Proceedings of the Standing Senate Committee on
Banking, Trade and Commerce
Issue 11 - Evidence - October 27, 2010
OTTAWA, Wednesday, October 27, 2010
The Standing Senate Committee on Banking, Trade and Commerce met this day at 4:20 p.m. to examine the present state of the domestic and international financial system.
Senator Michael A. Meighen (Chair) in the chair.
[English]
The Chair: Today we are pleased to welcome from the Bank of Canada Mark J. Carney, Governor, and Tiff Macklem, Senior Deputy Governor. They are here to discuss the bank's latest Monetary Policy Report and to explore other issues relevant to the bank's mandate.
I cannot help but say that I know the governor and senior deputy governor were in another place yesterday discussing these matters. However, that was really the practice round, governor. This is the real thing here, and we are pleased to have you back with us again, all joking aside.
[Translation]
Honourable senators, Mr. Carney was appointed Governor of the Bank of Canada on February 1, 2008, for a term of seven years. As governor, he is chairman of the board of directors of the Bank. He is also a member of the board of directors of the Bank for International Settlements (BIS), and chairman of its Committee on the Global Financial System (CGFS).
Born in Fort Smith, Northwest Territories, Mr. Carney received a bachelor's degree in economics from Harvard University in 1988. He received a master's degree in economics in 1993, and a doctorate in economics in 1995, both from Oxford University. Prior to joining the public service, Mr. Carney had a thirteen-year career with Goldman Sachs in its London, Tokyo, New York and Toronto offices. Mr. Carney was appointed Deputy Governor of the Bank of Canada in August 2003. In November 2004, he left the Bank to become Senior Associate Deputy Minister of Finance — a position he held until his appointment as Governor of the Bank of Canada.
[English]
Honourable senators, making his inaugural appearance before our committee is Tiff Macklem, and we welcome him most warmly. He was appointed Senior Deputy Governor for a seven-year term beginning July 1, 2010.
As Senior Deputy Governor, Mr. Macklem is the bank's Chief Operating Officer. He oversees strategic planning, coordinates the bank's operations, shares responsibility for the conduct of monetary policy as a member of the bank's governing council, and participates in fulfilling the bank's responsibilities for promoting financial stability.
Prior to taking up his new position, Mr. Macklem was Associate Deputy Minister at the federal Department of Finance and Canada's G7 deputy.
Born in Montreal, he graduated from Queen's University in 1983 with a bachelor's degree in economics and completed a master's degree and a PhD in economics from the University of Western Ontario. In 1984, he joined the Bank of Canada in the Department of Monetary and Financial Analysis for one year. He returned to the bank in 1989 following the completion of his PhD, and he occupied increasingly senior positions in the research department until his appointment as chief in January 2000.
He was appointed Adviser to the Governor in August 2003, and in 2003-04, he was seconded to the Department of Finance, returning to the bank as a deputy governor in December 2004. He rejoined the Department of Finance as associate deputy minister in 2007.
Welcome, Mr. Macklem.
Those are quite the resumés for both these gentlemen.
Governor Carney, we would be pleased if you had some opening remarks. I know you are always willing to take questions, which follow afterwards.
Mark J. Carney, Governor, Bank of Canada: Thank you very much, chair and honourable committee members. It is an honour for Mr. Macklem and me to be here for the main event, as you suggest. I would note how pleased I am, as are my colleagues at the bank and on the bank board, to have Mr. Macklem at the institution. He appropriately joined this institution on Canada Day, after that very impressive resumé and career, which is fitting.
We are pleased to be here to discuss our views on the Canadian economy and our monetary policy stance. I would like to give you some highlights of both of those that were included in our most recent Monetary Policy Report, which was published this past week.
[Translation]
The global economic recovery is entering a new phase. In advanced economies, temporary factors supporting growth in 2010, such as the inventory cycle and pent-up demand, have largely run their course and fiscal stimulus will shift to fiscal consolidation over the projection horizon.
The bank expects that private demand in advanced economies will become sufficiently entrenched to sustain the recovery. However, the combination of difficult labour market dynamics and ongoing deleveraging in many advanced economies is expected to moderate the pace of growth, relative to prior expectations.
These factors will contribute to a weaker-than-projected recovery in the United States in particular. Growth in emerging-market economies is expected to ease to a more sustainable pace as fiscal and monetary policies are tightened. Heightened tensions in currency markets and related risks associated with global imbalances could result in a more protracted and difficult global recovery.
[English]
The economic outlook for Canada has changed. The bank expects the economic recovery to be more gradual than it had projected in July, with growth of 3 per cent in 2010, 2.3 per cent in 2011 and 2.6 per cent in 2012. This more modest growth profile reflects a more gradual global recovery and a more subdued profile for household spending in Canada.
Overall, the composition of demand in Canada is expected to shift away from government and household expenditures towards business investment and net exports.
The strength of net exports will be sensitive to currency movements, the expected recovery in productivity growth, and the prospects for external demand.
Inflation in Canada has been slightly below the bank's July projection. The recent moderation in core inflation is consistent with the persistence of a significant excess supply and a deceleration in the growth of unit labour costs.
The bank judges that the output gap is slightly larger and that the economy will return to full capacity by the end of 2012 rather than the beginning of that year, as had been anticipated in July.
[Translation]
The inflation outlook has been revised down and both total CPI and core inflation are now expected to converge to 2 per cent by the end of 2012, as excess supply in the economy is gradually absorbed and inflation expectations remain well-anchored.
Important risks remain around this outlook. The three main upside risks to the inflation outlook are higher commodity prices, a stronger-than-anticipated recovery in the U.S. economy, and the possibility of greater-than- projected momentum in the Canadian household sector.
These upside risks are balanced by three downside risks relating to Canada's international competitiveness, global growth prospects, and the possibility of a more pronounced correction in the Canadian housing market. These risks are balanced.
[English]
In response to the sharp, synchronous global recession, the bank lowered the target rate rapidly over the course of 2008 and early 2009 to its lowest possible level. We almost doubled our balance sheet to provide the financial sector with exceptional liquidity. With our conditional commitment, the bank provided exceptional guidance on the likely path of our target rate. These policies provided considerable additional stimulus during a period of very weak economic conditions and major downside risks to the Canadian economy.
With the rapid initial narrowing of the output gap, the return of employment to its pre-crisis peak, the highly effective transmission of monetary policy in Canada, and the sustained momentum in household borrowing, the need for such emergency policies passed.
Since the spring, the bank has unwound the last of our exceptional liquidity measures, removed the conditional commitment, and raised the overnight rate to 1 per cent.
On October 19, the bank maintained the target for the overnight rate at that 1 per cent. This leaves considerable monetary stimulus in place, consistent with achieving the 2 per cent inflation target in an environment of still significant excess supply in Canada.
At this time of transition in the global recovery, with a weaker U.S. outlook, constraints beginning to moderate growth in emerging market economies and domestic considerations that are expected to slow consumption and housing activity in Canada, any further reduction in monetary policy stimulus would need to be carefully considered.
With that, senators and Mr. Chair, we would be happy to take your questions.
The Chair: Thank you very much, Mr. Carney. I hope my colleagues will forgive me for exercising my prerogative as chair to open the questioning.
I wanted to mention that Mr. Carney, as you have all noticed and read in the press, is certainly making a name for himself in the world beyond our borders. He played a leading role in the G20, working to create a more sustainable framework for global growth.
This past April, I believe, the governor was named one of the world's 25 most influential leaders by Time magazine.
This past summer the governor was named Chair of the Committee on the Global Financial System, a position formerly held by a member of the U.S. federal reserve board.
His committee's mandate, as I understand it, is to look for potential sources of stress in global markets and to promote reforms.
We wish you well, Mr. Governor, and we congratulate you on your appointment.
My question, Governor Carney, is the following: Current central bank policy is to allow the loonie to float freely, although I know you have said that you would intervene in foreign exchange markets to ``counter disruptive short-term movements'' in the currency. We recall the events when that happened in 1998.
