Proceedings of the Standing Senate Committee on
Banking, Trade and Commerce
Issue 3 - Evidence - April 20, 2004
OTTAWA, Tuesday, April 20, 2004
The Standing Senate Committee on Banking, Trade and Commerce met this day at 11:00 a.m. to examine and report upon the present state of the domestic and international financial system.
Senator David Tkachuk (Deputy Chairman) in the Chair.
[English]
The Deputy Chairman: Senators, I would like to welcome the Governor of the Bank of Canada, Mr. David Dodge, and Mr. Paul Jenkins, Senior Deputy Governor of the Bank of Canada, to our first meeting of 2004. It has been traditional for the committee to have the governor of the bank appear twice each year.
Mr. David A. Dodge, Governor, Bank of Canada: Senators, thank you for having us here this morning. As always, we appreciate the opportunities to meet with you twice each year. Our appearance today precedes our appearance before the committee in the other place. I think that this is the first time in a couple of years that that has happened. We hope that these meetings help to keep senators and, through them, all Canadians informed about the bank's view on the economy and about the goal of monetary policy and the actions we take to achieve it.
The economy continues to adjust to developments in the global economy, as stronger world demand, higher commodity prices and the realignment of world currencies, including the Canadian dollar, affect us in Canada. Emerging market economies, especially those of China and India, are contributing to intensified competition but are also creating new opportunities for Canada and Canadian businesses.
[Translation]
These developments require shifts in activity among sectors and create a need for adjustments by many businesses. Monetary policy is facilitating these adjustments by supporting aggregate demand, with the goal of keeping the economy near its full production potential and inflation on target.
When we appeared before this committee last October, we told you that economic growth in Canada was weaker than expected and that there was more slack in the economy than we had projected six months earlier.
As you know, the Canadian economy was affected by a number of shocks in 2003. Thus, despite a broadening of the global economic recovery and higher commodity prices, it turned out that the economy at the end of the year was operating well below the level that we had projected in our October Report.
Preliminary indications are that growth in the first quarter of this year was marginally below 3 per cent. Thus, the Bank's view is that the economy is still operating significantly below its potential.
[English]
The outlook for growth and inflation is essentially unchanged from that of our January ``Monetary Policy Report Update.'' The economy is expected to grow by about 2.75 per cent in 2004, picking up to about 3.75 per cent in 2005. Those are year-over-year numbers. This strong growth is expected to come from private domestic demand, reflecting the current monetary stimulus in the economy and high levels of business and consumer confidence. Such growth would return the economy to close to its production potential by the third quarter of 2005. Core inflation should average about 1.5 per cent over the remainder of this year. As excess supply in the economy diminishes, core inflation is expected to move back to 2 per cent by the end of next year, 2005.
The main uncertainty in the outlook continues to relate to how our Canadian economy adjusts to global developments. Overall, the risks to the outlook appear to be balanced.
Mr. Chairman, Mr. Jenkins and I would now be glad to take your questions.
Senator Kelleher: Mr. Dodge. I would like to ask you about bank mergers. I know this will come as no surprise to you. Last month, Mr. Clark, the CEO of TD Bank, said he believed that the government would fail to meet the proposed June 30 deadline to produce guidelines and ground rules for bank mergers. Certainly, you are well aware that this causes uncertainty, or can cause uncertainty, which is something businesses and banks do not like. Currently, the banks are sitting on about $14 billion in excess capital. I am sure they are trying to figure out what they should do with this capital.
Regardless of the final decision, either for or against bank mergers, are you concerned about the uncertainty that would be caused by any further delays in the government arriving at those decisions?
Mr. Dodge: Senator, as you pointed out, business, and especially financial business, does not like uncertainty. Anything that can be done to clarify situations and to increase certainty is always welcome.
Our prime concern at the Bank of Canada relates to the efficiency of financial markets. You will notice that in many of our statements, and at the conferences we hold, we are always driving at the financial system, the intermediaries in the system and the operation of markets in that system being as efficient as possible. This is for three reasons, one of which is directly related to us: monetary policy can only operate effectively if markets operate efficiently. Thus, we have a direct concern in the operation of efficient markets. Perhaps even more important for Canadians is that efficient markets allow for the much better matching of Canadian savings with the needs of businesses for capital for investment. It is important that markets operate efficiently so that can be achieved and risk can be appropriately distributed.
The final issue is, of course, what is the role of financial intermediaries, per se, in bringing about efficiency? Clearly, our real interest is that those financial intermediaries operate as effectively and efficiently as possible.
As you look at evidence from around the world, there is no single answer to this in terms of the structure of the intermediaries, that is whether they combine all the pillars of financial transactions or only some; nor is there a single answer about efficiency in terms of the numbers. Clearly, what is absolutely important is that there be effective competition to ensure that efficiency is maintained. There is no clear answer as to how many institutions that implies. Indeed, one can observe countries with very few institutions, for example, Holland, that have very effective competition, and one can observe countries with many more institutions where competition is effectively not as strong.
There is no absolutely clear answer, but our concern is efficiency of both institutions and markets.
[Translation]
Senator Massicotte: Governor Dodge, in your statements, you focus on the need to remain flexible in our structures and competitive as a country. Can you list two or three things the government should do, and do you have any measures to recommend to ensure that we remain globally competitive? In a recent speech, you spoke of India and of China, which has become a very significant player.
Mr. Dodge: Now that we have reached high employment levels, we can make adjustments to improve all workers' productivity in the economy. It is important to focus on investments which will increase workers' productivity in Canada in order to compete with other global markets. This means shifting activities from less productive sectors to more productive ones. It is extremely important, but it is difficult. We are now making these adjustments. This is precisely why we believe it is very important to spur aggregate demand to facilitate these adjustments.
With respect to China, India, and the Asian economies, I defer to Mr. Jenkins.
Mr. Paul Jenkins, Senior Deputy Governor, Bank of Canada: As you pointed out, there is intense competition, due in part to the strength of emerging-market economies such as China and India. Because of the presence of these forces in the global economy, there will be a shifting of activities between sectors and many businesses will have to make adjustments. Monetary policy will have to facilitate this adjustment by supporting the Canadian economies aggregate demand.
