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Proceedings of the Standing Senate Committee on
Banking, Trade and Commerce

Issue No. 8 - Evidence - October 19, 2016


OTTAWA, Wednesday, October 19, 2016

The Standing Senate Committee on Banking, Trade and Commerce met this day at 4:15 p.m. to study the present state of the domestic and international financial system.

Senator David Tkachuk (Chair) in the chair.

[English]

The Chair: Good afternoon and welcome to the Standing Senate Committee on Banking, Trade and Commerce. My name is David Tkachuk and I'm the chair of this committee.

I'm pleased to welcome Governor Poloz and Senior Deputy Governor Carolyn Wilkins back before the committee. Our last meeting with them occurred in April regarding their spring Monetary Policy Report.

Thank you both for being with us today to brief us on our October 2016 Bank of Canada Monetary Policy Report released this morning.

Senators, a link to the report was sent to your office and the bank also brought copies today. Please signal the clerk if you need anything.

Governor, welcome. The floor is yours.

Stephen S. Poloz, Governor, Bank of Canada: Thank you very much, Mr. Chairman. Good afternoon, committee members. Senior Deputy Governor Wilkins and I are happy to be back before you today to discuss the MPR that we published this morning.

It has been six months, pretty well to the day, since we were last here. Several of the broad themes that we spoke about back in April remain in place today. The Canadian economy continues to adjust to low resource prices against a backdrop of weak global demand. This weakness, especially in the U.S. in the first half of this year, has combined with ongoing competitiveness challenges here in Canada to hold back our export growth. In this environment, many businesses have continued to be reluctant to invest. These issues are not new. However, there have also been several developments over the past six months that affected the outlook for our economy. Let me fill in some of those details and outline the bank's current economic forecast before we turn to your questions.

[Translation]

The second quarter of 2016 was a difficult one for the Canadian economy, which shrank at an annual rate of 1.6 per cent. The two main drivers of this result were a large, broad-based decline in goods exports, and the impact of the Alberta wild fires. These factors more than offset the strength we saw in household and government spending.

However, the economy is poised to rebound in the second half of the year. This reflects, in part, a return of oil sands production and rebuilding activity in Alberta. Indeed, we saw non-conventional oil output jump by almost 20 per cent in July. As well, exports of goods increased in July and August, pointing to a solid third quarter. A pick-up in the U.S. economy should help goods exports recover some — but not all — of the ground they lost earlier this year.

[English]

Let me spend a couple of minutes on the export story because a revised export forecast was central to our deliberations, as discussed this morning. Even though exports of goods have more than fully recovered from their dramatic plunge in 2007 to 2009, that recovery has persistently lagged our forecasts. The strong export performance of 2015 gave us new confidence, but this was shaken again in the first half of this year when we experienced a sharp decline of exports over a five-month period.

In our July MPR, we advanced what we viewed as a conservative forecast for exports in the sense that it assumed only that exports would grow roughly in line with the U.S. economy. We've seen a significant recovery in exports since then, but the net effect of this choppy data is that the level of exports is well below where we thought it would be by now.

It is true that international trade has been surprisingly weak globally, and we offer a box in this MPR discussing a range of interpretations of this. Also, the U.S. economy was quite weak in the first half of the year in dimensions that are very important to Canada's export sales. These factors taken together explain about half of the shortfall in exports relative to what we were expecting. For the remainder, we are looking at a range of structural factors, including lost export capacity and competitiveness challenges.

On the latter, in our surveys, companies have mentioned a number of factors that can influence competitiveness or hinder exports directly. These include deficient infrastructure, regulatory uncertainty, rising trade barriers, relatively high electricity costs and the unknown status of current and future trade agreements.

This analysis suggests that more of our export shortfall may be structural than previously believed rather than cyclical. This is what led us to indicate in our September decision that the risks around our July inflation projection were tilted to the downside. Our latest projections incorporate, therefore, a permanent shortfall in exports relative to our understanding of fundamentals in order to rebalance our forecast risks. This reduces the projected level of GDP by about 0.6 per cent by the end of 2018 compared with our July projection.

Such a reduction in our outlook for exports may sound odd given the depreciation of the Canadian dollar against the U.S. dollar, but some of our competitors have also seen large depreciations in their currencies. For instance, the Mexican peso has fallen by more than 30 per cent against the U.S. dollar since mid-2014, while the Canadian dollar slid by less than 20 per cent over that same period. So while the exchange rate will continue to support the current level of Canadian exports, most of the impact on export growth has probably already taken place.

The export weakness is expected to lead to somewhat softer business investment here. However, there are signs that the worst of this may be behind us in terms of investment. Our most recent survey of Canadian companies found that many businesses believe resource-related activity may be near a low point. Resource companies are expecting their sales to either level off or increase modestly over the next year. Overall, more firms than in recent surveys say they plan to boost investment spending over the next 12 months.

[Translation]

Household spending has continued to support the economy, with employment and income continuing to grow outside of energy-intensive regions, particularly in service industries. The bank's accommodative monetary policy will continue to buffer the impact on wealth and income stemming from the fall in resource prices.

The rollout of the Canada child benefit should start giving an extra boost to households in the second half of this year. In addition, the impact of the federal infrastructure spending that was announced in budget 2016 should begin to be felt. These measures together will boost the level of Canadian GDP by about 1 per cent over the 2017-18 fiscal year.

[English]

One further new development I would like to mention is the government's measures to promote stability in the housing market. With house prices still elevated in the Vancouver area and resales and starts still robust around Toronto, these measures should dampen resale activity in the near term. Our analysis and historical experience suggest these measures will reduce the level of GDP by about 0.3 per cent by the end of 2018, although there is much uncertainty around that estimate. While household debt levels have continued to increase, these measures should, over time, help ease the growth of economic vulnerabilities related to household debt and housing.

All told, we now expect growth over the third and fourth quarters of this year to average about 2.5 per cent, which is lower than we anticipated in July. This reduction reflects the downward revision to exports, the pullback in housing and a modest shift in the timing of federal infrastructure measures that pushes some of the impact into 2017.

We have reduced our growth estimate for this year to 1.1 per cent. The expansion in both 2017 and 2018 should be about 2 per cent growth, higher than the growth rate of potential. However, because the output gap is now somewhat larger than we projected and will close later than we expected in July, the profile for inflation is now slightly lower. We project that total CPI inflation will remain below 2 per cent through the end of this year, as disinflationary pressures linked to excess capacity and year-over-year price swings for gasoline will more than offset the inflationary pressure coming from a lower exchange rate. Total inflation should be close to the 2 per cent target in 2017 and 2018, albeit slightly below.

As always, there are a number of risks surrounding this base case. These include the risks of more sluggish business investment and weaker household spending, slower growth in emerging markets, possibly stronger growth in the U.S. economy and higher oil prices. We judge that these risks to our inflation profile are roughly balanced at this time. I would point out, senators, that we have changed the way we present these risks, beginning with this MPR. We are now reporting on how we see various aspects of the risks developing as well as setting out the indicators that we are watching in evaluating the risks. I invite you to take a look at that.

