Proceedings of the Standing Senate Committee on
Banking, Trade and Commerce
Issue 6 - Evidence - April 29, 2010
OTTAWA, Thursday, April 29, 2010
The Standing Senate Committee on Banking, Trade and Commerce met this day at 10:30 a.m. to examine the present state of the domestic and international financial system (topic: Monetary Policy Report of the Bank of Canada).
Senator Michael A. Meighen (Chair) in the chair.
[English]
The Chair: Good morning. I see we have a quorum, so we will call the meeting to order.
[Translation]
My name is Michael Meighen. I am honoured to be chairing the Standing Senate Committee on Banking, Trade and Commerce. The committee's deputy chair, Senator Hervieux-Payette, is unfortunately still in another committee meeting, but she will be here shortly.
Today we are once again welcoming Mark Carney, Governor of the Bank of Canada.
[English]
We look forward to our semi-annual meetings with you, which provide us with an opportunity to question you on your latest Monetary Policy Report and explore other issues relevant to your mandate.
[Translation]
I would like to introduce the members of the committee, since there have been some changes. To my left are Senator Kochhar from Ontario; Senator Moore from Nova Scotia; Senator Ringuette from New Brunswick; and Senator Harb from Ontario. To my right are Senator Gerstein from Ontario; Senator Greene from Nova Scotia; Senator Mockler from New Brunswick; Senator Massicotte from Quebec; and Senator St.Germain from British Columbia.
[English]
If someone appears to be missing today, it is because the governor is appearing without his usual sidekick, Paul Jenkins. We are grateful for the many times Mr. Jenkins has appeared with you before us. We wish him well in his retirement from the bank and in his future endeavours, and we thank him for his indefatigable service to the bank and to Canada. We understand he is being replaced in July by Mr. Tiff Macklem, and we look forward to welcoming him at a future meeting of the committee.
The governor took up his position two years ago on the eve of the global financial crisis. His timing has always been impeccable. He has helped to steer us through that crisis, and for that we owe him a great deal of thanks.
To illustrate how times have changed, a year ago we were trying to wrap our minds around the concepts of qualitative and quantitative easing, and we were ecstatic to see oil prices north of $50 a barrel. I think today they are up close to $85.
Our economy is doing better than expected, and certainly far better than elsewhere. The issues of the day have evolved to include a strong dollar, productivity challenges, regulatory reform and a new set of financial problems beyond our border — this time in the European Union.
Welcome, governor, and welcome as well to those who are listening on the World Wide Web. Please proceed with your opening statement.
Mark J. Carney, Governor, Bank of Canada: Thank you, Mr. Chair, and I join you in commending Paul Jenkins and his service to the Bank of Canada and to all Canadians. He was an outstanding public servant and he will be a very difficult individual to replace.
However, I would like to assure you that if anyone can, it is Tiff Macklem. It is appropriate he is joining the bank on Canada Day. In the interim, he is serving the Prime Minister and the Minister of Finance in the run-up to the Toronto G20 summit. I am sure we will talk about some of those issues at some point this morning.
Good morning, committee members. I am pleased to appear before this committee today to discuss the Bank of Canada's views on the economy and our monetary policy stance. Before I take your questions, I would like to give you some of the highlights of our latest Monetary Policy Report, which was released last week.
[Translation]
Global economic growth has been somewhat stronger than projected, with momentum in emerging-market economies increasing noticeably and moderate recovery under way in most advanced economies. Global growth is now projected to average slightly above 4 per cent a year through 2012. In Canada, the economic recovery is proceeding somewhat more rapidly than expected in January. It is supported by continued fiscal and monetary stimulus, improved financial conditions, the rebound in global economic growth, more favourable terms of trade, and increased business and household confidence.
This year should mark the turning point when the private sector takes over from the public sector as the primary source of growth. GDP is now projected to grow by 3.7 per cent in 2010 before slowing gradually to 3.1 per cent in 2011 and 1.9 per cent in 2012.
[English]
This profile reflects stronger near-term global growth, very strong housing activity in Canada, and the bank's assessment that the policy stimulus resulted in more expenditures being brought forward in late 2009 and early 2010 than expected. At the same time, the persistent strength of the Canadian dollar, Canada's poor relative productivity performance and the low absolute level of U.S. demand will continue to act as significant drags on Canadian economic activity.
The bank estimates that GDP in the first quarter of 2010 was about 1 per cent below its peak in the third quarter of 2008 and some 2 per cent below its potential. The economy is expected to return to full capacity in the second quarter of 2011, one quarter earlier than we had projected in January.
The outlook for inflation reflects the combined influences of stronger domestic demand, slowing wage growth and overall excess supply. Core inflation, which had been somewhat firmer than projected in January, is expected to ease slightly in the second quarter of this year as the effects of temporary factors dissipate and to remain near 2 per cent throughout the rest of the projection period. Total consumer price index, CPI, inflation is expected to be slightly higher than 2 per cent over the coming year before returning to the target in the second half of 2011.
[Translation]
Despite the firming of the global and Canadian recoveries, there are considerable risks around the bank's outlook. There are two main upside risks to inflation. It is possible that the momentum in household expenditures and residential investment could be greater than currently expected.
Internationally, a faster-than-expected global recovery could stimulate external demand for Canadian exports and improve the terms of trade. On the downside, the combination of the persistent strength of the Canadian dollar and Canada's poor relative productivity performance could exert a larger-than-expected drag on growth and put additional downward pressure on inflation.
[English]
A second downside risk is that the global economic recovery could be more protracted than currently projected. In this regard, there is a risk that sovereign credit concerns could intensify, leading to higher borrowing costs and a more rapid tightening of fiscal policy in some countries.
Either of these factors would restrain global private demand relative to the bank's base case projection.
Over the medium term, global macro imbalances continue to impose significant risk to the outlook. While these imbalances narrowed during the recession, sustained improvement over the medium term will require fiscal consolidation in advanced countries, together with stronger domestic demand growth and real exchange rate adjustments in countries with large current account surpluses. In the absence of these measures, the cost to the global economy could be considerable.
The G20 framework is designed to help the global economy move in the right direction. This past weekend in Washington, the G20 confirmed its commitment to this important initiative. In Canada, in response to the sharp, synchronous, global recession, the bank lowered its target rate rapidly over the course of 2008 and early 2009 to its lowest possible level. In addition, in April of last year, the bank committed to hold it at that level, conditional on the outlook for inflation. This unconventional policy provided considerable additional stimulus during a period of very weak economic conditions and major downside risk to the global and Canadian economies.
With recent improvements in the economic outlook, the need for such extraordinary policy is now passing, and it is appropriate to begin to lessen the degree of monetary stimulus. That is why, on Tuesday April 20, 2010, the bank removed its conditional commitment. This, in and of itself, represents a tightening of monetary policy. Going forward, nothing is preordained. The extent and the timing of any additional withdrawal of monetary stimulus will depend on the outlook for economic activity and inflation and will be consistent with achieving the 2 per cent inflation targeted.
With that, Mr. Chair, I would be pleased to take your questions.
The Chair: Thank you very much, Mr. governor. I will take advantage of my position as chair to open up the questioning.