Some analysts say the Bank of Canada may have to consider intervention if other countries opt to ignore their G20 commitments. For instance, Mr. Avery Shenfeld, the Chief Economist with CIBC World Markets is quoted in today's National Post as saying:
If Canada is going to behave like a boy scout and eschew intervention, while others promote devaluation through quantitative easing [the U.S.], central bank intervention [China and Japan] or restraints on capital flows [Brazil and Thailand], it will be stuck with a strong loonie that will impede an export-led expansion . . .
Governor Carney, would you be good enough to comment on this statement? Could you also add a comment or two as to what extent and at what date you would foresee — I think Mr. Shenfeld said robust growth would return in 2012. I think you have said reasonable growth would come back at the end of 2012. To what extent is normal growth, let us say, contingent on having other countries play by the rules with regard to exchange rates?
Mr. Carney: Thank you for the question. It goes to the heart of some of the most important dynamics in the global and Canadian economy today.
Without question, heightened tensions in foreign exchange markets and the associated difficulties with the resolution of global imbalances, large current account imbalances, both surpluses in China, for example, deficits in the United States and their associated impact on the sustainability of global growth are directly relevant to the Canadian situation.
I would say that what we are doing is hardly naive or consistent with the characterization of the economist you reference. We are actively engaged, the Bank of Canada and the Government of Canada through the Minister of Finance and the Prime Minister, with our G20 partners on working on a multi-faceted strategy to address these issues through the G20, also bilaterally at the BIS and IMF. If you will indulge me, I will go through some elements of that and indirectly address our policy on the exchange rate in Canada in conclusion.
We see four elements, and we now have agreement within the G20, which was really cemented at the Toronto summit. I should note for senators the central role that Mr. Macklem played as the Prime Minister's and the minister's economic sherpa for that summit in June in Canada, cementing a strategy to address global imbalances on four pillars.
The first pillar is financial sector reform. We will probably have a chance to discuss that in more detail, but I think we all recognize that we need a more resilient and efficient global financial system that is centered in the advanced economies. There is a host of measures that need to be taken. A lot of progress has been made, and we can talk at more length about that if senators wish.
The second pillar is fiscal sustainability. A key element of the Toronto summit was to get an accord on a time path for moving towards sustainable fiscal balances, having deficits in advanced countries by 2013 and moving to sustainable debt to GDP levels by 2015-16, something that all advanced countries signed up to. Now they have to implement that and implement the policies that are consistent with that.
The third pillar is a host of structural reforms to enhance growth potential both in advanced and emerging economies, particularly in emerging economies, although in some advanced economies, such as Germany, structural reforms are necessary to enhance domestic demand to provide a new source of demand that will help adjust these imbalances.
This in many respects is the most difficult element of the package. These are multi-faceted. They will take place over many years. It is difficult to predict the exact impacts of them. Now that we are moving towards the Seoul summit and through the French presidency of the G20 next year, these should become more concrete and actionable.
The last element is obviously a move to enhance flexibility of exchange rates amongst all G20 partners. I am just back, with the Minister of Finance, from a meeting in Gyeongju City, South Korea. For the first time, we have a commitment from all G20 partners to move towards market-based exchange rates and to refrain from the competitive devaluations that you just referenced in your opening question. This is progress as a commitment but, of course, commitments have to be implemented and we have to see this measure put in place.
We are very aware of the potentially unfavourable dynamics that could arise from these tensions in currency markets. At a point earlier this year, more than 40 per cent of the trade weight of the U.S. dollar was being managed. The countries against with which the United States trade were managing their currencies in some respect and this, in effect, pushes adjustment pressure onto others, including Canada. We are working hard to get that percentage down, and all elements of the G20 strategy I referenced are central to that.
Canada's policy with respect, which is a shared policy between the Government of Canada and the Bank of Canada — it is ultimately the government's decision — to the currency contemplates intervention in the foreign exchange markets in two scenarios. The first is, as you referenced, Mr. Chair, if there is a disruption in the foreign exchange market, if there is gapping or if there are abrupt moves that could happen from time to time. This is relatively rare, but in order to have an orderly market, the bank would step in on those scenarios. Second, which is more to the point, is if extreme movements in the currency seriously imperilled the conditions that would support sustainable long-term growth in this country, which is a judgment that we would make, if necessary.
Finally, in terms of this issue unilateral intervention without backing policy action seldom works sustainably. If conditions warranted, we would look to act with our partners in advanced economies and emerging economies, if necessary. We would always work to ensure that underlying policy was consistent with the action.
Let me close on this issue with the point that, ultimately, our responsibility is to manage monetary policy to achieve the inflation target of 2 per cent. The exchange rate is extremely important in that context, but it needs to be seen in that context as well.
You asked one other question, I believe, on when we will return to normal growth. As I referenced to the opening comments, we see the output gap in the economy closing by the end of 2012. The pace of growth that we are forecasting at this point brings the economy back to its level of potential at the end of 2012. It is a different path than we had expected in July. It is a more modest path early on and there is a bit more of an acceleration later on. We effectively get to the same point in terms of the level of economic activity in the economy at that point.
Then from there on, if all transpires as forecast, once the economy is at potential, the normal rate of growth is the rate of growth of potential of our economy, which, as we detail in this report, we see now at 2 per cent real rate of growth by 2012, obviously that being the product or the sum of growth and labour input and productivity growth. I will stop there.
[Translation]
Senator Hervieux-Payette: I have a question about the contribution of exports and imports to the annual growth. You are expecting a decline in exports and imports for 2011 and 2012. What factors will be affecting this decline?
Mr. Carney: That is a very good question. I would first like to point out that the net exports are greater than the government's expenditures for the 2011 and 2012 projection period. But, as you said, that is not a big deal.
In terms of the 2011 decline and compared to the July report, the main factor is our projection of the decrease in growth rates and economic activity in the United States.
We have brought our 2011 projection for the United States down from 2.9 to 2.3 percentage points in real terms. The other factor, which is very significant and positive in terms of net exports, is an increase in the productivity of Canadian companies. That depends on the investment rhythm of Canadian companies. We are now expecting a sharp increase in our companies' investments. The increase started in the second quarter of this year, it is still continuing and we expect it to continue through the projection period.
Senator Hervieux-Payette: I have another quick question that will perhaps clear things up for us. We are told that, of all the G7 or G8 members, Canadians are among the most indebted, if not the ones with the highest debt. But there is also the issue of housing and mortgage. Is there a cause and effect relationship? We have studied the whole credit card matter here. I had an increase from 28.9 per cent to 29.9 per cent on one of my credit cards. You are supposedly keeping interest rates very low, but then I get a notice saying that there will be an interest rate increase on one of my credit cards — needless to say, I am going to return it.
I am trying to understand, because our consumers with average incomes who need to make payments and perhaps do not pay the total amount due on their credit cards, but keep a balance of just $200 at the end of the year, are increasing the debt significantly. What mechanisms make Canadians have higher debt than anywhere else?
Mr. Carney: Two main mechanisms have triggered the increase in the debt of Canadians since the beginning of the 2008 crisis — conventional mortgages and home equity lines of credit.
In the economy as a whole, these two credit factors go up much faster than the others. Personal credit, such as credit cards, does not go up very quickly and it is not the main reason. There is the fact that Canadians have been increasingly using equity loans to pay their credit cards; at the same time, their overall debt goes up. It is one of the challenges our economy is facing right now because the personal debt level has hit an all time record. It has reached over 140 per cent of personal income for the first time.
[English]
Senator Gerstein: In releasing your Monetary Policy Report last week, you indicated certain factors that are likely to moderate the pace of economic recovery. You suggested that the private sector demand is expected to become entrenched over the coming months; I believe you said in The Globe and Mail that the underlying momentum in the economy is there. You suggested that the focus in the medium term should be on increasing productivity and keeping household debt under control. From my perspective, I believe the government is very much on the same page.
