Wednesday, 14 September 2016

The Breakdown of Faith in Unconventional Monetary Policy

We are witnessing a breakdown of faith, outside central banks, in unconventional monetary policy (UMP). In recent days and weeks, the attack on UMP has intensified from a wide array of analysts including current and former monetary officials as well as highly regarded financial market commentators. 

Inside central banks, faith remains strong, as witnessed at the Jackson Hole meetings in August, where the keynote speaker, Fed Chair Janet Yellen concluded,
New policy tools, which helped the Federal Reserve respond to the financial crisis and Great Recession, are likely to remain useful in dealing with future downturns. 
As unconventional policy comes under attack, central bank credibility is eroded and diametrically opposing views are forming over what direction monetary policies should take next. 

Opponents of UMP favour a gradual unwinding of unconventional monetary policies of key central banks, namely the US Federal Reserve, the Bank of Japan (BoJ) and the European Central Bank (ECB), including quantitative easing (QE) and negative interest rate policy (NIRP).

Supporters of UMP favour even more aggressive use of these policies, by both the BoJ and the ECB to combat slow growth and deflation now.  Some advocate going further to implement "helicopter money" or monetary financing of new fiscal stimulus. 

Which of these policy scenarios plays out over the next few years will dramatically influence both economic and financial market outcomes, not only in the economies of the central banks employing unconventional policies, but across the global economy as the spillovers from the policies of the major central banks reverberate through global financial conditions.

The Critique of Unconventional Monetary Policy

Perhaps the most damaging critiques of UMP have come from current and former monetary officials.

In July, Claudio Borio, Head of the Monetary and Economic Department at the Bank for International Settlements (BIS), along with his colleague Anna Zubai, published a paper titled "Unconventional monetary policies: a re-appraisal". The paper traces the use of UMP and reviews the evidence on the impact of such policies. Borio and Zubai wrote,
They were supposed to be exceptional and temporary – hence the term “unconventional”. They risk becoming standard and permanent, as the boundaries of the unconventional are stretched day after day.
Following the Great Financial Crisis, central banks in the major economies have adopted a whole range of new measures to influence monetary and financial conditions. … But no one had anticipated that they would spread to the rest of the world so quickly and would become so daring.
[T]his development is a risky one. Unconventional monetary policy measures, in our view, are likely to be subject to diminishing returns. The balance between benefits and costs tends to worsen the longer they stay in place. Exit difficulties and political economy problems loom large. Short-term gain may well give way to longer-term pain. As the central bank’s policy room for manoeuvre narrows, so does its ability to deal with the next recession, which will inevitably come. The overall pressure to rely on increasingly experimental, at best highly unpredictable, at worst dangerous, measures may at some point become too strong. Ultimately, central banks’ credibility and legitimacy could come into question.
In August, just as central bankers were congregating at Jackson Hole, Wyoming for their annual get-together, former Federal Reserve Governor Kevin Warsh published another, more strongly-worded, broadside against UMP in an op-ed in the Wall Street Journal.
The conduct of monetary policy in recent years has been deeply flawed. 
The economics guild pushed ill-considered new dogmas into the mainstream of monetary policy. The Fed’s mantra of data-dependence causes erratic policy lurches in response to noisy data. Its medium-term policy objectives are at odds with its compulsion to keep asset prices elevated. Its inflation objectives are far more precise than the residual measurement error. Its output-gap economic models are troublingly unreliable.
The Fed seeks to fix interest rates and control foreign-exchange rates simultaneously—an impossible task with the free flow of capital. Its “forward guidance,” promising low interest rates well into the future, offers ambiguity in the name of clarity. It licenses a cacophony of communications in the name of transparency. And it expresses grave concern about income inequality while refusing to acknowledge that its policies unfairly increased asset inequality. 
At the Jackson Hole meeting, Christopher Sims, the influential Professor of Economics at Princeton University, attempted to answer the question of why unconventional monetary policies, including negative policy interest rates, have been ineffective in boosting growth and returning inflation to target levels, with the following assessment:
Reductions in interest rates can stimulate demand only if they are accompanied by effective fiscal expansion. For example, if interest rates are pushed into negative territory, and the resources extracted from the banking system and savers by the negative rates are simply allowed to feed through the budget into reduced nominal deficits, with no anticipated tax cuts or expenditure increases, the negative rates create deflationary, not inflationary, pressure.
These critiques from current and former monetary policy insiders, give added weight to the arguments against UMP that have been coming from private sector analysts for years. To quote a few recent examples,

James Grant, Publisher, Grants Interest Rate Observer: 
What is new is the medication of markets through this opiate of quantitative easing year after year after year following the financial crisis. I think that this kind of intervention has not only not worked but it has been very harmful.   
 John Hussman, President, Hussman Econometrics Advisors:
By driving interest rates to zero, central banks intentionally encouraged investors to speculate long after historically dangerous ‘overvalued, overbought, overbullish’ extremes emerged. In my view, this has deferred, but has not eliminated, the disruptive unwinding of this speculative episode. By encouraging a historic expansion of public and private debt burdens, along with equity market overvaluation that rivals only the 1929 and 2000 extremes on reliable valuation measures, the brazenly experimental policies of central banks have amplified the sensitivity of the global financial markets to economic disruptions and shifts in investor risk aversion. 
The Fed has insisted on slamming its foot on the gas pedal, refusing to recognize that the transmission is shot. So instead, the fuel is instead just spilling around us all, waiting for the inevitable match to strike. We can clearly establish that activist monetary policy - deviations from measured and statistically-defined responses to output, employment and inflation - have had no economically meaningful effect, other than producing a repeated spectacle of Fed-induced, speculative yield-seeking bubbles. 
Russell Napier, Strategist and Co-founder of the Electronic Research Exchange (ERIC)
Negative interest rates could, if filtered through into deposits in any significant way, lead people to prefer the banknote to the deposit. That used to be called a bank run.
"Policy Singularity" refers to the time when monetary and fiscal policy can no longer be distinguished. It is the final step in Bernanke’s famous helicopter speech. Briefly, the steps [taken by central banks] included quantitative easing; effectively pegging the yield curve; providing forward guidance; putting up the inflation target; and foreign-exchange intervention. The Bank of Japan has run through the entire range of Bernanke’s recommendations apart from the last one, which he calls helicopter money.  
At this moment I still fret more about the outbreak of deflation than inflation, but such concerns would have to be abandoned if ‘helicopter money’ were implemented. The likelihood of their eventual implementation grows by the day as the failure of monetary policy becomes more evident. ‘Helicopter money’ will produce higher levels of broad money growth and inflation. Crucially, the state will not respond by lifting policy rates to control such inflation. Crucially, the state will not allow the yield curve to reflect rising inflation expectations or debts, particularly short-term debts, cannot be inflated away. Crucially, the state will not allow the private sector to gorge itself on credit, the natural reaction when inflation is higher than interest rates. ... This analyst meets few investors who don’t see that financial repression, the process through which the state manipulates the yield curve to below the rate of inflation, is the policy of choice for the developed world.
A summary of the critique of Unconventional Monetary Policy would include the following points:

  1. There is little evidence (according to the BIS and others), that the UMP implemented since the Great Financial Crisis has provided a significant, lasting boost to either economic activity or inflation.
  2. There is strong evidence that UMP has had a significantly inflated real and financial asset prices. This has contributed to the widening inequality of income and wealth.
  3. Even if there are short term benefits of UMP, these are subject to diminishing returns and raise the risk of fuelling speculative bubbles. When such bubbles burst, the dislocations tend to feed through to the real economy, possibly triggering recession and/or deflation. 
  4. Increasingly aggressive UMP narrows the room to maneuver of central banks and risks leaving them with limited policy choices for dealing with the next recession.
  5. When the next downturn comes, central banks will be under political pressure to experiment with even more dangerous forms of UMP, including helicopter money (money financed fiscal stimulus).
  6. Central banks' independence is reduced as monetary policy becomes the servant of fiscal policy and the objective of targeting inflation gives way to the imperative of financial repression as the government requires that interest rates be held below the rate of inflation so that government debt can be inflated away.
  7. Breakdown of faith in UMP threatens central bank credibility and legitimacy.

