkins: Yes, senator, you have touched on two very key points. Going back to my earlier remarks, dealing first with the issue of debt service costs, as I noted, we have done sensitivity analyses looking at the household sector balance sheet and asking, if interest rates were to go up by 100 or 200 or 300 basis points, what that would do to the debt service levels that households are currently facing. Even with those sorts of increases, you still see debt service levels remaining very low relative to the experiences we had in the 1970s and 1980s. We cannot forget that the product of that is the low inflation environment we have been able to achieve, because that is what helps keep interest rates low and stable. They will go up and down as economic conditions change, but when you think about a five-year mortgage rate they are incredibly more stable than they were in those periods of boom and bust associated with inflation. We look at that because, as you pointed out, it is a very important aspect.
On the asset side, the other element is how those assets are being valued, in this case in the housing market. Yes, there are some markets where the rates of increase of house prices are very high. That is the case in most of Alberta. Do these pose a risk from a macroeconomic point of view? Our conclusion is that they do not when we add it all up from a national perspective, but at the same time individuals need to be very much aware of the debt levels they are taking on and the implications of those debt levels. They must ensure that they are not doing it for speculative reasons and get themselves over-indebted. That is clearly a risk and you want to do what you can to avoid it.
From our perspective looking across the country, from a macroeconomic or a financial stability perspective, we think the situation is reasonably good.
Senator Goldstein: To what extent does the exchange rate between the Canadian and American dollars play a role in your decision to change your target for the overnight interest rate? If the relative value of the Canadian dollar is a factor in setting the rate, is it because of its effect on economic growth or on inflation or both?
Mr. Dodge: There is interaction between growth and inflation, do not forget.
We tried to set out the answer to that precise question in our January 2005 monetary policy report. We may have oversimplified, but essentially we said that there are exchange movements that are largely driven by real factors. When demand for Canadian goods and services increases and the exchange rate moves up, the movement up in the exchange rate does something in terms of offsetting the additional demand; exchange rates are then moving in the right direction in terms of controlling inflation.
That is one type of movement you can observe. The other is an autonomous movement in the Canadian dollar that is unrelated to what is going on with demand for Canadian goods and services. At that point, that autonomous movement would have an impact and would cause us to react in terms of monetary policy. It is not either demand for goods and services or inflation, it is the inflation that comes about because of excess demands for goods and services or the threat of falling below our inflation target that comes from an output gap or deficiency in demand for goods and services.
Senator Goldstein: This morning you spoke of the need for the province of Ontario — and I take that to mean not only the province, but Canada as a whole — to develop a human and physical infrastructure to increase the efficiency and the productivity of our economy. Can you share with us your thoughts on how you think a government should balance its efforts between promoting growth through tax reduction on the one hand and promoting it through targeted spending by governments to develop human and fiscal capital on the other? How are those interrelated? What is the better combination of ways to help the economy more efficiently and productively?
Mr. Dodge: That is a question you must ask the Minister of Finance.
Senator Goldstein: Give us your thinking anyway.
Mr. Dodge: I do not think that that is really appropriate. At the bank, we look very hard at the impact of fiscal balance on what we do. It is absolutely integrated. We talk a lot about that because it goes to the heart of our business. Over the next 18 to 24 months, that has to be a key part.
Concerning the structural issues, while we are happy to talk about what affects financial markets and what affects the very long term, we jut do not think it is appropriate to get into the domain of the Minister of Finance. I will not give you a commentary on that.
Senator Goldstein: That is fair.
You will probably not want to provide an answer to this question, but it concerns a number of us here. I am referring to the increasing shortfall of pension funds in medium and large corporations in Canada to satisfy their pension payment requirements over time. Have you or your bank done any studies on that topic that you could share with us?
Mr. Dodge: Unlike the previous question, this one has a major impact on financial markets, and we spend a fair bit of time considering it. It is very important because the great bulk of private savings for the ordinary worker will come either through a pension fund — and that is a huge pool of capital for us — or through his or her individual savings plan. Historically, the pension funds have covered about 45 per cent or so of Canadian workers and accounted for more than one third of the pool of savings. Obviously it is a general concern, but from a capital markets point of view it is a big concern.