With that, Mr. Chairman, Carolyn and I would be happy to answer your questions.

The Chair: Thank you very much. I've got several senators who want to ask questions.

Senator Massicotte: Thank you for being here today. I must note, Mr. Poloz, that you've had a very difficult time since you joined the governorship. It hasn't been easy with all the turmoil. I appreciate your persistence and courage.

[Translation]

My copy of the report does not include the summary. Usually, the summary consists of two or three pages, unless I am mistaken. Is that right? I don't have the summary. Is that an exception or is it part of the communication plan? It may be an issue with my copy.

I have been seeing for a number of years that we — and we are not the only country — are faced with a major challenge of maintaining constant growth as in the good old days. This may be a matter of demographics, a matter of absorbing the blow of the 2008-2009 crisis. Is the past any indication of the future? Could we be going through the same experience as Japan, where there have been no wage increases or significant growth in 20 years?

There may be some advice that would make Canadians more optimistic, but all the news has been negative. What does the future hold for us? Can we be optimistic about the future or will we be told, in six months, that the growth is too high, once again, and in 10 years or 15 years, we will hear nice theories after the facts? At this point, we are not in control.

Mr. Poloz: There is a major debate in the profession on this issue. Our interpretation is that the global economy is facing the aftermath of the 2007-2008 experience. It was an extraordinary crisis in terms of debt levels. A lot of time is needed to remedy the underlying issues. You mentioned the Japanese crisis and what is happening 20 years later. It was more or less the same thing — problems stemming from overly high household debt. After the crisis in Japan, an extremely slow process ensued to remedy the underlying problems in the banking community.

However, the U.S. reacted very quickly by providing solutions to those problems. In Europe, the process has been much slower. You can see the resulting difference between the economies.

We depend on global economic performance more than those other countries do. We are not experiencing a crisis. The banking system has been very strong throughout this episode and it still is today. The only issue is the external demand. That is why we are emphasizing exports and performance. The results have been disappointing for several years. However, we think that we understand the majority of those fluctuations, although perhaps not entirely, as I said. Essentially, I think that the ingredients for a global recovery are there. We have to be very patient, as more time will be needed.

Senator Massicotte: We heard Ms. Yellen's comments this week regarding the damages caused in 2008-2009 in terms of the high unemployment rate. People often left the labour market for a few years. As we know a three-to-six-month absence from the labour market leads to a loss of advantages in technology and in knowledge, making the situation very difficult. She even suggests taking the political and monetary risk of overheating the economy in order to make up for lost time. Is Canada considering such an approach? Would that approach be beneficial given our economic context?

Mr. Poloz: It is clear that we are not there yet. We are behind the U.S. economy because of the oil shock. We were previously almost in the same situation.

It is true that a very prolonged cycle, like this one, leaves scars.

Ms. Wilkins could no doubt elaborate on this. It is not something we are currently concerned about. We first have to reduce the gap between the capacity and the economy before we take an in-depth look at this issue.

Carolyn Wilkins, Senior Deputy Governor, Bank of Canada: Obviously, given the crisis we have gone through and the unemployment rate that increased and then decreased, we are wondering whether some workers are discouraged and are not working as much as they would like to. If the economy experienced slightly higher growth, we could help those people re-enter the workforce, as their job searches would be more productive. What we must do in Canada — and what Ms. Yellen is doing in the United States — is thoroughly examine the labour market data. That can be done in several ways. We can examine the unemployment rate, which is only 7.6 per cent, and see whether we have another index that takes into account long-term unemployment — the rate of activity among individuals who are in their prime working years or other similar data — to determine the equivalent in unemployment rate. The index is currently at approximately 7.6 per cent. As you can see, the labour market gap is larger than the regular unemployment rate suggests. That is partially explained when we look at the situation of young people, an example we find especially useful. Their participation rate is lower now than it was before the crisis. This phenomenon is partially attributable to the fact that more and more people are continuing their education after high school. Of course, that is not the case for all those people. It is said that about 120,000 individuals — and this data is very approximate — are discouraged by their situation. Higher growth and a stronger economy encourage those people's entry into the labour force and help them develop their potential.

[English]

Senator Wallin: Thanks very much for being here. I have a couple of questions on the two key areas that you highlighted: housing and the export market. In some ways, it's the same question about the sensitivity of your tools and your ability to respond in these two areas.

You welcome the government's recent move on mortgages to make eligibility a little more difficult. You say it reduces vulnerability, but you also concede that there's weaker spending in that sector. It makes it tougher on retirees. We don't know what, if any, incentive there will be for millennials, who don't seem to buy into the idea of ownership. The CMHC says the housing market is now a strong risk.

In your own risk management frame, what are your tools to deal with the rather uncertain outcome of this? In an earlier time, you said you would even consider negative interest rates. Is that still on your horizon? Do you think we might get there?

Mr. Poloz: That's a pretty big frame. We focus most of our analysis on the housing market and our indebtedness in our FSR, our Financial System Review, which will come out in December. But for several issues in a row, we have been highlighting the risk around a hot housing market and the debt that goes with it. It's particularly the debt part that matters the most to us because it means, when you have these vulnerabilities, if there is a catalyst to create the risks — a catalyst would be, for example, a new slowdown in the world economy, which Canada feels right away, with even lower commodity prices and rising unemployment — you have people in trouble with their mortgages. What happens is the shock from the world into Canada gets magnified, and we could have a much deeper recession than we would in normal circumstances because the indebtedness creates this negative feedback loop.

That's why we care about it and that's why we welcome this kind of change, because a macro-prudential policy change, which is how we classify that, independently reduces or mitigates those risks to the future because it means that, in future, whatever debt accumulation happens will be of higher quality. It will be bigger down payments or a smaller mortgage relative to your income, that kind of thing, so better able to sustain the whole thing if there is a problem that arises. It makes the vulnerability lower. We welcome it in that sense.

Separate from that is the economic performance in the background. The economy as it stands, as we've said today, we talked today about how there were enough negatives this past period through the export revision primarily to at least have us talking about whether it was appropriate to move interest rates down further.

Given that interest rates are already very low, yes, we have talked about what tools we have in our tool kit if there is a significant downturn in the economy. It's not easy to appreciate, but we really don't have much room to maneuver using standard tools. It's what we call an unconventional tool kit, which would include such things as forward guidance. Usually that's meant to try to influence longer-term interest rates to bring a little more interest rate kick to the economy, or asset purchases, what we call QE, quantitative easing, which is an odd term, and negative interest rates as part of that tool kit.

We have no thinking of that in this situation in which we find ourselves. We believe the recovery is gradually gathering more momentum. It's just that it keeps getting hit by new bouts of uncertainty such as we discussed this morning. But they remain in our tool kit and, if that's what the situation calls for, that's where we would need to go.

Fortunately, this year we had an increase in planned fiscal spending, and that made a significant difference to that calculus, where the economy is relative to its potential.

Senator Wallin: If I just throw in the next area, which is the export situation, which again leaves us very vulnerable, we don't know how that's going to work out. As you say, these shocks are sometimes a bit of a surprise.