What is the Future of UMP?

Just because thoughtful people outside of central banks are losing faith in UMP does not mean that the decision-makers of the major central banks are planning to change their approach to monetary policy. On the contrary, it seems that advocates of UMP are committed to taking even more aggressive actions if their targets for economic growth and inflation continue to be unmet.

The central bankers and academics who gathered at Jackson Hole, perhaps anticipating and responding to the growing criticism of UMP, made the theme of their symposium "Designing Resilient Monetary Policy Frameworks for the Future". Fed Chair Janet Yellen left little doubt that, in her opinion, UMP will play an important and possibly increased role in future monetary policy. In the event that the current expansion falters and the economy moves toward a recession, Yellen suggested that the tools of UMP would be resorted to once again: 

In addition to taking the federal funds rate back down to nearly zero, the FOMC could resume asset purchases and announce its intention to keep the federal funds rate at this level until conditions had improved markedly--although with long-term interest rates already quite low, the net stimulus that would result might be somewhat reduced.
Despite these caveats, I expect that forward guidance and asset purchases will remain important components of the Fed's policy toolkit. ... That said, these tools are not a panacea, and future policymakers could find that they are not adequate to deal with deep and prolonged economic downturns. For these reasons, policymakers and society more broadly may want to explore additional options for helping to foster a strong economy.
On the monetary policy side, future policymakers might choose to consider some additional tools that have been employed by other central banks, though adding them to our toolkit would require a very careful weighing of costs and benefits and, in some cases, could require legislation. For example, future policymakers may wish to explore the possibility of purchasing a broader range of assets. Beyond that, some observers have suggested raising the FOMC's 2 percent inflation objective or implementing policy through alternative monetary policy frameworks, such as price-level or nominal GDP targeting.
In fact, Chair Yellen while solidly behind UMP measures adopted to date, was far from the most enthusiastic UMP advocate at Jackson Hole. Professor Marvin Goodfriend of Carnegie-Mellon University argued that, "It is only a matter of time before another cyclical downturn calls for aggressive negative nominal interest rate policy actions". The aforementioned Christopher Sims called for helicopter money financed fiscal stimulus as follows, "What is required is that fiscal policy be seen as aimed at increasing the inflation rate, with monetary and fiscal policy coordinated on this objective". Finally, Bank of Japan Governor Kuroda, who has overseen the most aggressive UMP to date, has no qualms about pushing ahead even further,
Looking ahead, the Bank of Japan will continue to carefully examine risks to economic activity and prices at each monetary policy meeting and take additional easing measures without hesitation in terms of three dimensions -- quantity, quality, and the interest rate -- if it is judged necessary for achieving the price stability target. QQE with a Negative Interest Rate is an extremely powerful policy scheme and there is no doubt that ample space for additional easing in each of these three dimensions is available to the Bank. The Bank will carefully consider how to make the best use of the policy scheme in order to achieve the price stability target of 2 percent, and will act decisively as we move on.

The Risks That Lie Ahead

With a developing professional view that UMP has gone too far, is subject to diminishing returns, and that short term gains from such policies are likely to give way to long term pain, there are significant risks to both the economy and financial markets no matter what path central banks decide to pursue. 

With the US economy having performed relatively well in the disappointing global expansion since the GFC, the Fed is in the strongest position to begin to remove unconventional monetary stimulus. Indeed, the Fed has already begun to do so by tapering quantitative easing, by lifting the policy rate by 25 basis points last December, and by providing forward guidance that the policy rate would continue to rise. However, each of these steps have caused corrections in global markets for risk assets and sharply increased volatility. The greatest volatility has come in China and other highly-geared emerging markets as the promise of tighter US financial conditions has spilled over into tighter global financial conditions. In response to this volatility and to slowing economic growth, the Fed has pushed back the timing of it plans for hiking the policy rate and eventually reducing the size of its' balance sheet.

Meanwhile, in an environment of slowing global growth and deflationary pressures, the adoption of negative policy interest rates, as well as continued large scale purchases of government bonds, by the BoJ and the ECB have pulled global bond yields down. At the low point in global bond yields, as much as US$13  trillion of government bonds had negative yields. Despite the Fed's intentions to reduce monetary stimulus, US bond yields fell to near record lows. In Canada, where the BoC has been sitting on its hands for over a year, the effect of foreign central banks' UMP has pushed bond yields to new lows, with the 10-year Canada bond yield falling below 1%. 

The fall in global bond yields has had three effects: it has reduced mortgage borrowing costs which has boosted prices and encouraged speculative activity in housing markets; it has caused investors to reach for yield in risky investments; and it has encouraged even highly-indebted governments to relax fiscal discipline by boosting debt-financed infrastructure spending plans.  

As consumer, corporate and government debt all continue to grow faster than nominal GDP, it becomes increasingly dangerous for central banks to remove monetary accommodation. Monetary policy increasingly becomes hostage to the need for financial repression, that is for interest rates to be pegged below the rate of inflation so that debt can be inflated away. Inflation targeting becomes less attainable and politically less popular.

Pushing further into unconventional monetary policies, say by moving towards "helicopter money", also known as central bank financed fiscal stimulus, might provide some short-term gain (as has resulted from other less drastic forms of UMP), it is also likely to result in even more long term pain.

Saturday, 2 July 2016

Global ETF Portfolios for Canadian Investors: 2Q16 Review and Outlook

The stay-at-home strategy continued to perform well in 2Q16. The major forces that drove markets in 2015 have reversed in the first half of this year. Crude oil prices have rebounded and the monetary policy divergences between the US Fed and the Bank of Canada have narrowed.

The price of WTI crude oil, which began the year at US$37 per barrel and touched a 12-year low of just over US$26/bbl in February, then rallied back to finish 2Q16 at US$48/bbl. On the monetary policy front, the Fed, which had contemplated as many as four policy rate hikes in 2016, is now not expected to raise rates even once. The BoC, after anticipating the Liberal government's promised fiscal stimulus, went on hold in January and remains firmly on hold. The BoC decision to stand pat, combined with the Fed backing off on tightening, sparked a 12% rally in the Canadian dollar from the January low of 68.6 US cents to 76.8 cents by the end of March. After rallying further to test the 80 cents level in early May, the Canadian dollar fell back at the end June to 77.4 cents, amid risk aversion related to Brexit and signs that Canada's real GDP growth had stalled in 2Q. 

