Since the Canadian economy is more susceptible to global growth and energy shocks, and Canadian households are more leveraged, the impact of the novel coronavirus on the Canadian economy could be larger, and the subsequent recession deeper, than what will be experienced in the U.S.
In fact, the Canadian economy may already be in recession. Last week, Prime Minister Justin Trudeau announced that an unprecedented 2.5% of the labor force had filed for unemployment insurance, and subsequent news reports suggest applications could have already risen to closer to 5% of the labor force.
The good news is that Canada has the fiscal and monetary means to recover. Along with the Bank of Canada’s (BOC’s) cumulative 100 basis point (bps) interest rate cut and efforts to stabilize money markets in March, the Parliament approved a stimulus package on 25 March. It includes roughly 1% of GDP in direct spending support and 2% of GDP in tax deferrals.
However, more is likely to be needed to bolster Canada’s economy. The continuing spread of the novel coronavirus is upending global supply chains and disrupting consumer behavior, while the fiscal response is barely enough to offset the energy price shock, according to our estimates. As of the time of this writing, three provinces – Quebec, Alberta and Ontario, – which make up over 75% of Canadian GDP – had mandated closures of restaurants, entertainment venues and retail outlets.
U.S. lawmakers are negotiating a bill that would provide an additional 10% of GDP in direct government support to households and businesses, while the Federal Reserve has cut its benchmark interest rate to zero, undertaken an aggressive buying program for Treasuries and MBS, and announced a number of special lending facilities aimed at stabilizing financial markets and ensuring the continued flow of credit throughout the U.S. economy.
Eventually, we think the Canadian government will need to make similar moves in an effort to counter the damage to its economy. And, as with the Fed’s actions, we think it’s quite likely that the BOC will cut rates to zero and begin large-scale asset purchases.
The stimulus package is estimated to be worth $82 (CAD) billion. It includes approximately C$27 billion in direct support to workers and businesses as well as C$55 billion in tax deferrals. It will augment unemployment insurance benefits, provide grants to families of low and modest means, and assist individuals whose livelihoods have been harmed by the outbreak. There also are measures to help distressed homeowners meet their mortgage payments, including payment deferrals, loan re-amortizations and special payment arrangements. The package also offers assistance to businesses, including a temporary wage subsidy and improved access to credit. These fiscal measures follow the BOC’s emergency 50-bp rate cut on 13 March, which took the benchmark rate to 0.75%, and the 50-bp cut on 4 March. The BOC has also recently announced additional measures to support financial markets, including a bond buyback program aimed at off-the-run bonds, expanded purchases of Canada Mortgage Bonds, and two facilities to support funding markets.
A more pronounced downturn
Nonetheless, the monetary and fiscal measures proposed to date may not be enough. Like the U.S., the Canadian economy is likely to fall into a recession this year, if it hasn’t already. However, compared to the U.S., the Canadian downturn is likely to be more pronounced and more prolonged for several reasons.
First, energy output is a larger share of the Canadian economy and exports. The energy sector accounts for about 8% of GDP, and 18% of business fixed investment (compared to the U.S., where the industry makes up around 3% of GDP and 4% of fixed investment), according to Statistics Canada, the official government statistics agency. Moreover, because Canada is a net exporter of energy, a fall in energy prices will have important effects on the country’s terms of trade and aggregate income. Research by the Bank of Canada, in response to prior commodity price shocks, has found that a 45% decline in oil prices shaves off around 1% of GDP in the two quarters that follow, with negative effects growing over time if energy prices remain depressed. Thus, we estimate that the 65% decline in oil prices, as reported by Bloomberg on 24 March, could shave off 1.5 percentage points, or more, as consumers are unlikely to spend the disposable income dividend from lower gasoline prices – at least not right away – due to virus-related social distancing measures.
Second, Canada is a more open economy and susceptible to a global growth slump. Exports of goods and services are 36% of GDP, compared to 11% in the U.S. Given the large role of trade in the Canadian economy, research by the Bank of Canada unsurprisingly finds a strong positive relationship between global growth and Canadian activity, as well as a high correlation between global activity and Canadian investment and trade. A weaker Canadian dollar, on the back of collapsing oil prices, should help boost the competitiveness of Canadian exports; on the other hand, it could hurt consumers who purchase relatively more expensive foreign goods.
Third, and perhaps most important, Canadian households are much more highly leveraged than their U.S. counterparts, contributing to economic imbalances that can exacerbate a downturn. According to Statistics Canada, Canadian household debt-to-GDP is around 100%, and has increased almost 30 percentage points over the last 10 years, which compares to a similar-sized decline in the household debt-to-GDP ratio of U.S. households to 75% of GDP.
Given strong home price appreciation across much of Canada over the past several years, much of this debt is concentrated in the housing sector. The Canadian mortgage debt service ratio (the ratio of required mortgage payments to total disposable income) is almost 7-to-1, according to official government data. And this starting point of high household leverage, and the subsequent need of households to deleverage, is likely to exacerbate the downturn. Indeed, research suggests that following periods of rapid credit growth, particularly in the household sector, subsequent economic growth tended to be lower (see Mian, Sufi and Verner (2016)). While Canadian regulators have taken steps in the past several years to slow mortgage activity and tighten credit standards, today’s elevated level of household debt risks a deeper and more prolonged downturn.
Canada has more fiscal and monetary space
The good news is that Canada enters this economic shock with a strong social safety net and a manageable government debt burden. Canadians have universal healthcare and sick pay, which is part of the national employment insurance program. Canada also has more fiscal and monetary space to ease – the ratio of government debt to GDP is only 30% (compared to 80% in the U.S., according to the U.S. Congressional Budget Office) – and the Bank of Canada’s balance sheet is small because it was one of the only major developed market central banks that abstained from large-scale asset purchases in the wake of the 2008 financial crisis.
What’s the bottom line?
While compared to the U.S., the shock to the Canadian economy could be larger, and the subsequent recession deeper, Canada has more monetary and fiscal policy flexibility to fight back.
We estimate the fiscal response so far is barely enough to offset the energy price shock – and that isn’t the only blow the Canadian economy will encounter. Although Canada has strong social welfare programs, policymakers will likely need to do more in the way of direct support to businesses and households through a period of virus-related disruptions if they want to avoid broad-based bankruptcies.
At a minimum, we think the Canadian government may need to double its fiscal support, while the Bank of Canada takes rates to zero and provides other means to ease financial conditions, including outright government bond purchases, to support the continued flow of credit to the economy.
This blog was published on 25 March 2020.
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Tiffany Wilding and Allison Boxer are PIMCO economists and contributors to the PIMCO Blog.