Given the nature of the recent recession, the ongoing recovery, and the policy responses you have put in place and which had been put in place, is there anything you would like to see happening from a policy perspective that is not?
Mr. Carney: Ah, from a policy perspective. There are lots of things I would like to see happen, like see the Oilers win the Stanley Cup. It is a young team; we are thinking long term.
On both those issues you raise, I will say first that our view at the bank is that there is always more to do in terms of laying the groundwork to enhance productivity in this country, from a policy perspective. However, it is important to recognize that much has been done by successive governments, both federal and provincial. The tax system has become much more competitive. There have been major investments, not only recently in infrastructure, but over more than a decade in our universities in primary research and development and in human capital.
There is a host of other framework type policies that have been put in place to look to enhance competition. We are dropping tariffs, signing trade deals and doing the things one needs to do. Also, at its base we have sound macroeconomic management. Obviously, from the bank's perspective, that is keeping inflation low, stable and predictable, and from all levels of government it means sustainable finances.
Much is there. We have to do more of same; we have to focus on some areas where there are log jams. We can talk more about that. There are issues in terms of the transition from a small enterprise in Canada to a medium-sized enterprise, where a lot of the advantages available to smaller enterprises are not available up the chain, and that may cause some friction.
Though this is more of a business orientation, but can be aided by government, we also need to change orientation more from north-south to all the way east and all the way west in terms of orientation to build new markets for Canadian business.
I should say ``not just north-south,'' but all the way south to Brazil and Latin America. We are very under- represented in the parts of the global economy that will grow for a considerable period of time, and there are tremendous opportunities there. There is a role for government.
Ultimately, these are private decisions and many of the conditions are in place. It is time to move on them.
On the household spending side, we see a moderation of it, as you noted, but not a cessation. We see it moving towards levels more consistent with the growth of income in the economy, so less of this increase in debt that we were just speaking of to finance household expenditures.
This goes to Senator Hervieux-Payette's question, but we need to be vigilant in a low interest rate environment, with relative price stability. In other experiences in this case, there have been real financial vulnerabilities that have built up. There were lots of other reasons for what happened in the United States in the first half of this last decade, but low and stable interest rates were one contributing factor, in our opinion. Therefore, we and other authorities who oversee the financial system need to be vigilant about the possibility of build up of excessive debt and vulnerabilities. There are some tools that can be used, and the government did act earlier this year with some adjustment to elements of the mortgage insurance qualifying levels. Mr. Macklem cannot respond because it is cabinet confidence, but he was there at the time.
This sort of use of a macro-prudential tool is the type of instrument that, in this environment, should be considered at the appropriate time. As I said, the government has acted and we are seeing some impact of that action, some impact of the move of interest rates and we are seeing some diminution of the rate of increase of household debt.
However, we need remain vigilant. Therefore, we are not calling for additional action at this stage except for the vigilance that needs to be there.
Senator Moore: I have a couple of points. Regarding Senator Gerstein's question, I do not know how the bank can act; your role must be limited in terms of trying to reduce household debt.
You have been here before, and you cautioned the public about six months ago about household debt, namely, the need to get personal debt, provincial debt and national debt down. I do not know how the central bank can effect reduction in personal debt. I understand your role, inflation at 2 per cent and so forth, but I do not know how you can have an impact unless people realize they are in some difficulty.
I was in Boston in July for the annual meeting of the National Governors Association, and we had a report by retired Senator Simpson and Mr. Erskine Bowles who were co-chairing the president's commission on the financial sector's responsibility and reform. Thinking about what you said in your report regarding the importance of the U.S. recovery, I want to cite a couple things they said, which may have a deep impact on what you are hoping for. Medicaid, Medicare and social assistance: those three things consume 100 per cent of the revenues that flow into the U.S. treasury each year. Everything else — defence, education, infrastructure, research — is all borrowed money. It is the highest deficit they have had historically, and if they do not get it in line by 2015, they will be paying out $1 trillion a year in interest.
I am sitting here thinking about all those factors. The United States is our biggest trading partner. We are counting on them to lead the advancing nations and their economies back into some area of stability and reasonable growth.
Do you want to comment on that? They are issuing the report in December, not before the election.
Mr. Carney: That is clever.
Senator Moore: They knew it would be a political football.
Mr. Carney: If I may, I will make two comments. First, with respect to the debt issue and the role of the bank, you are correct in that our role is limited, and, at this stage, our role is principally to identify the issue rigorously. There is an element of identification of the issue to the public, to ask people to be aware and remind them that we are living in abnormal times. Rates are abnormally low, and it will not always be the case. It is only prudent to ensure that people can service their debts under normal circumstances. It is also the responsibility of financial institutions to do that as well.
With respect to policy levers, it is early in the development of other policy levers that can address these types of situations. I reference the adjustments to the CMHC mortgage insurance. That is a sort of ad hoc, one-off episodic type adjustment. It could be done again, but it is not a continuum of adjustment of these types of levers.
We are working at the international level in developing counter cyclical capital buffers so that the capital requirements for banks would increase in situations, not necessarily exactly like Canada's, but more extreme versions of that under Basel iii. It is one of the elements of Basel iii, and that would help address more directly these types of things. These systemic instruments or macro prudential instruments are in their infancy. They need to be developed, and as the instruments are developed in all jurisdictions, including Canada, authorities will have to decide whether to implement them and how best to organize the implementation of them — who has the tools, who decides to implement the tools, et cetera. It is a big issue.
With respect to the U.S. fiscal situation, I will ask Mr. Macklem. I do that in part because he knows the answer — that is the main reason — but also because it is useful to put this issue into the framework of what was discussed in Toronto and to give that perspective.
Tiff Macklem, Senior Deputy Governor, Bank of Canada: Thank you, chair, I am very pleased to be here, and I hope it is the first of many visits over my seven-year term.
Coming back to the G20 summit in Toronto, one of the important elements of this package of adjustments that need to happen around the world to sustain the recovery, as the governor mentioned, is sustainable fiscal policies on the part of advanced countries.
The U.S. government deficit is very large. Given the extreme gravity of the global downturn, that was needed. Looking forward, it will be important to unwind that fiscal stimulus and turn to consolidation.
There is a balancing act here. On the one hand, we certainly know from experience that if you leave it too late, risk premiums start to get built into the term structure, monetary policy becomes less effective and fiscal policy itself becomes less effective and self-defeating. On the other hand, if there is a sudden synchronized global withdrawal of fiscal stimulus, there is a risk that the recovery will seriously stumble. There is a balancing act to be achieved.
At the Toronto summit, the G20 countries, in particular the advanced countries, agreed on a suitably gradual but sustainable withdrawal of fiscal stimulus, and the advanced countries agreed to cut their deficits in half by 2013 and get their debt-to-GDP ratios on a sustainable track by 2016. Certainly, we believe that achieves this appropriate balance, and President Obama wrote a letter at that time which committed to that proposal.
Are there challenges? Absolutely, there are challenges, and as with every aspect of what is called the ``Framework for Strong, Sustainable, and Balanced Growth,'' the challenge is implementation. That is where everyone around the G20 table needs to live up to their commitments.
Senator Moore: There seems to be a strong possibility that in the U.S., they will do a second round of quantitative easing. I am thinking about that, and I am thinking about the agreement around the G20 table. Then there is the huge concern in the U.S. about the possibility of deflation. That is being mentioned there in the financial sector. How does all that look in terms of what you are trying to forecast in a reasonable way for our economy?
Mr. Carney: The concern that inflation will not be as high as the Federal Reserve would like or would be lower than a level consistent with their interpretation of their dual mandate is a real concern of the Fed. That is in the public domain, and the chairman and others have talked about that frequently.
In our forecast of the U.S. economy, there is an assumption of additional monetary stimulus by the Federal Reserve over the forecast horizon precisely to address this issue of inflation being lower than the Fed would want. That has a positive impact in the sense of a better U.S. growth outcome than otherwise would be the case — a knock on there — but it also has other impacts through the financial channels.