Last weekend, as we all saw on television, you met with the other G20 central bank governors and finance ministers in search of reforms that would prevent another financial crisis. Throughout this crisis, our financial system in Canada continued to function well. No bank failed or had to be bailed out. No bank stopped paying dividends or experienced a run on deposits in Canada. Our regulatory system is held up in other places as an example of one that works and works well. I would almost venture to say that that allows us to lead from a position of some moral authority.
I would like to hear your observations on two points. First, could you speak to those areas where you think there is now agreement and where you see the discussions going from here as we move toward the G20 meetings in Toronto?
Second, would you agree that it was not just rules such as those concerning capital ratios that served our banks so well last year but also supervisory work on the part of bank regulators? If that is the case, should nations be looking not only at rules on matters such as lending and degrees of leverage but also at beefing up their supervisory system — and Ms. Julie Dickson, Superintendent of Financial Institutions, made that point — to ensure that those rules are enforced and are seen to be enforced?
I am interested in your reaction to those questions.
Mr. Carney: Thank you for the important questions. I will take the first one, which is on what aspects of reform there is agreement. I will enumerate them in a moment, but will qualify my answer by saying that there is agreement on direction. Substantial progress has been made on the details of that agreement. However, the timeline for final agreement is over the course of the next six months. November is the key date for a number of the initiatives that I am about to go through.
The first point is a direct result of the Canadian experience. There is agreement that the system globally needs more and better capital. By ``more capital,'' I mean it needs to run with a higher level of tier 1 capital. ``Better capital'' means that that tier 1 capital should be, as is the case in Canada, common equity and retained earnings — that is, straightforward, true, loss-bearing capital. That was one of the strengths of our system. In the application of the existing Basel II rules, our superintendent had a more conservative and stricter interpretation of those rules, which redounded to Canada's benefit. The question for the system as a whole, including Canada, is this: What should this new minimum be? Should it be higher than it is currently in Canada, including in the quality of that capital? Canada- plus is part of the question that is being discussed. There are some merits to thinking about further strengthening the capital regime in this country as well.
The second aspect on which there is broad agreement — and the devil is in the details — is a need to complement the existing risk-based Basel regime, with which I expect you are familiar, with a simple leverage test — that is, a belt and suspenders approach. That is in place in Canada. If I could spend a moment on that, the important concept here — that is, reality, as we saw in Canada — is that the sophisticated and detailed risk-based regime of Basel is quite effective for capturing the risk of assets on a bank's balance sheet that we know to be risky. There are estimates that are adjusted appropriately, and the bank has to set aside more capital for higher-risk product. A junk bond has a considerably higher amount of capital versus a Canadian government bond. That limits the extent to which banks can fill their balance sheets up with a certain allotment of capital with highly risky elements.
The problem with using only that system — and this was one of the key problems in the crisis — is that those assets that we think are not risky are risky. The classic example in the crisis was triple-A asset-backed securities, a whole range of sophisticated securities that turned out to be very risky. A number of international banks, particularly in Europe and some U.S. investment banks, had a large number of these on their balance sheet that the Basel standards did not capture because they were viewed as not being risky. A simple leverage ratio, as is used in Canada, does capture that. You need both of them together, and you need to calibrate them properly together. There is broad agreement on that approach. The issue is in calibration and definition. There is not a problem there per se; it is just to say that we are working it through. If we are together in October, or if you want to get together before then, we can provide more details as those discussions progress.
The third area where there is broad agreement, which is new, is the requirement to have tighter standards for liquidity measurement, both short-term and structural liquidity in financial institutions. That did not exist previously. There was guidance and it was looked at, but it was not applied as rigorously. Those have been worked on to be put in force.
The fourth area where there is agreement, which is extremely important, is the need to change market infrastructure. I will not go into great detail here, but we can discuss it. These are initiatives such as moving derivatives from the over- the-counter market — that is, those derivatives that can be standardized — onto transparent, central platforms. You can reduce both counterparty risk and interconnections between financial institutions, and you can increase in transparency in those markets, increase standardization and increase efficiency and de-risk that sector as a whole. That is an incredibly important component of it. There is broad agreement on that direction, but there is a lot to be done to get there.
Your second question, which is extremely valid, is that the best regulations are not worth the paper they are written on unless they are actually enforced intelligently. Regarding the example of the existing Basel regulations that we had in the run-up to the crisis, we can and should commend how the Office of the Superintendent of Financial Institutions, OSFI, interpreted them, enforced them, and supplemented them in a sensible way — made them not weaker, but tougher — to make our system more resilient.
The second point is that regulation, supervision, is a dynamic process. One of the benefits of the Canadian system is that we have the Financial Institutions Supervisory Committee, FISC. It is chaired by the superintendent, and the members of the committee are the governor of the bank; the head of our deposit insurer; the head of our consumer protection agency, the Financial Consumer Agency of Canada, FCAC; and the Deputy Minister of Finance.
We meet regularly and discuss all financial institutions, including banks and insurance companies, focusing particularly on the ones that have issues. It is a dynamic process; if there is an issue in an institution, it is raised with the board, and an action plan is put in place. In some cases, a capital penalty is applied to that institution until that issue is resolved.
Under the terms of the act, I am not permitted to go into detail. However, I can assure you that through that process, there have been issues that have caught control problems and management problems that could have grown into something much bigger if they were left unchecked. That is what is important in regulation.
At the G20, Canada is advocating for an adoption of principles of sound regulation so that the regulators recognize their responsibility for this type of supervision and so that the governments from which regulators derive their authority are giving proper, delegated authority and proper, principle-based instructions to their regulators.
I will stop there. I am happy to respond to questions and expand on any of those points.
The Chair: Pursuant to a decision of FISC, if an intervention is carried out, what is the publicity or the public nature of that? Is it regulated?
Mr. Carney: The conversations between the regulator and the institution cannot be disclosed by either side or by the members of the committee. It goes through an iterative process.
The Chair: If an order or a requirement is issued — for instance, you must improve your capital ratios or you must cease doing such and such — does that stay non-public?
Mr. Carney: It is non-public. If the institution is capital deficient, the institution itself has to make a determination about disclosing a shortfall or a requirement or the need for a change in strategy. However, that is not in the context of a supervisor order.
[Translation]
Senator Massicotte: Thank you, Mr. Governor, for being here today and for talking to us about monetary policy.
I would like to discuss Greece, Italy and Spain. Spain's rating was downgraded yesterday. There has been considerable talk about this for several days. In order to be able to inform Canadians, I would like to know what will happen. Is it a serious crisis? If the situation is not resolved with Germany soon, what can we expect and how will it affect us as Canadians?
Mr. Carney: The fact that you are asking this question indicates that this situation affects the global economy and not only the economies of the countries involved, such as Greece and a few other European countries.
We are currently witnessing the limits of budgetary relaxation in an international context. It is the responsibility of each country to figure out how to shore up its budgetary policies.
[English]
If I may draw more specifically some of the implications of the general situation — I am not talking about an individual country — we have done some work, and this goes back to the G20 framework that I referred to at the start in my remarks.
There are limits to fiscal stimulus. There is a requirement, and clear messages have been sent from the market to a number of countries — to all of us really — that we need to be on sustainable paths. If the only thing that happens is that a series of countries respond as they should to these messages — tighten fiscal policy, move fiscal policy back more rapidly onto a sustainable path — the world is in some risk of arriving in a situation of deficient demand. There would not be sufficient demand in terms of recovery.