The rise in crude oil prices combined with the 0.7% gain in the Canadian dollar in 2Q16 provided tailwinds for stay-at-home portfolios while unhedged global ETF portfolios were able to recoup some of their losses sustained in the first quarter. A stay-at-home 60/40 investor who invested 60% of their funds in the Canadian equity ETF (XIU), 30% in the Canadian bond ETF (XBB), and 10% in the Canadian real return bond ETF (XRB) had a total return (including reinvested dividend and interest payments) of 3.7% in Canadian dollars. All of the unhedged Global ETF portfolios that I track in this blog posted gains for 2Q16. Since we began monitoring at the beginning of 2012, however, the unhedged Global ETF portfolios have vastly outperformed the stay-at-home portfolio. 

Global Market ETFs: Performance for 2Q16

In 2Q16, with the USD depreciating 0.7% against the CAD, global ETF returns favored commodities and bonds. In CAD terms, 17 of the 19 ETFs we track posted positive returns, while 2 ETFs posted losses for the quarter. The chart below shows 2Q16 returns in CAD terms, including reinvested dividends, for the ETFs tracked in this blog.

The best gainer in 2Q16 was the commodity ETF (GSG) which returned 11.8% in CAD terms. The Gold ETF (GLD) returned 6.8%, while the Canadian long bond ETF (XLB) returned 5.3% in CAD terms. Other ETFs with strong returns for the quarter included Emerging Market Bonds (EMB) 4.9%; US High Yield Bonds (HYG) 4.5%; and Canadian equities (XIU) 4.2%.

The worst performers, were the Eurozone equity ETF (EWJ) and the Eurozone equity ETF (FEZ), which returned -4.4% and -0.3%, respectively in CAD terms. 

For 2016 year-to-date, the best performing ETFs in CAD terms were gold, the Canadian long bond and the Canadian equity ETF. The worst year-to-date performers were Eurozone, Japan (EWJ), US small cap (IWM), and US large cap equities (SPY).   

Global ETF Portfolio Performance for 2Q16

 In 2Q16, the Global ETF portfolios tracked in this blog all posted positive returns in CAD terms. This was true whether USD currency exposure was hedged or left unhedged, but the USD hedged portfolios performed better for a second consecutive quarter.  

A stay-at-home, Canada-only 60% equity/40% Bond Portfolio returned 3.7% in 2Q16. Among the global ETF portfolios that we track, risk balanced portfolios outperformed in 2Q16. A Global Levered Risk Balanced (RB) Portfolio, which uses leverage to balance the expected risk contribution from the Global Market ETFs, benefitting from strong levered bond returns, gained 3.8% in CAD terms if USD-unhedged and had an even better gain of +5.1% if USD-hedged. An Unlevered Global Risk Balanced (RB) Portfolio, which has less exposure to government bonds, inflation-linked bonds and commodities but more exposure to corporate credit, gained 2.9% if USD-unhedged and 3.4% if USD-hedged.

The Global 60% Equity/40% Bond ETF Portfolio (which includes both Canadian and global equity and bond ETFs) returned 1.4% in CAD terms when USD exposure was left unhedged, and 1.9% if the USD exposure was hedged. A less volatile portfolio for cautious investors, the Global 45/25/30, comprised of 45% global equities, 25% government and corporate bonds and 30% cash, gained 1.9% if unhedged and 2.2% if USD hedged.

On a year-to-date basis, the all Canadian stay-at-home ETF portfolio has been a solid performer, returning 6.4% ytd, outgunning all of the unhedged global ETF portfolios that we monitor in CAD terms. If USD exposures were hedged, however, the best performing portfolio was the Global Levered Risk Balanced Portfolio, which returned 11.2% in CAD terms.

Looking Ahead

The key market events of the first half of 2016 that influenced global ETF portfolio returns in CAD terms were: the market's rising conviction that the Fed is unlikely to raise rates in 2016; the BoC's decision to eschew further easing; and the improving balance between global supply and demand for crude oil.  These events occurred against a backdrop of further downward revisions to global growth expectations and significant geopolitical uncertainty.

After rising at a 2.4% annualized pace in 1Q, Canada's growth likely stalled in 2Q, in part due to the disruption caused by the Fort McMurray wildfires. Early indications for US growth, based on the Atlanta Fed's GDP Now forecast, point to 2.4% growth for US real GDP in 2Q, after just 1.1% in 1Q. On balance, 2016 growth expectations have been revised down quite sharply, for Canada to 1.5% in June from 1.9% in December and for the US to 1.7% from 2.4%.

Outside Canada and the US, growth prospects have also cooled. The UK real GDP forecast for 2016 has been cut to 1.5% in the wake of Brexit from 2.4% six months ago. Eurozone growth expectations have been marked down to 1.6% from 1.8%. Japan's growth now expected to reach only 0.7%, down from 1.1%. The sharpest cuts in expectations are for emerging market economies, with 2016 growth expectations down to 3.8% from 5.2%.

Meanwhile, Fed Chair Janet Yellen's message has been clear that the Fed will proceed cautiously with tightening, especially in light of the uncertainty trigged by the Brexit vote in the UK. In Canada, with substantial increases in government spending announced in the federal budget providing second half stimulus, the Bank of Canada is signalling that it will remain on hold for some time.  

At the end of March, we said "A sharp decline in worldwide oil and gas exploration and development spending suggests that crude oil production growth will slow, perhaps bringing global oil demand and supply into better balance as 2016 unfolds". That process continued through 2Q16, lifting crude oil prices to test US$50/bbl just before the Brexit vote. The rise in prices has halted the sharp decline in the North American rig count, but energy investment intentions continue to ebb, especially in Canada. Now that oil prices have recovered as seasonal demand for gasoline has hit its high point, the question is whether the crude oil price gains witnessed through 1H16 can be sustained, against a backdrop of sluggish global growth. 

This leaves markets in a similar position to where they were at the beginning of 2016. Equity market valuations remain stretched. Government bond market valuations are even more stretched as US and Canadian 10-year bond yields have fallen to new lows, while German, Swiss and Japanese 10-year yields are all negative.

The declines in global bond yields are a reflection of growth disappointments around the world and the market's assessment that this will result in more accommodative monetary policies than previously thought. Monetary ease has pushed up prices of gold and other commodities and has supported equity prices. We are living in an upside down world in which growth disappointments seem to lift financial asset prices because investors expect that weak growth will spur even more accommodative monetary policy. 

In a continuing uncertain environment, characterized by sluggish global growth, record high debt levels, unprecedented central bank stimulus, and a high level of geopolitical risk, remaining well diversified across asset classes, with substantial exposure to USD-denominated assets and with an ample cash position continues to be a prudent strategy. 

