Proceedings of the Standing Senate Committee on
Banking, Trade and Commerce
Issue 25 - Evidence - October 31, 2012
OTTAWA, Wednesday, October 31, 2012
The Standing Senate Committee on Banking, Trade and Commerce met this day at 2 p.m. to examine the present state of the domestic and international financial system.
Senator Irving Gerstein (Chair) in the chair.
[English]
The Chair: Members of the committee, we are delighted today to have with us Mr. Mark Carney, Governor of the Bank of Canada, along with Mr. Tiff Macklem, the Senior Deputy Governor.
As we know, Canada's economy has been functioning quite well. As a matter of fact, it has been at the forefront of the G8 countries, which is attributable to many but certainly including those before us today.
I recollect it is about a year ago that I had the privilege of saying that you would be named as Chairman of the Financial Stability Board. At that time, I recognize that it was not only a reflection on your professional ability and a reflection on Canada, but one that you should take personally as well and in which we all take great pride.
Governor, in your most recent Monetary Policy Report, you state "The economy is expected to pick up and return to full capacity by the end of 2013." That is good news. We look forward to hearing you expand upon this, as well as any other matters you wish to bring to our attention.
Mark J. Carney, Governor, Bank of Canada: Thank you. We are pleased to be with you this afternoon to discuss our October Monetary Policy Report, which we published last week.
[Translation]
The global economy has unfolded broadly as the bank projected in its July MPR. Growth has slowed in all major regions. The economic expansion in the United States is progressing at a gradual pace. Europe is in recession and recent indicators point to a continued contraction.
In China and other major emerging economies, growth has slowed somewhat more than expected. However, there are signs of stabilization around current growth rates.
Notwithstanding the slowdown in global economic activity, prices for oil and other commodities produced in Canada have, on average, increased in recent months. Global financial conditions have improved, supported by aggressive policy actions of major central banks. Sentiment, though, remains fragile.
[English]
In Canada, while global headwinds continue to restrain economic activity, domestic factors are supporting a moderate expansion. Following the recent period of below-potential growth, as the chair noted, the economy is expected to pick up and return to full capacity by the end of 2013.
The bank continues to project that the expansion will be driven mainly by growth in consumption and business investment, reflecting in part very stimulative domestic financial conditions.
Housing activity is expected to decline from historically high levels. The household debt burden is expected to rise further before stabilizing by the end of the projection horizon.
There are upside and downside risks around the evolution of household imbalances. Residential investment could regain momentum, thereby reinforcing existing imbalances. Conversely, continuing high household debt levels could lead to a sharper-than-expected deceleration in household spending. In this context, Canadian authorities, including the bank, are cooperating closely to monitor the financial situation of the household sector and are responding appropriately.
Canadian exports are projected to pick up gradually but remain below their pre-recession peak until the first half of 2014, reflecting weak foreign demand and ongoing competitiveness challenges. These competitiveness challenges include the persistent strength of the Canadian dollar, which is being influenced by safe haven flows and spillovers from global monetary policy.
After taking into account revisions to the national accounts, which had the effect of raising measured growth for this year, the bank now projects that the Canadian economy will grow by 2.2 per cent in 2012. Going forward, we expect growth of 2.3 per cent in 2013 and 2.4 per cent in 2014.
Core inflation has been lower than expected in recent months, and this reflects somewhat softer prices across a wide range of goods and services. It is expected to increase gradually over coming quarters, reaching 2 per cent by the middle of next year. As the economy gradually absorbs the current small degree of slack, the growth of labour compensation remains moderate and inflation expectations remain well anchored.
Total CPI inflation has fallen noticeably below the 2 per cent target, as the bank expected. It is projected to return to target by the end of 2013, somewhat later than previously anticipated.
[Translation]
The inflation outlook in Canada is subject to significant risks. The bank's projection assumes that authorities in Europe are able to contain the ongoing crisis, and that the U.S. fiscal cliff will be avoided. The three main upside risks relate to the possibility of higher global inflationary pressures, stronger Canadian exports and renewed momentum in Canadian residential investment.
The three main downside risks relate to the European crisis, weaker demand for Canadian exports and the possibility that growth in Canadian household spending could be weaker.
[English]
Overall, the bank judges that the risks to the Canadian inflation outlook are roughly balanced over the projection period. Reflecting all of these factors, on October 23 the bank maintained the target for the overnight rate at 1 per cent. Over time, some modest withdrawal of monetary policy stimulus will likely be required, consistent with achieving the 2 per cent inflation target. The timing and degree of any such withdrawal will be weighed carefully against global and domestic developments, including the evolution of imbalances in the household sector.
With that, we would be very pleased to take your questions.
The Chair: Thank you very much, Governor Carney. I listened assiduously to every word you said. There was one particular word I did not hear, and perhaps you might like it to comment on it — China.
Mr. Carney: I very briefly did mention China, Mr. Chair. Growth in China and other emerging markets has been slowing in recent quarters. Specifically with respect to China, to put figures around that, it has been growing at double digit rates for several years now. The most recent figures are in the 7.4 per cent annualized growth range.
The reasons for the deceleration of growth in China are several-fold, some positive and some cause for further study. The positive is that some of it is intentional. Chinese authorities had provided a great deal of stimulus following the fall of Lehman Brothers and the ongoing global recession, both fiscal and monetary stimulus. That had run its course. They tightened fiscal policy and lending standards for banks, and they tightened monetary policy quite significantly. The consequence of those three measures has been to slow the rate of growth in China.
Less anticipated by Chinese authorities, a few years ago by the Bank of Canada, certainly by European authorities as well, was how weak the European economy was going to be. Europe is China's most important export market, and Chinese exports to Europe have been falling on a year-on-year basis, not just slowing but actually falling, because of the weakness of demand in Europe. Obviously the United State's economy has been growing at a gradual pace, as we say, so there has continued to be positive export growth to the U.S., Canada and other jurisdictions. There has been more softening from external demand for China on top of measures they had taken.
The last element in terms of the slowdown in China is related to that second reason, which is the adjustment of demand or sources of growth in China. China, as many have remarked and we would agree, has been heavily reliant, perhaps overly so, on export-led growth and associated investment, with very high reliance on investment. To give one figure, the share of investment in GDP in China has increased over the last decade from about one-third of GDP to about one-half of GDP, and the consumption share has gone the converse, from one-half of GDP to about one-third of GDP. Consumption in Canada, for reference, is about 55 per cent of Canadian GDP. In the U.S., it has been 70 per cent of GDP.
China is in a long-predicted position, recognized by Chinese authorities as well, and it is very much recognized in their five-year plan, of trying to adjust to build more domestic sources of growth, notably domestic consumption, in a more sustainable investment profile within that economy. That is a welcome process, but it will take some time and will have some bumps.
All of that said, bottom line, we had expected China to slow. It has slowed slightly more than we would have expected, but we are at the bottom end of consensus on China. We are seeing signs that that deceleration may be ending, in other words, that the fourth quarter could be slightly stronger than the third quarter in China, and we do expect in our forecast the Chinese economy to expand about 7.75 per cent next year and the year following.
I said that was the last point, but I will make another last point, if I may. That 7.75 per cent growth will contribute the same amount of demand to the global economy as 14 per cent growth in China in 2007. That is how much the Chinese economy as a whole has grown over the intervening period, so the impulse of 7.75 per cent growth in China next year is $800 billion of new demand to the global economy, measured on market exchange rates.
That is one the reasons why, even though China is slow, we still think that it makes an important contribution not just to global growth but also to support commodity prices, which are important for Canada.
Senator Harb: My question, along the same lines as that of the chair, has to do with Basel III. Back in August, a gentleman by the name of Andy Haldane gave a speech and made some emphatic attacks on you. I quote, for the record: "Because complexity generates uncertainty not risk, it requires a regulatory risk grounded in simplicity." He said, "Less may be more."
