Good afternoon, Mr. Chair, vice-chairs, and members of the committee.
Thank you for inviting me and my colleagues to speak to you about Canada's economic and fiscal outlook.
These are challenging times for budget makers across the world. The level of economic uncertainty remains high. The pace of economic recovery has slowed for many G-8 countries at a time when economies are still operating well below their potential. The slowdown in growth is also taking place at the same time as governments are considering the end of fiscal stimulus programs and the implementation of austerity measures to reduce budgetary deficits.
There are significant policy trade-offs and risks. Policy makers need to steer a policy course between short-term support for a fragile economic recovery, on the one hand, and the avoidance of a buildup of public debt that will burden future generations on the other. There are also structural problems--low productivity growth, aging demographics, and fiscal imbalances--that will require structural solutions.
In this context, policy and budget makers in Canada need to place a premium on fiscal transparency and analysis to support policy debate leading up to the 2011 Budget.
Today, my office released a paper updating our five-year fiscal projections. We have updated our analysis of the cyclical and structural components of the projected federal budgetary deficits. We have provided a new quantitative assessment of the uncertainty and risks around these projections.
A few weeks ago, we made available analysis that looked at international and Canadian experiences with fiscal rules (i.e., legislative and/or strong political commitments to budgetary constraint).
We made the case that parliamentarians may wish to commence debate on the next generation of fiscal rules in Canada. It highlighted the need for this discussion to include a long-term perspective on Canada's fiscal challenges; to look at all levels of government in a fiscal federalism context; to account for risk and uncertainty; and to separate the cyclical from structural aspects to Canada's budgetary balance outlook.
In the weeks ahead, PBO will release analysis on the impact of fiscal stimulus in Canada with a focus on the Infrastructure Stimulus Fund. The goals of this work are: to estimate the short-run economic impacts; to track budget implementation; and to draw some preliminary lessons to aid future policy deliberations.
Next spring, PBO will release an updated fiscal sustainability report. The report will examine the fiscal actions required to maintain a steady debt to GDP ratio in Canada, not just from a federal perspective, but from a total government perspective.
I wish to highlight some messages and observations from the report we released today regarding our economic and fiscal situation and outlook.
Canadian economic activity still remains well below its level of full capacity--potential GDP. Given the average private sector forecast and PBO's estimate of potential GDP, the output gap is projected to narrow gradually over the medium term, and the economy will reach its potential by the end of 2016.
While real GDP has almost recouped all the losses from the first quarter of 2008 to the second quarter of 2009, Canadian economic activity still remains well below PBO's estimate of potential GDP of about 2.9 percentage points. Labour market indicators also suggest that there is a significant amount of excess capacity.
While the level of employment has returned to its pre-recession peak, it is important to recognize that total hours worked remain below their pre-recession level and 1.8% below their trend. This low level partly reflects the fact that recent employment gains have been disproportionately in part-time work. The unemployment rate remained at 8% in the third quarter of 2010, well above estimates of the natural rate of unemployment.
The Department of Finance's September survey of private sector forecasters indicates that the outlook for nominal GDP over the medium term—the broadest measure of the government's tax base—is little changed from the forecast on which Budget 2010 was based. However, private sector forecasters have revised down significantly their outlook for interest rates, with both short- and long-term rates approximately 80 basis points lower each year on average over the 2011 to 2014 period.
The near-term outlook for the unemployment rate has been revised down somewhat, although private sector forecasters now expect a slightly higher rate of unemployment in the medium term.
PBO projects a budgetary deficit of $40 billion--2.5% of GDP--in 2010-11, declining to $11 billion--0.5% of GDP--in 2015-16. This results in a projected cumulative increase in federal debt of $200.5 billion to $658.1 billion by 2015-16, or about 32.4% of GDP, when combined with budgetary deficits realized in 2008-09 and 2009-10.
The projected reduction in the budgetary deficit over the medium term largely reflects a cyclical improvement in the economy. PBO estimates that the government's structural deficit will decline only gradually to $10.2 billion in 2015-16, or 0.5% of potential income.
Notwithstanding the extent to which Canada's fiscal plan has been thrown off course since the recent global recession, Canadian fiscal balances and debt levels are in a relatively better position than those of many of our competitors. The magnitudes of Canada's structural deficits over the medium term are significantly smaller than the structural deficits observed in the 1980s and 1990s. From this relative perspective, it is fair to say that Canada's fiscal challenges appear less severe and more manageable.