I said at the start that we see a 4 per cent recovery. This is not our base case, but this is one of our two big downside risks. The first is the Canadian dollar; the second is this dynamic. I would like to spend a bit of time on it.
We have done some work that indicates that only fiscal consolidation in industrialized countries, because it is of such a size, moves the world back into a low-growth scenario and into a disinflationary scenario. What is required at the same time as these necessary adjustments are made is countervailing policies that are in the interests of other countries to expand domestic demand, particularly in emerging markets, to enhance flexibility in exchange rates and to keep the global financial system and trading system open.
That is what is at stake in the G20 this year at its highest level. Toronto will be a very important meeting for that reason, because it should allow leaders to recognize this dynamic. The first step to moving on a problem is to recognize that you have a problem.
However, the situation is serious. I guess to fully answer your question would be to look at what happens if these steps are not taken. I am saying what happens, what the dynamic is, if these steps are taken. If they are not taken, I hesitate to be too precise, but one can expect an increase in longer-term interest rates on a global level.
Even though the Canadian fiscal position is among the best, if not the best, of the G20 — jointly the best, I guess, with Australia — while we will do better than others, we will be pulled up by the rise in global interest rates. That will have a knock-on effect on investment and growth in this country.
Senator Massicotte: I will paint the scenario for you to help you along. Let us presume that Germany does not come across, the European Commission does not come across and Greece is forced to default on its debt. There is a run. It looks like there could be a run on Spain, and maybe even Italy, and you could see the disintegration of the European Commission regarding the common currency. If that were to happen, what is the consequence for Canada? Are we talking half a percentage point of growth or a return to the recession?
Mr. Carney: The scenario you paint is beyond worst case. Since the issue has been put on the table, I will take the opportunity to make absolutely clear that we have been in close discussions with our European partners, with the International Monetary Fund, IMF, and with the countries concerned. There are ongoing negotiations.
At this stage, it is a serious situation, but these are productive negotiations and they are continuing to make progress. We expect that they will be fulfilled, but obviously it is not over. The global agreement has not been reached with the Government of Greece, with the IMF and with the European Commission, but there are active discussions under way as we speak.
The issues are twofold. One is too rapid a consolidation or only a fiscal consolidation in a series of countries, as I outlined, then, in the absence of that, a sharper market reaction to perceived and actual poor fiscal positions in a number of countries. This would have implications for the cost of borrowing for the Canadian government, for Canadian businesses and for Canadians. It would have implications for the volatility of a variety of financial markets. In that context, one would expect an increased risk aversion of a host of both financial investors and, unfortunately, businesses and individuals as well. The net result of this would be negative for growth in Canada. Being central bankers, we have wrapped this up neatly into a reference to downside risk to our forecast from sovereign risk. Basically, that is what we are talking about more explicitly now, and it is a risk. There is a risk in terms of the spectrum here. The scenario you painted is not a scenario that we envision, but there are dynamics on that continuum that could feed back into our economy.
Senator Gerstein: Thank you for appearing before us this morning. It is not often that I would congratulate a witness before asking a question. However, I am sure I speak on behalf of all the members of the committee to congratulate you on being named this morning in TIME magazine's 100 Most Influential People of 2010. I suspect it comes as no surprise in economic terms that you were in the first quartile, coming in at 21. I am particularly taken by one of the comments TIME made about the governor; it said he gives ``. . . the sort of straight talk one rarely hears from a person whose job it is to juice the economy.''
Governor, Canada made it through the recession in far better shape than most other nations. No one is being asked to bail out our government, and our government did not have to bail out any banks. In fact, Canada has the lowest debt-to-GDP ratio in the G7, the strongest financial sector in the world, and the highest credit rating in the world. However, other nations have not fared as well, particularly as we have seen in recent days. To what extent do the debt levels of many of the world's large economies represent a serious threat to global recovery?
Mr. Carney: Thank you for your question. This is a major risk. The calculation of major economies 18 months ago, in the teeth of the crisis, was that the scale of the fall and the speed of the fall in global GDP required a forceful response. The response of the monetary policy side was well under way. It reached its culmination by the spring of last year, in the case of the Bank of Canada, with our conditional commitment as the ultimate additional stimulus that was provided.
The consequence of the fiscal decisions of major industrial countries — at least in the IMF's estimation, and we would agree with it — is that debt-to-GDP measured on a gross basis has risen from 80 per cent of GDP to around 120 per cent of GDP in four years. The scale of this is unprecedented, certainly in peace time. That shift is consistent with current stated adjustments to budget paths. A number of countries have in place desired budget paths, but not necessarily paths that are backed up by actual hard measures. The measures have not yet been identified in a number of cases, so there is a risk, even with this shift.
Let us take it at face value. Everyone will hit their stated targets, and debt will crest at around 120 per cent of GDP in 2014 or 2015. That will place upward pressure on interest rates — not quite to the same extent as we were talking about in the earlier discussion — which, on the margin, will make it more difficult or less attractive for businesses and households to borrow, invest and plan for the future. Of course, the risk is that the measures will not be taken consistent with those paths and governments will overshoot. That will put more pressure on interest rates, just from a pure supply-demand dynamic in capital markets. Also, it will dampen the confidence of individuals and firms because of prospective higher taxes and prospective sharper adjustments that could come.
The debt situation is arguably the largest risk to securing the global recovery.
Senator Harb: I am having difficulty trying to establish a correlation between the overnight rate of the Bank of Canada and the posted five-year mortgage rate. I am looking at Table 2 in the Monetary Policy Report, April 2010, from the Bank of Canada. On April 16, the overnight rate was 0.25 per cent; the posted five-year mortgage rate was 6.1 per cent. Two years ago, April 24, 2008, the overnight rate was 3 per cent, and the posted five-year mortgage rate was 6.99 per cent. The overnight rate is 12 times lower in 2010 than it was in 2008, while the posted five-year mortgage rate did not change by much, just by 0.89 per cent.
I do not understand. Is there a correlation? As a consumer, I would say, ``I do not care. Even if the Bank of Canada increases the overnight rate to 4 per cent or 4.5 per cent, the posted five-year rate will not change much.''
Mr. Carney: That is an important question. That is one reason we put this table in successive monetary policy reports. If I may plug our website, we also provide this information in much more detail in between reports, and we aggregate the cost of borrowing for both consumers and businesses into a weighted number so that we can have a general sense of where the costs of borrowing are going.
Second, the technical answer is that the five-year mortgage rate is a product of the five-year cost of funds in a fixed basis for financial institutions rather than the overnight floating cost of funds, which is what the Bank of Canada provides. For example, in the last five or six weeks, we have seen that, in general, five-year government bond rates around the world have been creeping up a bit consistent with the global recovery. When the concern about Greece and risk aversion comes up, they come down a bit, but in general they have been coming up about 40 basis points over that period. In addition, the cost of funds for banks above those government bond rates has been increasing as well, about 15 basis points or so. The cost of banks' funding in fixed in five years has gone up, and that has been passed on to the five-year fixed mortgage rates of individuals.
Part of that is a dynamic. Broadly, it is the global outlook. What will the Bank of Canada do about that, and what is our contribution to this overall dynamic?
The point you make is important. One thing that ensures the Canadian economy continues to enjoy low, stable, predictable inflation is not getting unnecessary steepness in longer-term interest rates. There is no inflation premium put into longer-term interest rates, so there is greater stability for us to achieve our inflation targets. All things being equal, governments running sustainable fiscal will keep longer-term rates better anchored. The longer-term rates have not moved around as much, which tells us that there is greater stability in having the fixed rate.