As the governor mentioned, it is very important for Canadian businesses to maintain a degree of flexibility because of the forces of the global economy. Businesses will have to increase their production. In addition, one must consider other global markets, aside from the United States. It is true that the value of the Canadian dollar has risen against the American dollar; however, simultaneously, it has taken a drop vis-à-vis the euro. With currencies, there are opportunities in other world markets. As the governor suggested, it is important to increase productivity because of the current level of competition.
Senator Massicotte: What should we do to be competitive with other countries? You focused on businesses, but are there specific policies, more government-based policies which could be implemented to make sure that we remain competitive and to encourage businesses to be competitive?
Mr. Jenkins: I agree that there are forces at play in world markets. It is important for the Canadian economy to be flexible and to adapt to this competition. It is certain that the presence of the Chinese economy, for instance, will give rise to a medium-term structural change.
With respect to policy, there are other elements that are just as important, such as China's fixed exchange rate for the US dollar. In order to adjust to today's global markets, the rest of the world, including China, must be flexible. We need a more flexible exchange rate system.
Mr. Dodge: I should add that the labour market is at its most difficult during adjustment periods. To facilitate adjustments in the labour market, it is very important for governments and companies to continue providing ongoing training to workers, so that they have the ability to move from one sector to another and from one position to another.
[English]
Senator Meighen: I could not help but notice that your statement this morning is considerably shorter than we have become accustomed to in your appearances before us. That is not a criticism. Indeed, I notice that there are far fewer journalists here today, which obviously points to the fact that you and Mr. Jenkins have everything under control at the Bank of Canada and the ship is sailing smoothly.
Having thrown you that soft pitch, let me continue. I was going to ask questions in another area, but Senator Massicotte, as is his wont, has piqued my curiosity on the subject of productivity and whatnot.
We were always told that when our dollar was lower it helped our exports but probably resulted in lower productivity. Can you tell us whether there is any empirical evidence to demonstrate that with the higher dollar, the Canadian workforce has indeed become more productive? Second, is increased productivity a goal of the bank, or is it simply a happy by-product of a higher dollar?
Mr. Dodge: Let me slightly rephrase your question, if I could, senator. You asked whether there is any evidence that productivity has become higher. I think it really should be ``is becoming,'' because this is an adjustment process that takes awhile and we would not expect to see any effect, essentially, a year after we have started to see an adjustment in the exchange rate. As well, productivity is probably the most difficult thing to measure in the short run because when dividing two very big numbers, small errors can lead to very misleading numerical results on what is happening.
Yes, there is a lot of evidence over time and across countries that indicates that when you change the relative price of labour and capital, which is what happened here, you do indeed get changes in productivity.
Taking a step back, let us remember that from the mid-1990s right through until the early 2000s, we were in a period of considerable excess supply of labour in our economy, and we were squeezing government fiscal balances at both the federal and provincial levels. This meant that if we were going to maintain employment at all through that period, we had to crowd in some foreign demand to employ people, and indeed Canadian labour over that period became relatively cheaper compared to labour abroad. We did squeeze in that demand and we have now taken ourselves back up to the point where our employment-to-population ratio is a little above where it was at the end of the 1980s.
It is very appropriate now that we put more emphasis on increasing productivity because without that we cannot actually raise real incomes over time. We cannot continuously increase the employment-to-population ratio. We are now at an employment-to-population ratio that is considerably above that in the United States. In fact, it is above the level the U.S. hit at its peak. It really is important now that we move our focus, not away from high employment, but toward increasing the productivity of those who are employed, because that is how we will increase our real incomes.
Is it a goal for the bank? You are damn right it is. The best thing we can do in supporting that goal is to continue to try to keep inflation at around the 2 per cent level, which is our target, and keep the economy operating as near as possible to full capacity. Therefore monetary policy has an important role here, but not an absolutely direct one.
Senator Meighen: Senator Massicotte asked you what we as parliamentarians could do. You indicated what the bank could do to encourage increased productivity. What can we do? I am not asking you to enter into the realm of government policy and debate, but, for example, if we were to rethink our corporate tax structure, and in particular if the capital tax in Canada were removed, what would that do to our dollar and what effect would it have on interest rates and, primarily, productivity?
Mr. Dodge: Senator, I do not think it is appropriate for the central bank to be telling governments or parliamentarians what the exact mix ought to be in terms of spending and taxing. We certainly speak very strongly about the importance of fiscal balance because that is extraordinarily significant in maintaining the confidence of Canadians, enterprises and investors going forward.
I do not think it is totally appropriate for us to be entering into that specific domain on tax policy, but I would repeat what I said in response to Senator Massicotte's question. I think that as parliamentarians and as Canadians, we have to always have in the front of our minds a concern to facilitate the adjustments in the labour market. Those are the hardest adjustments to make in any country and they are the ones that affect real people in their daily lives immediately.
It is important that parliamentarians do focus to ensure that those markets work as well as possible, that workers who are displaced from lower productivity activities have access to the training, the mobility and the help they need to move as smoothly and quickly as possible to the higher productivity activities.
That is a real challenge, especially for a country like Canada, where we are spread out geographically as well as having some pretty sharp industrial differences across the regions.
The Deputy Chairman: What do you mean by ``fiscal balance''?
Mr. Dodge: The balance between expenditures and revenues. Essentially, as we have said many times, we think it is very important, especially given the demographic situation that we will face in the middle of the next decade and beyond, to maintain everyone's confidence that federal and provincial governments will operate to try to reduce over time the ratio of the debt to GDP that they are carrying, so that the cost of that servicing in the next decade and beyond will be reduced and allow those governments the flexibility to deal with an aging population.
The Deputy Chairman: When you advise governments on fiscal balance, are you telling them that they should grow their way out of the total debt by decreasing the debt-to-GDP ratio, or should they pay down the total debt?
Mr. Dodge: That is a very tricky issue. The potential growth of the economy over the next decade, in nominal terms, is at about 5 per cent — two per cent inflation, 3 per cent real growth. If that happens, the burden of the public debt in proportion to (a) government's revenues, and (b) the size of the economy, would automatically decrease.