We have laid out a number of issues here that we think deserve attention relating to solvency standards, how we estimate liabilities, how we deal in an even-handed way to allow services to build up in good times, maybe draw down in poor times, and so on. I do not want to take the time of the committee this afternoon, but there are many issues here. It is very important for the functioning of our capital markets, and even more important for the future of our workers, that we get this right. We have had a drift, because of court decisions or other decisions, that has given a huge bias to corporations to not enter into defined benefits plans. That has deteriorated the efficiency of our capital markets.
Senator Harb: Thank you very much for your excellent presentation. Mr. Dodge, throughout your monetary policy report, you talk about the global imbalance and potential risk and how, if there is no further action is taken then, there might be some negative consequences to the economy. I presume that in this particular case you are referring mainly to the North American economy and probably the European economy.
When we talk about the trading system in general, and surplus and deficit and overall, normally we talk about trade in goods, trade in services and investment as part of a trading that takes place, whether by the same company or different companies. I am struck by the fact that finance ministers, trade ministers and industry ministers around the world have not come to grips with the truth that the private sector is miles ahead of them. A corporation might be located in the U.S. but it may have a division that produces goods for them in China, Europe or anywhere else. While the corporation may have its head office in the United States, the administration is done elsewhere, for example through branch plants located in India or elsewhere.
When we talk about global imbalance, I am not sure if we need to look seriously and generally at those three elements. I would like to hear your comment on that. If we ask anyone, ``Do you know about the investment balance between countries,'' we get different answers. When we ask, ``Are the services there,'' we get different answers. If we ask about services, we hear, ``No, we do not account for services. We don't know how much services we do back and forth.'' There is money in all three components, but statistically we do not seem to have much around us.
Mr. Dodge: That question has a great deal to it, senator. I do not think I will be able to deal with it adequately. The current account, which Mr. Jenkins and I tried to address earlier, is trade in goods and services; that is all current transactions including remittances, et cetera. The capital account is the other side. Obviously, if you are running a deficit on the current account, someone has to be making investment, either buying your bonds or buying your companies, because, in the end, accounts do balance.
Obviously, you have to look at both sides of the ledger. Potential disruption on the capital account side could well be one of the those disorderly adjustments we talk about, whereby for example people stop buying U.S. bonds and so the U.S. dollar bottoms and markets come to a halt. We saw what happened in Asia in 1997 when a big mismatch occurred in the currencies that they borrowed and lent. That was a capital account problem that led to an enormous retrenchment on the current account side.
It is complex and we cannot answer your questions quickly. An extraordinarily interesting paper given at the Jackson Hole conference this year pointed out that we have had a globalization of the provision of components. It is not so much necessarily trade in goods or trade in the final services but rather trades in the business services or components that go into the goods and services. It is more complex but the result in terms of the current account is the same issue.
Mr. Jenkins: That touches on the main point. It is highly complicated, as Mr. Dodge pointed out. The current account framework that we use tries to capture these elements. We take some degree of comfort that the numbers we work do reflect those flows in aggregate. Even if a corporation might go to China to produce goods and services or another component, we feel that that would get picked up in these trade flows we talked about, which lead to these imbalances. There are always measurement errors and issues. We talked about it in the context of productivity, for example. You need to bring judgment to bear on it but from the point of view of running monetary policy, we think that we have the information that enables us to make sound decisions.
Senator Harb: You have lowered your projection for 2006 to 2.8 per cent. Was it yesterday or the day before that a statement was made to the effect that the surplus has almost doubled? I would like to know whether that surplus would be reflected in those figures. Would the latest figure be considered?
Mr. Dodge: As we said earlier, governments tax nominal incomes, not real incomes. There can be large differences in the rate of growth of nominal income and real income because of changes in terms of trade. Indeed, it is interesting to look at those numbers, senator. For example, in 2003 we had nominal income growing at 5 per cent; in 2004 it was 6 per cent; in 2005 it was 6 per cent; looking forward in 2006, we think it will probably be only be 5 per cent; and in 2007 it will likely be only 4 per cent. That is consistent with the real growth numbers that we gave you.
That decline in the nominal income rate of growth leads us to be cautious about the revenues that the provincial and federal governments are likely to continue to receive from corporate and personal income tax over the next couple of years. It does not say that the revenues will fall out of bed, but if those nominal income projections are right — a big if — it would imply slower growth of government revenues, certainly the income and corporate tax revenues, as we look ahead.