Whether individuals are fixed or floating depends entirely on their personal preferences for risk and their outlook on where floating rates will go.
To tie it all back to the last two questions by Senator Gerstein and Senator Massicotte, one of the risks we are talking about is that global interest rates could be pushed up because of fiscal problems elsewhere. While Canada's rates should not go up to the same extent because of our better relative position, we are not immune because of the arbitrage across global markets. Our rates would be pulled up along with those of other countries. All else being equal, five-year fixed mortgage rates would increase. It is important for home owners and others that numerous governments get their respective fiscal houses in order in a proper fashion. We will do our bit to ensure that inflation is consistent with the target and that we do not have longer-term mortgage rates going up because of an inflation premium coming into the yield curve.
Senator Greene: Canada's victory in Washington last week with regard to the bank tax is one of the most important international victories we have ever won. I cannot recall one that is as important not only to Canada but also to other countries.
First, could you elaborate on that? Second, could you comment on whether the bank tax is off the table for good or whether it might return? Third, could you describe the mechanism that will be used to replace what a bank tax would have achieved?
Mr. Carney: The advantage of the discussions in Washington was to help to refocus the attention of policy-makers, ministers, governors and others on the core agenda of capital liquidity and market infrastructure, which I outlined a bit in response to the chair's question.
By way of background on the bank tax, or bank levy as it is discussed, one of the relevant issues is the variety of professed motivations for such a levy. The first is basic and understandable from a political perspective. In countries such as the U.S. and the U.K., where the governments had to invest public money to save institutions, the public wants that money back. The U.S. is the classic example of this: A tax is set up over 10 years to collect the $90 billion net that the U.S. taxpayer is out of pocket for direct investments in the financial sector. It is an ex post tax, which is understandable. The simple position of the Government of Canada is that we did not have to put money in and therefore have nothing to get back.
The controversy is around what we will bring to the table by way of a proposal instead of such a tax or levy. The suggestion is an ex ante tax or levy, in which we see no merit. The idea is that we will have another crisis down the road, so we will apply a levy to the financial sector, build up our reserves or reduce the deficit, even worse. In that way, when this crisis comes again, we will be able to rush in and save the sector or pick up the pieces of it. That is the theory.
First, we say good luck hanging on to the funds and not diverting them elsewhere. Second, this will change the pattern of behaviour in the financial sector, because if need be the government will rush in with a big pot of money to bail the sector out. This seems like a very foolish idea, and we want no part of it. If other countries want to do something odd, go ahead, but Canada is not with them. I would say that that was the general sentiment.
The issue remains: There will be bank failures in the future, so how do we ensure that the public purse is not being called upon to pick up the pieces? There are many ways to do that. This committee will have reviewed in the most recent budgets proposals to establish a bridge bank power for our deposit insurers, as well as other resolution mechanisms. We have a very sophisticated resolution set of powers in Canada between the Office of the Superintendent of Financial Institutions and the deposit insurers, although it could be improved. If individual institutions fail, they can be properly interred without taking others with them.
The second aspect that the OSFI, the Minister of Finance and I are advocating is to embed a fund within the individual institutions. This is a plan to have contingent capital within the institutions. We talked earlier about having tier 1 capital — the core common equity — in institutions. Contingent capital is over and above, say, subordinated debt. If an institution were to fail, that debt would convert into common equity. Those bonds holders would become equity holders; the existing equity holders would be heavily diluted; and the bank would be recapitalized by its own money.
This would have many advantages. First, the money to recapitalize would come from the sector. Second, the incentives would be right. Currently, an existing equity holder in an institution will wither swing for the fence or try to deny if the institution comes close to being in trouble. Under a contingent capital plan, the chances are much greater that the equity holder will know that he will be converted automatically and diluted and will support management or shed some assets or do a smaller equity deal sooner. The incentives are right for the shareholders to get that risk-return balance correct. In any event, the capital is there in the institution.
We are actively pursuing this issue. There is a fair bit of interest in it around the G20 table. However, it is a complicated mechanism, and we have to get the details right. It will take time to do that, but we are working on it.
Senator Greene: What triggers the capital contingent plan?
Mr. Carney: That is a good question. In some of its forms, people advocate a market-based trigger with the credit default swap, CDS, spread going here and the bank share going there. We think that is a bad idea because of the very unfavourable market dynamics. People tend to short the CDS spread and go long. You almost push the institution to conversion by the market dynamics. A more attractive variant, in our view, is a regulatory decision. In the end, we are talking about capital that would convert basically just before the regulator would come in and resolve the institution. Instead of that happening followed by the regulator going to the public purse for the residual, the regulator goes in and triggers the conversion of the contingent capital.
The market needs some guidance on the likelihood of that happening, which is why we have ratios. We are thinking through how we set up the new capital requirements for the institutions, but that is absolutely a key element. It needs to be a supervisory, guided decision.
Senator Ringuette: You indicated in your statement that the global growth will be at 4 per cent through 2012. This year in Canada, the GDP will be at 3.7 per cent. Yet, we are looking at almost 50 per cent less in 2012. That is about 50 per cent less than the global growth.
I understand your rationale and your estimates because of the stimulus withdrawal that will be happening, and the private sector may not able to keep up with the current GDP that is expected this year. Currently, we have to be realistic, and sectors of our economy have lost markets because of the Canadian dollar. Those markets are not opening up again. New markets are very hard to find because of the global crisis, and I am concerned that maybe we should not put a deadline on economic stimulus, as you had proposed. Have I gone around the full circle?
Mr. Carney: The first thing to say that is global growth at 4 per cent reflects increasingly the strength of major emerging markets. At present, we are moving to an era where emerging market growth used to be 50 per cent of global growth at the start of this decade. It is moving to 60 per cent, to almost two thirds of global growth measured on a purchasing power parity basis. There is this shift in terms of the strength, and, obviously, the speed limit of emerging market economies is considerably faster than that of developed economies. There is a lot of catch-up to be done, so whereas the Chinese economy can grow at 8 per cent to 10 per cent without developing inflationary pressures or reaching the limits of that economy, economies such as Canada's can grow considerably more slowly.
In 2010, there is a very important contribution to growth from government, and our views on this have been consistent. Regarding the federal and provincial contribution to growth in 2010, we see 1.30 percentage points of that 3.7 per cent growth coming from government. However, the fiscal plans of the federal and provincial governments crest this year, stabilize and then start to come off. Therefore, this is the last of net stimulus from government based on current plans, which, I think, is partially your point.
Governments have to take their decisions about fiscal sustainability. It is important that we are seeing the private side filling in some of the slack there, and for 2011, that 3.1 per cent growth is all private growth, in Canada domestically and abroad.
The issue in 2012, though, and beyond is that we see the Canadian economy coming back to its capacity, its level of potential, by the middle of 2011. Going forward from that point, the economy should grow at its level of potential growth, and the rate of potential growth in the Canadian or any other economy is a function of the growth and labour input, how many hours people work, how many people are working and productivity growth.