You responded that you thought he was flat wrong. I will quote what you said then and see if you still agree with the same statement. You supported the belt and suspenders approach. You said:
Things people thought were riskless turned out to be very risky in the run up to the crisis. A big chunk of this crisis was caused by things people thought were risk free — superior senior triple-A assets on bank balance sheets, or in SIVs or in the heart of the repo market. One of the reasons Canadian banks did not have a tone of it but the U.K. banks did was because of the leverage ratio, so I don't need anyone to tell me the leverage ratio is valuable. It's in the system and there for a reason."
I thought that was a very deep and important statement in response to a very simple and, frankly, very contradictory statement by Mr. Haldane, who talked about complexity generating uncertainty, not risk. I have not seen any place where complexity does not generate risk. I want to go on the record as supporting your statement.
Are you on good speaking terms now with Mr. Haldane?
Mr. Carney: Yes, we are on very good terms, I believe. I will have to check with Andy after.
I am glad you raised the question because this is an incredibly important issue. Andy Haldane, from the Bank of England, and I were saying similar things but in a different order. His basic point was that a big component of Basel III makes judgments about the riskiness of various assets. There are thousands and thousands of those judgments because there is a huge range of types of assets. In making those judgments, banks have to hold a certain amount of capital against those assets or those exposures.
To simplify, his argument was that it would be better to have a very simple measure — the leverage ratio — instead of this complex measure. All the leverage ratio does is takes the amount of assets a bank has and divides them by the amount of equity or capital the bank has, and you have a hard cap. We entirely agree. The Bank of Canada and OSFI entirely agree. This is exactly why the Bank of Canada and OSFI pushed, over the objections of some, which may have included the Bank of England at one point, for the inclusion of a leverage ratio in the Basel III agreement. That is why there is a leverage ratio in the Basel III agreement.
I will get to one of the points on which I differed from Mr. Haldane. The leverage ratio protects you from those risks that you think are riskless. In the crisis, there were a series of financial institutions, and I will take UBS as an example. They documented this very clearly. They created very complicated, structured products. They sold the risky bits, those bits that the rating agencies thought were triple-B or single-A, but they held on to the triple-A assets, the riskless assets, the ones that were supposed to be as strong as the Government of Canada, for example.
It turns out that those were not triple-A assets. The rating agencies got the rating wrong. UBS made the wrong judgment and effectively blew up the bank. They piled up the amount of "riskless" assets very high because it did not cost them anything, on a risk-weighted basis, under that complicated approach.
The belt and suspenders is to say that even if you think it is risk free, there is a maximum amount of assets that you can have relative to your equity. In Canada, that was set at 20. It effectively meant operating in the high teens because you never want to bump up against the level, and that helped to protect Canadian banks.
Full credit to OSFI for putting that in place. We pushed for that internationally and got it internationally.
The issue then becomes which of these binds first. Do you set the level of the leverage ratio so that a bank will bump into the leverage ratio constraint before it bumps into the risk asset constraint — the risk-weighted constraint — or do you do it vice versa? Mr. Haldane says that you do it that way. We say no. In our experience, if you do it that way, the bank will load up on the riskiest assets it can have within the risk-free approach. You have to flip the order, which is the way the current Basel agreement is structured.
It is a very important point. Your question is very welcome because this is in the Basel agreement, but it does not have to be implemented until 2015, 2016. It is already implemented in Canada, but we want to ensure that it is properly implemented in the U.K., Europe and the United States. It is good to have it front and centre and to give it the profile that you have given it.
Senator Harb: Dealing on the local level, the Canadian level, you talked about household debt burden. You believe it will at some point stabilize, but you indicated that there are upside and downside risks around the evolution of household imbalances. In terms of household debt, I would be interested to hear from you whether we take into consideration principal assets such as one's home. Do you consider that to be a debt burden? If so, we heard otherwise. People who appeared before this committee told us that that is the best debt you could ever have because it is where your retirement will come from.
Mr. Carney: It is an important question. There is a liability side and an asset side to any person's, company's or government's balance sheet.
For the household, the most important asset is almost always the value of their home. The question becomes the level of actual equity in that home. How much of their mortgage have they paid off? How much did they put down originally, and how much of the principal of the mortgage did they pay off? The level of household net worth is very high right now in Canada relative to income. At the same time, debt is high relative to income.
We all know this lesson, but it is important to re-emphasize it. The value of the asset can go up and down. The value of your home can certainly go up and down. Your stock portfolio, if you have one, goes up and down. The value of the debt stays the same. The value of your asset is not always liquid, and the obligation of your debt comes on a monthly basis. We have seen it over and over again, most recently in the United States. People get sucked into a balance sheet analysis that says, "I am very wealthy because my assets are worth more than my debts." However, they are liquid, and they cannot service their debts in part because either they lose their job or interest rates go up or both. We are not here to deny that there is not sometimes a connection between the two. That causes the default for the individual.
The broader point is that, when you are in a situation, as we are, where debt as a whole is very high relative to income in the economy, there is the possibility of procyclicality happening when there is a shock to the economy. If unemployment goes up, some people start to be unable to service their mortgage for obvious reasons. That starts to hit house prices. That reduces the willingness of people to buy houses at the moment. They hold back. House prices move down. There is less activity in the housing sector, and there is more unemployment. These sorts of procyclicalities can cause a problem. It is one reason that we focus on the debt side and the liquidity and ability to service that debt side in a variety of circumstances.
All that said, our warnings about this issue are driven from a position of the country, officials and individuals being able to do something about it. The horse is not out of the barn.
Senator Greene: It seems to me that we live in a very unusual time in that the success of national economies or national governments, and the international economy as well, is more dependent on the actions of politicians than we are used to. In the 1980s and 1990s, it was more of a laissez-faire approach. The economies were all doing well and politicians did not have to do much, but now it seems they have to do a lot. You can have a situation as we have seen in Europe where a government becomes elected for one set of policies that have certain consequences, then when it arrives in power it decides there is too much pressure to do that and they have to do the opposite, which has also a set of consequences. What does that do for economic modelling? How much does that affect the predictive ability of your work?
Mr. Carney: In terms of, say, fiscal policy particularly, fiscal stance, in general we take the agreed, announced, ideally legislated fiscal stance of whatever government is in place and estimate the impact of those policies, whether they are expansionary or contractionary. We would make a small exception, an important exception at the moment, for the United States, where there is a legislated fiscal stance, which is the fiscal cliff, so we have to make a judgment in our projection. We do not have to, but we chose to make a very transparent adjustment in our projection that some sort of deal will be struck — and we do not know exactly what the deal is or when — that would reduce that 4 per cent fiscal drag next year to 1.5 percentage points of GDP in each of the next two years, and spread it out, which would be a seemingly sensible thing to do. However, it is easier for us to say that here from Ottawa than the corridors of power in Washington. Maybe the better way to put it is that we have a different perspective on what is sensible from here.
The point I would take in terms of economic modelling and the forecast is that one of the challenges right now is that there is — and one can measure this, and people have — a relatively high degree of uncertainty about the stance of economic policy across many major jurisdictions. The net effect of the actual flip-flopping, to use your term, or the pursuit of more unconventional policies is causing business investment to be less robust than it otherwise might be. You see this most directly in the European Union.
We have done some calculations. I referenced them in a speech a couple weeks ago in Nanaimo. It is on the order of 1 percentage point of GDP lower for the European Union as a whole just because of the uncertainty effect on business investment. In the U.S. it is something similar, about 1.5 points on GDP over the last couple of years.
Those significant numbers are being caused by the unusual economic circumstance we are in and some perceived inconsistency or ineffectiveness of policy in some of the major jurisdictions. That obviously puts a premium on being transparent, effective, obviously — it is always good to be effective — but also consistent in the pursuit of major policies.
Senator Greene: We have seen recent newspaper stories that the European problem is beginning to affect Germany, which is the core of the European Union. Could you explain to us and Canadians out there listening how important Germany is to the European Union and to the world economy, and perhaps outline responses that you might take if the European problem becomes worse in Germany?