[Translation]
Senator Hervieux-Payette: Mr. Dodge, a few moments ago, you spoke about a question I have been interested in for a long time, because I was with SNC — infrastructure and public-private partnerships. SNC-Lavalin is still one of the largest engineering companies in the world, and has offices across Canada. I would say that one example of success in transportation infrastructure would be Highway 417 in Ontario.
There is something I would like you to explain: this infrastructure is such a good project that everyone would benefit from the yield standpoint. You talked about lack of expertise and a legal framework, but if we are already working with foreign banks — after all foreign banks financed the 417 — explain to me why, given that our own banks want to grow and look outside Canada for merger — I will not start with projects here — there is a barrier that prevents our own financial situations from prompting governments to move in that direction? What are the barriers to that approach?
Mr. Dodge: There are no barriers as such for our banks and financial institutions. They do not have the know-how — they have not developed the know-how we see in countries that have the legislation and will to form partnerships. It cannot come as a surprise that our institutions have not developed that know-how, since there is no domestic demand for that type of financing.
For example, take an Australian bank that has developed a great deal of know-how because the Australian states — South Australia and New South Wales — have fairly high demand for such investment vehicles. I do not know which comes first — the chicken or the egg. That, I believe, describes quite well the situation our banks find themselves in.
Senator Hervieux-Payette: Earlier, you said that the services sector was most likely to improve growth and productivity. Financial services are obviously one sector in which we could develop know-how. I am asking this question because I wonder whether governments have as much know-how as the banks, given that the banks can buy know-how internationally.
In any case, we have a significant vacuum at present. We know that there is over $20 billion in infrastructure demand. Governments are well aware of it, and people in the construction industry are prepared to enter into partnerships.
If within a few years, we were to start up projects to build $20 billion worth of roads, I wonder where we would find the manpower in Alberta or in British Columbia, but that is another question. Here is the question I am asking: Do you believe there is a lack of know-how even within our own governments — federal and provincial governments — to engage in the process?
Mr. Dodge: Entering into a risk-sharing contract which is good both for the government and the private sector is no simple thing. Now, we have examples outside Canada which can help us. There have been bankruptcies outside Canada — both successes and bankruptcies. We can learn from the experiences of the others. That is one thing. We have to develop the know-how, both on the government side and the business side.
There is a second problem. There is a price for services, both for the public and for the government. A price is established so that the market can operate and so that a contract can be signed with the company. That is true in almost any infrastructure branch. Here in Canada, there is resistance to establishing prices for those services. We do not like tolls on highways, water meters, and so on. If we do not agree to pay a price for the service, the issue becomes difficult. We should not blame government. The attitude that we have as citizens is not fully accommodating. However, it is extremely important and there are benefits in terms of efficiency. We have to work on these both on the government side and on the private sector side to improve the situation, because the infrastructure needs are huge.
Senator Hervieux-Payette: Do you see a relationship between this private-public partnership, which would be clearly explained to Canadians, and productivity? If we have a series of services, we should, in my opinion, be able to facilitate additional investment, for example more efficient transportation. It seems to me that there is some sort of cause-effect relationship, in addition to the fact that we would inject billions now in retirement funds into the economy.
In Quebec, the Caisse de dépôt et placement has invested hundreds of millions of dollars in London airport. It seems to me that if we can do a risk analysis of London airport's operations, we could at least think about financing our own infrastructure. Who is at fault here? What is the obstacle standing in our way? You tell me that part of the obstacle is the fact that citizens do not want to pay for the services, but citizens — Canadians — are intelligent enough to understand that when we loose tens of thousands of jobs, we might have to create some. This is a mechanism that would benefit all Canadians.
Mr. Jenkins: You are absolutely right. Investment in infrastructure is the priority.
Senator Biron: Average annual growth in real GDP for housing in 2006 was 0.2 per cent. In 2007, you are forecasting minus one per cent, and for 2008 minus one per cent as well. Financial institutions in the United States — particularly in Florida — arrange housing loans by capitalising half of the interest rate and lending for minimal amounts. If people want to buy a $1-million condo and pay a ridiculous amount to cover half of the capitalized interest, do you plan to up lending structures and allow our financial institutions to go the same route, or is there a real danger of what we are actually seeing in Florida — where condo values have collapsed — happening here?