In Canada, we are expecting to see that the demographics of our country will mean we will get less from that growth and labour input, which earlier in this decade and before would have contributed 1.5 percentage points, varied by the year of growth per year, to around what we are expecting going forward, which is around half a percentage point, and gradually diminishing as we go further into this decade. We are expecting productivity growth to pick up fairly sharply from very low levels right now to about 1.4 per cent by 2012 — the sum of the two, labour input and productivity, 1.9 per cent potential growth for the economy. The point is that that is about as fast as our economy can grow once we make up for the lost ground that we have had in the recession.
To get it growing faster, Canadians would have to decide to work longer into their working lives and work more. More attractively, perhaps, through a product of greater investment and better business practices, we could increase the productivity of the economy, and we do have a big 20 per cent level productivity gap with the United States, and a bigger productivity gap with countries such as France and Germany, for example. We have a lot of room to make up on that front, and if we can start accelerating productivity growth in this country, we can get that number, which you are concerned about, up higher, but a series of decisions in the private sector is required to do so.
[Translation]
Senator Hervieux-Payette: I was going to ask you about the fact that Germany and France each have five weeks of statutory holidays per year. Their work week consists of a maximum of 35 hours, and their retirement age is 60. Do they work faster than us? Do they think faster than us? Do their business people invest more than ours do? I want answers to those questions. I understand that with our age pyramid, we might have to work until a later age. I would like you to explain to me why, for the past 10 or 15 years, I keep hearing the Governor of the Bank of Canada say that our country is not productive. Who is to blame for this lack of productivity?
Fundamentally, we would all be better off if we were more productive, but we will not become more productive by working for less than the U.S. minimum wage. The people listening to us need to know what factors and criteria will make Canada more productive, and what role the government can play in the process. After all, you are talking to parliamentarians, so we have to find a solution to this lack of productivity.
Mr. Carney: Thank you for your question.
The Chair: It is a good question that will get a good answer.
Mr. Carney: I hope so. Several Canadian governments at the federal and provincial levels have made crucial decisions in order to increase the productivity of our businesses and our country. There have been several cases where governments have reduced corporate taxes along with taxes on new investments, on primary research investments and on secondary and post-secondary education investments. These represent major investments in our country's infrastructure.
The level of investment in our infrastructure, as a percentage of our GDP, is as high as it was during any other period in the past. It is not a question of the level of investment or a question of the level of corporate taxes, or the level of investment in primary research, public research.
So, what is the problem here? First of all, Canadian companies are afraid to invest because of the uncertainty surrounding the global economy and especially because of the uncertainty surrounding the future of the U.S. economy. This uncertainty has only recently manifested itself. Second of all, Canadian companies need to change their views about new markets.
[English]
In the end, our productivity gap is considerable. It is across the board in terms of factors. Our businesses do not invest as much in machinery and equipment, training of individuals or research as do American companies and many European companies. As a whole, there are still issues. There is more to be done. It is a marathon and not a sprint from the perspective of government policy, but various levels of government have made progress in improving the business environment in this country.
Our forecast is for a substantial investment response that will take our productivity growth from basically zero at this moment to just under 1.5 per cent by 2012. Your point is that a considerable gap still exists between the productivity of Canadian enterprises and the most productive enterprises in Europe.
I was careful in saying that it is the choice of Canadians whether they want to work into their fifties or sixties. I am not saying there is a policy in that direction, and we certainly should not penalize people for doing that. It should not be less attractive.
In France, that choice is reduced. Less work is encouraged, and as a result there are more productive enterprises but less overall growth in the welfare of the citizens of the country than there otherwise would be. I think the President of France has been absolutely clear on the shortcomings of that system.
Senator Ringuette: You are part of a committee called FISC that comes out of OSFI. When you look at financial documents, do you also look at new financial products that are being purchased or introduced by our Canadian banks into the Canadian market?
Mr. Carney: On occasion, but the responsibility of FISC is a micro-prudential one — the safety and soundness of the institutions themselves. Issues such as you are raising, which are important issues, would have to reflect on the financial health of the institution and what that meant, in the case of banks, for depositors — would depositors get their money back ultimately — and in the case of insurance companies, for policyholders. The mandate of FISC is restricted to micro-prudential issues.
Senator Ringuette: I have a small but very important question with regard to the G20. We all know that the global financial crisis was caused by a new financial product that was pushed into the market by financial institutions without regulations, and any agreement reached at the G20 should include regulations for that. If the root cause of the current problem is not overseen by the G20 group, there is no standard whatsoever in the global financial markets.
Mr. Carney: I am sympathetic to that point. There were several causes of the crisis that combined to make it more virulent, but certainly the rise of a shadow banking system driven by a series of products outside core regulation and that grew rapidly to a tremendous size was one of the contributing factors. One commitment within the G20 is to expand the perimeter of regulation so that one cannot conduct the same activities away from regulation. In other words, having an industrial company with a big financial services arm that is in effect a bank but not regulated as such must end, and there are a variety of ways to do that by expanding the format of regulation.
There is a shared recognition of the need to anticipate systemic markets that could be built up by new products such as you are referencing and to bring those, as much as possible, into public exchange traded or centrally cleared markets so that people can see what is going on and so that they are appropriately regulated.
Your point is exactly right. It is part of the work program, and the challenge will be less to identify what exists today, because that is easily done, than to design these regulations in a way that anticipates what will be invented tomorrow.
Senator Kochhar: Thank you for appearing here, Mr. Governor. I am a new senator, and it is a pleasure to meet you for the first time.
I want to talk about something you have already touched upon, and that is productivity in our country and the effect that our rising dollar has on that. The relative high value of the dollar has both positive and negative effects. You will agree that it is not the level of the dollar that needs to be addressed but rather lack of competitiveness. If our dollar is high and we cannot compete, it is not the dollar that is to blame but the competitiveness of our industry.
You will also agree that a benefit of a higher dollar will be to encourage business to invest in both machinery and research. You have already told us that the way for Canadian businesses to improve is through investment in research, machinery and business in general.
Given the high praise for the state of government policy, what additional measures do you think the bank can take to improve the productivity of our businesses?
Mr. Carney: Thank you, senator. I will first refer to our Monetary Policy Report. On page 21 of the English version and pages 22 and 23 in the French version, Chart 19 depicts unit labour costs in Canada and the United States, expressed in U.S. dollars, over the last two years. The red line is Canada. You see unit labour costs, which are a measure of productivity, rising about 10 per cent since early 2007; and you see unit labour costs in the United States falling over the last year about 4 per cent. Therefore, a 14 per cent gap opens up between Canada and the U.S. just in terms of the flow. Once the currency is rolled in, a 26 per cent or 27 per cent gap opens up between Canada and the United States. That is a very stark depiction of what we have been talking about.
On the important question about additional measures, I did say earlier that this is a marathon and more steps could be taken. I would say they are more of the same investment strategies of governments, that we are a leader in public investment. The challenge is getting the full spillover and commercialization benefits of that infrastructure investment. Infrastructure investment is best done over multiple years; it needs to be strategic infrastructure — economic infrastructure, if you will — to have the maximum spillover.
There are a couple of other issues, and I will come to the bank's role in all of this. Two issues bear consideration. One is the degree of competition, both domestic and international, in the economy, which is a spur to investment. The extent to which competition, both domestic and foreign, is allowed is a decision taken by different levels of government. I will make that observation.