Monday, 27 June 2016

After Brexit: What Canada Should Do Now

After the UK voted for Brexit, Canada's media was overwhelmingly shocked and dismayed. An example was the Globe and Mail editorial, The Brexit vote is complete folly, but there is still time to reverse it. The hyperbole was breathtaking in words such as these,
The foundational tenets of modern capitalism – that free trade brings prosperity and is the surest way of ensuring the peaceful co-existence of nations – have been rejected by one of the most advanced trading nations in the world.
As Colby Cosh points out, the media and the twitterverse, have maligned 17 million UK voters,
Look at the list of imprecations being hurled at Leave voters Friday, many of them by Canadians. They’re “small-minded,” “isolationist,” “short-sighted,” “fact-blind,” “racist” countryside boobs without vision or understanding.
But as Cosh correctly argues, what the Brexiters wanted is what Canada already has,
[T]he intellectual leaders of the Leave camp are constantly upholding Canada as a model for immigration policy, with its self-interested, skill-privileging, but globally indiscriminate points system. They also cite us as an obvious potential partner for the kind of bilateral trade deal Britain will now be free to pursue on its own. Basically, the Leave campaigners didn’t put it this way or incorporate it into a slogan, but they want the U.K.’s relationship with Europe — a polyglot kaleidoscope of radically dissimilar nation states, some of them failing — to be the same friendly, wary relationship Canada has with the United States. 
A few Canadian media voices took a positive view on the Brexit vote, including Terrence Corcoran's op-ed, Don’t be bamboozled, Brexit creates huge opportunities for the U.K.
British voters are proposing to leave a slow-growth fiscal disaster zone mired in sclerotic regulation and over-regulation, persistent protectionism, mismanaged immigration policy and an often corrupt political structure controlled by unaccountable power brokers with occasional thuggish tendencies... Brexit need not imperil EU trade deals with Canada or other nations, unless the EU becomes self-destructively vindictive and uses the Brexit threat to create turmoil in trade relations... Indeed, there is every reason to accelerate the creation of trade deals.
 Canada's political leaders have been relatively quiet. After urging Brits to Remain, Prime Minister Trudeau was booed by a crowd in Quebec City when he said, "We respect the choice of the British people and will remain a strong partner of the UK and the European Union". 

Canada's International Trade Minister, Chrystia Freeland, spoke to her European Union counterpart, Cecilia Malmstrom, and reiterated that Canada remains firm in its commitment to ratifying the Canada-European Union Comprehensive Economic and Trade Agreement​ (CETA). There was no indication that Freeland put in a call to her UK counterpart.

But, as Trevor Tombe points out, the UK accounts for half of Canada-EU trade and is Canada's largest non-US investment partner. 

And as RBC Economics observes, the U.K. has been a "champion of CETA, so the country’s exit from the EU removes an important supporter of the agreement at this crucial juncture". 

In my opinion, Canada needs to get its priorities straight and remember it's history. The most positive and constructive suggestion that I have seen since the Brexit vote has come from none other than Conrad Black, whose opinion piece in the National Post argued,
[T]his is a place where Canada could play a key role, as it could, and should, in reviving the top tier of the Commonwealth (Canada, U.K., Australia, India, Singapore, New Zealand) as a coherent but not artificially united bloc, in close relations with Western Europe and the United States.... It will be ...  a great chance for Canada, if for the first time since the Mulroney era anyone in our Foreign Affairs Ministry has the imagination to grasp it.
Canada should now be the first to step forward with an offer to its oldest ally, the United Kingdom, to negotiate a bilateral free trade agreement with the UK, which could be expanded to include other members of the Commonwealth. At the same time, it should continue to pursue the ratification of CETA and other free trade agreements that advance Canada's interests. 



Thursday, 23 June 2016

China Stimulus and Vancouver House Prices

In March 2014, I posted a note entitled, Why So Paranoid About Canada's Housing Market?, in which I argued that the housing market in Canada's least affordable cities, Vancouver and Toronto, did not seem overvalued relative to other major cities such as Hong Kong, London, Beijing, Singapore, Moscow, Sydney and Melbourne. More than two years later, that conclusion has been borne out, as the Vancouver and Toronto housing markets did not experience sharp corrections, as many were forecasting, but instead posted strong further price gains. 

The post concluded, 
Global central bank policies of low interest rates and massive liquidity provided by quantitative easing have affected all global housing markets, pushing up the value of real assets such as houses relative to the value of money. When central banks withdraw from their extremely easy monetary policies, housing markets in all countries may experience a slowing or a more serious correction. But there is no reason to single out Canada, as the Financial Times did, as “the next global housing market ready to burst”.
In this post, I want to further highlight how the spillovers from other countries monetary policies have affected Canada's most overvalued housing market, Vancouver.

Vancouver's Spiralling Housing Prices

There is no doubt that Vancouver's house prices have moved deeply into bubble territory.

The chart above, from the Real Estate Board of Greater Vancouver, shows that the average price of a detached home in Vancouver has surged by over 30% in there past year to over C$1.8 million (for a clearer view of this chart click here). The epic surge in Vancouver prices pushed RBC's affordability measure for the Vancouver area to 87.6 per cent in 1Q15, the worst ever recorded anywhere in Canada. The annual pace of increases in Vancouver house prices since 2002, as measured by Teranet, is shown in the chart below.

Finance Minister Bill Morneau recently promised that his department was undertaking a "deep dive" into Canada's housing markets to find "real evidence" behind the country's red-hot sector  and the role of foreign investors in those record-high prices. 

Bank of Canada Governor Steven Poloz said this month on the release of the Financial System Review (FSR), that "We are also seeing evidence, particularly in Vancouver but also in Toronto, where expectations of future price changes have become, to a degree, extrapolative and we think that those expectations are probably not going to be realized. The rate of price increase in those markets has been outpacing fundamentals and therefore would be unlikely to be sustained". In the FSR, the Bank of Canada acknowledged that "foreign demand is playing a role in specific sectors of the Vancouver and Toronto housing markets", but noted that the effect is difficult to measure because of the lack of data on foreign home purchases and ownership. 

Participants in both housing markets and financial markets so far have shrugged at these comments. The frenzy to buy homes in Vancouver and Toronto shows no signs of abating. Financial markets are pricing in no greater likelihood of Bank of Canada tightening policy to cool housing markets, as the economy continues to operate below full capacity and growth prospects remain lacklustre. 

Why are Vancouver Prices outpacing "Fundamentals"?

Both Morneau and Poloz noted that fundamentals such as immigration, job growth and income growth are stronger in Vancouver than in other parts of Canada. However, these relatively strong fundamentals cannot explain the strength of house price growth. The unanswered question is why are Vancouver house prices stronger than the fundamentals? Poloz suggests that it is because buyers, sellers and lenders seem to have adopted extrapolative expectations, extrapolating the current pace of price gains into the future. But why have price expectations exploded in these cities and not in other parts of Canada?

In my opinion, the housing markets in Vancouver and, to a lesser extent, in Toronto are responding not only to the extraordinarily easy monetary policies being pursued by the central banks of the US, Eurozone and Japan, but equally importantly to monetary policy in China given the relative ease with which residents of mainland China, Hong Kong and Taiwan are able to purchase real estate in Canada.

When the Chinese government wants to provide stimulus to the economy, it does so by encouraging Chinese banks to increase loan growth for a wide range of activities. When loan growth surges, Chinese house prices tend to post strong gains; and when Chinese house prices post strong gains, Vancouver house prices tend to do the same. The chart below shows four periods in which China loan growth has accelerated, and the behaviour of house prices in Beijing and Vancouver (Beijing data not available for the 1Q02-3Q04 period). 