The fact that Canada has relatively better balances does not mean, however, we have a fiscal structure that is sustainable. Assessing fiscal sustainability requires looking beyond projections of budget deficits and debt over a medium-term horizon to take into account the economic and fiscal implications of the population aging.
In our 2010 fiscal sustainability report, PBO calculated a federal fiscal gap of 1% to 2% of GDP, depending on differing assumptions. This suggests that sizable and sustained fiscal actions are required to maintain a steady debt-to-GDP ratio over the longer term.
Parliamentarians need to be aware that the cost of fiscal action increases substantially the longer actions are delayed.
The PBO fiscal projections, as well as those in the government's update, are based on the results of Finance Canada's survey of economic forecasts produced by private sector organizations. Both PBO and Finance Canada translate the average private sector economic forecast into a fiscal projection based on their own assumptions.
PBO projects budgetary deficits that are moderately larger on average than those presented in PBO's March report and the government's update, owing primarily to higher operating expenditures.
Given the lack of detail regarding the government's expenses subject to the operating freeze, PBO has assumed that these expenses will grow in line with population growth and inflation--equal to 3.2% on average--over the 2010-11 to 2015-16 period. This assumption is significantly lower than both nominal GDP growth over the same period—about 4.9%—and the 6.4% average growth observed in the five years preceding the government's economic action plan.
In PBO's judgment, the balance of risk to the current economic outlook is heavily weighted to the downside. These downside risks include both external and domestic risks, each of which could have a substantial negative impact on economic growth in the near and medium term.
External risks relate to the U.S. outlook; the recent appreciation of the Canadian dollar and ongoing global currency tensions; and sovereign debt concerns.
Over recent quarters real GDP growth in the U.S. has slowed, employment growth has remained weak and the unemployment rate has remained well above 9%. In PBO's view the balance of risks to the U.S. outlook are clearly to the downside, which could have an important impact on the Canadian economy.
Currency tensions among countries have escalated in recent months, prompting discussions of competitive devaluations and tariff barriers. This could pose a downside risk to the global economic outlook. A second currency risk relates to the strong rebound in the Canadian dollar, which, since the first quarter of 2009, has outpaced a movement in commodity prices, thereby restraining growth.
While sovereign debt concerns have receded somewhat in recent months, as noted in the Bank of Canada's October 2010 monetary policy report, credit spreads remain elevated for some European countries, and a negative shock would risk triggering renewed strains in global financial markets, resulting in higher-risk premiums that would put upward pressure on global interest rates.
Domestic risks relate primarily to the high level of household debt in Canada. Household debt has continued its upward trend, reaching 147% of personal disposable income in 2009, putting households in a vulnerable position. The high level of debt of Canadian households will likely constrain growth and consumption and housing investment over the projection horizon.
The PBO report released today provides new analysis for Canada on the quantification of uncertainty and risk around economic and fiscal projections. The purpose is to enrich the analysis of the planning environment facing parliamentarians to elevate the debate away from relatively small differences in the medium-term balanced budget projections to a richer assessment of the uncertainty that incorporates the historical track record of private sector economic forecasts and PBO judgment for risk. While the government's fall update introduces a risk adjustment in its projection, in our view it is small and does not adequately reflect the magnitude of the downside risks to the economic outlook.
On a status quo basis, according to PBO estimates, the likelihood that the budget will be in a balanced or surplus position over the period 2010-11 to 2013-14 is effectively nil. There is an 85% chance of probability the budget will be in deficit in 2015-16, and there's an 88% chance that the budgetary balance of 2015-16 is lower than the $2.6 billion surplus projected in the government's economic and fiscal update. In this environment, parliamentarians may wish to debate the appropriate fiscal adjustments for uncertainty and risk, in addition to the appropriate medium-term and long-term fiscal objectives with respect to budget balances and fiscal sustainability.
In closing, PBO recommends the government consider making available their analysis on cyclically adjusted budget balances, on longer-term fiscal sustainability, and a detailed assessment of uncertainty and risk so that parliamentarians and Canadians will have access to the same level of analysis that's provided in many other countries. PBO also recommends that the government provide additional transparency related to the status of the fiscal framework for money set aside for new and proposed programs and the departmental strategies to freeze operational expenditures.
Thank you for the opportunity to speak to you today. We'd be happy to take questions after others speak.
Thank you very much.