So it comes back to that same question, which is if the housing policy, this new approach to mortgaging, has these negative effects — I know the positive effects but the negative ones are there too — at a time where most of the benefits for global trade have been baked in already and some of the deals are in trouble, to say the least, so then how close are you to the tool kit that you only resort to in really tough times?

Mr. Poloz: In today's update, we've been very judicious in the new thinking around the export outlook. We have taken about half of the news that we received this year and treated it as a permanent decline in exports relative to fundamentals, which is a big change to our thinking because we figured eventually that would come back, but it could be because of firms we've lost that aren't there to export anymore or these competitiveness issues that we've raised.

We've taken that, and that means that exports from this lower level are projected to rise only roughly at the rate of the U.S. economy growing. So if we can maintain our shares in the U.S. economy, then we'll get that growth, which is a very conservative set of assumptions. You're right that that is risky. We have to watch those data carefully, and that would be the main variable that could disappoint us, because it's important enough.

On the housing front, we have worked in that basically housing would not contribute and it would actually be a drag on the economy next year because of these changes. However, I just want to remind everybody that it's like the cost of some insurance. When you buy your insurance on your house, you don't think, "Shucks, I wish I hadn't spent that money." It allows you to prepare for a bad scenario. It could cost the economy a great deal if we let those things get out of hand.

Senator Wallin: I appreciate that, thank you.

The Chair: I have a bit of a supplementary on that on the housing issue. There is the controversy about Vancouver, Toronto and high housing prices, but don't low interest rates induce people to invest in housing and so, therefore, by having the interest rates at 2 per cent and 3 per cent and 3.25 per cent mortgages for 20 years, why wouldn't you? You can't put it in the bank for 5 per cent anymore, so if you have cash, you're going to put it in, and now we're blaming the Chinese. Aren't we partly at fault for the ease of people to get into a house, which is driving the prices up?

Mr. Poloz: Most of that is absolutely true; maybe all of it.

The Chair: Your fault.

Mr. Poloz: Monetary policy is there in order for us to help stabilize the economy when something bad happens. We use our inflation target as our anchor to guide us when to do these things. If the economy goes into a lull, we will under-achieve our inflation goals so we cut interest rates in order to boost things. And of course, when we cut interest rates, we're hoping just that: Someone will buy a house a little sooner than they were planning, someone will buy a car that they weren't otherwise going to buy, and debt goes up and that fills that gap and brings the economy back up to speed. And companies too will invest more because the cost of borrowing is lower. That's part of monetary policy. That's always true and always has been.

However, what's happened this time is it's been for years and years in a row, and so those distortions, if you want to call them that, begin to accumulate and become more of an issue for the future if there is a catalyst. We've said it's like having a crack in a tree in your yard. The tree looks good, but the bad storm comes and then you find out just how vulnerable it was.

You're right, but fundamentally that is a personal decision made with the lender, right? The borrower and the lender sit down. They decide on the finances and they make that decision. It's not up to us to change that. Supply of housing, of course, is another question.

It does fuel that process but, importantly, since the crisis, all countries have developed a suite of macro-prudential tools. So changing the mortgage rules several times in recent years, and especially this latest change, is intended to gradually increase the quality of the underlying stock of debt so that you're better able to withstand those shocks.

That has actually made our system much safer than it was back in 2007. And you know that it rode through the crisis very well, so it's even safer today. That's, if you like, an investment in resilience, which is something that means that future growth in the economy is more sustainable than it would have been otherwise.

Senator Black: Thank you both for being here. With the indulgence of the chairman, I have a couple of questions. One occurred to me, governor, when you were presenting your remarks, and it's a tougher question, but I think it would be on some Canadians' minds, and it would be, I think: Do you as the governor and should Canadians have confidence in the forecasts of the bank, given that they seem to change every quarter?

Mr. Poloz: Well, I grew up in the bank as a forecaster a long time ago, so I've had the privilege of working at the rock face, if you like, of that, and so has Carolyn. I think what that does for us is that we know how to ask the questions and to guide what else we should be looking at, that kind of thing. This is not just a mechanical process like the computer tells us what will happen. It's a highly judgmental process aided by those kinds of tools.

We've been through a particularly difficult period since the crisis during which the economy has shifted in enough ways that it has called into question whether models can actually manage it. We've had to adapt on the fly, create satellite models or smaller modifications, and increase our reliance on anecdotal evidence, which is talking to companies, talking to the deciders, so we understand better what is going on.

I would stand by that as a process. We can't do policy without it and we make it absolutely the best we can. Carolyn may have something to add.

Senator Black: So you have confidence?

Mr. Poloz: We have confidence. I do.

Ms. Wilkins: I would just say I think that's a tough question, but we need to be accountable and so it's a fair question. We've done some work on the sources of our forecasters, and we put them up on the web. There's an analytical note that actually looks at that, because it's important for us to say every forecaster makes an error, but you start to wonder if your errors are in one direction. What we find is that the source of our error has tended to be in the U.S. economy, just underestimating the strength of those headwinds that the governor was talking about. At the same time, we've been hit with other shocks that we didn't see coming, like the oil. Oil was —

Senator Black: Or fire. We understand.

Ms. Wilkins: Yes, the fire, and in the U.S. there were budget issues that seem to happen every year at the end of the quarter.

Senator Black: I just wanted to test that you have confidence.

Ms. Wilkins: Yes; and so I would say from a growth perspective, it's something we've considered. When you look at the inflation forecasts, the forecast revisions have been much smaller and in fact, for the most part, we've kept inflation, for the whole time we've targeted inflation, within the 1 per cent to 3 per cent target bands. Of course that's our ultimate goal. That's why we look at growth.

We don't take errors lightly, but we certainly pay attention to them and are confident that our forecasts are going in the right direction.

Senator Black: Okay, thank you.

In the U.S., as we know, the fed releases their minutes. Have you considered doing the same?

Mr. Poloz: From time to time, we've talked about this. Central banks have changed their communication package, if you like, quite dramatically over the last 10 to 15 years. In many respects, the bank was one of the leaders in things like the press conferences that go with decisions. We have been doing that for some time and more recently for other central banks.

The idea of minutes has its pluses. It has its minuses too, which is that they tend to be sanitized or very difficult to glean insight from. You can imagine what those meetings would be like if you know every word is going to be right there, like our words today. It means that they become more formal and perhaps less like a dialogue or a debate that you would really like to have, such as the one we had over the past week in deciding what to do today. My sense is that the benefits of that equality of view-putting and dialogue around the table is of extreme value to us.

In certain institutions, you have a more geographical representation linkage to why you're at the table, such as in Europe or in the U.S. Because of that, there is an extra layer of accountability. How did you represent us in that conversation? And the minutes are a vehicle to, in effect, put a checkmark beside that accountability.

We don't carry that burden into the room. We are all equals. We are economists. Being given this input, we can have a genuine debate and come out unified, all standing behind the decision we made jointly, so there's no voting or dissenting, none of that. Personally, I think those benefits add up to a lot and are under-appreciated elsewhere.