Different provinces are in different situations vis-à-vis the amount of public debt they carry. There is not necessarily one precise description that fits every government. The goal of the federal government is to reduce that ratio to 25 per cent, which can probably be done by continuing with very small, nominal fiscal surpluses that will bounce around from year to year. However, it would keep the debt to GDP on a declining track.
[Translation]
Senator Biron: According to one theory, when Canada has a weak dollar, Canadian companies become less rigorous and make money on the weak dollar, instead of investing in equipment or in increasing productivity. According to a second theory, when interest rates are high, companies reduce their profits and investment capacity because the high interest rates increase production costs. And if companies do not make a profit, they cannot borrow to invest. However, does every entrepreneur not tend to invest in order to increase productivity and thus profit? Which of these factors has a greater impact on interest rate policy? Perhaps both have some impact.
Mr. Dodge: First of all, I do not believe in the first theory. Generally, people wish to respond to market incentives. When the Canadian dollar is weak in relation to the US dollar, in Canada this translates into cheaper labour and a higher cost for capital equipment. So there is an incentive to hire more labour with lower capital. In those circumstances, we would expect the increase in productivity to be lower than it would be in a period where labour was relatively more expensive and capital goods relatively cheaper. Canada has the incentives to increase productivity.
Moreover, at this time, there is a change in the relative prices of services and highly manufactured products on one side of the equation and raw materials and other industrial products on the other side of the equation. The focus is on raw materials and industrial products in order to attract labour and capital to that sector. This represents normal market operation, making the Canadian economy much more efficient.
At present, the business sector is doing well and profits — overall, not for individual companies — are somewhat higher than usual. This favours companies, particularly since interest rates are low, in the short or long term.
The cost of financial capital is fairly low at present, and companies have sufficient earnings to make investments. In this year and the coming year, we project that investment in the private sector will be fairly high. In our projections, you will find that the contribution to Canada's economy made by investment is higher than average. This will help productivity and increase Canadians' real income in the future.
Mr. Jenkins: Another important aspect is the role of the exchange rate on the macroeconomy. With the higher dollar, negative adjustments will be necessary in some sectors, including those highly involved in international trade. At the same time, fluctuations in the dollar are having a significant effect on the macroeconomic balance. For example, after the Asian crisis, commodity prices dropped by almost 25 per cent overall. The rising dollar has clearly helped commodity producers, but also facilitated the movement of resources among various sectors. Now, we are, one might say, seeing the other side of the coin. Some sectors are very involved in international trade. There will be some negative impacts there, but at the same time, in other sectors, the higher dollar has a very positive effect. The way we see things, achieving a balance among the various factors is important. This means the macroeconomic situation is pivotal, not only in the ways I described to Senator Massicotte. There are adjustments happening within Canada, but at the same time there are highly significant forces relating to the global disequilibrium caused by the trade deficit in the United States.
[English]
Senator Angus: Good morning. I too welcome the opportunity to exchange ideas with you. I think you said you would be here twice a year. I was hoping it might be more.
Everything that I have read originating from the bank in the past three or four months has been along the lines of what you said this morning.
Managing our economy is tricky and delicate right now. Dynamic changes are taking place, not only domestically but also globally. In the whole economic picture, there are realignments, new products, new ways of dealing with things, and the risks obviously remain to be assessed in some cases. How we react and adjust, I gather, is your point as to how you would conduct your own mandate.
We have had an adjustment, if you will, or a change of government here in Ottawa recently, February 12 or whatever, right at the time when these tricky adjustments are taking place or are being called for. You have talked about the need for greater transparency on how you conduct your mandate. I was just wondering what, if any, changes in direction on which you may have counselled this new government, the Minister of Finance and/or Prime Minister, in this regard. Might we look for a change in direction, first of all? That would be the preliminary question.
Mr. Dodge: I cannot really answer that last question, senator. I do not know the answer.
The counsel we have given continues to be quite clear. First, it is important to continue on the track of maintaining the fiscal balance to allow the debt to GDP to fall over the coming decade. That will help a lot with Canadians' confidence that governments will be able to supply the services to which they are committed and that they will not be creating upward pressures on inflation that would necessitate us taking strong action. That is an extraordinarily important piece of counsel.
The second point, which, of course, central banks generally make, and not just central banks but most commentators, is that market flexibility is extraordinarily important to allow adjustments to take place with the minimum of disruption. There is no unique, single way to go about doing that, but as I said earlier, it is important that labour markets remain as flexible as possible and that workers are supported as they move from one activity to another, because in times like these we are looking for considerable structural change in output.
Senator Angus: I assume that when you give advice, one thing you would do is point out particular economic risks that might exist in the system. Would that be a fair understanding on my part of your role?
Mr. Dodge: Absolutely, as best we can. It is not just to the federal government, of course. We do meet with the provincial ministers of finance, collectively and individually, and go through it with them as well.
Our commitment is to do what we said we would do, which is to aim for inflation of about 2 per cent, and if we are below to get us back up, and if we are above to get us back down. We recognize that a period of adjustment such as we are going through does create some pressures, and indeed, to the extent possible, we would support that through monetary policy. It is exactly appropriate because we have inflation that at the moment is well below our target.
Senator Angus: My question about any new advice you might have given was triggered by the one thing that seemed new coming out of this new administration, if you will, in their budget, which was the treatment of or the warning about income trusts. It has received a lot of comment in the economic press, of course, and some reaction. I read the other day that in the U.S., there is perhaps a bubble developing in terms of currency carriage traders who take these positions of borrowing short and take advantage of lower interest rates in different jurisdictions. At times, when the short rates may be about to increase, which we understand might be the case in the U.S., it becomes an issue or causes a fear amongst these kinds of traders.
When you talk about the dynamic changes taking place globally, one of those changes is the advent and the vastly increased use of these structured products and these highly risky instruments. You yourself said at an earlier session that literally billions of dollars could be transferred at the drop of a hat or the press of a button. We had a scary situation about five years ago in the States, with that big hedge fund that had to be bailed out by all the big financial dealers and banks in New York. I think it was called the LTCM. In any event, there seemed to be a lot of hedge funds out there dealing in these, and clearly it appears that is one area of risk.