Mr. Carney: The German economy is the fourth largest economy in the world. It is the largest economy in the European Union. In many respects, it is the engine of the European Union and more specifically the euro area, the countries that share the euro as their currency.
It is an economy that has undergone a tremendous transformation over the course of the last two decades, with the integration of eastern Germany, an entire rebuilding of that economy, and the competitive position of the German economy, to the extent that many of the challenges within the Europe zone are in part a product of Germany's success, by which we mean — and we always try to make this fundamental distinction — that in our view the euro crisis is not a fiscal crisis at its heart and not a banking crisis at its heart; it is balance of payments crisis.
Within the euro area itself, the challenge is that a number of countries — Spain being an example, Portugal, Ireland, Greece and others — have become quite uncompetitive vis-à-vis Germany. Their exports within the common area are uncompetitive, and they have reached the limits of the ability to finance what effectively are large current account deficits vis-à-vis Germany.
Getting to the second part of your question about what Germany can do as part of the euro area, there are three ways to rebuild that competitive position. The first is for prices and wages to fall in these economies. Given the order of magnitude in Spain, the starting point would be something on the order of about 25 per cent.
We talked a bit earlier about household debt. If you have any household debt — and Spanish households and businesses do have debt — if your wages go down 25 per cent, servicing that debt becomes pretty impossible. Obviously, there is a knock-on effect as well on demand. This is the experience, if you recall, that the U.K. had in the 1920s under the gold standard where they tried to deflate to adjust their competitiveness. That is the first option.
The second option is the textbook economist option, which is to improve competitiveness and productivity in Spain. That would be a good thing, and there are many things the Spanish can do in terms of liberalizing product labour markets, various investments, et cetera, to improve productivity. The Spanish government, to its credit, has implemented a number of major reforms in these directions. The challenge is that that takes a long time to pay off, measured in multiple years, maybe a decade, before you really see the full benefits of those so-called structural reforms.
The third way to re-equilibrate things is for German wages and German inflation to go up, German prices and wages to go up. The answer here is that all three need to happen in some degree, but the adjustment in Germany or the inflation or reflation in Germany we think is essential to resolving these imbalances. German real wages have barely moved over the course of the last two decades. It is an incredibly productive economy. There is an opportunity for those to move up, but it is also a society that is understandably less than enamoured with modest inflation. That is part of the challenge that is being played out in the euro area as we speak.
As I say, the answer in the end will likely be a combination of the three — hard reforms, fully implemented in places like Spain; this is being done and over time there will be some benefit from that. The large unemployment that we see in Spain at the moment will put downward pressure on wages. We have not fully seen that yet, but it will happen. Gradually, a monetary policy that will be quite loose, appropriately so, for Europe as a whole will build price pressures in Germany relative to the rest of the eurozone given its relative health.
I will not get into fiscal federalism, which might be part of the necessary solution for Europe as well, but that would play into it.
[Translation]
Senator Hervieux-Payette: Thank you, Mr. Chair, I apologize for being late, I had some work to do for the Speaker of the Senate.
I read some press clippings about the presentation you made yesterday. I was a bit surprised. You are usually logical.
[English]
Mr. Carney pushes tax incentives to boost spending, and Canadian companies are sitting on some $250 billion in cash. Why do they need tax incentives if they already have $250 billion in their bank account?
[Translation]
Could you please give us an idea about that? A bit later you talk about the capital cost allowance that we have greatly improved, and corporate taxes, which have been dramatically lowered.
Mr. Carney: Precisely.
Senator Hervieux-Payette: What happens to the $250 billion?
Mr. Carney: The articles are referring to the issue of dormant money in Canadian companies. One of the reasons this situation exists, is uncertainty about the global economy. That is absolutely clear. It is difficult for the Bank of Canada, for the government and even for the Senate to regulate or eliminate that uncertainty in Europe, in the United States and in China.
But we can provide certainty about monetary policy, and that is the responsibility of the Bank of Canada. Certainty about the budgetary situation is the responsibility of the Government of Canada. And through monetary policy, we can encourage investment now. That is one of the reasons why Canadian monetary policy is as accommodating as it is now, and a key interest rate of one per cent is of course very accommodating.
As for taxes, that is a decision left to the Government of Canada. I have observed measures that the government has already implemented such as the accelerator capital cost allowance, which is an advanced investment method. With such a measure, the investment period for a company is changed. There are several options. Others exist as well, but this matter does not concern the Bank of Canada.
Senator Hervieux-Payette: First of all, I get the impression, whether it is the business world or our banks, not to say that you are a voice in the wilderness, but you often say that Canadians are carrying too much debt. Do you meet with bankers and tell them that we should slow things down a bit with respect to indebtedness? Generally speaking, one carries a debt with financial institutions, not our neighbour. And then we have businesses that are more or less sitting on $250 billion.
I noticed the issue of incentives. I am not certain that would work. Are there any other mechanisms we could use, for example finding a new way to commercialize Canadian products?
With exports, we seem to be lagging behind most OECD countries. We do not export enough finished products. If we want to stimulate productivity, we should install more modern equipment and use technology more.
How can we help these businesses and assist them in opening new markets as Germany did? Germany is one of the world's largest exporters. Are there mechanisms in Canada to encourage our companies to progress rather than keep saving?
Mr. Carney: As you mentioned, it is one way to encourage investment by Canadian companies. Our exports are structured in such a way that we are too closely bound to the United States. Canada has lost 2.5 per cent of market share over the last decade. Our share has been chopped in half in the case of manufacturing exports. Why is that? One reason is that we do not have access to markets that are growing as rapidly as China, Brazil and India.
[English]
There is an opportunity to develop these markets, which is part of the solution to this issue. The more progress we can make on what is a very ambitious trade agenda that the government is pursuing the better. More tangible progress made there will provide clear opportunities for investment in new markets.
It should be observed that, with a broader network of trade partnerships, there is the ability for our firms to be part of global supply chains that might ultimately have an end demand in these emerging markets. It could end up just being an export. We could be part of a supply chain that accesses the U.S. and Europe and then goes on to China. That ability should help to unlock some of this demand. The major tangible things that can be done are on the trade side, as you have mentioned. It is not our role on tax policy, but it is merely an observation that that type of shifting in time of the incentives on tax may be appropriate.
The last aspect is to create an enabling environment for investment, to reduce — to the extent to which there are large development opportunities here in Canada — uncertainty about the ability for those projects to go forward and to develop new opportunities that the private sector can invest in.
Senator Tkachuk: The Wall Street Journal reported that Daniel Tarullo, a top Federal Reserve official who we were fortunate to meet last week due to your kind intercession, Mr. Carney, has called on Congress to consider capping the size of the nation's financial firms, making one of the highest profile challenges to the way Wall Street does business. I would like you to comment on that. Do we have those problems in Canada? Do we have any banks in Canada that are too big to fail?
Mr. Carney: The sting was in the tail there.
Well, no. Governor Tarullo's speech is important because behind that news report was a broader speech. It is important in the context of American regulation and the history of American regulation.
In the banking sector in the United States there has been a history of restrictions on the size of institutions. One of the core ones was that no institution could have more than 10 per cent of the deposits in the United States. That is a restriction that still exists. Some institutions are starting to bump up against that limit.
We have not had that history of explicitly restricting size. Obviously, we have a competition policy here, and there is a relationship between size, competition and financial stability that is watched closely by the bank regulator, OSFI.
There are two broader issues for a country like Canada that need to be considered. The first is the relative size of the financial sector versus the economy as a whole. I will give you my conclusion first, which is that we do not think this is the case in Canada, but there were other economies in the world where the size of their financial sector was multiples of their GDP — five, six times of GDP. In effect, there was a realization that the financial sector was too big to save. It was not too big to fail; it was too big for the resources for the country in question. Iceland would be one example of that. There were some concerns in Switzerland that the aggregate size of the financial sector was potentially too large. It was dealt with.
