David Dodge: The global economic landscape and the implications for Ontario
Remarks by Mr David Dodge, Governor of the Bank of Canada, to the 2006 Ontario Economic
Leadership Summit, Niagara-on-the-Lake, Ontario, 25 October 2006.
* * *
The Ontario Economic Summit is an important event, and I do wish I could have attended, not only so
that I could deliver my remarks in person, but so that I could listen to the various discussions that will
take place over the course of the next two days. You will be discussing topics that are central to
Ontario's future economic prospects. How can we develop human capital to its fullest potential, and
retain that capital? How can we foster research, innovation, and commercialization in this province?
How can we improve Ontario's competitiveness in the global marketplace? As policy-makers, labour,
and business leaders, how we answer these questions will go a long way in determining the economic
well-being of our citizens in the years ahead.
My purpose this morning is to set the scene for your discussions of these questions. I will start by
reviewing the outlook for the global economy as set out in the Bank's Monetary Policy Report, which
we published last week. I will then look at how global developments can be expected to affect the
Canadian economy in general and the Ontario economy in particular. Following that, I'll say a few
words about the themes of the conference and about a couple of the policies that I see as important to
securing Ontario's economic future. Finally, I will be happy to take your questions and hear your
comments for the remainder of my time with you this morning.
The global economic landscape
Let me begin with the outlook for the global economy as a whole, before turning to the implications for
Canada and for Ontario, in particular. Certainly, the headline numbers for the global economy are
encouraging. The strong growth of recent years appears set to continue. The Bank's base-case
projection is for real growth in the global economy of 5.1 per cent this year, moderating slightly to 4.5
per cent by 2008.
However, these numbers mask some important differences in the growth prospects of different
regions. Growth in Asia continues to be very strong, led by the economies of China and India. Indeed,
the Chinese authorities have their hands full trying to hold growth at a more sustainable pace. Growth
in other emerging markets is coming from areas such as South America and Africa, which bodes well
for the future of these regions. At the same time, it is very encouraging that stronger domestic demand
growth is finally taking hold in Europe and Japan.
But after several years of strong expansion, the U.S. economy is cooling down, restrained by a
pullback in the housing sector and slowing demand for automobiles. After growing at a 5.6 per cent
annual rate in the first quarter, U.S. economic growth slowed to just 2.9 per cent in the second quarter,
and may well have slowed to less than 2 per cent in the third quarter of 2006. Earlier this year, the
Bank had projected that the U.S. economy would begin to slow, but the pullback we are seeing now is
larger, and coming sooner, than we had expected. In our Report last week, we updated our projection
to say that U.S. growth should average 2 to 2.5 per cent in the second half of this year and the first
half of 2007. Activity should then recover to above three per cent growth in the second half of next
year and throughout 2008.
I don't want to minimize what we see happening in the United States. But I think it is important to
recognize this slowdown for what it is - a necessary cyclical correction in the U.S. economy. In our
view, this is likely to be a temporary slowing of growth, not a contraction. When our forecast is
expressed on an average annual basis, it perhaps does a better job of illustrating the mild and
temporary nature of this slowdown. We are expecting 3.3 per cent growth for 2006 overall in the U.S.
economy, 2.6 per cent growth in 2007, and 3.2 per cent in 2008.
In our base-case projection, we do not see the pullback in the housing and auto sectors spreading in a
major way to U.S. consumption more broadly, or to business investment. Nor should the slowdown be
very prolonged. Currently, this is a reasonable assumption. There are no signs of any systemic stress
in financial markets or among financial institutions in the United States. Nor is there anything in the
economic data to suggest that the pullback in these two sectors is spreading. Indeed, the Beige Book
published by the U.S. Federal Reserve made this same point two weeks ago, although I recognize that
this fact is cold comfort to those Ontarians whose livelihood is closely linked to the fortunes of the U.S.
housing and auto sectors. Of course, there is a risk that this projection could turn out to be wrong, and
I'll return to this risk in a few minutes.