On top of that, other things we've done about transparency are better than minutes, and so our discussion today, when we talk about our decision, we have an opening statement which is intended to fill the gap between the Monetary Policy Report, which is the fulsome analysis, and the decision, which is the press release. In between, there was a week of questions and more digging and rebuttal and argument, and all that gets boiled down — of course, we don't report the whole thing — but to lay out what we think are the top issues that we grappled with so people get an insight into how that decision was reached. If you try to substitute that for minutes, it would be very hard to read in the minutes produced how that actually occurred. I think you would have less insight.

Senator Black: Thank you very much. That's very helpful.

Senator Lang: Thank you for the update. It certainly is very guarded, and it isn't really a positive overview of the economy as we see it today in Canada. I'm not surprised, quite frankly. I don't think most Canadians would be either.

Recently, I read a number of articles in the financial parts of the reporting in the various newspapers and other publications, statements being made that the Bank of Canada is starting to become a cheerleader for government policy. I don't know if that's true or not, but you might want to specifically comment on that.

In the update, I was surprised to see that there was no real addressing the question of the deficit financing by government and the long-term implications of huge deficit financing by government.

It's been reported that the minister has moved from a position of a balanced budget in less than a year to a projected deficit of $29.4 billion, at least that has been reported for this current year; another $29 billion shortfall the next year; and then another $22.8 billion projected in 2018-19. Today we read that some economists are predicting that deficit may be even higher, $16.5 billion over the next three years, which would add between $80 million to $90 million of debt to the government's mandate.

My question to the Bank of Canada is this: What analysis has your organization done to show that government deficit spending when Canada's not in a recession, or at least we're told we're not in a recession, will actually boost the Canadian economy in a sustained manner rather than harm it? Do you have any concerns about this large deficit spending as we move forward, as far as it's going to affect Canadians?

Mr. Poloz: Perhaps I'll just say a word about the cheerleading comment first, which is a notion I would reject. We very rarely comment on government policies, except to evaluate what their macroeconomic effects would be, which is our responsibility. Because fiscal change will make a significant difference to the economic outlook, it therefore affects how we target the inflation rate. It doesn't get any simpler than that.

I've written papers myself around the issue of policy mix. When you have an economy that's falling well short of its potential for an extended period of time, it usually does fall to policy-makers to find a way to help close that gap. If you do it through monetary policy, it works in the way we were discussing before, which is very low interest rates and accumulation of debt by the household sector. If you do it through fiscal policy, interest rates would not be as low, and you would do it through an accumulation of debt by the public sector. So one needs to think about which pile of debt is more concerning, given the situation that we're presented with.

The situation we're presented with is post-crisis, labouring to get through with a weak global economy, layered on top of that the oil price shock, which is a massive change for Canada, $60 billion of income gone.

That is the situation we're in, and policy-makers have a choice about how that mix plays out. My comments have been around that. In this situation, interest rates are almost as low as they can go before getting into unconventional territory.

An entire book was written in 1936 about this situation, which is that this is where monetary policy begins to lose its effectiveness and fiscal policy has its maximum effectiveness. Dollar for dollar in terms of the two debt piles that I talked about, the impact of the federal fiscal action is much more impactful on the economy and brings more good than it would to try to encourage more indebtedness in the household sector by having rates even lower.

So that is just a choice, and we have tried to be clear about how those things impact the economy. I think all economists would agree that fiscal expansion in this situation will have a powerful impact on the economy, and we are about to see it over the course of the next 6 to 12 months. We will see the effects of the increase in the child benefit and the infrastructure program that the government has put in place. I don't really think of that as a debating point.

As for deficits, of course we care about deficits. But putting that context I just mentioned against it, the Canadian federal debt situation is one of the lowest in the world. There's capability to use this tool, but no one thinks it has to last forever. We think our economy and the world economy is getting traction.

Senator Enverga: Thank you, Governor Poloz, for appearing today. I have read all your notes here. I have some questions about our relationship with and our growing dependence on China. The current government is clear on its intent to expand our ties with China. There is alarming news and predictions about the Chinese economic slowdown and the threat of an impending debt bust in that country, something we all hope will not happen. However, the numbers are staggering when it comes to the debt-to-GDP ratio, which has soared from 150 per cent to 260 per cent over the past decade.

My question is, how will this debt bust, even if it's moderate in some spheres, affect our economy here in Canada, and what is the Bank of Canada doing to minimize any negative outcomes?

Mr. Poloz: I would not be among those who predict a debt bust, as you describe it. The Chinese economy, of course, is going through a phase where it is accumulating debt more quickly than its economy is growing. So, by the way, is Canada in terms of private sector debt. We have been doing that for some time.

As I was just describing, the issues are similar. The channel may be different. In the Chinese economy case, they're going through a significant restructuring, a reorientation of their economy to much more domestically driven and moving up the value chain. This is something that took a generation to do in economies like Canada and the United States, and they're trying to achieve it much more quickly. As it comes into fruition, it will be very positive for the global economy.

Today, China is much larger than it was 10 years ago. Ten years ago, a percentage point of growth in China was worth two in terms of what it does to our exports and to the market that we're selling into. So all of that I view as a positive thing, but of course with the risks that you mention. I understand those risks. It's not a free lunch. Potentially, it is a problem, what we would call a vulnerability, if you like, vulnerable to a negative shock.

Senator Enverga: My second question, which is also a supplementary.

Today's Monetary Policy Report shows decelerated projected growth for China. Your report also talks of weak global business, investment and trade that have slowed since 2012. It says:

. . . partly as a result of uncertainty over future prospects for global demand and ongoing structural adjustments in China.

Tonight, we will watch a third presidential debate, where the next President of the United States will not openly support free trade. Although the global economy may be regaining momentum, the vote in Brussels over the weekend and the U.S. elections both suggest global support for free trade is going in the wrong direction. Given this reality, are we not spreading false hope when we leave the impression that trade will help pay for our out-of-control deficit spending? Are higher taxes the only thing that we can say with any certainty that will bring deficit spending under control?

Mr. Poloz: I certainly share your concern about the future of the global trading system. I'm concerned about the spread of protectionist rhetoric. As I've said on the record and in public, it behooves all policy-makers and, for that matter, employers to explain better to people how important trade is to their companies, to their jobs and to their livelihoods. But this, of course, is well beyond monetary policy in terms of what it means for the economy.

Ms. Wilkins: I think there are two things here. One is the rise in protectionist sentiment that could roll back some of the progress that has been made. In our Monetary Policy Report, we talk about what's happened with global trade and the rise of protectionism that has already happened. An example is some 1,500 protectionist acts that have happened over the past few years.

There is something else going on when you think about what we should hope for. I think when you look at that, you need to look at what's happening structurally in terms of global growth. I think the demographic changes out there that are slowing potential growth, not only in Canada but elsewhere, are important because that means global growth and investments are going to be slower naturally, and trade with it.