Some of those countries, and I think specifically Switzerland, Sweden and the United Kingdom, where there are very large financial sectors relative to their economies, have been more aggressive earlier on concerning this too-big-to-fail question, and that is the second consequence for Canada. Every economy has to think about this question of ending too-big-to-fail and ending the perception of too-big-to-fail. Ending too-big-to-fail is central to the agenda of the Financial Stability Board and, by extension, to Canada as a whole.
There are a variety of mechanisms or policies necessary to do that. Some of them relate to reforms to derivatives and other markets so that those markets continue to function if a firm fails. We are implementing that. We have made some important decisions and announcements over the last few months on that. Others relate to resolution strategies, the ability to resolve an institution when it gets into trouble. The government has introduced and, I believe, passed legislative changes that affect some of the powers of CDIC, which is one of the resolution authorities in Canada, over the course of the last several years, so that aids through a so-called bridge bank structure.
There is another area that we are looking at internationally, which is to ensure more transparently that non-equity creditors can be bailed in if a firm fails. What that means is that instead of having taxpayers bail out an institution that runs out of the equity that it has because of losses, that more junior creditors, the subordinated debt holders or some of the unsecured debt holders — not the depositors — would actually have their debt converted into equity in the new bank to absorb some of the losses.
That would do a couple of things. First, it would prevent the need to put taxpayers' money up there to bail out the institution; and, second, the knowledge in advance that that is what would happen if the bank failed would mean that these debt holders actually worry about their investment in large bank bonds and they would be more cautious and hold the banks more to account, which was certainly not the case in the run-up to the crisis when bank paper traded and even very risky banks in the end traded at levels that were heavily influenced by the strength of the country in which they operated.
Those are some of the things that are being done and could be done to help address the issue you are raising.
Senator Tkachuk: I am not sure if you answered the question.
Mr. Carney: Was your question whether we want a cap? I thought it was a great answer to your question. Rate it as we go. Is the question, "Is it our view that we should have a specific cap on size in Canada?" The answer would be no. Do we have a cap on size in Canada? The answer is no, but is there a competition policy in Canada and are there other financial stability considerations here? The answer, of course, is yes. Do those effectively limit the degree of concentration in size? Yes, certainly in terms of concentration and mergers, with the ultimate responsibility being held by the Minister of Finance.
Senator Tkachuk: I have one more question. I am concerned, as you can tell by the first question, about what is happening outside of our country.
I want to go to Europe now. On the second page of your presentation, you said, and a lot of people use that word: "The inflation outlook in Canada is subject to significant risks. The Bank's projection assumes that authorities in Europe are able to contain the ongoing crisis . . . ." The word "contain" means kind of plug the hole with your finger, right?
Mr. Carney: Yes.
Senator Tkachuk: It shows that you or maybe the bank is not that hopeful that they would actually cure the problem, which would be the ultimate solution. If all they will do is contain it, to me all that means is that we are good for another three or four months and then all hell will break loose again. How long can this go on, containing it?
Mr. Carney: It can go on for quite some time and has gone on for quite some time.
Senator Tkachuk: That is a very good answer, too. It has.
Mr. Carney: It has gone on. It means exactly what you say. It is important that we all recognize that. We are not saying that we are assuming that they resolve the crisis; our projection does not assume that the euro is fully "refounded" and relaunched. In fact, by 2014, which is the end of our projection, the European economy is still smaller as a whole than it was in 2007. It has not clawed back to the level of 2007, which is true stagnation. That is the first point.
Second, what would it take to resolve the crisis? There, we argue — and we have said this publicly — that this should be measured in years, not months. It could take anywhere between three to five years for them truly to resolve this issue. It would actually be in everyone's interest, in our view, if that were transparently, upfront acknowledged and, in fact, a date were set for the ratification of certain amendments, which one would think from afar will be required of the European Constitution in order to have some degree of fiscal federalism, I will call it, which is a Canadian term — a transfer union, a European term, or euro bonds, another European term. Some element of pooling of fiscal resources would be required, clearly a constitutional adjustment. There may be constitutional adjustments required in order to enforce a true financial union, to create a banking union, in their terminology.
We talked earlier about the Spanish reforms as one example. The payoff for those reforms will take five years, probably. Even flawlessly executed, it will take that period of time. The adjustment on the fiscal side from big deficits to sustainable fiscal balances will take somewhere between that three- to five-year horizon.
Our suggestion to our European colleagues is obviously to continue doing what they are doing and working toward these solutions, but set expectations around that time frame, ensure that the countries that are most affected have access to resources to finance themselves over that time frame so we are not living through a series of crises every three months because country X will potentially hit the wall and needs to have things adjusted.
I will make a tentatively bold prediction that next time we are here we will be saying we assume the European crisis will remain contained — and contained and contained and contained — and it will be some time before we actually have an expectation or a forecast that has resolution of the crisis.
Senator Ringuette: Welcome on this trick-or-treat day.
You stated in your presentation that the bank continues to project that the expansion in Canada will be driven mainly by growth in consumption and business investment. Business investment, as you also indicated yesterday, is not that hot; they are keeping their money in the bank even though the interest rate is very low.
Last year we drastically eliminated most of the tariffs on equipment. I am looking at the most recent KPMG Competitive Alternatives Special Report on tax comparing corporate taxes from 14 countries. In overall corporate income tax rate, Canada is the lowest, at 15.2 per cent, followed by the Netherlands and then by China, who are at 23.5 per cent. You can then go into more detail and look at manufacturing. Canada ranks second with regard to corporate income tax for manufacturing at 22.5 per cent. China is first at 20.7 per cent, which is not a lot of difference with regard to corporate taxes. There is a big difference in the U.S., of course. We all know that.
With regard to the two premises that you have stated for economic growth in Canada, business investment is not there and the reduction in corporate taxes and in tariffs on equipment has done nothing to spur investment, so we need to seriously question the business investment scenario.
With respect to growth in consumption, the only way you can get Canadians or other citizens to consume more is to increase their income, and we all know that in the last 20 years income for middle-class and lower-class citizens has been practically stagnant.
I am looking at that scenario on the one hand and on the other at government deficit. We have a major deficit in our infrastructure. If there is ever more consumption that brings forth corporate investment, infrastructure will be desperately needed, and we are in a deficit situation, as is consumption. Your answer may be that this is a government economic policy.
The Chair: Senator Ringuette, half your time is up and the question has not yet arrived.
Senator Ringuette: I will ask my two questions.
That being said, first, you are asking for more corporate tax cuts although that has done nothing to spur growth. The other major issue is that we still have a very high Canadian dollar that is not helping to spur corporate investment in producing goods to be exported.
Mr. Carney: I draw your attention to page 25 of the English version of the report. In the bottom right corner, Chart 3-E shows in red the path of business investment in Canada since the recession and recovery. The blue line in the middle of the gray is the historic average.
We had a sharp falloff in business investment immediately after the recession, as indicated by the vertical line, and then a recovery from that trough. Business investment is growing in line with previous recoveries. Everything in gray is the path of business investment historically since the Great Depression. It is a little less than the historic average. We have termed that solid but not spectacular. That is a fair description of the business investment performance in Canada. The dotted lines are the forecast going forward.
Our forecast for business investment is growing between 5.5 and 6 per cent depending on the year. Again, that is solid business investment, and it is an important contributor to the level of growth because, from a contribution to growth perspective, in 2013, for example, our expectation is that we will get 0.7 percentage points of growth from business investment out of a total of 2.3 percentage points of GDP growth; that is, a little more than a quarter of growth will come from business investment. That is a decent share given the relatively small share of business investment.
We should be careful not to overstate the case on business. Canadian business is investing. One can make an argument that they have more resources to invest and more opportunities to invest in. Some of the uncertainty in the global economy is undoubtedly holding them back from taking full advantage of those resources and opportunities, and anything we can do to reduce that is welcomed.