Let me make one more point about the global economy before turning to the domestic outlook. For
some time now, policy-makers have been worried about global imbalances; that is, the very large
current account deficit in the United States, which is mirrored by current account surpluses in Asia and
major oil-exporting countries. The increase in demand we are now seeing outside North America, and
the slowing in the U.S. economy, is certainly helpful in terms of bringing about a gradual resolution of
imbalances, and reducing the risk of an abrupt, disorderly resolution. The Bank's base-case projection
assumes that this gradual, orderly resolution will take place. That said, it is important for policy-makers
to continue to take appropriate measures that allow market-based adjustments to take place both
within and across their domestic economies. If markets can be confident that these measures will be
taken, it will reduce the risk of a sudden swing in market sentiment and a disorderly resolution of
imbalances.
The outlook for Canada
Now let me turn to the outlook for the Canadian economy as a whole, before looking specifically at
Ontario. With the U.S. economy slowing more abruptly than had been expected, Canadian GDP
growth fell short of expectations in the second and third quarters. After expanding at a 3.6 per cent
annual rate in the first quarter of this year, the economy grew by only 2 per cent in the second quarter.
When Statistics Canada publishes the third-quarter figure at the end of November, we expect roughly
the same 2 per cent number.
As we look ahead, consumer spending should remain solid for the rest of this year and right through
the end of 2008, thanks to continued gains in disposable income and increases in household net
worth. However, housing investment should decline slightly in 2007 and 2008, following many years of
extraordinarily strong growth. The Bank expects business investment to remain solid as firms react to
capacity constraints, and to the expected high prices for energy and metals, continued favourable
financing conditions, and high levels of cash flow. In terms of governments, the Bank continues to
assume that this sector will operate in rough balance over time. This implies that the large surpluses
seen recently will not persist and that governments will bring their books into balance.
Once again, it is important to think of this as a mild, and likely short-lived, cyclical slowdown. The Bank
projects final domestic demand to grow by 4.2 per cent in 2006, by 3.2 per cent next year, and by 2.8
per cent in 2008. However, slowing U.S. growth will have a clear impact on growth in the Canadian
economy in the near term. The Bank is projecting that net exports will subtract 1.3 percentage points
from growth this year and 0.7 percentage points next year, and that net exports will not contribute to
growth in 2008. Overall, the Bank projects 2.8 per cent growth of real GDP in 2006, slowing to 2.5 per
cent in 2007, but coming back up to 2.8 per cent in 2008.
Report
In our last week, we said that the Bank currently judges that the economy is operating with a
slight amount of excess demand. Our projection for growth implies that this excess demand would be
eliminated by mid-2007, and that the economy should then remain near its production potential
through to the end of 2008.
Overall, the Canadian economy has performed remarkably well when you consider that it is continuing
to adjust to a number of powerful global forces. These include the rise to prominence of China and
India, which has led to both stronger global demand for many Canadian goods and services, as well
as increased competition for some Canadian firms. In turn, strong global demand has led to increases
in most, but not all, commodity prices, and to an associated rise in the Canadian-dollar exchange rate.
All of this has occurred at a time when central banks around the world have been withdrawing liquidity
from the global economy.
Of course, economic adjustment is easier said than done. And it is important to acknowledge that
adjustment is often very difficult on an individual level. Still, taken as a whole, the Canadian economy
continues to adjust quite well. However, recent sluggish growth in labour productivity has led us to
reduce our estimate of potential growth from 3 per cent to 2.8 per cent over the period to the end of
2008.
The Bank's projection is that core inflation should remain slightly above 2 per cent over the next few
months, before returning to 2 per cent in the second half of 2007, and remaining there through 2008.
As for total inflation, it will continue to be affected by the cut in the Goods and Services Tax and trends
in energy markets. We expect total inflation to remain below our 2 per cent target, averaging around
1.5 per cent, from the fourth quarter of this year to the end of the second quarter of next year.
Following that, total inflation should remain near 2 per cent until the end of 2008.
Now let me say a few words about the risks to our projection. The risks, both on the upside and the
downside, appear to be a little bit greater than they were earlier this year. The main risk on the upside
continues to relate to the momentum in household spending and housing prices. Household income
continues to grow, consumer credit growth is currently quite high, and house prices have been rising
sharply. These three factors could lead to higher consumption than we expect, which would put
upward pressure on inflation. In addition, the strong growth in prices and wages now seen in Western
Canada could also spread to other regions. On the downside, the main risk is that the U.S. slowdown
could be deeper and last longer than we expect. This would imply lower demand for Canadian exports
and broader weakness across our economy. The Bank judges that these risks to its inflation forecast
are roughly balanced. And the current level of the target for the overnight rate is judged, at this time, to
be consistent with achieving the inflation target over the medium term.