Since China joined the WTO, the other factor is the growth in trade was just so strong over the past 16 years that that sort of catch-up in world trade can't be expected to be sustained. The bottom line means that, absent protectionism, we can see trade continuing to contribute to growth but maybe not at the pace we've seen in the past because potential will be slower.

I think, when it comes to China, it's natural that they are slowing. They're going through the same demographic changes actually faster than some other countries, and their working age population is actually falling. But as the governor said, 6 to 6.5 per cent growth, what we think their potential growth is on an economy that is twice as big, is still adding a lot to the level of global GDP every year.

Senator Tannas: I was reading that the end of this year marks kind of the end of a mandate that the Bank of Canada would have with respect to many things. I want to ask specifically about target inflation and the one-to-three band that you've been operating in. Maybe I'll call it a softball here. Could you give us some of the benefits of what you think the current policy has been?

I'm also reading and hearing that there are lots of experts and commentary around raising that band or lowering that band. I understand that in the course of establishing or fixing the next mandate, it's not a one-way conversation. What would be some of the things going through your filter as you consider moving that band? What would it take to convince you that it's the right idea to move the band?

Mr. Poloz: It's true that the inflation targets that we've talked about institutionally have been developed as an agreement between the Bank of Canada and the Minister of Finance, which thereby creates, if you like, a joint responsibility for that, and then for us a direct accountability for that. It's done in a five-year cycle, so we have a sunset at the end of this year, so that process is nearing its completion.

That means five years of new research on the questions, many of the ones that you're raising, academic conferences, academic papers, joint papers, all that sort of thing to address those issues. Then we bring that together as a proposal to the minister and make a recommendation.

Carolyn mentioned earlier that we're approaching the twenty-fifth anniversary of this framework. This goes back to 1991. That framework has truly anchored expectations around inflation. You can just walk out on the street and ask somebody who doesn't know anything about economics, "What do you think inflation will be?" And they'll just come back and say, "Around 2 per cent." That is priceless, actually, because you can do that in other countries and you won't get that answer. What makes it priceless is that when bad things happen, that anchor is known, that the central bank is going to be working to maintain that anchor. They're not trying to do something else.

Let's say we have the global financial crisis and recession, and because of that recession, you cut interest rates, and nobody doubts why. They don't think you're trying to do something else. You're just trying to get inflation back to where it belongs and make sure it stays there. That's of great value because it gives you that maneuverability.

If expectations were not anchored, I'll give you a counter-example. We had the oil price shock, which was clearly negative for the Canadian economy. It was also clearly negative for the Mexican economy. With our expectations well anchored, we have been able to reduce interest rates to help cushion the blow to the economy. In Mexico, they found it necessary to raise interest rates during the same shock, even though their economy was slowed by the shock. The primary reason was that expectations were not quite as well anchored, so their exchange market interacts with this and it becomes more of a problem.

Those are the practical benefits.

In terms of raising the bands, this is a healthy debate that has gone on for the last several years. The essence of it goes back to the earlier question about when interest rates are low, would you consider negative interest rates. Imagine if the inflation target was 3 per cent instead of 2 per cent. That would mean when everything is normal, the interest rate would be, let's say, 4 per cent instead of 3 per cent. That would mean you'd have another percentage point worth of room to move your interest rate if something bad happened to the economy, without hitting the lower bound. That sounds like one reason, given what we've been through, to consider raising those bands. That's the context in which you've heard of it.

The other side of that is the experience over the last five years has shown us that unconventional monetary policies actually work. Before this, they never really were tried before. Back in 2008, we thought the interest rate would be rock bottom at 25 points. Now we believe that it could go a percentage point lower than this, if necessary, something in that zone, so less than zero. That degree of manoeuvrability is pretty similar to the degree of manoeuvrability you get from raising your inflation target.

The question you ask is, does it make sense to ask households and companies to pay an inflation tax every single day, forever, in order to ensure that we have room to manoeuvre when a once-in-a-lifetime thing happens again. That's the kind of question we're asking in this research for this inflation target renewal process.

Senator Tannas: It's rhetorical, by the sounds of it.

Mr. Poloz: But I must say there's good evidence on both sides. It has been treated as a live question, not a dismissed question at all.

Senator Smith: Economists have talked over the years about the issue of productivity in our country. Since 1992, we had a very competitive, productive position. I think we were somewhere between eighth or tenth in the world, and now we're up to the sixteenth or twentieth position. The point is there has been deterioration. There has been a lot of talk over the years in financial magazines and financial reports about our problem with productivity.

How do you folks look at the productivity issue? Have you made any recommendations to government and/or business as to what could be done to try to improve our position so that we can be more competitive in the world markets?

Mr. Poloz: Competitiveness and productivity kind of go together. In economics, they aren't precisely the same term, but from a business person's standpoint, they are the same thing.

This goes back to some of the things I mentioned in my introductory remarks, which are things that companies perceive as slowing them down or preventing them from trading. Even in a domestic situation, there are many other impediments that are similar that slow them down in doing business. It's domestic or it's international. Either way, there are these impediments.

I've argued that, in the past, maybe when the economy was growing around 3 per cent, if someone came along and said, "I've got a great idea that will raise the economic growth rate of Canada by 0.2 per cent forever," that sounds like something worth having, but maybe we didn't have the same incentive to get our elbows out and get it done when we're only going from 3 per cent to 3.2 per cent than we have today, because today we think the potential growth rate of the economy is around 1.5 per cent. That's like half a percentage point from labour force growth or a little more than that. Half of it is from labour force growth and the other half is from productivity growth which, as you say, has been quite slow.

What can we do to boost that number? If it's 1.5 and I say we can boost it by 0.2 forever, that sounds like a bigger value proposition than when we were starting from 3. That's why I would argue that every decimal point counts a lot bigger now given the world as it is. The list of things you could do would be things like interprovincial free trade. There's 0.2 or thereabouts. That's a lot of free money for incomes for Canadians. On free trade deals with others, you can get 0.1s and 0.2s coming into the picture. There is a whole array of other things that are affecting our competitiveness.

Ms. Wilkins: When I talk to businesspeople, it's interesting that there are some commonalties. If you're in pulp and paper or you're in technology, you might have slightly different challenges. There's a long list, but there are a couple that really stick in my mind.

We know that firm creation — young firms that grow quickly — are a real source of productivity growth. The fact that we haven't seen that in a while is a bit of an impediment. You have to look at what are those kinds of firms or start-ups saying in terms of the impediments.

What they tell me is that it's in part to do with the red tape, if I can call it that, and other things, but there are also things like finding the right workers. With respect to their education, young people today may not have exactly the right skills to fit or the technical skills they're looking for or the actual craft they're looking for, or they're not entrepreneurial enough to know how to take a really good theoretical idea in biotech, for example, and bring it to market so you can actually sell it to someone.

Another one is that firms that are starting up, especially in the technology area, have big fixed costs. They need labs and big computers to test their ideas, and that costs a lot for a small firm. The kinds of things that they told me they found useful are techno centres that allow you to share those costs. It sounds like practical things, but when you talk to firms, that can sometimes make the difference between an idea that grows and has legs and an idea that just stays on the shelf in somebody's office.