We do not have a big tax agenda. This is just an observation about a measure that the government has taken; it is not us pounding the table for additional measures. I wish to be clear about that. Also, it would not be appropriate for us to do that.
Consumption is about half of the contribution to growth space, so 1.2 percentage points of consumption contributing to growth. That is consumption growth of about 2 per cent per annum next year, for example. Our view on disposable income growth is that it will be about 3.5 per cent per annum next year. It has been running a little higher than that. It is slowing down a bit, but it is 3 to 3.5 per cent over the course of the projection horizon. Consumers are running into deficit with borrowing above and beyond consumption for investment in housing and other things. We see that starting to adjust over the course of the horizon.
While there are challenges with the growth of middle class wages and adjustment in inequality, again, relative to the overall economy, the income growth is certainly sufficient to support that level of consumption. Consumers could decide not to consume for a variety of reasons and other things could happen that would cause us to have to change our projection, but it is an eminently achievable consumption outcome, and it is a slower growth and consumption than we have seen previously.
I am not sure I caught the question on the dollar. I can say that we do have a dollar and it does float.
Senator Ringuette: How much influence can you have on the value of the Canadian dollar in order to enhance the opportunity for our manufacturing sector and our business community to be more competitive worldwide and have a better crack at the export market, although it has shrunk?
Mr. Carney: Monetary policy is an important determinant of exchange rates, although not the only determinant, but the objective of monetary policy is not so narrowly circumscribed. The objective of monetary policy is to deliver low, stable and predictable inflation, specifically, a 2 per cent increase, on average, over the medium term in total CPI inflation. That is the agreement with the Government of Canada. That is the mandate of the Bank of Canada, and we conduct monetary policy in order to achieve that. By being consistent in the achievement of that, we help to ensure that the borrowing costs for Canadian firms and Canadian households are lower and more stable than they otherwise would be, and we help to ensure, among many other things, that the most disadvantaged Canadians are not affected by high and variable inflation, because they are the ones who would pay the price if we were to not succeed in fulfilling our mandate.
Senator L. Smith: There is a fiscal cliff in the U.S. We have been told that by year end there is a cliff. There is an election coming up; the House of Representatives and the Senate have been at odds on getting things through. What has to be done? Will it take place? As citizens reading the newspapers, it is kind of scary. What is your assessment of what will be done? When and how does it all get done?
Mr. Carney: I will preface my answer by emphasizing that we are no wiser on this than anyone else. We are not in possession of any deep insight in terms of how this could be resolved. The challenge, as I am sure you know, is that there is an expiration of some fairly significant tax cuts, the so-called Bush tax cuts, and there is a disagreement between parties whether some of them should be retained — that is, middle-class and lower-class tax cuts retained and the upper-class ones allowed to expire or not. There are some immediate reductions in defence spending and other spending. There are other elements, but the sum of those measures — and they are all in legislation, so all will happen automatically if nothing is done — both in our estimation and in the estimation of many others, is in the order of 3.5 to 4 percentage points of GDP. We have U.S. growth next year of 2.3 or so, and embedded in that 2.3 percentage points — the net fiscal drag will be 1.5 percentage points in the U.S. next year. In other words, if none of this happened, and if everything else in the world were the same, you could argue that the U.S. would grow at 3.8 percentage points next year. That might not be a good strategy because ultimately they have to adjust their fiscal path, but that is where they are. If they had the additional contraction from the fiscal cliff happening and nothing changing, they would be pushed, on our numbers, into recession. That does not fully take into account potential confidence effects. Obviously, driving off the fiscal cliff and not doing anything about it would suggest a certain degree of policy gridlock that could be unsettling to both businesses and financial markets.
American authorities are fully aware of that on both sides of the House and Senate, so we would expect them to work toward resolving it. The challenge is, though, that it involves a negotiation and there are some fairly strong opinions on both sides. We have seen brinksmanship in the U.S. before and there is certainly a possibility of it again. We cannot easily map out the solution, and we will not even begin to get a sense of the hardness of positions until after November 6. It is an uncertainty.
Our view is that this uncertainty is actually helping to dampen the growth of investment in the United States at the moment because it is a material uncertainty at the moment.
Senator L. Smith: Is that the best worst-case scenario?
Mr. Carney: A reasonable scenario is some sort of fiscal adjustment on the order of magnitude that we have in here of 1 to 1.5 percentage points — something in that range, with some mixture. I would not want to speculate on the worst-case scenario. I think an unfortunate one would be a scenario where the measures were allowed to take effect and then the negotiation would be back from that level. You would have the drag that would be introduced from having the measures take effect January 1. That is, taxes would be higher and there would be less spending immediately, and then there would be an adjustment and a time lag before things were resolved. We will see. As will everyone, we will watch this one with interest.
To be absolutely clear, obviously, if the trajectory of the U.S. economy materially changes, that will have an impact on the outlook for activity and inflation in Canada, and obviously monetary policy would take that into account.
Senator L. Smith: Following that lead, household debt and changes in interest policy could be influenced by what happens in the U.S. and what happens in Europe. How do you condition people with mortgages at $100,000 to $200,000 at 2.5 points and suddenly interest rates go up by even 1 or 2 points so that people say, "It has only gone up one or two points," but it could be a double for some people? How do we condition people in terms of preparing them? I know you are talking a lot about it and saying watch your household debt. Other people are taking that message, but how do we avoid the reality of that occurring?
Mr. Carney: Part of it is talking about it and making sure that people understand the reasonable possibility of where interest rates could go and certainly over the lifetime of a mortgage where they could go. Second is to ensure that, to the extent possible, the underwriting standards of financial institutions are as robust as they should be. OSFI has taken measures to do that in the last few months, ensuring that the credit standards of CMHC are strong and that they have also taken those adjustments. Finally, one must ensure that the terms of the actual mortgage are prudent and not to excess.
Beyond that, it is a little difficult. There are obviously individuals who will take these decisions, but from time to time products have offered fixed rates for a five-year or ten-year period, which is a new product in Canada. Obviously, that insulates an individual family from that type of risk, which is a possibility.
To make one other point on that, the other risk that individuals have to take into account is not necessarily a bet on where Bank of Canada policy goes exclusively, because a mortgage rate is a product of where the bond market goes. While we are all familiar with how low government bond rates are on a global basis, there are scenarios where there could be an increase over time in government bond rates — not because of monetary policy but because of just the sheer level of borrowing and uncertainty that develop on a global scale, the sustainability — a credit premium coming into those bonds. That would also affect mortgage rates over time as people renew.
[Translation]
Senator Massicotte: First of all, if I may, I would like to clarify something. You mentioned that the economy grew by 2.3 per cent in 2012 and 2013. Canadians, hearing that number, will think that all is well, I am sure. But at the same time, the population grew by nearly 1 per cent.
What percentage would be required for Canadians to feel that their personal income is increasing? Because over the last decade, they have seen very little improvement. We also see a problem of income disparity. The average Canadian has not saved anything and has not increased his income, and yet we hear about an economic growth rate of 2.3 per cent.
What percentage of growth do we need to attain for Canadians to feel richer and to start spending more money and stimulating the economy?
Mr. Carney: First of all, we are talking about the medium-term rate of productivity growth. The Bank of Canada has updated its estimates of the productivity growth rate and the rate of labour supply in Canada. Ultimately, the Bank is forecasting a 2.1 per cent yearly rate of growth for the Canadian economy by the end of 2014.
This gives us a sense of the challenge involved in significantly increasing the well-being of Canadians in the context of such rates of growth. In the medium-term, it is undesirable for the economy to grow more quickly than the potential rate because the current productivity gap is approximately two thirds of a percentage point.
So in order to have a sustainable rate of growth and the low, stable, predictable inflation rate we want, there are limits to having a growth rate that is much higher than 2.5 per cent.
Senator Massicotte: When you say 2.3 or 2.5, you are talking about the country's GDP growth rate.