The chart shows that in the period from 2Q05 to 3Q07, as the US housing bubble was forming, China loan growth accelerated from12% to 17% y/y, Beijing house prices accelerated from 5% to 9% y/y and Vancouver prices surged from 9% to 23% y/y. 

In the period from 4Q08 to 2Q10, in the wake of the Global Financial Crisis, China loan growth surged from 13% to a peak of 33% (in 4Q09), the price of homes in Beijing went from a decline of 1% to a rise of 12% y/y, and Vancouver house price gains rose from 1% to 16% y/y.

In the most recent period, from 3Q14 to 1Q16, a period when China has seen two stock market crashes that have driven nervous investors away from equities, China loan growth has been boosted through stimulus measures from 13% to 15%, as the increase in bank loans hit an all-time record in January. In response to the stimulus, Beijing house price gains accelerated from 2% to 18%y/y and Vancouver house price gains jumped from 7% to 21%. It is worth noting that prices in other big cities in China surged by even more, to over 20%y/y in Shanghai and over 50% y/y in Shenzhen.  It is also worth noting that because the Chinese Yuan (CNY) appreciated by about 11% versus the Canadian dollar over the period, Vancouver house prices actually became more affordable for Chinese buyers (in CNY terms) relative to homes in Beijing, Shanghai and Shenzhen, even as homes in these cities became much less affordable for the majority of both Chinese and Canadian citizens.

As financial strains have increased in China, there seems little mystery in where much of the government stimulus ends up. It flows from banks through both state-owned and private enterprises to senior officials and highly paid employees and then into home buying, both in major Chinese cities and in cities abroad that are attractive places to own property (although not necessarily to live) and for their children to be educated, such as Vancouver. This process has been well documented in David Ley's insightful book, Millionaire Migrants: Trans-Pacific Life LinesCanadian governments -- federal, provincial and municipal -- have been actively encouraging this type of foreign investment since at least the late-1980s.

While Mr. Poloz is probably correct to say that Vancouver house price expectations have become extrapolative, that the pace of recent price gains in unlikely to be sustained and that the risk of a potentially sizeable house price correction has increased, there is little that the Bank of Canada can or should do about it. As long as global central banks continue to pursue reflationary policies at any cost, keeping policy rates near zero or even negative, and willing to encourage high rates of credit growth even as debt ratios reach new highs, the Bank of Canada cannot raise rates to lean against the housing bubble without further appreciating the Canadian dollar and stifling the export-led growth that the country needs. 

While Poloz is correct that financial stability risks are rising as Vancouver and Toronto house prices grow to the sky, it is the job of Finance Minister Morneau, along with provincial and city officials, to decide what measures might curb the influence of foreign central bank stimulus on Vancouver and Toronto house prices and how these measures might be applied without bringing about the sharp house price correction that everyone fears. This is also probably one of the reasons why what worries the Bank of Canada even more than housing is a concern about financial stress in China

Sunday, 24 April 2016

Why Does the Bank of Canada Now Believe that Fiscal Stimulus Works?

Here are some quotes from a famous article in the November 1963 issue of the Canadian Journal of Economics and Political Science by Nobel Prize winning economist, Robert Mundell, then of McGill University. He is writing about the effect of a fiscal stimulus generated by an increase in government spending financed by borrowing in an economy with a floating exchange rate in a global environment of extremely high international capital mobility.
Increased [government] expenditure creates excess demand for goods and tends to raise income. But this would increase the demand for money, raise interest rates, attract a capital inflow and appreciate the exchange rate, which in turn would have a depressing effect on income. In fact, therefore, the negative effect on income of exchange rate appreciation has to offset exactly the positive multiplier effect on income of the original increase in government spending. Income cannot change unless the money supply or interest rates change. ... Fiscal policy thus completely loses its force as a domestic stabilizer when the exchange rate is allowed to fluctuate and the money supply is held constant. 
If my assumptions about capital mobility were valid in Canada, it would mean that expansive fiscal policy under flexible exchange rates [would be] of little help in increasing employment because of the ensuing inflow of capital which keeps the exchange rate high and induces a balance of trade deficit: we [would observe] a zero or very small multiplier. 
Of course the assumption of perfect capital mobility is not literally accurate... To the extent that Canada can maintain an interest rate equilibrium different from that of the United States, without strong capital flows, fiscal policy can be expected to play some role under flexible exchange rates... But if this possibility exists for us today, we can conjecture that it will exist to a lesser extent in the future.
Mundell's classic "Capital Mobility and Stabilization Policy Under  Fixed and Flexible Exchange Rates" clearly laid out that in a global economy with a high degree of capital mobility, fiscal stimulus in a small open economy operating with a flexible rate is likely to have little if any lasting impact on real GDP growth.

Fast forward 50 years and empirical studies by the US National Bureau of Economic Research (NBER) and by the Bank of Canada confirmed that fiscal multipliers for Canada are very low.

The NBER summarized its results as follows:
Based on a novel quarterly dataset of government expenditure in 44 countries [including Canada], we find that (i) the output effect of an increase in government consumption is larger in industrial than in developing countries, (ii) the fiscal multiplier is relatively large in economies operating under predetermined exchange rates but is zero in economies operating under flexible exchange rates; (iii) fiscal multipliers in open economies are smaller than in closed economies; (iv) fiscal multipliers in high-debt countries are negative. 
Specifically, the NBER found that for economies, like Canada, that are "open to trade or operating under flexible exchange rates, a fiscal expansion leads to no significant output gains. Further, fiscal stimulus may be counterproductive in highly indebted economies. Indeed, in countries with debt levels as low as 60% of GDP, government consumption shocks may have strong negative effects on output".

The Bank of Canada found that while Canada benefits greatly from fiscal stimulus conducted by the United States and other G20 trading partners, "Canada’s high level of openness sharply curtails the effectiveness of a domestic [fiscal] stimulus." Specifically, the 2010 study by BoC researchers found that, for Canada, fiscal multipliers for government spending were very low: ranging from virtually zero for increases in general transfer payments, to 0.40% for government investment expenditures, to 0.80% for government spending on goods, to .98% for spending on government services.

The findings of the NBER and the BoC, corroborate Mundell's theoretical insight and support his view that as global capital markets became ever more efficient, fiscal policy has become ever less powerful in small open economies with flexible exchange rates.

So it is somewhat surprising to me that in recent days, the Governor and the Senior Deputy Governor of the Bank of Canada have gone out of their way to tell members of the press that they believe that Canada's latest fiscal stimulus will have a substantial positive effect on real GDP.

Governor Stephen Poloz told the Canadian Press, "we're fortunate in Canada that we have that fiscal capability right now to shift our policy mix ... as the government has done... This is exactly the setting where fiscal policy is its most effective and its also where monetary policy is its least effective." 

