Terms of Trade Advantage to Help Canada Outperform US Economy

Paul Ferley, RBC Economics Research, Toronto
This article appeared in the May 2008 issue of Current Economics with permission of the author.

Key Concepts: Economic Growth | GDP Growth | Growth Forecast | Terms of Trade | Inflation Forecast | Economic Outlook |
Key Economies: Canada | United States (US)

Even with the recent downgrade to the global growth outlook, the world economy is still growing at a respectable pace that is likely to keep commodity prices high compared to historical norms. This is a key support for our view that Canada’s economy will outperform the US economy in 2008 (1.6% for Canada compared to the US 1.2% pace) because of Canada’s sizeable net export position in a number of key natural resource products.

Forecasts for 2008,
% change
Gross
Domestic
Product
Personal
Expenditure
Machinery &
Equipment
Investment
Consumer
Prices
Current
Account
(C$bn)
Royal Bank of Canada 1.6 4.3 8.3 1.4 -2.7
Consensus1 1.3 4.3 8.1 1.7 -5.2
1 Source: Consensus Forecasts, May 2008

The so-called “terms of trade” measures the performance of Canadian export prices relative to import prices. The combination of high commodity prices, an appreciating Canadian dollar and a rising share of imports from lower-cost producers has boosted Canada’s purchasing power and directly increased national income. The prices of goods that Canada exports have risen 22% during the past five years, which is more than the prices of the goods Canada is importing. As a result, for each dollar of export-related income, Canadians can buy more imported goods and services. Additionally, the increased demand for the goods that Canada is exporting, mainly commodities, has helped support the increase in the value of Canada’s currency. The stronger currency is also a mechanism that has boosted Canadians’ purchasing power by making imported goods cheaper.

The result has been that Canada’s gross domestic income (GDI) has risen strongly during the past five years (see chart, below left), supporting increases in consumer spending, business investment and import demand, and domestic demand growth has averaged 4% during that period, the fastest pace of increase since the late 1980s.

Real GDP and GDI growth comparison Debt-to-asset ratio
Canada GDP Growth Canada Debt-to Asset Ratio
Source: Statistics Canada, RBC Economics Research Source: Statistics Canada, RBC Economics Research

Labour Market Buoyant

The benefits of the terms of trade improvement are evident throughout the economy with the labour market enjoying strong growth. From 2002 to 2007, the economy generated more than two million new jobs and the unemployment rate fell to a 33-year low. In the first two months of 2008, the strong momentum in the labour market continued with an average of 45,000 new jobs created. The strong demand for labour has boosted wage growth — average hourly earnings for permanent workers were up 4.7% in February compared to a year earlier. This was down only slightly from January’s rate of 4.9%, which was the strongest gain since the series started in 1997. The tight labour market and rising wage growth will support consumption in 2008 and help offset the impact of tightening credit conditions. We forecast a 4.3% increase in household spending this year, only modestly slower than the 4.7% average pace in 2007, although the increase has been helped along by the high level of activity going into 2008 boosted by strong gains late in 2007.

Debt Load Rising, But So Are Asset Values

Household balance sheets remain in fair condition with the ratio of debt-to-assets remaining within the range of the past 40 years. Still, with debt service costs high relative to personal disposable income, the recent tightening in credit conditions does present some downside risks for the outlook for consumer spending this year. Mitigating this, however, is the strong growth in asset values — house prices have recorded gains of about 10% for six years running and the TSX posted a decent 7.2% return in 2007 despite a soggy fourth quarter. However, if the weakness in equities evident late last year and early this year persists, it would present a clear downside risk to household spending during the forecast period.

Stretched Affordability to Exert Modest Downward Pressure on Housing Market

The rise in house prices has stretched affordability. RBC’s housing affordability index showed that conditions were the worst since early 1990 for homebuyers in last year’s fourth quarter. Our view that the Bank of Canada will continue to lower interest rates, with attendant easing in credit market tightening, and that the pace of house price increase will slow this year both point to a modest improvement in affordability. There were 227,000 new homes started in Canada last year, marking the sixth year that starts were greater than 200,000 units. The erosion in affordability and uncertain global economic environment will likely result in slower housing market activity in 2008, although, with interest rates declining, the weakening is likely to be relatively modest.

Business to Boost Investment

Business investment in construction is likely to post a decent gain in 2008 as falling interest rates support spending on structures and a strong currency keeps the prices of imported machinery low. The annual survey of 28,000 Canadian private and public enterprises showed a surprising pick-up in the intended pace of investment spending this year, with current dollar investment in non-residential construction and machinery and equipment expected to rise 6.8%, faster than the 4.7% increase in 2007. The breakdown showed strong gains in both categories, with spending on non-residential structures forecast to rise 7.9%, stronger than 2007’s 5% pace, while spending on machinery and equipment was forecast to rise 5.7%, up from 4.4% last year. Spending on equipment will be robust as the strong currency exerts downward pressure on the price of US-made machinery. Three-quarters of all machinery and equipment purchased by Canadian companies comes from outside our borders and the lion’s share comes from the United States.

Import Demand to Outstrip Export Growth for Seventh Year Running

Rising demand for imported capital goods will keep import growth running hotter than exports, resulting in the restraint from net exports growing in 2008 to its highest rate on record. RBC forecasts that the trade sector will trim 3.6 percentage points from the 2008 annual GDP growth rate, with a more modest one percentage point cut expected in 2009. The drag from the trade sector near-term along with credit tightening will keep the Bank of Canada on its current path to easier monetary conditions.

Canada's overnight rate Canadian dollar
Canada Interest Rate Forecast Canadian Dollar Forecast
Source: Bank of Canada, RBC Economics Research Source: Bank of Canada, RBC Economics Research

Core Inflation Rate Falls as Retailers Discount Prices

Inflation does not present an obstacle to further rate cuts as Canada’s core inflation rate dropped from 2% in September to 1.5% in February, reflecting a steady stream of discounting by Canadian retailers looking to shore up market share. The strong Canadian dollar has led to a narrowing in the gap between Canadian and US prices as retailers work to stem the tide of cross-border shopping. Canadian overnight travel to the United States rose to the highest level last November since the end of 1991. We expect the combination of the falling core inflation rate and the one percentage-point cut to the GST rate at the start of 2008 will produce a decline in the all-items inflation rate to 1% by mid-year. Our forecast is that Canada’s inflation rate will average 1.4% this year, with the core rate at 1.6%.

Bank of Canada to Cut Rates to Mitigate Impact of Trade Drag

The Bank of Canada cut the policy rate by 25 basis points at each of its December and January fixed action dates, concluding that “further monetary stimulus is likely to be required in the near term” to mitigate the downside risks coming from the widening in credit spreads and the weakening US economy. The Bank picked up the pace of easing in March to 50 basis points, sending the overnight rate down to 3.50% as concerns about the US economy escalated. Continuing concerns about the downside risks to growth will send this policy rate down to 2.75% by mid-2008.

Canada's Dollar to Give Back Some of Its Recent Appreciation

The Canadian dollar continues to trade around parity with the US dollar on the back of increases in commodity prices and with short-term Canadian/US interest rate spreads holding at around 100 basis points. We expect that the currency will remain around parity in the early part of the year but that support for the US dollar will emerge around mid-year as markets anticipate a turnaround in the US economy and a cessation of Fed easing. By the end of this year, we expect the loonie to average 90.9 US cents. This depreciating trend will extend into 2009 with the currency dropping further to 87.0 US cents by the end of that year.

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