Mr. Carney: Yes.
Senator Massicotte: Per capita, with a population growth of nearly 1 per cent.
Mr. Carney: Slightly more.
Senator Massicotte: In other words, if we need 1.5 per cent to get to the same point, per capita, we have economic growth in the region of 1.0 or 1.2 per cent, which is not enormous. And with income disparity between a percentage of the Canadian population who have enjoyed a major increase in income and the middle class, which has remained stable, the situation is not very encouraging. Perhaps we are giving Canadians a false idea as compared to their expectations.
Tiff Macklem, Senior Deputy Governor, Bank of Canada: As the Governor just mentioned, on page 25 of the French version of our report, you will find a table that illustrates our forecasts between now and 2015 in terms of potential growth, which is divided in two factors: labour productivity and trend labour input growth.
The issue you have raised is whether labour productivity can increase the standard of living for Canadians. According to the table, the 2012 rate was 1.2 per cent. We anticipate this rate to increase slightly to 1.5 per cent for 2014-15. This year, the investment growth rate is approximately 10 per cent. In our forecasting, as the Governor just mentioned, we anticipate a solid performance but not a spectacular one like 5 or 6 per cent. This rate is higher than the GDP rate, where the amount of productive capital in the economy will continue to increase. This is one of the major reasons why we are seeing an increase.
It is also possible that everything will progress more rapidly. We have discussed several times the challenges and opportunities for businesses in increasing their productivity. These would be investing in machinery and equipment, developing new external markets, especially in countries that are growing rapidly and investing in talent and the workforce. So it is possible that everything will progress more rapidly, and I hope that will be the case. The economy can grow more quickly with stable inflation. However, our forecasting must be balanced, and that is what we have provided.
Senator Massicotte: Let us consider the issue of income disparity. This is a very serious problem in other countries such as the United States, less so here in Canada. Over 10 years, 1 per cent of wealthy people have seen their income increase much faster than that of ordinary Canadians. Could you comment on the importance of this disparity? We must find a solution. Historically, wars have often resulted from too great of a disparity in incomes. It is not a problem in Canada. But it is something we should be more and more concerned about.
Mr. Carney: Income disparity and inequality is a problem. This problem exists in all the major advanced countries, and the situation has been worsening over the last few decades for several reasons, including globalization and the increasing use of technology in the workplace.
In Canada, we are in the middle of the pack of advanced countries with respect to the Gini coefficient. You are correct in saying that the disparity ratio in Canada, as in the other advanced countries, has worsened over the last decade. What can be done? According to the Bank, the solutions are rather medium-term. There are no immediate solutions nor simple ones. The level of talent must increase as well as opportunities for all middle class people in Canada. It is mainly a question of education and training in the workplace. In Canada, just as in the other advanced countries, we have observed an increasing gap in salaries between jobs that require technological skill and other types of employment. We have also noticed that more and more responsibilities or jobs are interchangeable. More and more services, for example, or aspects of a service, are being shared.
[English]
It is produced in other jurisdictions, and their wages have an influence on the wages that are paid here in Canada. The way out of that challenge is, as I said, to increase the skills of individuals and to ensure, in the broadest sense of the term, that our position in global value chains is at the higher end of those value chains as opposed to the lower end. The alternative of this, in our view, would be more of an "immiserating" strategy of locking ourselves off from the global economy, which would not serve.
[Translation]
Senator Maltais: It is always a great pleasure to see you and more specifically to listen to you. You teach us a great deal about international economics.
Governor, in your report, without being alarmist, your advice to Canadian families and to the economy is to be prudent. In that respect, I will come back to comments made by Senators Smith and Massicotte. The average Canadian makes up a large portion of the Canadian population.
Take the example of a couple whose combined income is $70,000. They own a small house and a car, and have two children. Naturally, they have a mortgage on the house, car payments to make, children to send to school, property tax to pay and insurance costs. That couple does not have much room to manoeuver. Unexpected expenses would be difficult for them.
What advice would you offer that couple for the coming year, in order to get through the slowdown that you are suggesting in your report?
Mr. Carney: We try never to give investment advice to Canadians. We hope that all Canadians understand that, even in a difficult economic situation across the world, in the United States, in Europe and to some extent in China, as we began to indicate today, Canada still has a lot going for it.
We have a lot of natural resources, a financial system that works well, a monetary policy that works, a budget standard that is solid and we are making gradual progress. But it is still progress. You must be prudent in managing your affairs, but ultimately, the Bank of Canada expects the Canadian economy to move forward, and that the growth rate will accelerate towards the end of this year and over the course of the next year. It will not be spectacular, but it is growth and it is progress.
Senator Maltais: So there is a fundamental stability? Everyone should be a bit prudent, but the situation is stable. We are not heading for a slump and the couple I used as an example is not heading towards disaster.
Mr. Carney: That is not the basic scenario.
Senator Maltais: He is not going to see a dramatic increase in his salary. He will have to make do with what he has, in order to get by, by being prudent. This is a prudent period.
Mr. Carney: That is right, a prudent period for Canadian families because we have seen an overall growth in Canadian household debt. So it would be best to be prudent.
In the Bank of Canada projection, our premise, our expectation is that prudence. We have a slight increase in household debt. Towards the end of the projected period, that comes to an end. So that prudence for your family is within that projection. Even with that prudence, the Canadian economy will grow, that is the Bank of Canada's expectation, our economy will grow at a very respectable rare. Consequently, wages and overall employment will both grow as well.
Senator Maltais: So the future does not look so bad for my couple, as long as they remain prudent.
Mr. Macklem: I might just add that we are beginning to see signs of a bit more prudence. That has just begun, so we should still watch this closely. That is why our report underscores the risks associated with household debt. Some indicators suggest a greater degree of caution, others indicate the opposite. So we are getting mixed signals, but the overall message is that we should be vigilant and watch this closely.
[English]
Senator Moore: Governor, back in April I asked you some questions. You said that the monetary policy stimulus is the overnight rate, and that is what you held at 1 per cent the other day. I am looking at the bank's financial statistics of this month and I am looking at the business loans. I heard what you said earlier about trying to encourage this. However, in 2008, those loans stood at $180 billion and are relatively the same this year; they are up a little bit, but nominally. I look at that and I have to wonder whether you would agree that the policy is not getting the results that you had hoped for.
Mr. Carney: I would take a step back and look at the Canadian economy as a whole, which opened up a very large output gap in the immediate aftermath during the great recession, globally, and which grew at a rate stronger than virtually all major advanced economies. Importantly, that was due to the degree of monetary stimulus that was provided at the time. It is an economy that is now in an expansion, not in a recovery; we have fully recovered not just the jobs lost but the GDP that was lost in the recession. Incomes are growing. Employment has grown by a further 300,000-plus jobs.
I would note that our output gap is now around two thirds of a percentage point. Also, despite the very considerable headwinds that this economy faces from abroad — weakness in the United States and Europe being examples — and the strength of our Canadian dollar, which is related to that, we continue to grow. Our expectation is that we will, over the course of the next year, take up the remaining amount of slack gradually.
There is a final thing I would note. On an aggregated basis — so building up from not just the line item you are citing there but the broader business credit growth, which would include capital markets, issues and other ways of raising credit in business — on page 21 of the report, you do not have to necessarily go to it — but we have seen that business credit growth has picked up above its historic average. It is also growing at about 6.5 percentage points on an annual basis. What we have seen, and what is shown very clearly in that chart, is that the rate of household credit growth has decelerated, as we and others would desire, while business credit growth has accelerated. Business credit growth is now growing faster than household credit.
Mr. Macklem: The other point is that debt equity is very low. Corporations have lots of retained earnings, so there is ample scope to invest.