I was just wondering if that was perhaps the fine hand of Governor Dodge suggesting maybe we had better take a second look at these income trust funds, which seem to be trading in an unregulated way and could be an issue here.
Mr. Dodge: There are a lot of issues in there, senator. I would like to start in the middle of your points.
There have been, over the course of the last 15 years, a lot of new financial instruments invented that distribute risk, that allow for a different distribution of risk than the traditional, plain vanilla, 1980s instruments that were out there.
We, and I think every other central bank, and certainly the IMF and the BIS, have done a lot of work in trying to ascertain exactly what has happened. What we know from this, and this is very much to the good, is that financial intermediaries, in particular the banks, have been able to move some of the risk that resided right there in that very focused sector out to other risk bearers through the use of these various instruments.
What we do not know, and what gives us a wee bit of pause in our enthusiasm, if I can put it that way, is where these ultimate risks are residing and whether indeed the capacity to bear the risk is stronger. We think it is stronger, but we do not know quite where it is.
A lot of work is going on right now to try to establish that, but certainly the evidence from 2001-02 was that these instruments in fact have helped a lot in putting risk where it can be more effectively borne and taking the concentration of risk off the banking system. Certainly the evidence so far is that these instruments have been very helpful to the system as a whole.
Then you come to the particular issue of the income trust, which, of course, were created very specifically in the form of rates and royalty trusts to provide for an efficient mechanism for the market. We in Canada do not have a highly developed, non-investment grade, long-term debt market. We have been trying, and in some sense, the income trust plays a small role in filling that particular gap.
This is not necessarily a bad instrument. Indeed, we specifically created it to try to deal with royalty and real estate income. It is clearly appropriate in some other circumstances as well.
I think the Department of Finance was trying to get at the problem that always exists when there are tax implications that are rather different for you or I holding them in our ordinary portfolio than they are for pension funds or other tax-exempt entities. You would have to ask the department, but I think that was the issue.
Ten years ago I might have known enough to comment on that. I am no longer close enough to comment on that issue.
Finally, I will speak to the issue of hedge funds and institutions playing the curve. At the moment, we are coming to the end worldwide of a period where we had extraordinarily low interest rates. The assumption of markets is that not only are rates going to move up across the curve but also that the curve will flatten. There is somewhat more risk going forward for any institution that is relying on the slope of the curve for its activities.
Mr. Jenkins can address your last issue, with respect to the carry trade on currencies.
Mr. Jenkins: It is not an element that at the moment we view as being particularly significant in terms of the information that we look at and the forward positions of traders in these markets. We do track this information fairly closely. You do see times where that can get offside. At the moment, it does not appear to be a major force in the market, certainly not in the Canadian dollar market.
Senator Harb: My first question deals with the interest rate spread between Canada, the United States and Europe. What are the factors that determine the level of the spread? Is it the exchange rate or inflation? What are some of the factors that come into play when we determine the interest rate level in Canada?
At what point does the Bank of Canada decide to either buy or sell currency in order to stabilize the situation?
Mr. Dodge: First of all, Senator Harb, it depends a great deal on which part of the L curve you are talking about in terms of spreads. The overnight rate, the fed's funds rate or the bank rate in Europe is clearly central bank policy. That is what we can directly influence.
Central bank policies are all different. In Australia, for example, they have had some real worries about inflationary pressures. Their bank rate is quite high. In the United States, where they have had exactly the opposite, the bank rate is low. In Japan, where they have had deflation, it is very low. That is central bank policy.
The more interesting issue is what is it that influences rates at 10 years or 30 years out there in the curve? Inflation expectations play an enormous role. We can see in Canada those expectations are anchored at 2 per cent. There is not much uncertainty.
One of the great advantages of inflation targeting, whether it be in Canada or other countries, is that it provides an anchor. It is quite clear that inflation matters a lot.
The expectations about the relative supply of and demand for money, in particular, currencies, play a role over time. You will see that even when inflation expectations are similar in different countries, you do get some differences at the long end.
That is very much market driven. As we said earlier, corporate demand for funding, because of relatively high profits here and in the United States, bad profit performance in Europe and recovering profit performance in Japan, has not been that great. There has been much internal funding. Corporate demand for funding has not been all that large, although there has been some attempt by corporations to move from short-term to longer-term debt.
The real issue is government. In all of the G7, with the exception of Canada, there are relatively large deficits and relatively unclear plans as to how those will be dealt with over time. That exerts upward pressure on bond rates in other countries that we do not have here.
It is very interesting to look at Canada and the United States. You find that at the very short end of the curve there is a difference of 75 to 100 points in yield. At the long end of the curve, it is almost flat.
Those are the factors.
There is one other thing that is a little worrying to all central banks around the world. Nominal interest rates are relatively low. Therefore, there is a search for yield. There is a tendency at the moment, because of these low nominal rates, for investors to be moving into riskier markets at relatively smaller interest rate spreads than are traditional.
That is true in the domestic markets. You can see from our report that the spreads have come down.
It is true in the international markets and government markets. Spreads have come down.
We know that rates will begin to move up, driven in particular by the U.S., but other countries as well. These spreads will widen out. One worries a little that investors have not taken fully into account the risk of that happening.
Let me pass it to Mr. Jenkins because this is an issue that we will discuss in Washington this coming weekend.
Mr. Jenkins: Implicit in the governor's comments so far, particularly when you look at the issue of interest rate levels across countries, is that central banks run monetary policies appropriate to their domestic situation. As the governor indicated, the situation does differ substantially across the globe. Implicit in that as well is that most countries in the industrialized world have a flexible exchange rate, which is the framework within which we operate in Canada.
We believe that this flexible exchange rate has served the Canadian economy well. Going back to part of our earlier discussion, the issue is not whether you can insulate yourself from all of these global adjustments that are taking place, but rather how you can best adjust to them. The exchange rate for Canada has played, in our view, this important ``shock-absorber'' role. For example, there was the effect of the Asian crisis on Canada and the issues we have been discussing today that have led to a stronger currency.
