Global economic growth in 2004 was the best in 27 years, at 5.1% according to the IMF, powered by continued strength in the US and China. The US easily led the acceleration common to all the G7 nations, with its real GDP rising 4.4%. The increase defied widely held concerns about the sustainability of US growth in the face of record highs for oil prices and the trade deficit, fears that found an (inaccurate) expression in a year-long stall in the US leading indicator. The UK was next with 3% growth–just ahead of Canada, followed closely by Japan (although its GDP contracted in the second half of the year). Continental Europe continued to lag with gains of less than 2%: nevertheless, this represented an improvement on negligible growth in 2003.
Global events continued to be the driving force behind developments in Canada’s $1.3 trillion economy. The Canadian dollar rose on average another 5 cents against the US greenback, after a 7-cent increase the year before. These were the largest ever back-to-back gains in the exchange rate, reflecting the devaluation of the US dollar against most major OECD currencies. Commodity prices saw their best consecutive increases since the early 1970s. This partly reflects China’s ongoing rapid integration into the world economy.
Rising export demand accounted for all of the upturn in Canada’s GDP growth from 1.7% in 2003 to 2.8% last year. Final domestic demand growth was virtually unchanged at 3.8%, supported by strengthening business investment. Inventory accumulation was slightly faster, mostly after manufacturing demand slumped in the second half. As well, farmers held on to cattle as the US border remained closed to our beef exports.
A number of measures suggest the Canadian economy performed better than the volume of GDP or employment would indicate. The increased purchasing power from rising commodity prices helped boost command-based GDP (which takes account of our higher terms of trade) by 4.7% after a 4.5% gain the year before.1 This is nearly twice the growth of GDP over this period. Similarly, our net national wealth grew on average 6.3% in 2004 due to the increased value of land as resource and housing prices rose. And GNP outstripped GDP growth. The country-wide surge for housing and commodities also led to a more even regional and rural-urban distribution of growth.2
Several other long-term trends continued unabated. Despite the rise in commodity prices, inflation and interest rates remained at historically low levels. And the sectoral pattern of lending and borrowing was unchanged, with huge surpluses for firms and sizeable ones for government, combined with a record current account surplus. Households went further into debt to finance their housing spree, emboldened by rising net worth resulting from strong housing and stock market prices. The inevitable aging of the population continued to alter our demographic profile.
The soaring loonie
While the appreciation of the exchange rate was again the year’s most striking economic event, it had a less pernicious impact than in 2003. Not only was the increase smaller than the year before, it was concentrated in the last half of the year (the initial upturn in 2003 was felt throughout the year). Partly as a result, the surge in the dollar last year did not stop exports from pulling out of a 3-year tailspin.
The higher exchange rate increased Canada’s terms of trade. But unlike 2003, this was not just because of import prices falling (which slowed from -7% to -2%). Export prices edged up last year, as higher commodity prices outweighed the depressing effect of a rising dollar (especially for goods priced in US dollars). The driving force behind this turnaround was more rapid growth in China. Its voracious demand for resources translated directly into more Canadian exports as well as indirectly boosting prices for commodity shipments elsewhere.
The appreciation of the dollar also affected direct investment flows. The loonie’s higher purchasing power abroad, especially in the US, made it easier for Canadians to make foreign investments. Direct investment abroad rose to $57 billion last year (close to its record in 2000), on top of $30 billion in 2003. The increase was led by the takeover of finance and energy companies in the US.
Conversely, the higher exchange rate made it dearer for foreigners to invest in Canada. After averaging nearly $50 billion from 1998 to 2002, when the dollar was falling, direct investment inflows slowed to less than $10 billion annually in the last two years, its lowest since 1993.
The stronger dollar also encouraged Canadians to make a record number of trips abroad, especially overseas. But it did not discourage overseas visitors to Canada, who returned after the SARS-related drop in 2003.3
Canada’s current account surplus hit a record high of $33.8 billion last year. A recovery in export earnings sent the goods surplus to a 3-year high of $67 billion. The better performance of exports reflects growing shipments to China, where exports rose 39% after a 15% gain in 2003. Most of the increase was in non-energy natural resources, which account for about 80% of our shipments to China (and over half of the increase in these exports last year). Manufactured goods to the US also rose in the first half before the rising dollar slowed them in the second half, while energy shipments south of the border were strong all year.
Overall export volume rose 5%, after falling 4% since 2000. Growth was evenly spread at about 7% for all sectors outside of energy and consumer goods (which posted marginal gains). But rising prices led to double-digit increases in export earnings for energy, forestry and metal products, while prices fell for manufactured products such as autos and machinery and equipment (the higher dollar shaved 4% off industrial prices over the last two years).