Bloomberg News reported Poloz as saying that the size of the fiscal multiplier depends on the “situation you start in.” When the economy is in equilibrium, government spending triggers higher interest rates and higher currency, crowding out private spending. In equilibrium, fiscal policy “has no effect except it changes the mix of what is going on in the economy. So this gives rise to sort of cavalier statements from some that would say, 'well that won’t have any effect.'" Poloz went on to say that in low growth settings, “fiscal policy begins to add demand in the economy (and) basically nothing else happens except that demand goes up and what happens then is that you get the maximum effect of fiscal policy because there are no offsets such as upward creep in interest rates or movement in the exchange rate.”

BoC Senior Deputy Governor Carolyn Wilkins was singing from the same hymn book in an interview with Macleans magazine, where she opined that fiscal policy is more effective than monetary policy in boosting productivity and growth when interest rates are low. In the interview, she said "If fiscal policy can do some of the heavy lifting, that’s a positive thing. Fiscal policy at low interest rates is also just more effective. In a world where growth is going to be structurally slower because of demographic changes, monetary policy can’t fix that. If we want sustainable growth, we need to boost productivity, not only in Canada [but in] the global economy. That’s the only place growth can come from."

Mr. Poloz seems to be basing his enthusiasm for fiscal policy on the degree of slack in the Canadian economy. Indeed, some studies do indicate that government spending multipliers for OECD countries, on average, are near zero in periods of expansion or low unemployment but are higher in recessions or in periods of very high unemployment. But Canada is not in recession and unemployment is close to the threshold level of 7%, only above which fiscal multipliers might be somewhat higher. And Canada is not an average OECD country; it is a smaller, much more open economy than the US, the Eurozone or Japan and it is much more sensitive to movements in its exchange rate.

Mr. Poloz and Ms. Wilkins seem to be arguing that one of Robert Mundell's Nobel prize winning theoretical insights does not apply to the Canadian economy, the very economy where Mundell pointed out that his theory was most likely to be true. They seem to be arguing that the 2010 empirical results of the NBER and of the BoC's own researchers, which showed zero or very low fiscal multipliers are not to be believed.

I am not convinced. On the contrary, I believe that Mundell's theory is more valid today than it ever was. The economy has some slack as Poloz suggests, but not so much, as by the BoC's estimate it was operating somewhere between 98.3% and 99.4% of full capacity in the first quarter of 2016. One can concede that fiscal stimulus may lead to a short run pickup in growth. However, the market's perception of improved short-term growth even before the budget measures were implemented and the market's anticipation of a further fillip to growth from fiscal stimulus has already raised interest rate expectations compared to what they were when the BoC was still perceived to be in easing mode prior to January 20, when the BoC signalled that it would stand pat. The higher interest rate expectations for Canada, combined with more accommodative monetary stances by the US Fed, the ECB and the BoJ, have already caused the Canadian dollar to appreciate by 15% against the US dollar from its January low. The stronger Canadian dollar has already caused the BoC to downgrade its export growth forecast. As the fiscal stimulus feeds into the economy in 2016 and 2017, growth of private sector production for export markets will be suppressed by the stronger Canadian dollar and will be supplanted by increased public spending on infrastructure and on low multiplier transfer payments. With Canada's G20 trading partners not moving to large-scale fiscal stimulus, the result will be what the BoC researchers predicted in 2010: Canada’s high level of openness and flexible exchange rate will "sharply curtail the effectiveness of domestic fiscal stimulus."

It also seems to suggest that the stance of the BoC's monetary policy relative to our major trading partners is still a very powerful policy instrument.

The eventual outcome of the fiscal stimulus being applied in a non-recessionary economy without similar actions in Canada's trading partners is unlikely to be sustained stronger economic growth. Instead, the cumulative impact on the level of real GDP is likely to be negligible. However, the composition of real GDP and the level of government debt will be affected. 

Real GDP will be shifted away from private sector output of goods and services toward public sector construction output and subsidized green energy projects. With private sector construction of pipelines and LNG terminals stalled by government regulations, and with coal-fired power plants being shut down, productivity seems more likely to fall than to rise, as Ms. Wilkins argues.

Public debt to GDP is already rising and will continue to rise. According to the National Balance Sheet Accounts, total government debt rose to 76.2% of GDP at the end of 2015 from 72.8% a year earlier. Recent federal and provincial budgets suggest that the increase in total government debt to GDP will accelerate over the next few years. This could put Canada quickly into the situation described by the NBER researchers in which fiscal multipliers in high debt countries may have strong negative effects on real GDP.

Finally, even if one believed that fiscal stimulus would work to boost real output and employment on a sustained basis [which I don't], one can only wonder why an independent Bank of Canada did not voice this opinion a year ago when the economy was actually contracting, but then praised stimulus after the newly elected government tabled a budget promising much higher spending and deficits.

Sunday, 3 April 2016

Global ETF Portfolios for Canadian Investors: 1Q16 Review and Outlook

After being a terrible strategy in 2015, Canadian investors did well to stay at home in 1Q16.

In 2015, the major forces driving markets were the plunge in crude oil prices and the monetary policy divergences between the US Fed, which announced its intention raise its policy rate, and other major central banks, including the Bank of Canada, which were expected to ease monetary policy in response to weak growth and below target inflation. These forces shifted in 1Q16.

The price of WTI crude oil, which began 1Q16 at US$37 per barrel, touched a 12-year low of just over US$26/bbl on February 11, but then rallied back to finish the quarter at US$38/bbl. The rally in crude oil was triggered by two factors. First, the market perceived, and the Fed confirmed, that it would move more gradually to raise its policy rate. This led to profit-taking on long-USD positions and sent the US dollar index (DXY) down by 5% from its late-January high to its March 31 low. The weaker USD, combined with an agreement between Russia and Saudi Arabia to cap oil production at current levels, helped boost crude oil and other commodity prices. 

On the monetary policy front, in 2015, as the Fed promised that it would raise the fed funds rate, market participants viewed the Bank of Canada as one of the group of central banks that were expected to ease policy further. However, while the central banks of Japan, the Eurozone, China, Sweden, Norway and New Zealand did ease further in 1Q16, the BoC failed to validate the market's expectation of further easing, deciding to defer any further action until after the federal budget provided details of the new Liberal government's promised fiscal stimulus. The BoC decision to stand pat, combined with the Fed backing off on tightening, sparked a 12% rally in the Canadian dollar from the January 19 low of 68.6 US cents to the March 31 high of 77 cents.

This 12% rally was hard on unhedged Canadian portfolios with substantial global exposures. For example, as the Fed signalled a more gradual pace of tightening, the S&P500 ETF (SPY) reversed its early January losses: it gained 10% in USD terms from January 15 to March 31, but lost 1.5% in CAD terms. Similarly, the US 10-20 year Treasury bond ETF (TLH) gained 3% in USD terms over the same period, but lost 7.8% in CAD terms. 

As a result of the sharp C$ appreciation, all of the unhedged Global ETF portfolios that I track in this blog posted losses for 1Q16. Meanwhile, a stay-at-home 60/40 investor who invested 60% of their funds in a Canadian stock ETF (XIU), 30% in a Canadian bond ETF (XBB), and 10% in a Canadian real return bond ETF (XRB) had a total return (including reinvested dividend and interest payments) of 2.6% in Canadian dollars. This was a partial reversal of the 3.0% loss posted by the all-Canada portfolio in 2015.