From a monetary policy perspective, we do not take a view as to what the level of the currency should be. Our objective is within the framework of inflation control as the most important contribution we can make to sustain good performance of the Canadian economy, and to set interest rates at levels that promote that with the exchange rate, responding to the kinds of developments that we have seen in playing that role. We have a framework with an inflation target, a flexible exchange rate and set interest rates at levels we deem to be appropriate to achieve that basic objective of inflation control. That is what we contribute to good, sustained, ongoing economic performance.
Senator Harb: In light of these low interest rates, does there seem to be a tendency of consumers to borrow and accumulate debt? Is there concern that at some time, as the interest rates creep up, we may have some kind of by- product of this debt accumulation by Canadians and consumers around the world? Such debt may have an adverse effect when some consumers come to realize they cannot meet their financial obligations at higher rates of interest. Do you have any advice for government on sending out the message to consumers that the party might come to an end?
Mr. Jenkins: In response to your question, senator, we think that the household sector balance sheet is in reasonably good shape overall. That is also true, as the governor noted earlier, for the corporate sector. This is one of the fundamental strengths of the Canadian economy at the moment. Having said that, it is absolutely true that debt levels relative to income levels have continued to rise. However, when you work through the implications of that for the overall household sector balance sheet, relative to other ratios of debt to assets, a goodly amount of the borrowed money in recent years has gone into real estate. We are seeing some increases in house prices, but not at rates that we would consider to be speculative and certainly nothing close to the experiences we had in the boom-bust cycles of the 1970s and 1980s, to which we do not want to return.
More important is that debt service ratios are very low and, of course, this is one of the by-products of the low- inflation environment that we have now. The real pressure of the 1970s and 1980s occurred as those interest rates moved up to extremely high levels in response to high and rising inflation. That does not exist today and we do not want it to return.
We have done sensitivity analyses around this issue because it is important to understand how these relationships play out as we move forward. We have looked at the household sector balance sheet and prepared sensitivity analyses in terms of the implications if interest rates were to go up 200 to 400 basis points. This is not a forecast but merely to gain insight into the implications of such a scenario. We believe that even with such an increase in interest rates, the household sector balance sheet and its debt levels, given the low debt service costs, would still be in solid shape.
Senator Moore: My question relates to Senator Harb's question. I was thinking that one result of lowering the interest rates is increased consumer purchasing. I recall that last Christmas, it was reported that consumer debt in Canada was quite high. Perhaps that was one of the reasons that retail sales were not as high as anticipated. I expect that your bank monitors consumer debt closely.
How do you achieve a balance in the central bank rate such that people will continue to purchase goods, so that productivity is sustained at that level, but not overextend themselves to the point that they pull back and stop spending, thereby creating a huge drop in product demand that causes producers to lay off employees? What kinds of factors do you look at to achieve such a balance? How big a role does that play in your setting of the central bank rate, which is followed, of course, by the chartered banks' interest rate?
Mr. Dodge: Senator, that is precisely the issue we confront every six or seven weeks when we sit down to deal with the setting of rates. At the broadest level, we are trying to keep the economy operating as close to capacity as possible so that we are not putting undue pressure on markets, which would drive inflation up, and not leaving such a big gap between the potential and the actual production such that we would drive inflation down. That is where we would like to be.
It is easy to express but considerably more difficult to execute because the concept of an output gap is not absolutely precise, is difficult to measure and requires a certain amount of judgment. In times such as now, when change is taking place both in the structure of demand and in the structure of production in the economy, it is even more difficult to know precisely where you are. Much judgment comes to bear and inflation targeting does not remove the judgment in any way, shape or form. Rather, it provides a framework in which to make that judgment. That is precisely why we issue these reports twice each year and quarterly updates, to tell the world the basic framework, in our view —
Senator Moore: — for the Canadian economy?
Mr. Dodge: We start with the world and then move to Canada. Knowing that basic framework allows everyone to make some kind of judgment and to understand how we see the world. They are able to judge whether our view is likely to be right or wrong, or high or low.
Senator Moore: Or more risky.
Mr. Dodge: It also gives some indication — that projection of the balance of aggregate demands and supply will move in Canada and the world — if that holds, how the central bank will likely react over time. We believe this to be an extraordinarily good way to do business, not that we will always get it right. Basically, everyone has some understanding of what we think about how the economy is likely to perform and about the framework within which we will react. That adds a great deal of stability to the operation of the economy.
Our experience with this framework since 1991 is that we have continued to refine it over time to make it better. Our experience has been extraordinarily good. Many other countries have called on us to lend a hand as they have tried to create a framework that does the same sort of thing.
Senator Moore: Every six or seven weeks you look at the numbers. Do you then have a figure as to what the consumer debt is in Canada?
Mr. Dodge: We know what is happening. We review the economic numbers, the credit numbers, the international numbers and the expectations of businesses' numbers, and obviously we rely on other surveys for consumer expectations and what is going on in financial markets. Those five viewpoints are presented because they may not always show exactly the same thing. It is against those five pieces of analysis that we make our judgment.
Senator Moore: Is there a number that would cause you to say, ``Gee whiz, this is too high, folks, we have to rein this in, we have to exert some pressures on the economy and get this debt load down, consumers have to be given a message here to live within their means.'' Is there a number, or would all these other factors dictate that?
Mr. Dodge: Obviously, senator, there is one thing when you say ``a number.'' If we acted purely in terms of aggregates, I do not know what the number is, but it is above where we are currently.
Senator Moore: I gathered that, because you have not taken any steps.
Mr. Dodge: There is another issue, that is, the distribution of that household debt. If you look back in time, what has got not only us into trouble, but also other countries, has not just been the aggregate level, but that credit was extended to people who had relatively limited capacity to deal with it.
We do, obviously, look not only at levels, but also at conditions and how the banks are lending, what they are lending on. In terms of the housing market, or as Senator Massicotte knows very well, the commercial real estate market, we look very carefully at the degree of security, if you will, in those areas. We have learned from bitter experience that that really does matter. There are distributive and others elements, not just the level.
Mr. Jenkins has been on the bank side longer than I.
