With the U.S. presidential election upon us, one probably does not need to search too hard for pledges by friends or family to move to Canada depending on the outcome. Regardless of the credibility of these threats, it is necessary for our purposes to take a deep look at the investment environment north of the border. Canada, like the U.S., is generally a low-risk investment environment with a number of positive attributes. It is a country with a vibrant democracy and high level of social cohesion. The Canadian political system and institutions function effectively due to a mature and tested system of checks and balances, which enhances political stability and policy predictability. Canada is a technologically advanced and innovative country with a highly skilled and entrepreneurial labor force as well as a solid demographic backdrop. As a complement to this, the country’s labor laws are quite flexible, its regulatory burden is relatively light, and its corporate tax rates are low.
All of these attributes make Canada quite attractive to foreign investors, but there are a few drawbacks. The country’s foreign investment rules leave much to be desired, with several barriers to foreign direct investment, including a somewhat arbitrary “net benefit” requirement that serves as a prerequisite to large scale foreign acquisitions or mergers with Canadian firms. Various barriers to competition also exist in several key services industries, such as telecommunications, professional services, and electricity. The result of these various distortions is that productivity growth has been quite weak in Canada and has consistently lagged that of the U.S., acting as a headwind to an improvement in living standards.
From an economic perspective, a few things stand out about Canada. First and foremost is its enduring interconnectedness with the U.S. During boom times, this is a clear advantage for Canada, as around 75% of its exports go to the U.S. Moreover, the two countries are increasingly connected by various supply chains and shared infrastructure. For these reasons, the two economies tend not to deviate too much from each other. Here, it is also useful to look at Canada’s size in context. If Canada were a U.S. state it would be a large one—its GDP is a little less than California’s and about the same as Texas’, and its population of 35 million is slightly less than that of California. Overall, U.S. GDP is roughly twelve times that of Canada. Given the interconnectedness described above, wherever the U.S. economy goes, so goes the Canadian economy.
While we do not expect long-term trends to diverge, there are sometimes short-term divergences caused by differences in economic composition. Canada is somewhat reliant on its natural resource bounty, particularly oil, for economic growth. Its currency tends to follow trends in global commodity markets, which acts as somewhat of a countercyclical shock absorber for the economy. In other words, when global demand is weak and commodity prices soften, Canada’s other export goods usually become more affordable in global markets. This helps to explain some of the resilience we have seen in Canadian growth in recent years. Without a strong rebound in commodity prices, however, it is difficult to make a case that the path of Canada’s economy will decouple from the U.S.
Another structural aspect of Canada’s economy that supports our view of slow global economic growth is that, like the U.S., Canada is a high-debt economy. The composition of its debt loads, however, is different. While the U.S. has piled debt onto its government balance sheet as its consumers have to an extent deleveraged after the global financial crisis, Canadian consumers have continued to take advantage of very low rates to push debt levels to new highs as a percentage of disposable income. This has created new risks for the economy that must be watched in addition to any risks from weak growth in the U.S.
One risk that we have been monitoring closely over the past few years has been the relentless rise in property prices that has been associated with the low interest rate environment and the steady upward march of consumer debt. The steep climb in prices has been particularly worrisome in a few overheated markets, such as Vancouver and Toronto. While a housing bust would certainly be a risk to the economy, we have been of the view that such a deflation in the market would result in a drag on consumer spending rather than a full-scale, U.S.-style financial crisis.
There are two main justifications for this view. First, some of the key distortions that were present in the U.S. situation are absent from the Canadian market. Namely, Canada does not have a specific tax and regulatory policy designed to increase homeownership for social purposes. Mortgage interest is not tax deductible, which is a policy that artificially boosts demand for housing in the U.S. More importantly, Canadian mortgages are full recourse, which means that households would not have a financial incentive to walk away from their homes if price drops were to place them in significant negative equity. This policy exacerbated the price declines in the U.S. as more supply was hitting the market than otherwise would have been the case.
Second, a major difference between what the U.S. experienced and the current situation in Canada is that there is arguably much more foresight on the part of policymakers and regulators in Canada. Several measures have been enacted to limit appreciation in frothy markets. These include tightening eligibility requirements for mortgage insurance, a 15% tax on purchases by foreigners in Vancouver, and an elimination of a capital gains exemption for foreigners. We have little doubt that much of the incremental demand has come from foreign, particularly Chinese, purchases. This is a phenomenon that is also quite clear in some of Australia’s hotter markets such as Sydney. These measures represent a politically palatable way to limit speculative demand, and should cool the rate of growth over the medium term.
Besides being a solid hunting ground for investment opportunities on account of its political stability, innovation, and globally competitive companies, Canada offers other reasons to pay close attention to what happens there. We believe the country is important beyond its own borders because it is somewhat of a microcosm for what is happening in terms of attitudes toward debt and deficits, particularly among the policy crowd. Recently elected Prime Minister Justin Trudeau campaigned on a promise to take advantage of the low interest rate environment globally and stray from a path of conservative fiscal policy to stimulate the economy via infrastructure spending. In our view, we are seeing a gradual but undeniable shift among academic and policy circles away from austerity and toward looser fiscal policy to complement loose monetary policy. Canada may become a true trail blazer in this move away from fiscal orthodoxy, paving the way for other countries to follow suit.
Canada’s being at the forefront of this shift is particularly interesting because the country was not so long ago the poster child for the benefits of fiscal orthodoxy. To fully appreciate this, one must examine where Canada has come from in terms of the management of its fiscal situation. As recently as the mid-1990s, the country was more or less considered a fiscal basket case. It had a large debt load with interest costs eating up a massive portion of revenues, as well as expenditure levels rivaling those of some Western European countries today, measured as a percentage of GDP. When policymakers finally could no longer ignore the problem, they enacted an austerity program that consisted almost entirely of deep spending cuts with some tax increases, a reduction in government employment, and a shift in the tax structure toward less distortive forms of taxation, such as the implementation of a valued-added tax.
The result was that Canada ran fiscal surpluses throughout the 2000s until the global financial crisis, while the unemployment rate actually fell. This last fact is an extremely inconvenient truth for anyone prescribing an anti-austerity stance. However, we do acknowledge that the global economic backdrop was very different during Canada’s correction than it is today. Global growth tailwinds were much stronger then, led by China’s ascension to the World Trade Organization, as well as the demand created by the formation of the U.S. housing bubble. Moreover, Canada was well placed to capitalize on these trends, as its currency was pummeled and its exports became competitive on the global market.
Today, most developed economies are in a similar situation to where Canada was in the mid-1990s, with the key differences being rock bottom interest rates and slow growth all over the developed world. With monetary policy seemingly at its limits in terms of its ability to be the sole driver of policy stimulus, the world is at somewhat of a crossroads. It remains to be seen whether developed countries will follow the example of the Canada of yesterday and continue to try to live within their means, or if they will follow the Canada of today down a road of intervention and continued debt build-up, hoping that interest rates never rise so that this debt remains easily serviceable.
Either way, we believe that Canada has a pretty bright future ahead of it, relatively speaking. With its knowledgeable and entrepreneurial population, well entrenched rule of law, and plethora of natural resources, we think the country is in the enviable position of being able to help solve many of the world’s problems. As a major food and fertilizer producer, the country will help feed the world’s population as it grows in size and wealth. It will continue to benefit from its proximity and interconnectedness to the world’s most dynamic and innovative large economy. Canada may even benefit from a few hard-working but disgruntled Americans heading across the northern border in search of a better life, depending on how the U.S. election turns out.