With respect to quantitative easing, that is one mechanism by which the Fed, given that they are at the zero lower bound, could provide additional stimulus. What we chose to do, when we were at the zero lower bound to provide additional stimulus was to provide additional transparency on the path for monetary policy, and we found that was quite effective in providing that additional stimulus for our circumstances. It is no secret that additional quantitative easing is being discussed by the Federal Reserve, and the point is to avoid further disinflation and deflation. Given the debt dynamics in the United States not just at the government level but, very importantly, at the personal level, it would not be helpful to move into a deflationary environment. That is a downside risk, obviously, for the Canadian economy, and it is one we watch closely.
Senator Oliver: All of my questions relate to Basel iii, and I have three or four questions related to it.
As I understand it, after the crisis of 2008, the central bank governors got together and looked at possible new regulations and safeguards designed to prevent an overexposure of banks to the kind of risks that caused a lot of damage. Basel iii found new capital and liquidity regulations. What are some of them? What are the proposed or known higher levels of capital acquired? You indicated to the chairman that you just came back from Korea. How have the details of the Basel iii Accord changed following the G20 meetings in South Korea last week? Is the Bank of Canada opposed to any of the proposals being discussed there? Does the bank think there are any missing components to the changes that are being proposed in Korea?
Finally, how will Canadian banks be affected by all this by way of costs or benefits? When can our banks start lending again? Is there anything they should be afraid of in terms of more capital requirements?
Mr. Carney: This is a very important topic. I will try to do it justice. Please follow up if I do not.
First, let me say that Basel iii makes the global capital regime look more like Canada's did coming into the crisis. There are some innovations, without question, for Canada as well. We commend the Superintendent of Financial Institutions for running effective add-ons to Basel ii.
To go to your point about some of the risks and risk capture, there are some very important and sizable technical adjustments to how risk is captured in the trading books of banks, which effectively triple the capital required to be held against trading assets.
Senator Oliver: That applies to Canadian banks?
Mr. Carney: Everything that I will say applies to Canadian banks.
Second, there is an introduction on a global basis for the first time of a leverage ratio, which is something we had in Canada. The Basel ii Accord is quite complicated because it says you need so much capital against not your assets but a risk weighting of your assets, so it shrinks the actual level of the assets. It is a more sophisticated way of doing things. That is great if you get the risk weightings right. The problem is if you think something is risk free and you put a very low risk weighting on it but it is actually risky. That was the problem that we found in the financial crisis in that the most senior tranche of structured products, of the securities — more securitized products. If you took a pool of loans — the triple-A tranche was viewed as triple-A and so is likely to fault in theory as a triple-A sovereign such as Canada. The fact was it was misrated by the rating agencies and it was much riskier to the borrower. From a Basel perspective, you only had to put a tiny bit of capital against that asset.
Where we were helped tremendously in Canada is we had a leverage ratio, which is a very simple tool that says forget about all the fancy risk weighting; just tell me how many assets and how much capital you have, and you cannot go above, in our case, 20 times that ratio. That saves an institution and a financial system from risks that you think are low but in fact are not. That innovation has been brought in. You need both.
Senator Oliver: Is the Basel rating 20, like in Canada?
Mr. Carney: It is 33. It is a different definition of capital. It is substantially equivalent because it is a tighter definition of capital than in Canada.
There are other aspects of risk that are captured better now, including bringing back onto the balance sheet a bunch of off balance sheet measures, particularly securitizations and liquidity facilities.
One of the key elements, though, moving to the second key change for Basel, which again is more like Canada, is that not only does the capital have to be higher but it also has to be higher quality. We use the word ``capital.'' It is used fairly freely around the world. In Canada, it basically means tangible common equity. In Canadian banks, 75 per cent of your Tier 1 capital has to be tangible common equity. It is a real equity.
In effect, in Basel you could get away with 50 per cent under the old system of your assets and tangible common equity. In fact, you could carry a lot of assets that were not really assets if you got in trouble, so you could get away with 25 per cent. We are at 75 at least. In fact, many of these international players had only 25 per cent of their Tier 1 capital in tangible common equity.
The market did not care when everything was fine, but as soon as the trouble began, they saw right through this and realized the emperor had no clothes over here, whereas the Canadian banks were rock solid in terms of their capitalization.
Basel has now moved to Canadian-style predominance of tangible common equity, and the minimum has been raised much higher. That minimum went — and this is a bit of an apples and oranges comparison — from 4 per cent to 7 per cent for Tier 1 capital. What senators need to know and Canadian institutions understand, in effect, it went from 1 per cent to 7 per cent for the reasons that I just described, that you did not really have to have equity and you could carry these assets that were not assets. It is a sevenfold increase in the level of capital that is required.
For Canadian banks who are carrying high levels of tangible common equity and continued to build through the crisis —
Senator Oliver: They were already there.
Mr. Carney: — their ease of transition to the higher standards will be relatively straightforward, although as the superintendent reminds us today, they should be prudent in adjusting their dividend policies. I am referring to a speech made by the Superintendent of Financial Institutions Canada today.
You asked about unfinished business on Basel. We would highlight two elements particularly of importance. The first is the countercyclical capital buffer that I discussed earlier. I mentioned that it is a bit in its infancy. It is part of the accord, but it still needs to be specified as to how to use it.
The second thing, which is incredibly important, and Mr. Macklem and I have been working directly on this along with the superintendent, is instruments called contingent capital or bail-in securities. The point of these securities is that if an institution gets to a point where it would fail or ceases to be a going concern in the judgment of the Superintendent of Financial Institutions, those securities automatically convert to a lower level of the capital structure. In other words, a contingent capital instrument converts to equity. You get to a point where you need more equity, you have it in the contractual terms of that security and the bail-in security is written down ex ante, which creates more capital for the institution.
We think this is central to the ability to remove moral hazard from the system, to have more readily resolvable institutions. This is something that Canada along with Switzerland has been pushing for some time, and I am pleased to say that it really does have traction now at the global level. It still has to be finished, but it is there.
I think your last question related to how this all affects Canadian banks. I will generalize it slightly, if I may, as to how it affect Canada. We published a detailed report, which we are happy to have resubmitted to the committee if they would like. We published this summer an economic assessment of the impact of these reforms on the Canadian economy.
Our bottom line is a positive net present value of more than 30 per cent of GDP because these will reduce the probability of crises not just in Canada but very importantly abroad. Of course, I think we all know that it is great having our own financial system in good order, and we got through this crisis better than anybody else, but if some of our G7 partners will blow up in the future, we will still suffer the aftershocks of that.
The sum of these reforms have, in our opinion and in the opinion of the Basel committee — I should say that the Basel iii Accord was approved without change this past weekend by ministers and governors, so it will go for submission to leaders in two weeks' time. Supervisors, ministers and governors have all recommended this to leaders, and we would expect it to be fully endorsed then.
Senator Oliver: That is good news.
Mr. Macklem: I realize that was already a very complete answer, but maybe I would just add one further thought.
The other key element of all this is not only strengthening the rules but actually ensuring they are applied. There is no question that one of the aspects of the crisis, particularly the sub-prime crisis in the U.S., is that the rules that were there were not properly applied.
I will just underline two elements of that. The first is ensuring that rigorous supervision and oversight of the financial system exists in all countries. As part of looking at this aspect of it, the Financial Stability Board, under the leadership of Julie Dickson, Superintendent of Financial Institutions, has developed a series of recommendations on how to strengthen supervision across all countries, effectively learning from the leading practices across countries.
This speaks to issues around their mandates, their resources and the tools at their disposal. For example, we have something in Canada called early intervention, so they can act proactively.
These recommendations were taken to governors and finance ministers in Guangzhou last weekend, and endorsed. They will go to leaders shortly at the Seoul summit.