Imports rose 6% last year, surpassing their previous peak set in 2000. All of the increase represented higher volume. Imports from China jumped another 30%, and have doubled in the last three years. Imports from all other countries have been flat since 2001. Machinery and equipment led imports, up 13%, followed closely by energy and consumer goods.
Meanwhile, the deficit for investment income fell over $1 billion, largely because the rising loonie made it easier to service Canada’s external debt. As well, profits from our past investments abroad were buoyed by the thriving global economy.
Energy exports soar
Rising energy prices, led by oil breaching a record $50 (US) a barrel, challenged the rising dollar as the year’s most important economic event. Energy consolidated its place as Canada’s leading resource export. Since oil prices bottomed out during the Asian crisis in 1998, the share of energy in exports has more than doubled from 7.3% to 16.1%.4 Most of this growth was at the expense of the share of autos and machinery and equipment, with losses of over three percentage points each (each point represents over $4 billion). Consumer goods was the only other sector to post even a small increase. Other natural resources saw small declines in their share.
Canada’s surplus in trade in energy is now almost as large as all other resource exports combined (including forestry—for long our largest export—food and metals). Energy exports have doubled since 1999, driven by higher prices and new sources of supply.
This reliance on energy for such a large part of exports might raise questions about our vulnerability to a collapse in prices, such as for oil in 1986, 1991 and 1998. But the OECD noted that markets expect “oil prices will be permanently higher”5. Far futures prices (up to 7 years ahead) have risen to nearly $40 a barrel, whereas they remained stable at $20 despite large fluctuations in spot prices in the 1990s.
Canada is well positioned to profit from soaring energy prices. Over the past decade, firms have devoted one-third of their investment to the energy sector, boosting its gross capital stock by $218 billion since 1994. Over half this expansion was in oil and gas, including such mega-projects as Hibernia, Terra Nova and Sable Island off the East Coast, Ladyfern in BC and especially the tar sands in Alberta. Of course, all these projects needed a substantial increase in pipeline capacity to bring product to market. The strong growth in Canada’s energy revenues in recent years partly reflects the pay-off from these huge and often risky investments.
The scale of energy investment dwarfs all other industries. The financial industry had the next largest increase in capital stock since 1994, up $56 billion ($30 billion alone in the 3 years before the Y2K conversion). Telecom and retailing expanded by $40 billion and $25 billion, followed by air transport ($21 billion) and the auto industry ($11 billion). Still, all these industries combined did not equal energy investment over the past decade.
Since 1994, the growth in investment in conventional oil and gas was outpaced by non-conventional projects in the tar sands, which rose from $400 million (or less than 4% of conventional) to $8.5 billion this year (equal to 26% of investment in conventional projects). The tar sands’ share of oil output rose to 41%, closely tracking their share of all investment in oil and gas due to the very capital-intensive production process. A major investment at the turn of the millennium was followed by a surge in tar sands output starting in 2002, and new capital spending is starting to re-accelerate with an eye to boosting output later this decade.
The development of the tar sands is the inevitable consequence of declining reserves of conventional oil, even with the discovery of more offshore oil. Oil reserves in tar sands have risen to four-times those for conventional oil.
While reassuring for our future energy security, the lower energy efficiency of tar sands extraction could increase greenhouse emissions. The tar sands consumed 4% of western Canada’s natural gas in 2001 to extract the oil from sand and to generate steam for ‘in situ’ (on the site) production.6
The concentration of growth in our capital-intensive resource sector also helps explain the increase in profits relative to wages and salaries in recent years. In fact, labour income’s share of GDP fell to less than half (49.4%) last year for the first time ever.
Business investment strengthens
Business investment slowly began to recover from the over-investment in ICT at the turn of the millennium, returning to its previous high set in 2001. After retreating over the previous three years, firms spent 6% more on investment last year and plan to invest an additional 8% in 2005.
Almost all of the increase in 2004 was directed to machinery and equipment. Computers remained popular, while industrial machinery sustained growth of about 10% as manufacturers moved to boost productivity. Even spending on telecom equipment pulled out of a 3-year slump.
Business spending on structures remained split between gains for engineering and cuts for building. Engineering was driven by energy. But building remained the most depressed sector of the economy, falling 4% for its fifth straight decline (totalling 25%). The glut of office space at the turn of the decade was reinforced by falling capacity use in factories in recent years, following the ICT bust.7
Compounding these problems, prices for non-residential structures jumped another 5%, pushed up by the strength of housing construction. The concentration of investment in the tar sands also created local shortages in Alberta. With the price of machinery and equipment falling another 4% due to lower import costs, this gave firms an added incentive to shift investment away from structures.