Regarding the second issue, I think this committee has looked in the past at the welfare wall on personal taxation. Our tax system has a variety of very appropriate social programs and tax credits and progressivity, which unfortunately has the undesired impact that as one comes out of poverty and begins working, one's marginal effective tax rate is high because things are clawed back. The government has introduced the Working Income Tax Benefit, WITB, to help smooth this impact on the personal side; it is still there but it has been smoothed and reduced.
If you think of the analogue for small business, we have a very attractive small business tax rate. We have an attractive regime for R&D investment for small business. We have a variety of other factors that are targeted to small business and then end once the business stops being small.
Canada also has a much larger share of small businesses than other economies do. That is a good thing; it provides lots of jobs. However, we do not want businesses to be small; we want them to be able to grow. As a longer-term issue, looking at all levels of government, it is worth considering whether we have the right incentives and whether it is smooth for businesses to grow from small to medium and up to large. There are other priorities and issues, but I put that on the table.
The bank's contribution to this, first and foremost, is to achieve our inflation mandate so that the one thing businesses and individuals do not have to worry about is inflation being anything other than low, stable and predictable. That keeps their financing cost lower than it otherwise would be and allows them to focus on the job at hand.
As well, we have two other responsibilities. One is to work with the Department of Finance, the Minister of Finance and other agencies like the Superintendent of Financial Institutions as part of the processes such as the G20 to improve our financial system. It can always be improved to make it more resilient and efficient.
Finally, because in fulfilling our core responsibilities we have to look at the macro economy as a whole, we have to try to identify these broader trends and issues so that others who have more direct responsibility for them can respond with public policy. Importantly, the message we have been trying in recent months to give Canadian businesses is that the recovery has gained some strength. The level of uncertainty, while it is still higher than usual, has been reduced, and a productivity gap has opened up. Financial conditions are very good; it is both a good time to invest and a necessary time to invest. However, we leave it to them to make those decisions as appropriate for their businesses.
Senator Moore: I want to touch on something Senator Massicotte asked in regard to the so-called Europeans PIGS — Portugal, Ireland, Greece and Spain. Is Canada holding any of the bonds of those countries? If so, how much?
Mr. Carney: I do not have the figures at hand. The exchange fund account, which is the reserves of the Government of Canada — the bank acts as the government's agent — from time to time is invested in the most high-quality sovereign securities. It will, from time to time, hold securities of the higher quality of some of the countries you reference. I do not have the exact breakdown at hand.
Senator Moore: Given what is happening in Greece, as was mentioned by Senator Massicotte, and what the holdings may be, I expect you are probably looking at that and monitoring that closely. Is it of concern? Is the quantity such that it has your attention?
Mr. Carney: For the committee's comfort, our asset management, which is done jointly with the Department of Finance, is not passive. In other words, we are aware of what credit ratings are from the independent agencies of these countries, but we do not rely on those ratings to dictate where we make our investment decisions.
They are an initial filter, but we do our own analysis of the creditworthiness of the countries and the appropriateness of these investments and adjust accordingly. I would not want anyone to take from that answer that we are expressing concern about any of the countries that you referenced.
Senator Moore: Do you have concern today with regard to Greece?
Mr. Carney: I do not have any concern with respect to the investments in the exchange fund account of the Government of Canada.
Senator Moore: That is a little different, but I will take that answer.
Mr. Carney: I was just going to repeat it, otherwise.
Senator Moore: Concerning your remarks about the aspects of reform you are working on, with regard to the tier 1 capital — so the public understands — you are basically saying it is hoped that through these negotiations and meetings a new standard will be set whereby the banks will need to have more cash on hand from equity or retained earnings to cover their obligations. Is that correct?
Mr. Carney: Yes, more capital, but effectively capital that has been built up directly from share sales or retained earnings.
Senator Moore: You talked about the Basel rules, and you mentioned the shadow banking, which I understand was a system whereby ``banks'' would set up a shell company located in an offshore tax haven, load it up with debt and then sell the debt packages off their books. Many countries that adhered to the Basel rules are still there. Have are they recognized the ill of that kind of activity, and are they prepared to stop doing it?
Mr. Carney: Yes, I would say that what you identified was one of the elements of the shadow banking sector. There were many others that also have to be caught. I reference, for example, industrial conglomerates having finance subsidiaries that effectively were banking subsidiaries. There was also a series of money market type, shorter-term investment vehicles that borrowed at very short term and lent at long term, in other words classic maturity transformation, which is one of the core functions of banking, in the absence of a safety net. A host of such activities need to be captured with consistent regulation.
Senator Moore: Do the members at the table recognize that that was a key element of what happened, and are they prepared to act positively to prevent that in the future?
Mr. Carney: Yes. We still have to present you with the final agreed-upon rules.
Senator Moore: I am glad to hear that that is being addressed.
Mr. Carney: I believe the experience of everyone was that most of the problems were the result of a chain that began in the shadow banking sector and then, in some way or another, collapsed back into the formal banking sector through some sort of relationship, be it a moral obligation or direct contractual obligation to those entities.
Senator Moore: Further to Senator Ringuette's question with regard to instruments, there are allegations that some of the institutions in the U.S. created funds, loaded them up with high-risk instruments, sold them to the public — communities, institutions and governments — knowing they were going to fail, did not tell the investors about it, and then bet against them and cleaned up. We are talking about unregulated derivatives and hedge funds.
Is your group that is formulating new rules looking at those kinds of situations in order to prevent them and to get these instruments regulated? Even the so-called sophisticated investor does not know what is behind these things. Are you trying to get that out front so that there is regulation, public disclosure and transparency?
Mr. Carney: The short answer is yes, and I will give you two examples.
First, on the issue of transparency, we are familiar with the situation in Canadian non-bank asset-backed commercial paper, which was a classic example of shadow banking, absence of transparency, failure of the rating agencies and failure of the investors, because it was reliance basically on the rating. It is very difficult to find an investor who did a true, independent analysis of the quality of these securities.
In that case, the Bank of Canada, although we are not the ultimate people to do it, in order to provide stability and direction to the other bit of that asset-backed commercial paper market, which was actually backed by real credit card receipts, car loans, et cetera that were programs run by our banks, dramatically changed the transparency requirements for that before we would take it as collateral in any of our operations and to ensure that the information we received was available to all potential investors. In our view, that is a bit of a template to hand off to securities regulators and others to consider for broader disclosure on asset-backed securities. Ultimately, disclosure decisions are for securities regulators, and I know the CSA, the Canadian Securities Administrators, is working through these issues, and we are in contact with the CSA on that.
Your broader point was on complex derivatives and what reforms will make a difference around that. I would stress the importance of moving standardized derivatives onto centrally cleared platforms.
Senator Moore: By ``platforms'' do you mean exchanges?
Mr. Carney: Not exchanges per se, because if we tried to move them onto exchanges we would restrict the number we could do. For something to be on an exchange it has to be absolutely identical, so it would have to be, for example, an interest rate contract that had exactly the same maturity and lot size of contract. On a central clearing house, you can have different maturities for a fixed floating derivative contract or a credit default swap on a certain reference name. You can have different aspects that can be cleared through the same entity. All the trades are reported, so they are all public and we have all the information, which we do not have now. We would have the information about what is happening with trades and at what price. Importantly, we get tremendous benefits from the netting of collateral that is done in order to centrally clear.
Senator Moore: Then you know how much is out there.