Senator Moore: I am cognizant of your remarks with regard to a possible bubble in the housing market. I look at the starts in 2008 — we were at 211,000 — and this July, the average is 209,000. However, residential mortgages have gone up from the same period — 2008 to 2012 — from $487 billion to $864 billion, a 43 per cent increase. I see the same or less housing stock and a huge increase in mortgages. Housing prices must be hyperinflated. I am cognizant of your comment about the household debt being 167 per cent, so where do you see that going?
Mr. Carney: Household debt?
Senator Moore: No, the issue with regard to mortgages, housing and so on.
Mr. Carney: Our expectation is spelled out in aggregate in terms of the share of residential investments, which are new houses, renovations, and included in that share is the commission component on resales. That has been running above its historic average. It has been running about 7 per cent of GDP in the last few years. Our expectation is that that will come off over the course of the projection horizon toward this historic average, that actually there will be a decline in residential investment that is started.
Senator Moore: Do you think the mortgage number will come down?
Mr. Carney: There is a lag with mortgages in terms of how they show up in the statistics, but over time there should be a continued deceleration in new mortgage credit in Canada. Our expectation is that the household debt number will peak over the course of the projection horizon by the end of 2014.
Senator Moore: You mean by the end of the 2014?
Mr. Carney: By the end of 2014, it will stop. In our projection, it is consistent with the end of the growth of household debt measured against income, which is just one of the aspects of this, obviously.
Senator Moore: That is if these assumptions hold.
Regarding personal debt, you mentioned that in 2008, credit cards were $49.9 billion and line of credit was $160 billion. Now they are at $76 billion and $241 billion respectively. There is almost a 50 per cent increase in personal lines of credit. It looks to me like people are taking on debt at interest rates that may be prohibitive and we do not see the economy moving ahead, so the banks or the institutions are lending money out. Are we setting up a trap here for consumers? How long will you keep the rate? I do not know how else you can deal with some of these things unless you send a solid message.
Mr. Carney: Let me deal with the specific and then move to the general.
There has been a move to increase personal lines of credit because those are credits secured against the equity in housing. There are fairly strict restrictions in terms of the amounts, the underwriting standards. In fact, OSFI, which oversees this, has tightened those standards further in the course of the last couple of months. Those have now come into effect.
This shift toward personal lines of credit in many respects makes sense. It is not substituting more expensive debt; it is substituting less expensive debt. If you are repaying your credit card with a personal line of credit, it is very tough to be paying a higher interest rate than you were on your credit card in that example, so there is some logic there. That said, our estimate has been that up to about 20 per cent of consumption over the course of the last several years has been financed through increases in personal lines of credit — not just the shifting of one debt to another but actually using it. This can be consumption for home renovation or for a variety of things. Obviously, that is a channel that, as you borrow against the equity of your home, is a dynamic that tends to happen when house prices are increasing but not when house prices start to move sideways or fall.
Senator Moore: Are you saying that mortgage figure includes that? That is not correct.
Mr. Carney: No, the personal line of credit, which you were referencing, should include that. That is the specific.
To the general, which is what is the role of monetary policy in all of this, as we have been discussing, there are many headwinds against the Canadian economy from the rest of the world. There is a challenge to encourage business to invest. There are pressures on the currency. There are a variety of reasons why it is advantageous to have a very accommodative monetary policy. That is what we have here in Canada, a very accommodative monetary policy consistent with the achievement of that 2 per cent inflation target.
One of the known side effects of having low interest rates for a period of time can be the buildup of financial imbalances in various sectors of the economy. We are talking quite rightly about the household sector. That is one of the known side effects.
There are various lines of defence to address those risks. The first is the responsibility of individuals in ensuring that they understand the risk, as we were talking about with Senator Smith; the responsibility of financial institutions in their lending practices; then it is the regulations of OSFI in terms of how much capital is required, how good their underwriting standards are. Then it measures the so-called "macro-prudential measures" that the Government of Canada has taken, which has been to tighten the mortgage insurance rules of CMHC on four different occasions. All of those are more targeted ways of reducing the risk that you are focused on. Monetary policy ideally is complementary to that, so it is not pushing in a different direction.
Under our flexible inflation targeting regime, we could use monetary policy as the last line of defence to reinforce these other measures if it were necessary. As Mr. Macklem just noted, we are actually getting some mixed signs in terms of the evolution of household imbalances. There has been a slowing of the rate of growth of debt that is notable. We think that is continuing as we speak. There have been signs of adjustment in the housing market itself in various pockets. The condo market is still pretty hot, but the other housing markets are adjusting.
We, with others, are continuing to watch the situation, be vigilant, and we will respond as appropriate.
[Translation]
Senator Bellemare: Good afternoon, Mr. Governor, my questions deal with the forecasted growth rates for potential production. In 2015, we are told that we will get a potential production of 2.1 per cent. And on page 29, in table 24, we see that unemployment rates remain fairly high in Canada.
Perhaps we have become accustomed to living with such levels. In the United States, people would be highly critical of a labour market with levels of unemployment like that. If we reached the production potential — and I gather we are not far from doing so — what would the unemployment level be according to the assumptions for the growth of potential production?
Mr. Carney: Thank you for your question. I apologize for the answer I am going to give you. The bank does not actually provide a specific forecast of the national rate of unemployment. Naturally, the unemployment rate will go down somewhat with the expected rate of potential growth for the economy by the end of 2013.
I can state that there is still an excess supply in Canada's labour market. The employment to population ratio that we observe is probably two percentage points lower than it was before the recession. There is still some latitude in the labour market; when the potential level is reached, the unemployment rate will go down, but I cannot give you an exact number.
Mr. Macklem: On page 25, you see the trend labour input growth, which reflects several aspects of the state of the labour market, such as the employment rate, the percentage of active workers in the population and the number of hours worked. Estimates of future growth rates are shown and they take all those labour factors into account.
Senator Bellemare: If I understand correctly, there is still some latitude for the unemployment rate as you said, meaning that it will remain relatively high. Especially since it may vary from one province to another.
Mr. Carney: It is possible that the unemployment rate will remain higher than it was before the recession. There are several reasons for that, but one of them is the adjustment of the economy within sectors. People will have to learn new skills and acquire new talents, and that will require time. This partly explains the longer periods of unemployment we are seeing currently in Canada, much longer than in the United States, unfortunately.
Senator Bellemare: My second question pertains to your conclusions regarding the future risk of inflation where you say that things are quite balanced, that the risk of upward or downward inflation is balanced. Do you have any fears in that area? It has not been written down. Could you elaborate further? Do you have any concerns about cost-related inflation? Here we are more concerned about demand-related inflation, such as we experienced during the oil price shocks of the 1970s.
In the immediate or mid-term future, does your radar screen show the likelihood of an unpredictable spike in cost- related inflation? Now that our economy is strong but the unemployment rate is high, we may find ourselves reliving the disasters we experienced back in the 1980s.
Mr. Carney: There is always the possibility of a price shock for raw materials, of course. As far as the Canadian economy is concerned, some price shocks for raw materials are positive. The price of crude oil has risen dramatically. That has a positive impact on the income earned by Canadian companies and workers. That also has an impact on investment levels. But, as far as the Bank of Canada is concerned, the most important question is whether the shock is temporary or persistent.
If it is temporary, it is better to weather the shock. If we react immediately, if we adjust the key lending rate very quickly and it has no immediate effect, the temporary shock then goes away. There is too much volatility. But if the shock is longer-lasting, the Bank of Canada will react.
Senator Bellemare: Thank you very much.
Mr. Macklem: I wanted to add that one strength of this system to target inflation is to be clear about our two per cent objective. Our ability to anticipate inflation is much better tied to targets than it used to be. The likelihood of a temporary spike in the cost of commodities or oil having an impact on other costs in the economy and on salaries, has been reduced significantly compared to when we had no clear target.
We are now observing that supply-related shocks are having significantly less of an impact on inflation than has been the case in past years.
Senator Bellemare: That is good!