Investment growth in 2004 was led by resources, notably metal mining (+38%) and energy (+8%). This follows a decade when investment in metal mining did not keep up with depreciation, leading to a drop in its capital stock (the only industry to post a decline). The surge in energy prices evidently caught this industry off guard, as they had planned no increase in 2004. Energy firms forecast even larger gains in 2005 as confidence grows that prices will stay high for several years. Telecommunications and finance also boosted capital outlays at a double-digit rate.
One reason investment did not grow faster last year was the shock to manufacturers from another sharp rise in the dollar. They responded by cutting investment from the 4% increase they intended at the start of the year to a 1% decline, especially for structures (down 20% for its fourth consecutive decline). But firms learned that to adapt to the higher dollar they must raise productivity, and plan a 17% increase in spending on machinery and equipment in 2005, by far the most of any sector even as they cut back further on plant.
The gathering recovery of investment reveals that firms found it both more profitable and affordable to invest. Corporate profits rose 18% for their best increase since 2000, led by extraction industries, especially mining and energy. Retailers and banks also reported healthy gains.
Affordability has improved on a number of fronts. Besides lower prices for investment goods, corporate bond rates declined faster than government rates over the last two years. In fact, corporate bond rates barely fell between 2000 and 2003, even as government of Canada (GOC) rates eased nearly a full percentage point. But since August 2003, corporate yields have fallen nearly a full point, closing their spread over government rates.8
This vote of confidence in corporate financial health reflects a number of improvements, primarily a record surplus of $88 billion. This was used to strengthen balance sheets (notably the interest coverage and debt/equity ratios). At the same time, corporate governance scandals have receded.
All these factors led to a general upgrade of corporate debt and increased confidence in bond and stock markets. New equity issues hit $27 billion last year. Particularly notable was a recovery of initial public offerings to a 4-year high, with nearly one-third in mining.
The Toronto stock market rose by 12.5% last year, its second straight increase after a 2-year bear market, although it remained 19% below its September 2000 peak. The Canadian market outperformed the US (up 9%, mostly after the presidential election), largely because of the larger presence of high-flying resource stocks. Energy companies rose 29% on top of a 24% gain in 2003. Foreigners rushed to purchase Canadian equities, buying a record $35.8 billion last year. Conversely, the rising loonie discouraged Canadians from investing in stocks abroad, which fell to the lowest level since the mid-1980s.
Consumers target housing and durables
The housing boom continued unabated last year. The 47% increase in the volume of residential construction beginning in 2001 (when the stock market crash and terrorist attacks ushered in an era of historically low interest rates) is the largest 4-year gain in over four decades (Figure 12). Housing was the fastest-growing sector of demand in each of these years. The sharp drop in interest rates that began in 2001 accompanied a marked shift to new house construction, while spending on renovations slowed.
Household wealth jumped 5%, buoyed by the strength in both housing and stock markets. Households continued to go further into debt to finance the housing boom. Households owed $900 billion last year, although net worth hit $4.4 trillion.
The recent run-up in housing prices and debt raises concerns about a bubble forming in the housing market, such as in the stock market in 2000. But most indicators are reassuring that much of the recent increase in prices is largely making up for losses in the 1990s. The ratio of existing home prices to disposable incomes remains below its average from 1990 to 1994. Neither does the ratio of the cost of housing to renting suggest an imbalance. The increase in both existing and new home prices slowed last year, and never exceeded 10% this decade after averaging less than 1% a year in the 1990s.9 Still, homeowner equity has risen nearly 50% since 2000 as house values rose faster than mortgage debt.
Consumer spending trends were driven by the proliferation of new electronics, often combined with sharply lower prices (many of these goods are imported from southeast Asia). Non-auto durable goods led the way, fuelled by home electronics and computers where prices fell at double-digit rates. Large retailers reported booming sales for large screen TVs and CD and DVD players. Falling import costs also lowered clothing prices, helping boost sales volume 5%. Finally, gift cards continued to proliferate, changing the pattern of Christmas sales and boosting retail margins.
Vehicle sales fell for the second straight year, with cars down more than trucks. The higher cost of insurance and gasoline outweighed the continued proliferation of special incentives to purchase. Transplant automakers captured 20.7% of the market, up from 15.9% in 2000 and 5.3% in 1992. This was reflected in Honda surpassing Ford as the third largest producer in Canada.
Sharp price hikes at the pump did not deter drivers from buying 2.1% more gasoline.10 This partly reflects the growth of SUVs to 17% of Canadian auto sales (just below their share in the US).
Spending was encouraged by rising personal incomes even as inflation moderated. Labour income growth reached a 4-year high of 4.1%. Falling part-time jobs slowed overall employment, but full-time jobs grew 2.4%.
Personal income taxes edged up from 15.3% to 15.5% of income last year. While only a small increase, this was the first hike since 1998. Federal income taxes rose faster than the provinces, who relied more on higher payroll taxes to raise revenue.