Mr. Jenkins: These are numbers that we follow closely. We gather household sector and corporate sector credit figures from a number of different sources. We look at those on a monthly basis. This is an information set to which we pay quite a bit of attention. Again, there is not one number; we look at the figures in the context of the overall balance sheet.
If I may just, Mr. Chairman, take a minute, I would like to loop back to a question that Senator Meighen posed earlier and link it to the governor's comment about the framework, and that is the issue of productivity and is it a goal. The answer was definitely yes, but it is important as well in the context of the framework that we have this notion of the output gap and where the economy is currently operating relative to its potential. One component of that potential is productivity growth. It is a concept that is important within this framework as well. If productivity is growing at 2 or 3 per cent, that will influence how rapidly the economy can grow without inflationary pressures materializing.
Not only is it important in terms of raising standards of living in the country, but also it is an important component in this framework. It is a concept and an area of research that is quite important to the bank.
The Deputy Chairman: In response to Senator Harb, I believe you used the term ``searching for yields'' and your concerns in that regard. Where are people searching for yields and where are institutions searching for it? Where are they investing that so concerns you? I understand you have a meeting in Washington about this subject this weekend? Could you follow up on why that is a concern?
Mr. Dodge: There are two areas. I was looking for the chart.
Mr. Jenkins: We do not actually have it.
Mr. Dodge: I was looking for the chart on spreads that we have in our financial systems review, but we did not put it in the documents that we have brought to the committee.
We have seen two things, senator. First, we have seen the spread on single and double B relative to double or triple A domestically. In North America, those have been squeezed. A single B corporation is rated single B versus a double A for good reasons. The interest rate spread, certainly in absolute terms, is relatively narrow by historic standards.
When I say ``searching for yield,'' what we are seeing is that people not wanting to accept the very low rates on good investment grade securities have been moving into the non-investment grade market and, hence, are accepting a little more risk in order to get that yield. This is a perfectly sensible thing to do, but it does mean that they are taking on more risk and those spreads have become relatively narrow, which should make people just a little nervous that perhaps the amount of risk they have taken on relative to the additional return may not be exactly right.
Where we have seen an even greater compression of spreads is in the market for emerging market government debt, where spreads have come in from exceptionally wide levels, admittedly, but to really quite narrow levels. Those who have lived through earlier instances of problems are somewhat nervous that with these narrow spreads, bondholders are not fully taking into account the risks. In addition, while it is extraordinarily helpful to highly indebted nations, it does provide more incentive for countries to take on debt at levels that might not be totally appropriate. That is why we all are somewhat nervous, because the potential for those spreads to widen out now is quite high.
Mr. Jenkins: The meetings the governor was referring to are the central bank governors and finance ministers of the G7 meetings in Washington Friday night and Saturday, and the semi-annual IMF meeting, also in Washington.
Senator Meighen: We spoke about consumer debt and the high levels at which that presently sits. Is it axiomatic that if the figure for consumer debt is very high, the figure for consumer savings is very low? I understand that the figure for consumer savings is at a record low.
Mr. Dodge: Yes, except you have to be careful not to mix up a stock and a flow. The debt is a stock; the savings rate is a flow number. In aggregate, if you look at consumers' net worth, the net worth of households has been rising.
Senator Meighen: That is why Mr. Jenkins was saying that notwithstanding record levels of consumer debt, he is not as worried as he might be if aggregate household income were not rising?
Senator Moore: Plus, because the type of debt is in real estate, you are saying it is of lesser concern than if it was consumer goods. That is the impression I got.
Mr. Jenkins: The point was that the debt is not in assets where we would view there to be a speculative play, if you like. Thus, the value of that asset, we feel, will be preserved. That is really the essence.
Senator Harb: The key phrase is ``net worth.''
Mr. Jenkins: These savings rates from the national accounts are important measures but they are only partial measures. That is why we continue to place emphasis on the overall balance sheet, which captures the assets and their value to drive you through to this net-worth calculation, which, for the household sector, has been rising at a reasonably rapid rate.
Senator Meighen: Is it a fair statement that the spectre and the concern about deflation are off the table now?
Mr. Dodge: I do not think you heard us talk about the spectre of deflation.
Senator Meighen: No, but some commentators did, and were worried a year ago, at least, that we could fall into a deflationary period. It is not a concern of yours, obviously.
Mr. Dodge: It is always important to go back to fundamentals, and what will drive inflation or deflation is a huge gap that persists over a long time between the potential, in this case, of the world economy to produce and current levels of consumption. That will happen over time, and so collectively, in the end, if we each do our own job right, then we will not have a problem. If some do not do their job right, especially the big players, then there can be problems.
I think the issue that we had looked at or that had been driving some of that concern was the very sharp, measured increase in labour productivity in the United States during a period of relatively slow economic growth, something that is almost unprecedented in history. Because of that, people say, there is something really different happening here.
In fact, a rise in productivity is fantastic because that is what enables us to have a rise in real incomes. However, there is a bit of an adjustment process as we go through it. I think people got a little too mesmerized by and perhaps a little too focused on that.
On the other hand, let us be clear, there was quite a significant output gap in the United States, however you go about measuring it, and so it was very appropriate for the Federal Reserve to be running pretty expansionary monetary policies.
Perhaps there was a concern. Indeed, perhaps that concern led to policy that ensured, at least over time, that it did not become a reality.
Senator Meighen: Finally, long-serving members of this committee will remember a number of appearances by your predecessor, Governor Thiessen, and the great interest evidenced at these committee hearings and in the public in general in the great question of to peg or not to peg the dollar. You have made numerous references today to the advantages that you see in the inherent flexibility in our present system.
In your mind, is the pegging question ``off the table,'' to repeat that phrase? Do you think that the flexibility you have enjoyed and the results you have achieved because of it have demonstrated beyond much doubt the wisdom of not pegging the dollar?
Mr. Dodge: For the foreseeable future, it would be hard to see a convergence of circumstances that would make it more advantageous for us to have a fixed rate with the U.S. as opposed to a flexible rate. That is not a theological point of view at all, but rather a pretty hard-nosed, empirical point of view that the structures of our two economies are quite different. There will be periods such as the one we are in right now, where we have a relatively strong movement in commodity prices. If we had to move all prices in our economy up to adjust for it we would be in some trouble. In 1997, we would have had exactly the opposite problem. That is number one.