Mr. Dodge: We believe that the housing market here is healthy at this time. We do not have problems as significant as those within Florida, in Boston or in California, for example. The Bank of Canada is fairly clear about the fact that there is a risk involved in exotic mortgages, and we might end up with the same problems we are now seeing in Florida.
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Senator Angus: As a committee we have just done a little fact-finding mission to New York where we met with some of the regulators and some of the other financial services sector institutions. At the Federal Reserve Bank of New York in particular we had a discussion about various developments in the capital markets, and the issue of hedge funds came up over and again. We found that they were divided a little in the Fed about whether there is a need for regulation or not, but as we went through our interviews over a two-day period, we found that when they did regulate and required registration and disclosure of the investments, it was good; there was a positive result. Unfortunately, the regulatory provisions were struck down on a technical appeal, and that decision was not appealed.
Now we are finding that there is a great incidence of investment. These funds are growing up everywhere and no one knows who owns them or what they are investing in. We are getting the sense that we should do a study on it. I have looked through your own documentation, and they do affect the capital markets a great deal. Do you think we on the right track if we investigate these funds?
Mr. Dodge: I would encourage you to do the investigation. There are three comments that one could make. First, by and large I think the work that has been done so far, whether at the Fed of New York or at the Financial Services Authority in London, which are the two agencies that have done the most work, would indicate that hedge funds have, on balance, made a positive contribution to the distribution of risk and to the functioning of financial markets.
Second, all regulators, including those at the Bank of Canada and at the Office of the Superintendent of Financial Institutions Canada, recognize clearly that one great problem can arise when banks that lend to hedge funds do not carefully watch and monitor their risks. Our colleagues at OSFI watch this carefully, as does the Federal Reserve Bank of New York in its regulating activities of banks. That is an important issue.
Third, I really cannot comment on the issue of the investor protection and disclosure side of it. Are the wrong people buying these rather complicated products that they do not understand? That question should be addressed to the security commissions because we are not experts in investors' protection. Those are the three key issues.
Our conclusion, from a financial stability standpoint, is that although Canada does not have as many of these hedge funds, resulting in a smaller share of the Canadian market than they have in the New York market or in the London market, they do not pose a financial stability systemic problem at this time.
The Chairman: I have a brief question. There is a big debate in Ontario and across the country on increases in minimum wage. We know from our statistics that the working poor in Canada are growing as a class and that within that class are single working mothers. One of the key factors that might alleviate some of those problems is increasing the minimum wage for adults. Have you done any economic studies to support the position that some ministers have taken that an increase in the minimum wage for adults would be detrimental to job creation?
Mr. Dodge: No, we have not done such a study, senator. We cannot shed any particular light or bring any expertise to bear on that issue, although it is an important issue and I am sure the committee will look at it in the future.
The Chairman: Yes, we intend to look at that.
Senator Massicotte: A report written recently at the C.D. Howe Institute by one of your previous advisers puts into question the appropriateness of maintaining a 2 per cent inflation target and suggests it should be lower. The agreement between the Bank of Canada and the Government of Canada is due out soon. What are your thoughts on that and where are we heading?
Mr. Dodge: Allow me to say that the C.D. Howe Institute continues to make valuable contributions to the debate on monetary policy. That paper written by Mr. David Laider is a valuable contribution. You will note that he said in his paper that we should begin to think about where we are going in terms of the next agreement because expectations are well anchored. That was a reasonable point made.
The Chairman: Thank you.
Mr. Dodge: I want to ensure that I did not misspeak. It is not in the agreement that will come out at the end of the year but in the agreement subsequent to that.
The Chairman: If there is anything in the transcript that you wish to correct, please do so. Mr. Dodge and Mr. Jenkins, thank you for appearing today. The committee will pursue its studies on income trusts, hedge funds and on the question of interprovincial trade barriers. It will also take your sound advice on regular surveillance of productivity growth.
We look forward to hearing from you again.
Mr. Dodge: Thank you, Mr. Chairman. I am sure you will keep up the illustrious record that this committee has had since 1867.
The committee adjourned.