Mr. Carney: You know how much is out there, and you dramatically reduce the risk that is involved in these trades between entities, which potentially allows one of these entities, one of these banks that trades in them, to be separated off if it is failing without bringing the whole market down.
The third important thing is that through the Basel process there will be a different capital charge for derivatives that are traded or cleared through a central counterparty versus those that are just traded between two banks. It would be much more expensive to trade the derivatives between the two banks. In that way, it should dramatically reduce the derivatives to those that really make economic sense, because they will have to jump over this higher hurdle.
Senator Moore: I agree with your comments about the proposed bank tax. That would create a moral hazard for the way that people would function and operate. I am glad we stopped that.
Senator Ringuette: Who would supervise that central clearing system for these products?
Mr. Carney: Under the Canadian Payments Act, the Bank of Canada has responsibility to oversee systemic payment systems, and, separately, central clearing entities are normally regulated as well by security commissions. For example, the TSX has a central counterparty, so you would have a joint responsibility, but if this entity comes into being and is successful, it should be systemic. In other words, the scale of transactions through this should be large enough that it would be a systemic event if the central counterparty were to fail.
If the process were successful, which is still an open question, we would look very hard at designating it as a systemic payment system, and then our responsibility is to ensure the safety and soundness of that entity so that market participants have confidence that it will continue to function, just as market participants have every confidence that the large value transfer system, which is the overnight market where huge volumes are passed through that we oversee, will always function so that they are able to transact.
[Translation]
Senator Mocker: I want to talk about the mortgage issue. As we know, regardless of where they live, Canadians aspire to own their homes. Various media have been reporting that the Governor of the Bank of Canada is concerned that the increase in rates will affect households. I have three questions to ask you.
[English]
The bank lowered interest rates, which made it more affordable to buy or refinance a home. Yet, the bank has also been concerned that many who financed or refinanced their homes at lower rates may have difficulty when rates finally rise. However, in February of this year the Minister of Finance announced new mortgage rules that will require all borrowers to meet the standards for a five-year fixed rate regardless of what term they take, lower the amount that can be withdrawn when refinancing a mortgage, and require a minimum of a 20 per cent down payment for government- backed mortgage insurance on properties that the owner will not live in.
That said, from the perspective of the bank, is it a good thing that the government did move on those measures? Would you agree that we do not have a housing bubble but that we very much need to ensure that one does not develop? Finally, would you agree that Canada's housing market did not see the excesses that caused instability in housing bubbles in other jurisdictions in the world?
[Translation]
Mr. Carney: These are important questions. I will answer them, but first, I would like to emphasize that as far as the current state of the Canadian economy is concerned, the Bank of Canada has observed that household spending during the second half of last year and the first quarter of this year was stronger than expected, especially in the residential investment sector. This is due to very low interest rates and to the scheduled introduction of the new HST in Ontario and in British Columbia.
[English]
With respect to residential investment, you had the Home Renovation Tax Credit incentives for those investments.
Therefore, to make the point, which is important for understanding our projection, there is an element — it is not the whole story — of front-loaded growth in our projections, so there has been a pull forward of demand, particularly in housing and other consumer demand at the end of last year and start of this year. Some of that will come off, and in fact we see housing investment and residential investment as a whole, including renovation, in our terms weakening markedly over the balance of this year. That is not a comment on prices but on the level of investment.
As to whether we welcomed the measures introduced by the Minister of Finance, yes, we did. We thought they were entirely appropriate. As required by the Bank of Canada Act, the minister and I consult regularly, and we did discuss those measures in advance. Obviously, it was the minister's decision, and we welcome those measures. We think they will help to curb unnecessary speculative activity in the housing sector.
Regarding the state of the Canadian housing market, as people know, housing markets in many respects are regional. There are regional variations. As a general point, housing valuations have risen considerably over the course of the last year. Housing is more firmly valued in this country. In terms of the level of activity in that market, we expect to see a weakening.
That said, regarding your last question, there are structural reasons and structural advantages in how the Canadian housing finance and housing markets are organized. Through our mortgage insurance system, there is an ability to regulate and adjust as appropriate, as the Minister of Finance has just done, the prudential requirements for someone taking out a high loan-to-value mortgage, and that can be the credit scores, the length of amortization, the use of proceeds, whether for an investment property, or the amount of money that is put down. As I say, that provides a measure of control and can be adjusted, and the minister's moves are an excellent example of that.
The other advantage of the Canadian system, certainly vis-à-vis the United States, is the absence of tax deductibility of interest. In the U.S. there is an inherent desire to re-leverage a property as soon as equity has built up, because in many cases it is tax efficient for the individual, which obviously leaves the system as a whole in a more precarious position, as we have all seen to our cost.
Canadian financial institutions securitize only about one third of their mortgages; they keep the bulk of their mortgages on their balance sheets on an uninsured basis, so they have direct exposure, and this creates the right incentives for maintaining underwriting standards in those institutions.
Finally, speaking hypothetically, if there ever were a problem in the Canadian housing system, the nature of mortgage insurance is such that there is not a feedback to the financial institutions. What happened in the United States and some other countries is that when there was a problem in the housing sector, obviously, there were losses. Those losses reduced the capital of the financial institutions, and those financial institutions therefore could lend less money to households and businesses. That worsened the recession, which meant more falls in housing, which reduced the capital, et cetera.
In Canada, if we were ever to have a problem, the structure, for good or ill, is such that the costs would go directly to the mortgage insurer, and there would not be the feedback into the financial institutions, so at least the financial institutions would be able to move forward. There are advantages, but there are issues, and the minister's actions were very welcome.
The Chair: On that, governor, am I correct in thinking that in the United States an element that encouraged speculation in the housing market was the fact that any recourse is limited to the house itself, whereas in Canada, of course, the individual's assets across the board are available?
Mr. Carney: Both senators are absolutely right. In Canada, yes, the mortgage borrowing is recourse to the borrower, with the exception of Alberta. In the United States, in the vast majority of states, it is non-recourse. There are exceptions to that rule, but that is an aspect that encouraged certain behaviours and has made resolving the issues more difficult in the United States.
[Translation]
Senator Hervieux-Payette: When Canada restructured its Bank Act, it decided to follow the international model, which allows banks to buy brokerage firms. At that time, I had my doubts, but since the Americans, and especially the British, had put together what they referred to as the four pillars, I figured it would be a recipe for success. The main characteristic of a bank is the security it offers its customers, whereas the main characteristic of a brokerage firm is risk-taking. Basically, brokerage firms viewed banks as their safety net.
As part of the examination you are undertaking with the G20, are you looking at the possibility of separating banking and brokerage operations? The banking industry has been put in a risky situation because of the brokerage industry's aggressiveness.
I have another question about the dollar.
Mr. Carney: First of all, I think that the merging of brokerage firms and commercial banks in Canada has its advantages.
The bank supervisor regulates the companies jointly. So, the regulations are the same for brokerage firms and commercial banks. One of the problems in the United States was that some brokerage firms were under the authority of the SEC, and commercial banks had control of the currency and were subject to other regulations. There were major differences in the ways the two sectors were regulated, especially when it came to company leverage ratios. The majority of problems in the United States were being experienced by investment banks because of a strong increase of leverage ratios during the 2000s.
Second of all, it is important to understand that, in terms of capital, there are new rules in place for supporting the trading activities of investment banks.