The other element is to provide an incentive for countries to live up to their responsibilities. That comes down to effective international assessment and peer review. The IMF plays a big role in this through something called the Financial Sector Assessment Program. Canada had one, fortuitously, before the crisis and that was helpful for us. Now all G20 countries have committed to do those and publish those to be transparent. It is a way of putting peer pressure on the system.
The other new element is an international system of peer review, which is run through the Financial Stability Board. I actually chair what is called the Standard Implementation Committee, which has been charged with creating what we call ``Race to the Top'' in the adherence of international standards. We have already done two peer reviews; we have further ones in train for this year. There are two types of them. Thematic reviews take a topic. For example, we have done one on compensation practices to look at the application of standards across the FSB membership. We also look at individual countries and examine their adherence to international standards. We have done one for Mexico. Spain and Italy will be done this year.
This is really a way to put some transparency in the system and encourage everyone to live up to the standards.
Senator Greene: I would like to ask a question about a comparison between Canada and the United States. The American central bank right now appears to be on a track of wanting to inject more stimulus, whereas I think the Bank of Canada is really asking only for a pause in the withdrawal of a stimulus. Is that an accurate description? Also, could you give me the three or four underpinnings of the Canadian and American economies which lead their respective central bankers to take those positions?
Given that we as a country came out of the recession, or are coming out of the recession, relatively better than anyone else and given that your knowledge of monetary policy is probably unsurpassed in Canada and perhaps the world, could you describe a couple of things that you learned during the recession with regard to the tools that you have and whether some tools worked better than expected while others did not?
Mr. Carney: I will not endorse your characterization of our monetary policy stance. I will merely refer you to my opening statement which states our monetary policy stance as clearly as we would like, and the caution with which we will proceed with respect to any further reduction in monetary policy stimulus.
The situations in Canada and the United States are considerably different. Let me focus on four aspects.
First, if you look at the functioning of the financial sector in the United States, there continue to be considerable tensions in that financial sector. There has been considerable repair in the core of the financial sector and there has been some recapitalization. However, a tremendous amount — up to half — of the credit provision in the U.S. was through, not the regulated financial sector, but through the shadow banking sector and through securitization. It was through chains that ran from money market funds through a variety of vehicles that provided effective finance to U.S. corporations and, ultimately, individuals.
That sector continues to shrink at a significant rate, and aggregate credit creation in the United States continues to fall. The United States continues to ``de-lever'' on the household and corporate side. Some of that is necessary, but there is also a considerable challenge in the United States with access to credit. It is an element that affects the U.S. housing market and, very importantly, it affects small and medium enterprises in the United States.
It is important to recall that, earlier this year, up to 40 per cent of the job losses in this recession had been through small and medium-sized enterprises in the United States. For the prior recession — the tech recession — that figure was less than 20 per cent. Therefore, this credit constraint has real implications for the economy.
In Canada on the other hand, as we have been discussing, our financial system has continued to function extremely well. Credit is there for large and small enterprises if they want it. The conditions are tighter for small enterprises than it is for larger enterprises, but those conditions have improved.
Credit is available. Credit is available on attractive terms for Canadian households and they have been taking up those terms. We have seen quite remarkable credit growth over the course of this recession and remarkable recovery for the Canadian household sector.
Therefore, there is a marked different between the two. All of this means that the transmission of monetary policy in Canada has been much more direct and effective than it has been in the United States.
The knock-on effect in the United States — embracing my second point — has been to employment. The U.S. job market is in very difficult shape. It is not just a question of the level of unemployment, which is above 9 per cent, but the long-term unemployment in the United States is over 40 per cent, as I think we detail in the report. Therefore, more than 40 per cent of the unemployed have been unemployed for more than half a year.
In Canada that figure is less than 20 per cent. We have recovered all the jobs that we lost in the recession. We have had more people come into the labour force, so the unemployment rate is higher than where it was when we came in. However, we have recovered all the jobs. The United States recovered about a fifth of the jobs that they lost. Their labour force continues to grow with demographics as well. Therefore, it is a very different employment picture between the United States and Canada.
In terms of the overall level of activity in our economy, we are back to the level we were prior to the recession. Officially, we are moving from recovery into an expansion. The United States is not yet back to the level they were.
The last aspect, which is particularly relevant for monetary policy, is that there has only been limited progress in closing the output gap in the United States, which is the difference between activity and potential of the economy. That is because growth has been slower, but also because the potential growth in the U.S. is higher than it is in Canada. There has been limited progress on that.
The combination of all those factors is exerting important disinflationary pressures and prospective ones in the U.S., which is warranting more stimulus policy at the central bank level in the U.S. and prospectively additional stimulus. As I referenced in my opening comments, Canada has seen a rapid initial closing of that output gap. It is still considerable; it is still an important output gap that is left, which is why rates are where they are and why we have taken a pause where we have, but we have made considerable progress.
There is quite a difference between the two countries. All of that said, I think we are all aware of the importance of the U.S. economy and its outlook in terms of the outlook for Canada, so there is a direct link between developments.
Regarding the second part of your question — what we learned in recent years about monetary policy — we did a variety of liquidity measures. They were of varying degrees of effectiveness; some were effective and some were not. I think we would be smarter if we had to provide that liquidity again.
In our view, the conditional commitment that we provided — that transparency — was effective; once we got to the zero lower bound with the rates as low as we could go, was effective. We have done some research on that. It added additional stimulus to the economy, and we felt that it was a superior alternative to the alternatives, which were quantitative easing or credit easing at that time.
We do not have direct experience with quantitative and credit easing. I would say our read of those non- conventional measures is that these interventions into the markets are most effective when markets are not functioning well, as was the case during the crisis. That is not to say they will not be effective if they are used now that markets are functioning effectively, but the transmission is much broader and diffuse now that some form of stability and functioning has been returned to financial markets.
Senator Harb: There is quite a bit of discussion about the currency issues. There is a lot of blame going around with the Americans as well as the Canadians lately criticizing China for the RMB. Everyone seems to be running toward devaluation of their currencies.
There is a lot to be said for the fact that maybe some attention should be placed on the failure of the trading system. Part of the criticism, particularly by the Americans, against the Chinese seems to be on the balance of trade; the fact that the Chinese currency is low and is helping them to export more to the U.S. market.
I find a part of that debate somewhat distorted in a sense because out of the S&P 500 in the U.S., almost every single one of the companies has a branch plant in China. They use those facilities in order to produce product in China, take it back to the United States and sell it to consumers in the U.S.
To what extent is there a discussion about setting up some proper standard when we talk about accounting when we talk about balance of trade? What do we mean when we talk about the fact that the Chinese balance of trade is to the benefit of China rather than that of the United States when, in fact, over 40 per cent of the import from China to the U.S. is actually done by American companies that have branch plants in China?
I am somewhat bewildered because I do not see a lot of the leaders on the international scene talking about the need for the establishment of proper standards when it comes to those kinds of accounting principles.
Second, in light of this, there seems to be some people talking about moving away from currency, such as the dollar, to gold. Is that a viable option; is that perhaps something that we should be talking more about or is it an issue for speculators and should be avoided at all cost?
Mr. Carney: Those are diverse questions.
First, trade balances can be more directly measured, particularly for economies such as China. Current account balances themselves are a broader measure that includes shorter-term income flows and have elements of survey and estimation to them, so they are not perfect measures.
That said, let us walk through the scenario you are talking about. It is a real scenario, by the way. You take a variety of tech products for which the manufacturing is effectively outsourced in China. The design, the marketing, the head office and all those other elements are resident in the advanced economy.
We will use the U.S. as an example. The import is a shipment to the U.S., whereas the profit itself largely accrues not to the contract manufacturing but to the higher order elements, which are design, marketing, et cetera.
There is no distortion in terms of the value-added of the product; it is only the element of the product that physically is shipped on a net basis that shows up in the trade accounts. Though it is not a distortion but an important dynamic, ultimately, if one owns a plant in China and it is a profitable plant, one is building up capital in that entity. The question is what happens to the capital. Do the dividends come back to Canada, if it is a Canadian company that has a plant? That is a positive account on our current account; that improves our current account balance.