Number two, as I said earlier, the single market to which we really have to pay a lot of attention is the labour market. It is the market where adjustment is the most difficult. Certainly, the Canada-U.S. border makes it much more difficult for labour market adjustments to take place back and forth.
I think there are two very powerful reasons to lead one to the view that it is advantageous for us, and indeed for the United States, to have a flexible exchange rate.
Senator Massicotte: Let me just go to another subject, a broader one, if I may. I would like to make use of your personal knowledge, as well as of the bank's research. As you know, the Bank of Canada has one of the premier research institutions in Canada from an economic point of view, and let me try to make use of it to allow me, and others, to understand better what is happening. I am talking about demographics. We read lots about how, within 20 years, we will see a major change in the type and nature of our population. Statistics Canada, around six months ago, came out with different projections of population trends, and I would summarize it quickly by saying that the workforce population will go down in all parts of Canada, with the exception of Toronto, Vancouver and, perhaps, Montreal. Rural population will decrease significantly. We will see tax-related dollars to governments going down significantly. Obviously, income will go up. I know your solution re the health costs, which will go up dramatically, is to reduce GDP to debt ratio and allow governments flexibility to meet those needs. From an economic well-being point of view, what other structural elements do you see yourself facing within 20 years in dealing with the fact that in most parts of the country the number of people working will be smaller? Obviously that affects the infrastructure and real lives. Can you comment on what we should be careful to look at?
Mr. Dodge: Senator, I think you raised an extremely important issue. In me, you do not have the greatest expert sitting at the end of the table to try to give you some views on it. However, it would extraordinarily useful for this committee to follow up with other witnesses in dealing with it.
Let me first say I really cannot give you any insights on the geographic distribution. I have done little work on that.
What I have done more work on, and what we have done more work on at the bank, is the impact of the changing age distribution.
First, let me correct one particular phrase in your question, ``fewer workers.''
We will have relatively fewer. It is not an absolute decline, at least not so far forward as we can see with any certainty, given any reasonable assumptions about immigration, but we will have fewer workers relative to the size of the old age population. The number of active members of the labour force per retired person will indeed shrink quite dramatically, starting probably sometime in the middle of the next decade. At some point, the absolute number shrinks, but that is a bit further on.
An interesting question, as we move through this next decade, is: What will happen to the participation rate of workers over 60? We noted in the 1990s a dramatic reduction in the fraction of 60- to 64-year-olds who participated in the labour force. We now have a large group of people born after 1946 who are about to enter this cohort. Our sense is that there are many economic forces that will mean that those participation rates will in fact rise, so that will attenuate some of this impact for a time.
Second, if we think of the age 65 to 70 cohort, which, when you get out to the end of the next decade, will be a very sharply rising one, given the better health of people, there is a tremendous opportunity for greater participation, either in the market economy or in the voluntary, or third, sector, by this very healthy, young-elderly part of the population.
Indeed, the operation of markets, the operation of social forces and so on, will quite naturally lead us in that direction. We have to prepare for it, but it will not be quite as abrupt as one would think if one simply took the participation rates in 1990 and ran them forward. We have to prepare for it. I do not want to diminish the problem. I just say that we must be a little careful.
Second, the tax issue is an interesting one. People often forget how we treat savings for retirement. First, we allow the deduction of pension contributions, RSP contributions and so on at the time that they go in, but we tax them as they come out. Therefore, as we get into that period when we have more retired people, we have a change in the balance between the amount of saving by younger people and the amount of income being paid out to older people, so the situation is not quite as severe as you would imagine. The fiscal impact is not quite as severe as one might imagine simply because of the way we have treated contractual savings, be they pension, CPP or RRSP. That is an important issue.
The third issue is health. This is a very difficult one, as you well know, but here again one needs to be a little careful because we do know that, while health expenditures tend to rise by age cohort after the age of 50 or 55, most health expenditures for any individual actually occur in the year or two prior to death. Therefore, the fact that the population is aging does necessarily mean that you will have a huge demographic push. However, the real issue is that medical science keeps inventing new things we can do for people. Those tend to be things to deal with chronic diseases and, hence, there is a technological push that continues to increase health costs. How to deal with that is a debate for another committee at another time.
In conclusion, it is an extraordinarily important issue. It is one about which we must all be concerned, either as individuals or as society and government as a whole. We must be careful not to panic too much, in the sense that there are natural adjustment mechanisms that will take place.
Mr. Jenkins: To add an additional comment to that in the context of demographics, the one issue we continue to hear quite a bit about from various associations that we talk to is the trades. It is the question of training and education and ensuring that we have in place the mechanisms to provide apprenticeships. Governor Dodge has talked about the health side and the tax side, but there are also implications on the educational side as a result of these demographics, and there are sectors of our economy that are experiencing pressures.
Senator Massicotte: You are right that the overall workforce population in Canada will be going up by a relative percentage. Statistics Canada made three projections and used the median one. That is only the case for Vancouver, Toronto and Montreal, because most immigrants go to those cities. The quantum will actually go down in 20 years and that is alarming to many cities.
I want to paint a scenario with regard to the Monetary Policy Report. I am sure that you will tell me I am being too simplistic, but I will try. You say that inflation will be at 2 per cent at the end of 2005. You also say it takes six to nine months to see an impact from monetary decisions you take. One would suggest that interest rates will remain the same, if your projections are accurate, until probably the second quarter of 2005. We also know, as you note, that the American economy is doing better. Productivity has been high and employment gains have been significant, so one would project that interest rates will rise there. One would project that the American dollar will go up and that our dollar will go down, relatively speaking, if interest rates remain the same. What is wrong with that picture? Is it okay?
Mr. Dodge: That is your picture, senator. It is not okay, and I do not say that facetiously. At every meeting, we have to make a judgment on interest rates against what has been transpiring, but it is quite clear that in world terms there will be upward pressure on rates, both at the short and the long end, as we get into 2005. We have had a period of abnormally low long-term rates in the industrial world, and we know that these are going to move up at some point. They will move up differentially in different economies because those economies are performing somewhat differently as we go forward.