[English]
Senator Stewart Olsen: I would like to go back to household debt briefly. The Canadian economy is doing very well through this global crisis and recovery time, but the one little cloud on the horizon that was raised was Canadian household debt. You are now saying that it is slowing and that things are looking good. However, you also identified the slowing as a probable risk. What is your balance point?
Mr. Carney: That is a very good question. As we said, we are seeing some mixed signals. There has been a deceleration of the rate of growth of household debt, but it is still growing faster than household incomes, 5.5 per cent, and most recent figures say household disposable income is going at 3.5 per cent, so there is still that increase overall in the debt burden across Canadians. We are seeing mixed signals in the housing market where resales are below their historic average but housing starts are still well above the rate of household formation. I believe 220,000 starts, roughly, was the most recent figure, whereas new household formation was around 190,000 new households, so we see some mixed signals there.
In terms of a balance point, there exists the prospect of an equilibration of the household debt burden over the course of the horizon. Our expectation is that it will balance out and stop growing by the end of the horizon. Assuming that is the case, households as a whole in Canada will be in a position where the actual debt service ratio of households is only marginally above its historic average. The actual cost of taking that household debt out is only marginally above. An important but still relatively modest proportion of households are in a challenging debt service position, that is, those who are spending more than 40 per cent of their income on debt service itself. Those are so-called vulnerable households. In that environment, we have reached a point where we have had an adjustment that is consistent with our economy growing ultimately to our rate of potential over the horizon and the household debt burden still being manageable.
The downside risk is that there is a much sharper adjustment in the housing market, the pace of accumulation of household debt associated with household consumption and economic growth, and that is reinforcing. We do not see that, but we do expect some adjustment. In the very short-term, given that the new standards of CMHC have come into place, and the government's measures and also the underwriting standards of OSFI have come into place roughly at the same time, we would expect to see some volatility in new mortgage underwriting given that whenever changes like this happen, often you have mortgages pulled forward before the changes come into effect, and then there is a bigger drop-off afterward. We will take a few months to look through the data to see how the things are, to use your term, balancing out.
The Chair: That completes round one. We now have three senators who would like to ask questions on the round two. These are the short, snappy questions, starting with Senator Massicotte.
[Translation]
Senator Massicotte: My question pertains to the same topic and I would like to give the Governor a chance to respond to an issue raised this morning in the newspapers, and on CBC, regarding mortgage debt. According to them, you somewhat overstate the risk of personal indebtedness to the economy.
According to their analysis, the disposable income in Canada, as a percentage, includes all health costs. By comparison, that is not the case in the United States. They, along with a number of senators, comment that the quality of the debt and the percentage of indebtedness are much less, and that a large number of Canadians have already locked in their interest rates. We will not talk about personal risks because that subject is too specialized, but the risks for the economy are perhaps not as great as what you and the government are claiming. I would like to give you an opportunity to respond to the comments made by those esteemed economists.
Mr. Carney: Fair enough. We are always receptive to comments from other economists and particularly by Canadians.
When the bank analyzes Canadian household debt, it uses a great deal of data. The analysis has several components. There is more than one ratio used. It is useful to base yourself on only one ratio in order to compare yourself to the Americans — or the English, who are in the same situation as the Canadians. In England and in Canada, there is no tax advantage in holding a mortgage. We do a great deal of detailed analyses in our reports on the financial system. These analyses use microdata, real measurements based on tens of thousands of Canadian households, their debt, their income and obligations. We do stress tests with the data.
There clearly is a problem, even with respect to the level or ratio of fixed indebtedness. There is a problem if the unemployment rate goes up. We quickly find ourselves in a situation where one out of 10 Canadian households has a problem or is vulnerable. We primarily use data provided by the CMHC. We do stress tests with the OSFI, we stress test the banks with the OSFI and we do many other analyses. We do not just do one graph.
[English]
Senator Ringuette: Last April, I asked you how much we had in the foreign exchange reserve and you said $60 billion, which was twice as much as 10 years before. Is it still at $60 billion? How does Canada have $60 billion, while the United States has $20 billion and seems to be content with that?
Mr. Carney: Do you want to answer that, Mr. Macklem?
Mr. Macklem: I missed the last part of the question.
Mr. Carney: Why are we content with —
Senator Ringuette: The first question is: Do we still have $60 billion?
Mr. Carney: I do not know the precise figure off the top of my head.
Senator Ringuette: Roughly?
Mr. Carney: We are in that order of magnitude.
The way Canada runs its foreign reserves, which are not on the balance sheet, we are the agent for the government.
Senator Ringuette: I know. I asked Minister Flaherty the same question. He referred the question to you, and you referred the question to him. It is hard to get an answer.
Mr. Carney: I will give you an answer. The first thing that senators should know is that the way the Government of Canada funds those reserves, it earns a small so-called "cost of carry" on those reserves. It borrows funds that are cheaper than the reserves it invests in. The government makes money on that $60 billion. That is the first point, and it is a relevant point.
Second, why do countries hold reserves? Traditionally, you hold them for prudence reasons. If you were the reserve currency, which the United States is, you would not have that issue of having a shortfall of foreign exchange because you are the numéraire of all foreign exchange. The United States is unique in not needing to have reserves.
That said, our proportion of foreign reserves, based on traditional metrics of foreign trade and of capital flows relative to the size of the monetary base in Canada, is actually quite small relative to history and to some other countries. This is because we have an open capital market with a free flow of capital and money markets in both directions and because we do not use these reserves, except in exceptional circumstances, to intervene in the market. In fact, the reserves are seen as part of a much broader liquidity plan for the Government of Canada to ensure that it has a variety of sources of liquidity for any possible eventuality. One thinks of market outages, natural disasters and financial crises. The government has a sophisticated liquidity plan, which includes foreign exchange reserves, assets on the balance sheet of the Bank of Canada and liquidity in a range of financial institutions to ensure that it can meet its obligations in a timely fashion.
Senator Moore: In their book A Monetary History of the United States 1867-1960, Milton Friedman and Anna Jacobson-Schwartz — you probably had that textbook at Oxford, governor — cited a study done by the Chicago Federal Reserve in 1944, coming out of the Great Depression. The study was to find out, as far as possible, whether and to what extent the small volume of bank loans was due to the desire of banks to retain or attain liquidity, the attitude of the examining officials or the unwillingness of businessmen to assume the risk of borrowing to maintain or expand their operations. The authors conclude that there exists a genuine, unsatisfied demand for credit on the part of solvent borrowers, many of whom could make economic, sound use of working capital. One of the most serious aspects of this unsatisfied demand is the pressure for liquidation of old working capital loans, even sound ones, and this pressure is partly due to a determination on the part of bankers to avoid the reoccurrence of the errors to which they attribute much of the responsibility —
The Chair: Senator Moore, the question please?
Senator Moore: The question is related to your comments with regard to the $250 billion in dead cash, the hoarding of money and the fact that you can lead a horse to water but cannot make it drink. Is this some of the frustration? Is history repeating itself here?
Mr. Carney: I think the difference is that in this decade in Canada, as opposed to the United States in the 1930s, businesses are readily able to access capital from the financial sector if they have uses for it.
I will finish with this. One of our messages to business is that if one of the reasons business is not investing in Canada is because they are worried that we could have a dramatic event from offshore that affects the Canadian economy and the Canadian financial system, it is our responsibility, alongside OSFI and the Government of Canada, to ensure that the strongest financial sector in the world is there in difficult times as well as in good times. Given the amount of capital and liquidity that the system has built up in recent years and the strong starting point that they had, that is a reasonable expectation. Business can rely on this financial system, borrow from this system and invest in productive projects if they have them.
The Chair: I think the Standing Senate Committee on Banking, Trade and Commerce's record will show that you very successfully answered a question out of a 1944 publication.
Senator Moore, we appreciate your bringing that to the attention of the committee.
Governor Carney and Senior Deputy Governor Macklem, on behalf of all members of the committee, this has been a most informative presentation, as always. We thank you for appearing before us.
(The committee adjourned.)