Given the growth and expansion prospects for China that are considerable, the vast majority of profit capital that is being built up in these entities is being reinvested. That is one of the reasons why foreign direct investment is consistently high into China. That is a net capital inflow, even though it is capital retained in the country.
Ultimately, at some point, given the ownership, there should be some flow back. However, this is a point very far in the future and is not something that would address the scale of the imbalances that are here.
Maybe it is not perfectly clear, and we can talk more about it if you would like. We do see there are very fundamental structural factors — by ``structural'' I mean policy factors — that are enlarging the Chinese trade surplus and current account surplus. They go from structural policies that affect the social safety net and the way the financial sector is structured, and they very importantly include the exchange rate policy, in our opinion.
There are issues that can be addressed and are being addressed through the G20 process.
Regarding gold, no, it is not a viable solution. I will give you just two aspects to that answer. First, in the looser version of the gold standard, the gold exchange standard, which operated after the First World War, the backing of currency of gold was 40 per cent. In other words, you had to have 40 per cent of the currency in circulation and you had to have gold reserves consistent with that.
Current gold reserves, even at this all-time high price, are not 40 per cent of global money supply. They are not even 40 per cent of global foreign exchange reserves. It is 10 per cent of global foreign exchange reserves. It is a very small proportion of global monies supplies.
Therefore, there is a huge deflation adjustment there.
Second, there was the experience in the 19th century of basically gold shortage relative to the rate of growth of the economy. The monetary policy was whether there was a discovery of gold in South Africa. Gold was discovered, which helped remove some of the deflationary pressures in the latter half of the 19th Century.
We do not see it as viable at all. However, we believe the discussion of adjustments to the international monetary system of a different form will be increasingly prevalent over the coming years.
Senator Ringuette: I will slip into my usual role to bring us back to the crude reality of the situation. People have been told for many decades to rely on market economy. The market economy has failed because of structural financial problems that you described as the emperor having no clothes. I would like to add to that statement that he is still the emperor. You have indicated in regard to the G20 that, over two years, there may be an agreement that may be put in place that may be supervised.
That is many ``maybes.'' The citizens of most countries had to watch this scenario unveil for the last two years of financial institutions behaving irresponsibly. Canadians and most of the citizens of the world had to bail out those financial institutions through their tax dollars. It was agreed that stimulus programs had to be put in place in order to create some kind of sustainable economy. Now they are being told that because their tax dollars were used to bail out market malfunction, they will now also have to pay the price through cuts in different government programs.
At the same time, I have not seen any bankers going on EI; bankers are collecting their usual bonuses. It is fine and dandy to try to explain to the public what is happening out there, but I am telling you that I have never seen the level of frustration from the public I have seen in the last three months when they hear about government cuts coming. They understand the reality that their tax dollars were used to bail out a financial institution and other economic structures. In Canada, we can talk about GM and Chrysler.
If the leaders of the G20 countries do not shortly enforce the major regulations that you seem to have agreed upon, I do not see how governments will be able to put in place reductions in spending that will affect the average worker.
Mr. Carney: The political economy aspects are extremely important, but we are not best placed to comment on them. However, I would make a couple of points. First, we all recognize that no tax dollars in Canada were used to bail out financial institutions in Canada, but we suffered a sharp, deep recession that affected millions of Canadians as a result of failures of financial systems outside our borders.
We, more than anyone, are intent on ensuring that the global financial system is fixed. We had a system that functioned well. It served us in good stead through this crisis, but it did necessitate extraordinary monetary policy and major fiscal action to limit the fallout from the global financial crisis for Canadians. That will, in turn, necessitate some tough choices on the fiscal side to which you alluded to return budgets to sustainable levels at all levels of government.
We are intent on ensuring that there is a global financial system that looks more like Canada's, that is more resilient and effective. That is why we at the bank, the Superintendent of Financial Institutions and her colleagues and the Minister of Finance and his colleagues are all devoting a vast proportion of our time to global financial reform. First and foremost is getting it right. Second, it is to ensure, as Mr. Macklem is doing, that our peers around the world are implementing what they say they will do, and that we are putting in mechanisms, including the one he referenced and also with the IMF and their programs to ensure that happens.
I will make another point to close. You referenced my reference to the ``emperor has no clothes.'' That was with respect to the capital of large international banks. One reason these institutions could get away with not having much capital is that there was an implicit guarantee from the state. There was a sense that these institutions were too big to fail. That turned out to be right in the heart of the crisis. The underlying purpose of many of the reforms is to remove that implicit guarantee, to end ``too big to fail.'' That is why we want to have capital structure to be bail-inable. In other words, if you own the debt of a large bank and it has problem, you own the equity and you have lost money. We want to ensure that all supervisors have strong resolution powers to do this effectively in a timely fashion, the so-called Dodd-Frank resolution powers. We want to ensure that the infrastructure for key markets, whether a funding market like a repo market or a derivative market, can survive the loss of one of these institutions, so they do not have to be saved to keep market X, Y or Z open.
Those are all aspects of the reforms. It is a fundamental aspect to re-inject market discipline into the centre of the financial market that should have been there all along.
I take the tone of your comments and the point to heart. It is what Canada is working towards, and I would assure you we are making progress on all these fronts. It is not done, but we are making considerable progress. We would have referenced a variety of these factors as Canadian priorities a year ago. Now they are G20 priorities and they are being put in place. They are at the heart of the Basel Accord in many cases, we are moving forward on them, but we have to continue.
[Translation]
Senator Massicotte: Thank you, Mr. Carney and Mr. Macklem. It is always great to have the opportunity to discuss the global and Canadian economy together.
I would like to bring up the matter of the currency war. We have already talked about it at great length and I am deeply concerned about this topic. I would first like to congratulate you on reaching an agreement with South Korea and also on your news release on principles. Protecting our currency is, in fact, an indirect subsidy like protectionism. Congratulations on your accomplishment. My concern and everyone else's is that subsidizing our currency is not in the world's interest.
But, when each finance minister gets home, I do not doubt their intentions and I fully agree, but, as you said earlier, if it threatens long-term growth, reasons are found to manipulate or invest in the currency market. My concern is that it is one thing to make fine statements and another to get to the desired result. Given each country's sovereignty, without any significant leverage or threats, countries like China, the United States or Brazil will not end up honouring this good intention and this fine news release.
What threats or leverage do we have to force those countries to increase their domestic consumption, countries like China, for example? How do we achieve that without the consequences being too severe? Because it would be serious if we had a currency war.
Mr. Macklem: As you have just mentioned, we emphasized in our report that tensions are very high in currency markets. We stressed that this means risks for Canada in the growth of our net exports. So it could have an impact here in Canada for sure.
We are really sharing the risks you mentioned. As you said, when the governors go home, they will feel pressure domestically. But the important aspect of the agreement on strong, sustainable and balanced growth is that it is about a package of policies. That was shown by the IMF, and the Bank of Canada conducted a similar study that led to very similar conclusions.
If all countries put that package of policies into effect, in a context of exchange rate flexibility, the world would be better for it. It is important for some countries to allow flexibility in their exchange rates. There is agreement that it will be difficult to put the package of policies into effect, which is why the G20 leaders have set the agreement as a priority.
Mr. Carney: I would like to add something. There are two other elements, which, in a sense, are the same; but there will be an IMF assessment of the sustainability of economic growth in the large countries and the reasons for it that influence those countries' competitors. That will influence the decisions.
The second point, probably the more important, is that, in the last decade, the G7 was seen as a club of people all thinking the same way, all sharing the same policies and all believing in flexible exchange rates. Today, the G20 is not a club yet. It is more like a forum that is on the way to becoming a club. There is a process of understanding and discussion that is moving slowly forward.