Mr. Poloz: That is exactly right. These are things that facilitate growth. I have no doubt that Dominic Barton's growth council have good ideas over time that they will deliver to us. However, here's a practical one: Companies tell me that it costs them twice as much for electricity in Toronto than it does in Detroit. Those kinds of things feed directly into competitiveness.

As economists, we usually think of competitiveness as your wages and your productivity, and if the exchange rate moves, it helps balance things out for you. But there are many other things, like regulatory uncertainty, whether free trade deals will happen and those kinds of things and practical things like electricity costs or other energy costs or other regulatory costs that go into that cost equation. Companies are telling us over and over that this is why they can't quite get ready to invest yet, and therefore their productivity is falling short of where it would be if they did invest.

Many of these things are barriers that are fixable. We have what we call structural policies. They're not monetary and they're not really fiscal. They're policies that require capital because they mean negotiating or changing rules or something, so they're slow to happen. I'm hopeful that, with lower growth rates of 1.5 per cent, people will see more value in those kinds of changes to our business environment.

Senator Smith: Of course you know that the group around this table did a very good report on interprovincial trade.

Mr. Poloz: Yes, I do.

Senator Smith: My second question is a little different. You mentioned in your comments earlier about the importance of the infrastructure program and the commitment the new government has made based on the history of the prior government's $60-billion commitment and then now with another $60-billion commitment to go to $120 billion.

Do you folks do any form of analysis as to the pros and cons of infrastructure and how to measure infrastructure? Our Finance Committee is doing a study on infrastructure, and what we're quickly finding out is part of it is to get the money out and get the projects going, but there's a real issue in terms of measurement. I wonder how the bank looks at that whole issue of measuring results and trying to determine what potential results could impact the economy.

Mr. Poloz: We look at it primarily from a macro point of view, which is not allowing you to evaluate individual ideas. It fits exactly into the framework that I just mentioned. Many companies, before they mention electricity, will mention deficient infrastructure as a big barrier for them. What would it look like? Is it high-speed rail? Is it the twinning of a highway in New Brunswick to help deliver seafood to the northeast United States?

Senator Day: That would be good.

Mr. Poloz: There is one, one that is not long completed, and that did boost the seafood business.

It's that kind of infrastructure that is targeted at things that are clearly growth enabling. I think that's the only criterion that I really take to heart. If that's the case, then it goes into the common capital stock, which is a bit like a firm investing to boost its productivity. It's the shared capital stock, the investments coming from the public side, and it is boosting everybody's productivity, if they ever get to use that infrastructure. I think of it in exactly the same way.

We have the announcements built into our forecast, and it's going to raise Canada's GDP by the end of the 2017-18 fiscal year by about 1 percentage point, which is a significant amount.

Senator Smith: How do you make that determination?

Mr. Poloz: That's based on, commonly agreed among economists, how these things feed their way through the economy. Like anything in economics, there is uncertainty around those estimates. Some would argue they should be bigger. Others say there could be leakage and maybe they will be smaller. There's room for debate and we'll never know exactly, because it will just go into the economy and the economy will show up as stronger, and afterwards we try to figure how much it was.

But just to give you an example, a paper was written by one of our own deputy governors, Sylvain Leduc, when he was at the Federal Reserve Bank of San Francisco. They were analyzing bridges and highway infrastructure in the United States. It was very basic stuff, and they showed that over a period of eight years, a dollar spent there became over $3 worth of economic impact. The reason for that is because it's growth-enabling. It's not just the money you spend but what else it allows to happen. It actually affects the trend line that I mentioned before. The 1.5 might become 1.6 or 1.7, and it all adds up year after year.

That's just one paper, though. There are a lot of analyses, as economists are wont to do. They can debate that endlessly, but there's no doubt it will have a positive effect, both in terms of its first spend, creating jobs then, but provided it is properly targeted, which in my understanding it is very well targeted, it will have these extra growth dividends.

Senator Ringuette: I'm puzzled, and maybe you can put the pieces together for me. This is the issue. For years, we've been told that the hot housing market in Vancouver, more than Toronto, but it seems like it's the situation in Toronto too, was caused by foreign ownership. All of a sudden, it seems that the issue happening in these two cities warrants having a national policy that will probably negatively affect other regions of the country. I'm surprised that I see in your report that you're supporting a national initiative, a national policy, to deal with a situation that is mostly happening in one city within our nation, and some in Toronto. To me, it's not an understandable national policy to deal with two pocket issues. That will have a negative affect mostly on our young families.

Were there other options, and have you studied other options with regard to removing the hot button from the housing markets in Vancouver and Toronto?

Mr. Poloz: Let me just start with a brief word on the fundamentals, and then I'll turn it over to Carolyn.

It's important for us to bear in mind that Greater Toronto and Greater Vancouver are our two fastest-growing economies in Canada. If we could define them as an entity, we would find that they have by far the fastest employment growth, the fastest income growth and therefore the fastest growth in the demand for housing. So we begin with that. The fundamentals are very strong.

When you have a hot housing market, if the whole of Canada were growing at that rate, you would expect to see a hot housing market everywhere in Canada, but we see it kind of in these pockets where strong immigration growth, strong job growth and strong income growth create the starting point for the analysis.

Ms. Wilkins: The strong starting point of the fundamentals is important to put the foreign ownership part in context, which was what you were mentioning with respect to especially Vancouver. We've long said it's hard to get a handle on exactly how important that was. It certainly was an important enough factor to cause the comments that were made. It doesn't seem to me that it explains all the rise in prices in those cities because of the fundamentals.

The other question, though, is, why do a nation-wide policy when the problem is local? I think that when you look at exactly what that policy does, you'll see why. The main changes that were made were made to do a stress test to see that the borrowers had enough income to cover the debt service at a rate that was probably higher than the contracted rate that they were getting. So it would now have to be the posted rate. That's just to make sure that the family itself wouldn't get into any trouble should interest rates rise for whatever reason. In fact, everybody is better off when that's the case.

If you look at the data, and we have looked at the data and we had a box in our Financial System Review in June, and it looked at where the trouble spots were in terms of people taking on mortgages and having a debt service ratio that started to get pretty high. Above 44 is a little bit high, and that translates into high loan-to-income ratios, so your loan is big relative to your income. We were seeing really strong growth in the past few years in loan-to-income ratios in cities like Vancouver and Toronto. What that says to us is that this particular measure, while nation-wide, is actually quite targeted at a very specific issue with respect to affordability of the loan and loan quality. Because of that, it's going to affect borrowers across the country that may not be the most secure borrowers, but at the same time it's most likely to have the biggest effects in the cities where we saw the largest increases.

For that reason, I think it's a more appropriate policy than an alternative one. The government has taken many steps up until now. They stopped giving mortgage insurance for houses worth more than $1 million. They have taken many other steps over the years.

Another step could be that some have suggested why not just raise interest rates, and that would definitely be a step that would definitely affect everyone across the country by affecting all asset prices, not just the price of a mortgage. It would affect many areas of the economy — consumption and housing and exports and investment.