[English]
There are new trading book rules under Basel II that triple the amount of capital required for trading activities. We have agreed that those institutions are ready to implement them. The expectation is that they will be implemented globally. The timetable is the only issue. In Washington this past weekend we had discussions with European, American and Asian officials about the exact timing of the implementation. Currently, it is scheduled for the end of this year, although it might be slightly later. We were given assurances from the highest levels of U.S. authorities that they will be implemented in the United States as soon as they are ready to be implemented here.
Important to your concern and our concern about the amount of risk in the trading activities of these institutions is the fact that we are changing the economic incentives by tripling the capital required in these trading books. We expect to see a shifting of activity on the margin from the investment banking side to the commercial banking side and an overall de-risking of the system.
[Translation]
Senator Hervieux-Payette: Let us imagine that the American dollar was not seen as the currency against which other world currencies are valued — before, we had gold, and now we have the American dollar. Let us also imagine that we were assessing the state of the American economy as it compares to the state of the Canadian economy, and comparing U.S. currency with Canadian currency and the euro, while taking into consideration the role China is playing by holding vast reserves of dollars. In that hypothetical situation, could the Canadian dollar reach a level that would be acceptable for our manufacturing industry? Its value fluctuates greatly. When the value rises from 60 cents to 98 cents, the effect on our manufacturing industry is staggering. What kind of regulations could we implement without having control over the exchange rates? It seems to me that a game is going on here, and it is detrimental to the Canadian dollar. What steps is the Bank of Canada taking to ensure that the Canadian dollar regains some of its stability?
Mr. Carney: Your question has to do with the risk that the rising dollar brings. It affects our economy adversely and causes inflation to rise.
This issue is an important concern for the Bank of Canada. The persistent strength of our currency, combined with our recent productivity, could have an impact on our economy, on inflation in Canada and on the monetary policy of the Bank of Canada. That much is clear.
[English]
The U.S. dollar is the reserve currency and will remain the reserve currency for the foreseeable future because there is no viable replacement for the U.S. currency. For the medium term, it is important that U.S. authorities and all others establish sustainable fiscal plans. Canada is using its co-chairmanship with Korea of the G20 to encourage such measures. I suspect that will be one focus of discussion. I know that U.S. officials understand the importance of that issue.
Senator St. Germain: Mr. Carney, I have a quick comment about the bailouts impacting the world economy. It concerns me that 80 per cent of the population do not pay taxes. I do not know where this leads us, but that is more of an observation than anything.
My question relates to seniors. The down side of the historically low interest rates offered by the banks is that they have a negative impact on the retirement savings of elderly Canadians who typically hold guaranteed investment certificates, GICs, and bonds. The low rates have forced some seniors to live off their capital because they cannot afford to live off the interest at such low rates. In search of a higher yield, many have turned to high-risk investment, which might not be age-appropriate and which they might not fully understand. Those purchasing an annuity must settle for a considerably lower annual payout than was the case a few years ago.
In setting monetary policy and interest rates, is any consideration given in your deliberations to the effects on those who depend upon interest income and annuity values? There is such a focus on wanting people to save, and yet they have to dig into their principal just to survive.
Mr. Carney: Thank you for raising this issue. We do take into consideration the impact of our monetary policy on all classes of Canadians, all age cohorts, whether people are savers or borrowers and the total impact across all individuals and businesses on the outlook for the economy and for inflation.
We are aware of this issue, and we are aware as well that running a monetary policy that would cause persistent undershooting of the inflation target would be more detrimental. It would cause the Canadian economy to grow more slowly or perhaps to continue to shrink. That would reduce the wealth in this country and reduce the returns on equity investments, on businesses and on household investments across the country. On the other side, we are certainly aware of the equal pain that would be caused in a different way of running inflation policy too loose and higher than the 2 per cent target. Of course, that would penalize in particular any individuals on fixed incomes and could penalize seniors who are locked into certain products. After careful consideration, the Government of Canada and the Bank of Canada have agreed on a 2 per cent inflation target as the balance of these two forces. Inflation is low enough so that it does not enter into the decisions of individuals but not so low that we push ourselves into a deflationary situation and its consequences.
Yes, we take it into account, but we cannot run policy for a specific group of Canadians only, whether regionally, by age group or by the type of investments they have.
Senator St. Germain: When you reduced the bank rate to 0.25 per cent, many banks raised the interest rate on revolving loans and business loans. The idea was to keep interest rates low to generate activity in the economy, yet they raised their rates. We want our banks to be profitable, but this appeared counterproductive, and they did it right across the board. Their excuse was that their cost of borrowing had gone up and they were reflecting that. However, this did not make sense, because they seemed to be working in the other direction from what you were trying to accomplish. Will you comment on that, please?
Mr. Carney: First, the cost of borrowing for banks, the spread between where the bank borrowed versus where the overnight or the interest rate was, went up during the course of the financial crisis. It has come down as a spread but has remained higher than it was prior to the start of the financial crisis in August 2007, and you see that in the very shortest terms of the money market and farther out. Their cost of funds in relative terms had gone up, and that explains parts of it.
We have taken that into account, which is why we ended up where we did, because obviously we look at the net cost that Canadians, businesses and individuals, pay, and while people can quibble about the prime rate spread, the absolute level of the prime rate is at an historic low, as is the level of variable rate interest.
Finally, going back to the earlier conversation around Senator Harb's question about five-year fixed mortgage rates, one reason for the profitability of the banks has been the relatively lower cost, even with that spread of funding, at the shorter term and then the steepness of the difference between the short-term rates and the longer-term rates and the stickiness of those rates because of global interest rates.
The Chair: Thank you. I am afraid we will have to leave it at that. We are over our time limit. It remains for me to express on behalf of all senators our usual effusive thanks for your presence today. This has been an interesting exchange. We appreciate very much your willingness to attend twice a year at these hearings. It is useful for us all and for people watching on the webcast.
Governor, we wish you well in your endeavours. We applaud the success you have had to date and know you will continue in that direction.
We will now have clause-by-clause consideration of Bill S-3, to implement conventions and protocols concluded between Canada and Colombia, Greece and Turkey for the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income. I thank Senator Hervieux-Payette for having chaired last night's meeting, at which this bill was examined, in her usual professional and successful way.
Is it agreed that the committee proceed to clause-by-clause consideration?
Hon. Senators: Agreed.
The Chair: Shall the title stand postponed?
Hon. Senators: Agreed.
The Chair: Shall the short title, clause 1, stand postponed?
Hon. Senators: Agreed.
The Chair: Shall clause 2 carry?
Hon. Senators: Agreed.
The Chair: Shall clause 3 carry?
Hon. Senators: Agreed.
The Chair: Shall clause 4 carry?
Hon. Senators: Agreed.
The Chair: Shall Schedule 1 carry?
Hon. Senators: Agreed.
The Chair: Shall Schedule 2 carry?
Hon. Senators: Agreed.
The Chair: Shall Schedule 3 carry?
Hon. Senators: Agreed.
The Chair: Shall the title carry?
Hon. Senators: Agreed.
The Chair: Shall the short title carry?
Hon. Senators: Agreed.
The Chair: Shall the bill carry?
Hon. Senators: Agreed.
The Chair: Is it agreed that I report this bill to the Senate without amendment and without observations?
Hon. Senators: Agreed.
The Chair: Thank you very much.
(The committee adjourned.)