Senator Massicotte: You say that this is not very reassuring. We all agree that the principles work to the benefit of the world. But everyone goes home, and I hope that Canada will be the exception by keeping its currency very low and encouraging exports. I assume that the implication is that the biggest members will say, ``You want to start a war? We have a tax if you impose tariffs and we have limits on imports.'' That is real life, clearly, everyone is looking out for their own interests. It is dangerous, and we have to talk about it because major countries like China are going to go home and do what suits their interests best.
Will there be discussions? There have to be eventually.
Mr. Macklem: I think that, if that happens, everyone will lose; it is not in a country's interests to take that route. That is a major reason why all countries are going to continue the discussion process. As the governor mentioned, we have put a lot of effort into that process and we are pushing as hard as we can. We are looking forward to seeing more progress. It is clear that the recovery is going to continue, and the rate should increase, making the recovery sustainable.
Senator Massicotte: Can I —
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Senator Ataullahjan: Last June, Canada played host to both the G8 and G20. Would you term these meetings a success, and would you say that progress was made in setting the stage for sustainable economic growth? In addition, what would you consider to be the key accomplishments of these meetings?
Mr. Carney: I will respond first and I will pass to Mr. Macklem, who attended both meetings.
From our perspective, these were extremely important meetings, the G20 particularly from an economic perspective. We have talked a bit about the elements of the Toronto summit accord with respect particularly to fiscal policy but also the financial reform structural policies and exchange rate flexibility.
There was an important move by the Chinese in the run up to Toronto that was connected to Toronto to further enhance the flexibility of their currency. There was the agreement on fiscal sustainability, which book-ended, if you will, the process that began with the London summit a year earlier when there was an agreement on coordinated fiscal expansion. Then the Toronto summit produced a path towards fiscal sustainability, which was extremely important.
Further progress was made on a variety of financial reforms, including important discussions on the margins of Toronto, in which we both participated, that I believe helped set the stage for the Basel Accord. That accord was reached over the course of the summer, up to early September, and was just ratified over the course of this past weekend.
I recognize that it is difficult sometimes with fat, wordy communiqués and peering behind fences with the jargon used at these summits. I was not personally there.
However, I would say that these were important steps along the path to achieving a more sustainable and balanced growth in the global economy and they will ultimately have great benefit for Canada. It also reflected well, I believe, on the government's and Canadians' efforts to secure these agreements.
Mr. Macklem: I would like to add briefly to that. I think the G20 summit was very successful in getting the G20 focused on the truly core issues, the things that will really make a difference.
In the depths of the crisis, there was a strong common interest in taking coordinated action. It was clear the global economy was on the brink of collapse. All the indicators were pointing down and there was a strong incentive for everyone to come together to provide considerable stimulus. That worked. We got ourselves back from the brink and got our economies into recovery.
The challenge was in how to maintain that degree of cooperation. It comes back to Senator Ringuette's point that this cannot happen again. What will we do to ensure that it does not happen again?
I think we were very pleased that the Toronto summit got the G20 focused on the core issues. In terms of the so- called framework for strong sustainable balanced growth, what are the key elements of ensuring the appropriate rotation in global demand so that the recovery is sustained and the type of global imbalances that no doubt fuelled the crisis do not re-emerge?
This is an ongoing project; it is not over. However, I think Toronto was very successful in getting us focused on a policy package that would make the difference. That has to be implemented.
Second, on financial reform, there are many ideas about what needs to be done. Certainly, Canada's view is there is a complex crisis, but there are basic things that were proven to work, such as higher capital standards and cap on leverage. We were very pleased to see as a result of Toronto more focus on some of the core things that worked. I also talked about strengthening supervision. Then there is a system of peer review and international assessments. Every country has an appropriate incentive to live up to its commitments.
Again, Toronto was successful in getting in those core elements. There is much more work to do and there will be, no doubt, more distractions. Our challenge is to keep it on the right path.
[Translation]
Senator Mockler: Gentlemen, I am going to give you some quotations. I also want to make an observation and then I will finish with a quick question.
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According to what John Thompson, Chairman of the Board of the TD Bank, told the Agriculture and Forestry Committee, of which I am the chair, that venture capital is very low in Canada. Here is a quotation of one of your statements:
Overall, the composition of demand in Canada is expected to shift away from government and household expenditures towards business investment and net exports. The strength of net exports will be sensitive to currency movements, the expected recovery in productivity growth, and the prospects for external demand.
I want to talk about farmers, fishermen, the forest sector and the resource-based industries. Without credit, you cannot buy equipment or make other capital investments. Without credit, we cannot finance our inventory or buy fuel to run our tractors, and the list goes on with the loggers, et cetera. However, during the financial crisis that began two years ago, many people who had been good credit risks in the traditional banking system were cut off. Then the government stepped in with measures to help them under the following structures: the Business Credit Availability Program, the expanded mandates of the Export Development Corporation and the Business Development Bank of Canada, and Farm Credit Canada.
Would you agree that that played a role to help mitigate the effects of the financial crisis on the agriculture and resource sectors? Will your policy framework help SMEs have better access to venture capital and better access to credit?
Mr. Carney: As I said earlier, during the course of the crisis, the financial system in general functioned very well, but there were areas of difficulty. Farm credit was one. Conditions were tightened more for small- and medium-sized enterprises than for larger enterprises. Export credit was an issue. Export insurance related to exporting and receivables insurance was also an issue. There were important issues in certain private label securitization markets, including auto leases and floor plans for auto dealerships, which are in relatively small in global terms but important in Canadian terms. Equipment dealerships would have an impact for the agricultural sector as well.
The government put in place a variety of measures to try to target these issues. The overall stance, of course, of the Bank of Canada was assess and recognize the impact of these restrictions, as well as more general restrictions as banks as a whole became more risk averse and banks' cost of funding went up considerably. Our job was to recognize the sum of this impact and its implications for investment activity and, ultimately, economic activity in Canada.
Our view is that we recognized very quickly the scale of the issue, which is why we moved rapidly to lower the interest rate and, ultimately, bring the interest rate to its lowest possible level of 25 basis points.
That in and of itself brought accommodating credit conditions to most but not all aspects of the Canadian economy, and you have touched on several of them. The government did put in place the programs that you referenced, including a program that my colleague worked on when he was at the Department of Finance for auto leases, and the elements of securitization that had gone away that were important.
The presence of these programs did, in our opinion, have success, and their presence helped to encourage associated lending in these sectors as well because there was competition. For example, there was less take-up of the securitization program. It had more allocated to it than was taken up, but in part, its presence catalyzed some banks to lend to those sectors on balance sheet, so they had a broad effect.
With the recovery and with the sharp drop in the cost of bank funding, credit conditions are improving quite considerably for the small and medium-sized enterprise sector. We monitor this closely, both by surveying senior loans officers and by surveying directly the enterprises, meeting with enterprises, with the CFIB, and discussing with others. Things have improved. However, they are not perfect, and that is part of the factor that determines where monetary policy is in Canada.
Your specific question on venture capital is not an area for which the bank itself has a policy. This is ultimately equity that has to be put in place as opposed to financing, but I would agree with where you started, and where Mr. Thompson started, which is that there is a deficiency of venture capital in Canada. It is one of our longer-term challenges. It will have an impact on productivity in the country and currently has an impact on the effectiveness of some of the investments that are made in public universities, in primary R&D, because the transmission of those investments to the commercial sector is inhibited by the absence of venture capital.
It is an issue. It is not one we can address directly.
Senator Kochhar: There are always countries that do not want to play by the rules, and China is one of the few countries that does not allow the value of its currency to fluctuate by market value. They have purchased an immense amounts of currencies of different countries to play different ball games.
Could you elaborate as to the cost to the global economy due to the lack of exchange flexibility on the part of China and other emerging countries?
Mr. Carney: This issue, as we have been discussing this afternoon, is an extremely serious one. It has had an impact in terms of the rate of growth in the global economy. It has a prospectively more serious impact on the level of activity in the global economy over the coming five to 10 years, which is why we are working so hard on this four-pronged strategy for a strong, sustainable and balanced growth, including with the Chinese.