Since we began monitoring at the beginning of 2012, we have found that the unhedged Global ETF portfolios have vastly outperformed the stay-at-home portfolio. However, as you will see in this post, that behaviour reversed in 1Q16.

Global Market ETFs: Performance for 1Q16

In 1Q16, with the USD depreciating 6% against the CAD (after appreciating 19% in 2015), the best performing global ETFs in CAD terms were an unlikely trio: gold, local currency emerging market bonds and Canadian equities. The worst ETF returns were in the Japanese and Eurozone equities and commodities. The chart below shows 1Q16 returns, including reinvested dividends, for the ETFs tracked in this blog, in both USD terms and CAD terms. 

Global ETF returns varied widely across the different asset classes in 1Q16. In USD terms, 14 of the 19 ETFs we track posted positive returns, while 5 ETFs posted losses for the quarter. However, just 9 of the 19 ETFs posted gains in CAD terms, while 10 posted losses. 

The best gain was in the Gold ETF (GLD) which returned 9.3% in CAD terms. The Emerging Market Local Currency bond ETF (EMLC) returned 3.8%, while the Canadian equity ETF (XIU) returned 3.4% in CAD terms. Other ETFs with positive returns for the quarter included Canadian Long Bonds (XLB) 2.8%; Canadian real return bonds (XRB) 1.6%; non-US sovereign government bonds (BWX) 1.6%; non-US inflation-linked bonds (WIP) 1.4%; Canadian corporate bonds (XCB) 1.3%; and the emerging market equity ETF (EEM) 0.1% in CAD terms. 

The worst performers, were the Japanese equity ETF (EWJ) and the Eurozone equity ETF (FEZ), which returned -11.4% and -9.2%, respectively in CAD terms. Other ETFs posting sizeable negative returns in CAD terms were the commodity ETF (GSG) -8.8%; US small cap stocks (IWM) -7.3%; the S&P500 ETF (SPY) -4.7%; the US high yield bond ETF (HYG) -3.7%; US inflation-linked bonds (TIP) -1.7%; and US Investment Grade Bonds (LQD) -1.4%.

Global ETF Portfolio Performance for 1Q16

In 1Q16, the Global ETF portfolios tracked in this blog all posted negative returns in CAD terms when USD currency exposure was left unhedged. However, if the USD currency exposure was hedged, all of these portfolios would have realized positive returns. 

A stay-at-home, Canada only 60% equity/40% Bond Portfolio returned 2.6%, as mentioned at the top of this post. Among the global ETF portfolios that we track, the Global 60% Equity/40% Bond ETF Portfolio (including both Canadian and global equity and bond ETFs) returned -2.6% in CAD terms when USD exposure was left unhedged, but +0.9% if the USD exposure was hedged. A less volatile portfolio for cautious investors, the Global 45/25/30, comprised of 45% global equities, 25% government and corporate bonds and 30% cash, lost 1.6% if unhedged, but gained 1.7% if USD hedged.

Risk balanced portfolios underperformed in 1Q16 if unhedged, but outperformed if hedged (the reverse of their performance in 2015). A Global Levered Risk Balanced (RB) Portfolio, which uses leverage to balance the expected risk contribution from the Global Market ETFs, lost 1.3% in CAD terms if USD-unhedged, but had the biggest gain of +5.8% if USD-hedged, benefitting from strong levered bond returns in USD terms. An Unlevered Global Risk Balanced (RB) Portfolio, which has less exposure to government bonds, inflation-linked bonds and commodities but more exposure to corporate credit, lost1.3% if USD-unhedged, but gained 3.5% if USD-hedged.

Looking Ahead

In my view, the key market events of 1Q16 that influenced global ETF portfolio returns in CAD terms were: the Fed's shift to a less aggressive tightening stance; the BoC's decision to defer further easing; and the agreement between the Russians and the Saudis to cap oil production at current high levels.

As we look ahead, it is fair to say that prospective returns on these portfolios will depend on how views on monetary policies and crude oil prices evolve in the coming months. 

Recent economic data suggest that 1Q16 real GDP growth will turn out to be stronger than expected in Canada and weaker than expected in the US. It should be noted however that US economic data is more timely than Canadian data. Early indications for 1Q16, based on the Atlanta Fed's GDP Now forecast, pointed to close to 3% growth for US real GDP, but that estimate has now been cut to 0.7%. Similarly, recent upward revisions to 1Q16 growth forecasts to 3% for Canada have been heavily influenced by a strong gain in January GDP. It would not be surprising if these expectations are tempered somewhat, just as US forecasts have been cut as more current data has been released. Nevertheless, the combination of the bounce in Canada's GDP combined with substantial increases in government spending contained in the federal budget, will likely keep the Bank of Canada on hold for some time. Meanwhile, Fed Chair Janet Yellen's message has been clear that the Fed will proceed cautiously with tightening, so the shift in monetary policy expectations that occurred in 1Q16 is likely to persist.

A sharp decline in worldwide oil and gas exploration and development spending suggests that crude oil production growth will slow, perhaps bringing global oil demand and supply into better balance as 2016 unfolds. While crude oil prices have come off their late March highs, they are unlikely to dip back below US$30/bbl any time soon.

This leaves markets in a similar position to where they were at the beginning of 2016. Both equity and bond market valuations remain stretched. Global growth remains sluggish. Deflationary forces remain strong. China's credit growth remains worrisome. Geo-political risks remain elevated.

As I wrote three months ago, "in a continuing uncertain environment, characterized by significant global divergences in growth and central bank policies, and depressed oil and other commodity prices, remaining well diversified across asset classes, with substantial exposure to USD-denominated assets and with an ample cash position continues to be a prudent strategy". While this strategy generated modest losses in 1Q16 as the Canadian dollar surged, it still seems prudent to me. 

Monday, 29 February 2016

Big Deficits, Bigger Debt: Who Cares?

Canadian governments are leaking out the bad fiscal news that comes along with slow growth and a collapse in commodity prices. The Government of Canada revealed that even before implementing the bulk of the Liberal government's spending promises made in the recent election, its projected fiscal deficit for 2016-17 has jumped to C$18.4 billion. Oil-rich Alberta's recently elected New Democratic Party Government has let slip that its projected deficit will rise to a record $10.4 billion. Newfoundland's recently elected Liberal Government has murmured that its deficit will rise to an unprecedented $2 billion (about 6% of provincial GDP).

As the bad fiscal news trickles out, many prominent Canadian economists are arguing that more fiscal stimulus is needed. Some say that a $30 billion federal deficit would be appropriate, some say $40 billion, some even say $50 billion.

They argue that Canada is in the enviable position, after almost 20 years of working down its federal government deficit and debt, of having plenty of room to add fiscal stimulus to boost an economy experiencing sluggish growth.

Personally, I don't think that allowing fiscal automatic stabilizers to push up budget deficits is a bad thing. But I do think that urging governments to increase deficits by 2 or 3 percentage points of GDP for several years carries far more risk than these economists are letting on.

Canada's Total Debt

While Canada's federal government has done a very good job of getting its' fiscal house in order over the past 20 years, Canada's total debt levels have increased dramatically over the same period. 

In 1995, Canada faced a government debt crisis. The combined gross debt of all levels of government reached 91% of GDP, with the federal government debt at 55% of GDP and other levels of government adding another 36%. At that time, Canada's total debt to GDP was 231%.