This targeted macro-prudential tool is the appropriate tool to address the quality of the borrower issue.

Senator Ringuette: Mr. Poloz, do you have anything to add?

Mr. Poloz: No, I thought that was a really good explanation.

Senator Ringuette: Ms. Wilkins did confirm that it was a national policy to address economic issues in two areas of the country. The end result, I'm afraid, will see that housing markets in smaller communities and rural areas will be negatively affected. I have major concerns.

I will turn to my second question. This is a repeated question for many years now, every time you come in front of us. I talk about the state of reserves from major corporations in Canada that are still not being invested in economic growth for their business or this country. Where are we now and why are we still at that place?

Mr. Poloz: Before I answer that, let me clarify, as I was sitting here. Ms. Wilkins did not say that we approved of a national policy that should have been targeted a local issue. What she said was the policy that was put in place was extremely well targeted at the two areas of the country where the issues were greatest. That's a pretty big difference. That's a well-designed policy.

By the way, Greater Toronto and Greater Vancouver sound like two places, but they happen to add up to over 40 per cent of Canada's housing market. The interaction between the high cost of housing and high indebtedness is the interaction we're most concerned about, and it is almost all there. That's why that policy is targeted at that.

In terms of investment, you're right; it's a perennial question. Companies appear to be well-placed to make investments. They have the capacity. The companies that I talk to have the willingness, they're ready, and yet it seems every time I talk to them they've got a new reason that's making them wait a little longer. I mentioned a few previously. Regulatory uncertainty is something that government gets to control, but from a business point of view, it sounds like a pretty big variable, like what could happen to me next when you go through a U.S. election campaign where it sounds as if not only future trade deals may be in doubt, but existing trade deals on which your company may depend every single day are in some sense in doubt. I have every reason to think that not just in the U.S. but also in Canada, investment is being held back this year because of the uncertainty that's being raised by the rhetoric around the U.S. election. It's why we mentioned it this morning.

One of the big sources of uncertainty for us today, among others that we've mentioned, is the export behavior. When the fiscal measures start to show up, the second half of the data should begin to appear. We need to analyze those things as we go along, but a really big one is we've had to scale back our investment outlook for the U.S. The same thing happens in Canada almost right away, because we're so tied into the same supply chains supplying those very same companies. The natural sequence is that as our exports go up, companies get to full capacity and then they invest. The exports faltered in a significant way earlier this year and raised those doubts again.

It's been a difficult year from that point of view, and I'm afraid that since we last spoke there's been no real progress on this, except to say that total investment in both Canada and the United States has clearly been dragged down by the oil price shock. Those are really big investors. It's a very capital-intensive business. And not only oil, but other extractive businesses, other resource businesses.

Everything we're seeing suggests that that process has pretty well run its course. There are still adjustments to the low oil prices that must happen, primarily from the loss of income at the macro level, but the investment cuts appear to be mostly behind us.

We know there are lots of companies doing well. We know that the other 87 per cent of the Canadian economy is growing by about 2 per cent, which is a trend growth, not a sudden 2 per cent but a steady 2 per cent growth, and they are much more likely to be ready to invest because they have been experiencing this. When the climate feels more reassuring to them, we are going to see exactly that.

We don't assume a huge rise in investment in our forecast, but we expect it to begin to make a positive contribution, having been a negative contribution for the last two years.

Senator Day: My first question is a follow-up to a couple of points that have been raised. You talk about your projection based on a number of factors. You say, "If this happens, then . . ." but when we see the projection, there's no "if" there. So what are your cut-off lines? For example, Ms. Wilkins was in Trois-Rivières, and they're worried about the Softwood Lumber Agreement expiring. That's going to impact a very significant part of the economy in a part of Canada. There's a little bit more speculative TPP and the European trade agreement. When do you cut things off and say, "If that happened, then this, but this is what we're projecting is likely to happen?"

Mr. Poloz: To simplify it to some degree, we only put things in our forecast if they have been enacted. There's nothing in our forecast that represents CETA or TPP or anything like that because they have not crossed the finish line. We would need to think those things through, and I gave a framework that we would use. We would go through the arithmetic of how many firms could take advantage of those deals, and we've got studies of their impacts. As I said in my speech a couple of weeks ago in Quebec City, CETA might be 0.1 or 0.2 percentage points on the trend growth rate, which is important for us to have in, but it's not there now, until we know it.

The other side is what if something is going to happen that is a negative. On the example of the Softwood Lumber Agreement, again, we don't know how that will turn out. Negotiations are ongoing. I hope, like everybody, that things get worked out and business goes on in the normal way.

If something goes wrong with that, then we have an experience from the past to model. We would be able to say how big an effect that would be on the economy if it ran its course like last time. That's how we try to adjust our outlook for that.

But these things are too big of an "if" to build in. People are always asking us, "Well, what if this happens? What would you do?" Honestly, if it did happen, I'm not sure how it would affect the economy. I'm certainly not going to assume it will happen and try to figure out in advance what we might do a year from now if it occurred.

What we would do instead, like all good central banks, is we would be monitoring our data. If that happened, we would say, "Wow, that could have this effect or that affect. We'll have to watch for this." Then we would see in our model that we are over-predicting, say it was exports, say it was lumber exports that were falling, and then we would be able to see that directly in the data. We would know what the maximum effect will be and we could build that in, and then we would be able to formulate our own policies on a new forecast. But we would react to how the effects actually manifest themselves as opposed to guessing in advance.

Senator Day: Thank you. That's very helpful.

The second question I have is with respect to services. A lot of your comments have been with respect to the export of goods. The reason we had negative growth in the last quarter is because of broad-based goods exports and the problem with respect to the oil sands. However, the economy has been growing from the point of view of services, such that services make up about 70 per cent. I think you said in your material.

Mr. Poloz: Yes.

Senator Day: That's about 70 per cent of our economy now.

Can you relate the service aspect? We haven't talked about that. What's likely to happen from the service point of view? Does that make up for the obvious decline in goods and goods export growth?

Mr. Poloz: I'm delighted that you raised that. It's one of my favourite subjects. I will just point you to chart 5, which is on page 9 of our report. It looks like yours is not colour but in black and white. The smoother line is the exports of services and the jagged line is the exports of goods.

Senator Day: The red one.

Mr. Poloz: There are two scales. What's important is that exports of services are in the order of $80 billion to $90 billion per year, whereas exports of goods are on the order of close to $500 billion. So, give or take, 20 per cent of our total exports are in the form of services.

Just like our economy, the services exports have been growing very steadily. Before I turn over to Carolyn, I want to say the line is smoother for services, and that's because we don't have monthly data on services exports. They are quarterly data. You hardly hear about them because they come out the same day as the national accounts, which of course is a very exciting day. How much did the economy grow? Well, by the way, services grew. Well, I'm not too interested. How much was the GDP? Whereas in the United States, every monthly release of the trade data has both goods and services, so you get a better tracking of that. In any case, it's been doing well.