Both the Minister of Finance and I over the weekend met in a broader setting with the Chinese and others in the G20, but we also had individual bilateral meetings with our Chinese peers. I meet my Chinese counterpart every four weeks. It is the advantage of the placement of Canada-China on the alphabet in that we sit next to each other at these meetings. We have a regular dialogue on these and other issues.
Sustained intervention can achieve nominal exchange rate adjustment in economies that have closed capital accounts and relatively suppressed financial systems. The challenge is that the frustrated adjustment of nominal exchange rates does not prevent the ultimate adjustment of real exchange rates. The real exchange rate adjustment does not come by the change in the actual exchange rate but rather from inflation differentials.
We have a situation where Chinese currency has pressure to appreciate. If that nominal appreciation is slow or frustrated, it will come through higher inflation in China relative to its major trading partners. If inflation is relatively low in China, all things being equal, it will push towards a disinflationary — even deflationary — environment in major economies such as the United States.
What we are seeing now is disinflationary pressures in the United States and increasing inflationary pressures in China. That is one of the reasons why Chinese authorities raised interest rates last week for the first time since the crisis. This dynamic is a much more difficult adjustment. It brings ultimate costs in growth.
I am trying to answer your question. Mr. Macklem referenced earlier some work that the Bank of Canada had done and published. It looked at the difference between the scenario we were working towards in Toronto, and which we are now working towards in the run up to Seoul and over the course of the next year for the global economy, and the scenario where there is not sufficient fiscal adjustment and no flexibility in exchange rates.
That difference for the global economy, by our calculations, is that by the end of 2016 — five years' hence — is $7 trillion net difference in the level of the global economic activity. Now, take all economic projections with a grain of salt, certainly the further out they get. It is illustrative. However, if you think of the global economy that is $60 or $65 trillion dollars, it is a material shortfall in the level of economic activity.
That is what we are trying to socialize with these discussions. We want everyone to understand that everyone loses from this suite of policies, and that the numbers are very large.
Mr. Macklem: I will add that the IMF has a study with similarly, impressively large numbers, or depressingly large numbers, perhaps I should say.
The Chair: Thank you all. We are just about on time. Our last questioner is our special guest today, Senator Murray, one of the distinguished senators and former chair of numerous committees.
Senator Murray: I had a couple of softballs to lob on fiscal and monetary policy, but I will pass on them.
I am wondering about another matter. If the proposed takeover of Potash Corporation of Saskatchewan proceeds, would the potential impact on the Canadian dollar be negligible or something more than that? I recall that one of your predecessors, Gerald Bouey, found it necessary at the time of the National Energy Program to point out in his annual report that the otherwise commendable efforts of the Hon. Marc Lalonde to encourage Canadians to buy back foreign- owned oil companies was creating, in that case, an outflow of funds which was causing havoc — my word, not his — for the Canadian dollar.
The only question that is fair to ask you is whether there is an official interest or concern on the part of the bank with regard to a transaction of this nature and of this order of magnitude, and whether you would expect to be consulted by the government on its decision.
Mr. Carney: If the bank is consulted on any matter by the government, we would offer our advice in confidence. It is the prerogative of the government to seek advice on any such matter related to the economy, and we certainly would proffer any advice we had with the appropriate caveats of where we are expert and where we are not.
I am certain there are many considerations that are being looked at by Industry Canada, the federal government and the provincial government with respect to that specific transaction.
I think it would probably be most prudent to not elaborate on our views on aspects of those considerations, given their commercial nature. We are not unaware of the issue, though, I would say.
Senator Massicotte: I have a ``soft one.'' You have talked about the dollar and about our currency. I will make the observation and maybe you can comment on it. It is amazing that many countries like China and Brazil are putting in exchange controls and working very hard to keep their currency low. I remember that perhaps 10 or 15 years ago, our currency was reasonably low, and all the major policy people told us it was bad because our dollar was far too low, was negative for the economy, discouraging productivity, et cetera.
It is amazing. Now ours is higher and everyone is trying to emulate what we thought was a poor situation. There is something wrong here.
Mr. Carney: I would agree with that. There is something wrong in that, ultimately, exchange rates should find their natural appropriate level that is consistent with fundamentals. We in Canada have benefited tremendously over the years from having a flexible exchange rate. It has acted as a shock absorber for our economy, and it has made Canada a wealthier country as a whole when combined with a host of other factors.
However, it is ultimately unsuccessful to resist fundamental adjustments to currencies. That adjustment will come, as we were just discussing. If it comes through relative inflation rates, that is a far more difficult adjustment than through the nominal.
If I may put myself in the shoes of these other countries, a shared concern is the speed and the sharpness of adjustment. There are mechanisms that can be put in place to address that situation which are still consistent with market-determined exchange rates. The commitment of the G20 as of this last weekend is exactly that, to move towards market-determined exchange rates. We expect to see that progress.
Senator Ringuette: In regard to policy, we have had for many years a 2 per cent inflation target. You are now talking about a price level targeting. How would that differ, and what kind of intervention would you take?
Mr. Carney: To be relatively brief, the bank has been conducting research on the future of the Inflation-target Control Agreement. We have looked at three aspects. The first is whether to lower the inflation target. Would it make sense to have a lower than 2 per cent inflation target, recognizing that 2 per cent means that the value of money is cut in half every 35 years or so, and what are the net benefits of having a lower inflation target?
Second, and I will not go into detail, a very relevant issue that has come out of this crisis has been the relationship between monetary policy and financial stability. We touched on that earlier when we discussed the household debt situation in Canada and the challenges of having low interest rates for a longer period with relative price stability and whether that creates financial vulnerability. Therefore, how do you connect between the two? I will not go into detail on that.
The third issue we have been looking at in some detail — and you referenced it, senator — has been the possibility of moving to a price level target. What is the difference between a price level target and an inflation target? With an inflation target, Mr. Macklem, our four deputies and I get up every day and, sadly — perhaps not ``sadly,'' as it is our job — the first thing we think about is how we get monetary policy in order to achieve 2 per cent inflation over the relevant horizon from that moment hence. Whatever has happened in the past, bygones are bygones. We look at where the economy is, where we think it is going and how we should set policy.
With a price level target, our job would be to ensure that the path of prices stays on a predetermined path. Let us say it is a path where the equivalents of prices grow at 2 per cent each year. Why not pick on the period when Mr. Macklem joined, so I can blame him? Since July, inflation has been running less than 2 per cent. Our job would be to determine how we make up that difference — that under-shoot relative to the price path. How do we set monetary policy so that we are actually staying on this overall path of increasing at whatever rate is determined? Now, why does that make any sense?
It could make sense if one has a very long-term contract and wants to have a higher degree of certainty about where the price level will actually be; where cumulative inflation actually will be in 10, 20 or 30 years. It makes sense if one is close to the zero lower bound. A host of research suggests that greater certainty about making up past misses will get an economy out of a disinflationary or deflationary environment more effectively and more rapidly if there is a price level target.
That is one reason why you will hear more about price level targeting in the near future. You will hear it not because of the Bank of Canada's research but because of the situation that some major economies find themselves in. There have been musings about the relative effectiveness of moving out from this situation.
Let me finish with something, if I may. To be absolutely clear to senators, the combination of inflation targeting regime and a floating exchange rate has served Canada extremely well. It is a very high bar to make any adjustment to that regime. It is our job to look at any potential adjustment, and we are doing that. We will report to Canadians. If it is of any interest to this committee, we are happy to devote a session to discuss our research on this.
[Translation]
The only thing remaining is for me, on behalf of all the senators, is to thank you, Mr. Governor, and you, Mr. Macklem, for being here. I am sure I am right in saying that we have enjoyed a productive discussion, as always. We look forward to seeing you back here next spring.
[English]
Keep up your excellent work and we thank you on behalf of the Standing Senate Committee on Banking, Trade and Commerce and, indeed, all Canadians.
(The committee adjourned.)