In 2015, Canada's total debt has reached 312% of GDP. While federal debt has fallen from 55% to 34%, the debt levels of all other sectors have increased significantly. Over that period, household debt has risen from 63% to 95% of GDP; non-financial corporate debt has risen from 58% to 72% of GDP; financial sector debt has risen from 19% to 69% and debt of other levels of government has risen from 36% to 42%.

Saying that Canada's federal government has plenty of room to borrow to add fiscal stimulus ignores the sharply increased debt levels of every other sector of the economy. Just looking at the government sector, it doesn't appear that the situation in 2015 is much better than it was in 1995.

Total government debt at the end of 2015 was 76% of GDP, up 24 percentage points from the recent low of 52% in 2007.  Over the past 55 years, only during Canada's government debt crisis period, which began in 1991, did total government debt exceed the level it reached in 2015. 

How Does Canada's Debt Compare?

The world is awash in debt. How does Canada compare with other countries? In 2015, the McKinsey Global Institute published a revealing study titled Debt and (not much) deleveraging. The chart below shows, on the left, McKinsey's breakdown of total debt to GDP in 2Q14 for the global economy, USA, Germany, China and Canada; and, on the right, Statistics Canada's breakdown for Canada in 2Q14 and the most recent data for 3Q15.

The comparison shows that in the McKinsey study, Canada's total debt to GDP, at 247%, was significantly higher than the global average but slightly lower than Germany (258%), USA (267%), and China (269%). Statistics Canada data, from the National Balance Sheet Accounts, shows Canada's total debt to GDP was somewhat higher in 2Q14 than the McKinsey estimate, at 287%, mainly because of a higher estimate for the debt level of financial corporations. StatCan's measure of Canada's total debt to GDP for 2Q14 is higher than the McKinsey estimates for the USA, Germany or China, in large part because of the high level of household debt. StatCan's most up-to-date estimate shows Canada's total debt to GDP has surged to 312% in 2015, reflecting increases across all sectors, but with the biggest jump in the non-financial corporate sector. A good part of the increase in corporate debt was to fund expansion in the energy and other commodity sectors of the economy when commodity prices were high.

Those economists who are encouraging the federal government to undertake stimulus to push the federal deficit up to $30 billion, $40 billion, or $50 billion are saying that the government has plenty of room to run bigger deficits. When the additional $20-30 billion deficits of the provincial governments are added, total government deficits could reach 3% to 4% of GDP over the next few years. This would push Canada's total government debt to GDP back above 80%, the level that marked the beginning of the government debt crisis of 1995. And it would come at a time when Canada's total debt to GDP was nearing 320%, compared with 230% in 1995.

Debt and Growth

A 2011 Bank for International Settlements (BIS) paper, titled The real effects of debt, summarized their research as follows,
At moderate levels, debt improves welfare and enhances growth. But high levels can be damaging. When does debt go from good to bad? We address this question using a new dataset that includes the level of government, non-financial corporate and household debt in 18 OECD countries from 1980 to 2010. Our results support the view that, beyond a certain level, debt is a drag on growth. For government debt, the threshold is around 85% of GDP. The immediate implication is that countries with high debt must act quickly and decisively to address their fiscal problems. The longer-term lesson is that, to build the fiscal buffer required to address extraordinary events, governments should keep debt well below the estimated thresholds. Our examination of other types of debt yields similar conclusions. When corporate debt goes beyond 90% of GDP, it becomes a drag on growth. And for household debt, we report a threshold around 85% of GDP, although the impact is very imprecisely estimated.

In the detail of the research, the authors report, "we see that public debt has a consistently significant negative impact on future growth. And, the impact is big: a 10 percentage point increase in the ratio of public debt to GDP is associated with a 17–18 basis point reduction in subsequent average annual growth [over the next 5 years]". In Canada's case, this suggests that the 24 percentage point rise in total government debt since 2007 could already be responsible for slowing real GDP growth by almost 0.5% per year. And the sharp rise in household and corporate debt is likely acting as a further drag on growth. 

Kenneth Rogoff and Stephanie Lo argue in in their 2014 BIS paper, that their leading candidate for the sluggish growth in the period since the financial crisis is the overhang of debt across all sectors of the economy. They argue that "these debt burdens need to be analysed in an integrative manner in order to assess the extent of an economy’s vulnerability to crisis or, in the case of advanced economies, the impact of higher debt on potential growth". They cite research that suggests "the impact of debt on growth in any given sector – whether it is government, household, or corporate – is worsened when other sectors also hold high debt. Therefore, an economy’s overall debt level and composition matter, both because private defaults can create contingent liabilities for the government and because there can be amplification mechanisms across sectors that exacerbate the negative effect of debt on growth. (For example, if private sector defaults lead to weaker growth, this affects the sustainability of government debt; if households are suffering debt problems, this can lower demand and can lead to strains in corporate debt)".

Another 2014 report, Deleveraging? What Deleveraging?, by Luigi Buttiglione, Philip R. Lane, Lucrezia Reichlin and Vincent Reinhart, surveys the inexorable rise in global debt to GDP across all sectors and concludes,
We observe a poisonous combination – globally and in almost any one geographic area – between high and higher debt/ GDP and slow and slowing (both nominal and real) GDP growth, which stems from a two-way causality between leverage and GDP: on the one hand, slowing potential growth and falling inflation make it harder for policies to engineer a fall in the debt-to-GDP ratio, and on the other hand attempts to delever both the private sector (especially banks) and the public sector (through austerity measures) encounter headwinds, as they slow, if not compress, the denominator of the ratio (GDP).


After the G20 meeting in Shanghai last week, Canada's new Finance Minister Bill Morneau said, "I received very positive feedback on Canada’s new path for long-term growth"... and added that the March 22 budget “will demonstrate Canada’s commitment to making smart and necessary investments in order to grow the economy." However, the Financial Times reported that G20 finance ministers clashed over the wisdom of additional fiscal stimulus. The FT quoted Wolfgang Schäuble, German finance minister, as saying from the sidelines the Shanghai meeting, "The debt-financed growth model has reached its limits. We therefore do not agree with a G20 fiscal package as some argue … There are no short-cuts that aren’t reforms."  

While many prominent Canadian economists have supported larger deficits, they do not seem to have considered the impact of bigger deficits on Canada's total debt to GDP and the consequences of record high total debt levels for medium and longer term growth. This is a particularly important at a time when Canada is facing the largest, most rapid and potential longest lasting deterioration in its terms of trade in decades -- itself a serious blow to Canada's GDP and it's capacity to support its' high level of total debt. 

In my opinion, this is an environment in which great caution is required in the formation of fiscal policy. In particular, fiscal measures that contribute to a lasting increase in structural budget deficits at either the federal or provincial level should be avoided. Government deficits will rise; automatic stabilizers should be allowed to work; some infrastructure spending that supports private sector growth should be undertaken, temporary tax incentives to encourage private sector investment could also have a positive short-term effect without increasing structural deficits. But large increases in federal and provincial government budget deficits -- at a time when the debt of other levels of government and the private sector are at record highs -- would pose a significant threat to Canada's longer-term economic growth and stability.