The increase in the government surplus last year reflected buoyant incomes and slower spending. Government revenues rose 5%, led by increased collections from both personal and corporate taxes as incomes accelerated. The slowdown in outlays was most pronounced for capital projects, which rose only 2% in volume after spending on infrastructure had nearly doubled over the previous five years. Almost all of the higher government surplus was at the federal level, as provinces have changed the structure of resource royalties.11
Growth more even
Last year was notable for a more even distribution of industry growth. Recent years were dominated by rapid gains in a few sectors, such as manufacturing (2000) or housing (2001) and sharp declines in others (travel-related in 2003 or the farm drought in 2002). This left double-digit gaps for growth between the best and worst performing industries. But in 2004, the spread narrowed to just six points (from wholesale at 6% to utilities at 0%). Statistically, the standard deviation of growth in the 17 major industries relative to the average for GDP fell steadily from 3.6 in 2001 to just 1.5 last year.
The narrower dispersion of growth last year partly reflected the absence of any major industry posting a decline. Accommodation and food rebounded from its SARS-induced loss in 2003. Manufacturing improved across the board except for paper and clothing-related industries, after a stagnant performance the year before. Particularly notable was an upturn in ICT manufacturing after three years of retreat. The recovery of international trade also helped transportation recover from an off-year in 2003. Arts and recreation posted the largest slowdown, with losses for spectator sports.
All provinces have benefited from gains in housing and, to a lesser extent, resource extraction. In fact, no province has posted a drop in jobs in any year since 2001 – a remarkable string for a country as diverse as Canada, facing a series of shocks ranging from drought to disease outbreaks to the soaring loonie.
The net result was a more even distribution of provincial job growth, whose standard deviation from the national average was only 0.06, one-third of 2000 and 2001 when Ontario dominated growth. Instead, Ontario has reverted to the national average. Only Manitoba and Saskatchewan lagged significantly last year (due to weakness in farming). Alberta led growth thanks to its energy sector.
That all of the acceleration in output came from exports sheds additional light on the reasons for the slowdown in 2003. At that time, much commentary focused on a series of negative shocks, including SARS, mad cow, strikes, power outages, hurricanes and fires. But with steady growth of domestic demand in both years, it was the slowdown of exports in response to the initial surge of the dollar that most dampened growth in 2003.
Weather was as disruptive in 2004 as in 2003, but since the economy picked up it was perceived as less of a problem. A cold, wet spring and summer on the prairies and in central Canada suppressed crops and fires, but very dry conditions on the west coast cost more hectares to forest fires in the Yukon alone than in all of Canada last year.
Lower import prices check inflation
Inflation in Canada slowed to 1.9%, dipping below the US rate (2.7%) for the first time in three years. This marks a return to the pattern of the 1990s, when for eight years in a row the CPI rose more slowly north of the border. The sharp drop in import prices in Canada helped this decrease (while the falling US dollar and higher oil prices raised the US import bill). The initial downturn in Canada’s import prices in 2003 was partly offset by sharply higher insurance premiums and tobacco taxes, neither of which were repeated in 2004.
Prices fell the most for durable and semi-durable goods, where import content is the largest. A record 1.6% drop for durable goods was the largest of five straight annual declines. This long slide in prices was led by computer and electronic goods, reflecting rapid technological change. The decrease for semi-durables was the third straight, driven by clothing where falling import prices provided the spur. The cost of imports from China was lowered by its policy of maintaining a fixed exchange rate with the falling US dollar.
Lower import costs were not always passed on to consumers. Retailers captured some of the drop in higher profit margins, a trend that began in 2003. These increases offset the erosion of margins accepted by retailers when the loonie fell and import prices rose early this decade.
But even the increase in the cost of services in Canada slowed to a 5-year low of 2.3%. Prices of services in personal expenditure rose even less (1.8%), partly due to the sharply lower cost of travelling abroad (not captured in the CPI, which includes only goods and services in Canada).
After a decade of export-led growth in the 1990s, Canada had turned to domestic spending to sustain growth in recent years. Last year saw both domestic and export demand improve. Domestic demand continued to grow rapidly, with household spending increasingly buttressed by an acceleration in business investment. Investment firmed in all sectors as financial markets were increasingly confident that the over-investment and poor corporate governance at the turn of the millennium were rectified.
But resources, especially energy, were the driving force for about half of all the investment growth. Soaring energy prices were behind Canada’s record trade surplus. With exports rising and the higher dollar lowering our import bill, the terms of trade again swung sharply in Canada’s favour. This allowed Canadians to consume more than the volume of output would indicate.
2004 also was noteworthy for the absence of any major sectoral or regional losses in output or investment, while jobs rose in every province. The more even distribution of growth reflects gains in resources and housing in every region, and the increasing purchasing power of the rising loonie.
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