Implications for Ontario
Having laid out the Bank's projections, I will now look at the implications for Ontario's economy. There
are really two sets of issues here. The first relates to the implications of the short-term cyclical
downturn. The second relates to the longer-term structural challenges facing Ontario. Let me address
these in turn.
It is clear that the cyclical pullback in the U.S. housing and auto sectors is causing particular difficulties
for Ontario. Given the degree of integration of the Ontario and U.S. economies, this province will feel a
significant impact from the U.S. downturn throughout the second half of this year and the first half of
2007. When you consider that automotive products made up 44 per cent of Ontario's merchandise
exports last year, it is clear that the U.S. downturn will likely affect Ontario more severely than other
provinces. Related manufacturing industries could also continue to face serious challenges. But I
remind you that roughly 70 per cent of Ontario's economic activity comes from the service sector, and
that sector remains in good shape. Overall, Ontario may well underperform the Canadian average for
the balance of this year and in 2007. Nevertheless, modest growth in Ontario's economy should
persist.
Those are some of the short-term issues facing Ontario. Now I want to say a bit more about the
longer-term structural issues facing some of Ontario's industries. The forest industry, including pulp
and paper, is facing a number of structural challenges. These include increasing competition from
places such as Brazil and Indonesia, as well as a flat or declining global demand for newsprint. In
addition, wood costs in eastern Canada have risen faster than elsewhere, adding to the challenges. In
terms of automobiles, there is an ongoing shift in the structural demand for motor vehicles within North
America. Although Ontario has been making adjustments in response to these changes, more are
needed. And the prospects for other industries, where value added has traditionally been rather low,
will also continue to be limited in the face of intense competition from Asia and elsewhere. Here, I am
thinking of industries such as furniture, clothing, and textiles.
However, while acknowledging these structural challenges, we should remember the importance of
Ontario's healthy service sector. The prospects for many service industries, including those with high
value added such as financial and business services, remain very positive, and these should continue
to support the Ontario economy for some time to come.
But no matter which sector we are talking about, we should also remember that the importance of
improving efficiency is paramount. And so it is encouraging that firms in the province have been
investing in machinery and equipment, most often with a goal of improving efficiency and productivity.
We all need to improve efficiency, and this means that policy-makers need to pay particular attention
to improving the efficiency of our financial markets. And, as I've said in many other speeches,
policymakers have a particular need to keep efficiency in mind, both in terms of fostering competition and
improving our regulatory framework, throughout the economy.
Policy priorities for Ontario
I'd be happy to say more about the need to improve efficiency in our question and answer session. But
before I turn the floor back over to you, let me close with some comments about two of the issues you
will be discussing over the next few days - developing human capital and improving infrastructure.
Ultimately, the strength of our economy depends on the skills of its workforce. To maximize these
skills, we need to take a truly lifelong approach to learning and to skills development. There is no
single approach or policy that will do the trick. Skills development must be a priority for everyone - for
parents, for students, for workers, for governments, and for employers.
Having a highly skilled workforce begins with parents. They need to do their best to get their children
ready to learn by the time they enter school. There is clear evidence that early childhood development
is vitally important in preparing children for their years at school. But parents need support in this role,
and governments need to do their part in providing this support. Public investment in early childhood
education has a high payoff.
This role for governments continues during the school years. The public sector must invest in
improving the effectiveness of education. To be clear, the point is not to keep children in school longer.
Rather, the point is to make sure that children actually are acquiring necessary skills while they are in
the classroom.
Of course, post-secondary education is critical to the development of our workforce. At the college
level, we need to see more close co-operation between colleges and employers in order to integrate
learning with the work environment. In this way, we can maximize the relevance of education, and
students can receive valuable experience in genuine workplaces that employ the most modern and
advanced technology. I have seen good examples of this kind of co-operation between Humber
College and firms in sectors such as design, merchandising, and high-end manufacturing. These are
positive steps, but we need to see many more of them.