Ms. Wilkins: It's true. It's something that we don't tend to focus on. When you look at it from the output side and the export side and you can see the growth, you can also see it in the employment side. If you look at all the job growth that we've had since the end of 2014, about 250,000 jobs were created in the service sector. And of course in the goods sector, it's fallen by about 70.

You have to think about what kind of services. It's interesting. Over that period, it's been pretty high value-added services, like finance and insurance and air transportation, health care. Others, like hospitality, are also growing, but 75 per cent of those jobs have higher than the average hourly wage, just as an example of what kind of jobs they are. So it is a positive story.

On the goods side, it is not such a positive story with manufacturing, for example, employment being virtually flat recently. We're not seeing the job growth there yet, which we'd like to see. We've seen some positive sales in manufacturing in the last couple of months, so we're going to be monitoring that closely.

Senator Day: As a follow up, is your forecast that the growth in service is likely to make up for the not-so-robust growth in goods?

Mr. Poloz: No. It can in a growth sense, but with the size of it — as I was indicating, service exports are only about 20 per cent of the total, so it's very hard for them to make up. Take, for example, what we've lost in terms of the oil shock. The disappointment that we experienced this year on the export side has all been in the goods side. We often say non-commodity exports.

The most important areas in their weakness are connected to the investment story that we have talked about in a few questions today. So investment is slow globally. It's slow in the United States. It's slow in Canada. Investment goods are one of our most important export categories. So when the U.S. investment category gets slower, that has a disproportionate impact on our export of goods performance.

We're pretty confident that we've turned the corner on that, and we're looking forward to better numbers. We want to see it before we start banking on it.

Senator Day: Thank you.

Senator Ringuette: Can we go to chart 9 on page 14?

Mr. Poloz: Sure.

Senator Ringuette: Non-energy goods exported to the U.S., and it's in U.S. billions. When you look at the chart, for instance in 2011 to 2015, we see that there's stagnation in U.S. billion dollars.

Mr. Poloz: That's right.

Senator Ringuette: Not in Canadian dollars.

Then you see the increase of Mexican exports to the U.S., even though you insist that the U.S. economy is not in the growth mode that it used to be.

Mr. Poloz: Yes.

Senator Ringuette: And Canada and Mexico are in the same free trade agreement with the U.S.

Mr. Poloz: Right.

Senator Ringuette: So what is happening here? Mexico has managed to increase their exports to the U.S. over the last five years, and we have not.

Mr. Poloz: This is really the theme I was laying out in my introductory remarks. Our competitiveness has not been what it could be.

When a company is deciding to expand their footprint and they're deciding where in NAFTA they should do it, if Canada has a lower competitiveness than Mexico, they can just as easily do it in Mexico and get a fine, dedicated workforce. They get the advantage of lower cost than, say, if they went to southwestern Ontario, say an auto parts manufacturer. Through these years, we have lost a considerable share to Mexico in the auto sector in particular, in that when a new assembly plant gets built in Mexico, they would much rather have the suppliers be reasonably close by.

There have also been expansions in the United States and just some small parts in Canada, by comparison. So the auto sector is an important player in what you're observing but not only. I don't want to say it is just auto. For example, there's a nice, well-developed aerospace supply chain now in Mexico, and a cluster has emerged in Mexico for aerospace parts. Aerospace parts get moved farther because they're high value. They don't want to have to be next door to the assembly. So a plane that's assembled in Toronto or Montreal has parts that are made in Mexico today. That's an example where those plants could have been located in Canada somewhere and that would change those things that you're observing. Those are specific examples.

As I mentioned in my opening remarks, we have depreciated against the United States, and that makes us more competitive than we were when oil prices were high, but Mexico has depreciated even further than that. Therefore, when you do that calculus, we have not gained within NAFTA, if you like.

Senator Ringuette: I would certainly appreciate, and maybe the other members of the committee would as well, if you had more information in regard to this situation on the competitiveness between Canada and Mexico in relation to the U.S. market.

Mr. Poloz: This is the work we're doing since we had this disappointment this year in exports. As I was saying, we felt we could explain perhaps half of the missing exports.

On the other half, we're saying that since we can't explain it, it must be due to some of these things that we call competitiveness, and we can't put precise explanations beside that. We can observe and companies will tell us they didn't put that plant in Ontario, they put it in Mexico because of this, this and this — electricity costs or something. They cite these reasons.

We can give you some stuff but it's not as precise as you may be hoping. We can't really account for it all, so we're assuming it's permanent in our forecast and that we've lost that. Hopefully we can win back other business in other ways, but we have to see it before we assume it.

Senator Lang: I would like to go back to your report. You referred to it a number of times initially in your address and then a little later on with some of the questions where you say we are now reporting on how we see various aspects of the risks developing, as well as setting out the indicators we are watching in evaluating the risks.

I want to go back to my question earlier about the question of deficit financing for the government. My major concern is the size of the deficit as it accumulates over time. When does that become a risk to the economy generally? We've experienced this in the past, in the 1990s, when the deficits got out of control. From your perspective, when does that become a risk? Today you know what the projected figures are for three years, as closely as they can be and could be even more. When does that become a risk to the economy that you as the Bank of Canada have to conclude that deficit financing will have a long-term effect?

Mr. Poloz: There is no bright line where it becomes a risk to the economy, so it's important to bear that in mind. However, we do have a lot of history around fiscal deficits and economies that do have problems. Here in Canada, you're absolutely right that we had a phase where that was true.

At that time, the debt-to-GDP ratio in Canada was I think 70ish per cent for the federal debt. In other words, it was well more than double than it is today. Not only that, but the deficit appeared to be high and increasing. The cycle in the economy was suggesting it was in a sense unsustainable. When it became noticeable to financial markets in that frame, then we saw the exchange rate come under selling pressure in the markets and the Bank of Canada found it necessary to raise interest rates to calm things down, et cetera.

Those are signs that the markets are thinking the numbers are getting too big. We are very far away from anything like that in this situation. Other countries have much higher ratios of debt but aren't showing those kinds of stresses even now.

All I can say to you is that it does not seem to be an issue at this time. You can make a second argument, which is it depends on what use is being made of the money. If the money is being used to, in effect, invest in Canada's future growth, that is, the infrastructure program, then it's very likely to add to Canadian growth and in that sense it creates a positive loop where it creates more revenues later.

When a company makes an investment, it may borrow to get the funds to invest in that new machinery or expand their plant, and that allows the company to grow more, and then they're able to not just pay off the debt later, service that debt, but also grow more jobs and grow their company. The situation in the Canadian economy, as a macro concept, is very similar to that if that money is being used in what I would call an investment in growth — growth-targeted infrastructure.

The Chair: Thank you, Governor Poloz and Senior Deputy Governor Wilkins. It was a very good hour and 45 minutes. It's much appreciated.

Before I adjourn, colleagues, we will go in camera for a couple of minutes to discuss a couple of issues. We will have a two- or three-minute break to say good-bye to our guests, and then we'll reconvene here for an in camera meeting. It is kind of important, so I'd like you to stay.

(The committee continued in camera.)