In terms of the Canada-U.S. differential in exchange rates, that is a factor influencing exchange rates, but only one of a number of factors, so you have to be very careful not to make the error of thinking that very short-term differentials are driving things. It is one influence, but only one, on the movement in exchange rates.
Senator Angus: Gentlemen, I thought those comments on the previous question, about the demographics, were very thoughtful and interesting. I am hoping we will be able to continue that dialogue in another session, because these are really issues for all Canadians — how we will manage our economy or how we will carry on in the future.
I would like to come back to where I was earlier, on the adjustments — these tricky adjustments that need to be made to the changing global economy. You have talked about improving productivity to respond to the increased competitiveness, and maybe moving our economy more into the high productivity sectors, if possible. You have talked about managing the risks, such as those posed by the search for yield, and I was just wondering, what other adjustments need to be made? Clearly, adjustments have to be made because things change overall, as you have pointed out so well.
Could you perhaps leave us with a list of two or three areas that we have not touched on, where adjustments are in order and where the way they are made is critical to our economic well-being?
Mr. Dodge: Yes. Senator, let me take one issue that I think continues to concern us at the Bank of Canada, and on which we continue to have discussions with a lot of people. That is the supply of skilled labour to make a number of the major capital investments that we will be making, whether it is pipelines to the North, whether it is oil sands, whether it is offshore oil and gas, whether it is mines, whether it is infrastructure in cities.
Senator Angus: Let me understand that. In other words, there is a shortage of the necessary labour to make these quantum leaps forward, is that it? It was clear in the oil sands; I saw that.
Mr. Dodge: That is right. ``Shortage'' has a very well-defined meaning for an economist so I want to be careful, but I want to be quite clear that it is extraordinarily important that we train more young people in these skills going forward. We can foresee, at least for a time, an emphasis there, and we know that in the past that skilled labour has been a constraint in these areas, number one. Number two is we know that in many areas, the skilled labour force in this country is relatively old.
While it may be okay as a central banker, at age 65, to carry on manipulating statistics on a piece of paper, it is a lot harder to continue to lift 40-pound blocks or do some of those skilled jobs, whether it is millwright or whatever, as one gets older. It is very important that we do better in this regard. That is something that is important not only for federal and provincial governments, but also extraordinarily important for enterprises to take into account.
There is an example of something that we can see quite specifically that we have to be concerned about; and we do not hesitate to speak to business, or to labour groups, or to governments, telling them that this will be quite important.
Senator Angus: Are there other obvious ones?
Mr. Jenkins: If I may, I would like to shift this a little. The focus, quite rightly, has been on adjustments vis-à-vis the Canadian economy. However, in the context of these global developments, there is a global adjustment that is also important to bear in mind here. This comes back to some of these international imbalances that we were discussing earlier, through trade imbalances and the fact that the U.S. is running this very large current account deficit, overlaid now with this fiscal deficit. The people providing the funding for that are the Asian countries — China, Japan, Korea, Thailand — so there are a number of issues around this adjustment of an international nature that are also very important.
The point we have been making internationally in discussions, and I am sure we will again this weekend, is what we call the ``multi-faceted'' nature of it. Clearly, on the issue of exchange rate adjustment, although it was not a direct response to Senator Massicotte's question, that is why I mentioned the exchange rate regimes in Asia as part of how we should be thinking about these adjustments globally. The importance of having strong demand worldwide, and how that plays out, of course, will continue to have an implication for the Canadian economy.
Yes, we are thinking about it very much in the context of what it means for adjustment within Canada, but also in the context of what it means for the global economy and the types of adjustments that are needed to move this forward.
Senator Harb: In line with what Mr. Jenkins is talking about — what has taken place in the Asia-Pacific region versus the account deficit in the U.S. — one cannot help but observe that a very large percentage of companies that are producing the goods in, say, for example, China or elsewhere in the Asia-Pacific, are in fact American companies, and American capital went to those countries in order to set up shop there.
We are seeing a number of phenomena taking place internationally, first, in terms of regionalization of trade between blocs — you have the European Union, you have the Asian blocs, you have the free trade with America now that a number of countries are pursuing. You have that on one front, and then on the other front you have what one might call a pursuit of bilateral-type arrangements between specific economies — the European Union going after Mexico, the United States going after other countries in order to establish direct bilateral links. Then you have the third component, and that is the multilateral type of track, whether that is the World Trade Organization or other international institutions.
When you are deciding on monetary policy, whether that is here within Canada or on the international scene, to what extent do you look at those types of trends? Is that something that policy-makers such as government have to take note of to a large extent, or is it something that would pass with time and does not necessarily have to register in the government's mind or the banker's mind?
Mr. Jenkins: I think the first point to emphasize is that the growth of world trade has been beneficial to economies. Therefore, certainly from our perspective, when you think about an improving world economy, that would be one element that we would continue to talk about. In fact, as the governor was suggesting earlier, when you look at the types of adjustments the Canadian economy has gone through, continued openness of markets has been a contributing factor.
Indeed, in terms of these global imbalances, if you like, you do hear talk of protectionism, and that is not where you want to go. As a policy-maker, you want to continue to talk about the importance of opening markets, and having flexibility through those markets to not just facilitate stronger economic growth but also the adjustment of economies to circumstances that will always be changing.
The risk, of course, is if you are not always moving forward, you will not just stand still. The risk is you will slip back. Therefore, yes, I think it is an important part of how we think about the functioning of the global economy and what we consider to be right not just for Canada; if the global economy is working better, it benefits us as well.
For example, we do not do a lot of trade with Asia, but we certainly got caught up in the Asian crisis and it demonstrated very vividly that those links do exist. These are certainly part of the discussions we have and the way we think about the functioning of the global economy and Canada's position within that.
The Deputy Chairman: I would like to thank Governor Dodge and Mr. Jenkins. It was a very good session. We got past some of the broad policy questions and into some detail. I enjoyed that very much and I am sure the senators did as well. We will see you in the fall.
The committee adjourned.