The need to focus on skills development continues through to the post graduate level. We have seen
how research centres can grow to become the centre of gravity for economic development in a certain
sector. The obvious example in Ontario is the close connection between Waterloo, Research In
Motion, and quantum computing. This type of partnership helps to build comparative advantages for
Ontario, and the province needs to develop more of them, quickly.
Outside of the academic world, it is crucial that, as employers, we take seriously our responsibilities to
invest in the skills of our workers. I spoke about this issue at length last year in a speech at Humber
College, so I won't spend a lot of time repeating those points. Instead, I'd invite you to read those
remarks, which can be found on the Bank of Canada's website.
The last point I would make about skills development is that we need to keep demographic pressures
in mind. The population is aging, and we will soon face the challenge of how to make more effective
use of the skills of workers in their sixties, and even beyond. We will need to examine employment
incentives, work environments, and other issues to ensure that older workers who wish to contribute to
the labour force can still do so.
Aside from developing the skills of our workforce, we also need to remove as many barriers to mobility
as possible. As I've noted, economic restructuring is happening in Ontario, as it is across the country
and around the world. To take full advantage of this restructuring, people need to be able to move. To
this end, I was encouraged to see Ontario signal its desire to join the Investment and Labour Mobility
Agreement between Alberta and British Columbia - this would be a very helpful step by all three
governments.
It is also important to recognize that skills gained in one industry may well be easily transferred to
another industry, with only a small amount of additional training. It is important for businesses and
policy-makers to focus on this and not allow occupational licensing requirements to act as an
unnecessary barrier to the transfer of labour.
And of course, it is extremely important that we take steps to maximize the contributions of skilled
immigrants to Canada. We need to find ways to smooth the process of recognizing foreign training and
credentials, and supplement them to meet the needs of the Canadian economy, so these highly skilled
people can take their place in the workforce.
I have focused on the development of human resources in this section because it is a necessary -
though not sufficient - condition for Ontario's future prosperity. In this vein, I'm glad to see there will be
discussion of the Irish experience, as that country's remarkable success was predicated on developing
a skilled and adaptable workforce.
While policies to get the most out of our "human" infrastructure are important, we also need to develop
our physical infrastructure in order to reach our full potential. This critical infrastructure includes public
assets, such as highways, public transit and transportation facilities, power, waterworks and waste
water, schools, hospitals, and other facilities. It also includes private infrastructure, such as pipelines,
rail, and telecommunications networks. Having modern, reliable infrastructure in place allows
businesses to invest with greater certainty, thus furthering the ability to adjust and compete in a
changing global economy. Ontario needs public policies that can support both public and private
investment in infrastructure so that firms can become more productive.
The key questions here are how to improve the efficiency of infrastructure investment, and how to
finance that investment. There is evidence from other countries that public-private partnerships can
both increase the efficiency of investments and support their financing. Now is the right time to
encourage partnerships between the Government of Ontario and private providers, given the climate
of low nominal interest rates and the presence of large pension funds that are searching for these
kinds of investment opportunities. Of course, the most efficient and timely allocation of resources for
infrastructure occurs when the incentives are right. And it is true that the hardest incentive to get right
is proper pricing. A lack of pricing that appropriately reflects demand and supply conditions may be
one reason why there have been relatively few PPP infrastructure projects in Canada. But new
technologies provide new opportunities to gauge demand for public services, and to price them
accordingly. Clearly, though, if public-private partnerships are to deliver on their promise, it is essential
that the risks be appropriately shared between governments and the private provider. And I do
recognize that constructing appropriate risk-sharing arrangements is not easy.
Conclusion
Let me conclude. I have set out the Bank's projections for a strong global economy, although
nearterm weakness in the U.S. economy will lead to some slowing in Ontario. But this slowing should not
be prolonged. The real challenge for policy-makers is to address the long-term structural issues facing
Ontario's economy.
Today, I've stressed the importance of human resources development and infrastructure. But I know
there are other crucial issues to discuss. So let me now turn it back over to you, so I can take your
questions and hear your comments.