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Tightening of Canada’s Monetary Policy

2009 was a year when OECD government (excluding Germany) decided that it was a good idea to fully open the economic stimulus faucets. Nobody doubts the amount of economic stimulation undertaken by various governments. The U.S. federal government went full blast with a $1 trillion (OK I know that this was the headline number, and actual stimulus money was a fraction of this amount, still…). China also stimulated its economy with $1 trillion (in their case the amount underestimates that level of stimulation).

Now that the “worse of the crisis” is over, governments are re-adjusting their policies; here in Canada there is little question that the Bank of Canada’s accommodative monetary policy will come to an end the odds are for changes to occur this summer, but at the latest next winter. Canada’s monetary policy is largely driven by externalities. If Canadian monetary policy becomes too restrictive when the rest of the world continues to suffer from economic stagnation, the impact on Canada’s economy could be dramatic, and tip it back into recession. Two very recent changes would appear to indicate that extreme caution is being exercised: (a) Australia’s central bank just put on hold its monetary tightening, and (b) Jim Flaherty Canada’s finance minister announced that the Federal government’s budget will remain stimulative.

Canada’s economy like that of Australia is one of the most open. As such externalities have a significant impact on the BoC’s monetary policy. Canada’s drivers are (a) recovery of the US, (b) continued growth in China and (c) No major disturbance in Europe. We take a short detour to each of those aspects.

US Recovery: Cash for Jobs

The current U.S. administration has undertaken a further stimulus program; $80 billion “cash for jobs”, where companies will receive cash (up to $50k) for each new job they create. At $50k per job, the federal government is proposing subsidies for slightly less than 2 million jobs. However, the ranks of the unemployed (and underemployed – U6) is near 15 million. Last week the U.S. government released its Q4 GDP figures which came out at an impressive 5.7%, substantially above all estimates. David Rosenberg of Gluskin Sheff’s has written extensively on U.S. GDP figures

  • A 5.7% GDP quarter has never before occurred in the context of a 40bps increase in the unemployment rate (the fastest growth ever posted amid such a poor labour market backdrop was 3.6%). On average, real GDP contracts at a 0.5% annual rate when the jobless rate backs up that much in a given quarter.
  • If you take the GDP report at face value, then potential growth must be close to 7%. That is ludicrous.
  • Never before has real GDP managed to muster such strength with hours worked down 0.5%.
  • With all the dramatic stimulus from the government, demand growth should be 10% and not sub-2%. That tells you just how strong the headwind is from the ongoing deleveraging process.
  • It usually takes 4-5 quarters to re-attain the pre-recession peak in GDP. This time around, eight quarters later, and the economy is still, in real terms, 1.8% smaller than it was when the recession began. By now, in a “normal” cycle where recessions are mere corrections in GDP in the context of a secular credit expansion, hardly what we have on our hands today, real GDP is already 8% above the old highs posted in the prior up-cycle.

That’s Rosenberg’s take on the U.S. GDP growth for Q4/2009, there will be a drastic revision, equal or larger than that which occurred for Q3 numbers (3.5% Vs. 2.2%). Others take far more bullish view, in fact one economist of my acquaintance bet me a good bottle of whiskey that non-farm payroll for January will be +100k (consensus is +8k). The bet will be settled in the next 48 hours.

Bottom line the jury is still out on America. V shape recovery is now out of the question, corporate earnings are excellent for the last quarter of 2009, well ahead of expectations, but most of the 2009 growth is the result of government stimulation. Companies that do not have access to the debt capital market are largely unable to borrow (read here: HIRE). Despite figures showing that banks are more open to lending, small and medium sized companies are still largely unable to borrow.

China – the big fix:

Last week Jim Chanos made a presentation on the topic of China’s property bubble. His point was that currently, in the 20 largest urban centers, commercial property vacancy rates are in the order of 20% (this was the lowest estimate he found – some were higher). Shanghai in particular has vacancy rates of almost 50%. The problem is that currently, under construction, there is nearly 30 billion square feet of office space under construction (not a typo) . At one point the madness will have to stop, and it will be the government that puts the breaks – as they will on most aspect of infrastructure spending.

We are not concerned with the Chinese economy; because they will find a solution or will have a crisis (they’ve had several already). It is the impact on Canada that is of interests here – one wonders if the Australian central bank didn’t come to the same conclusion. If demand for infrastructure spending moderates, price for natural resources will fall (Canada and Australia are the biggest OECD players in this segment). In fact, what was interesting in Chanos’ statement was not that he was going to short China, rather he was going to short “the first derivative” suppliers (e.g. mining companies, CAD). Chanos’ point was that China is the marginal buyer for many of these goods that are used to “over-build” their infrastructure.

At one point the building of excess capacity will have to stop, there may already be signs that government policy is shifting here. Nevertheless, for Canada this is a major factor, as an exporter of natural resources this could have a dramatic impact on the balance of payment and on economic growth.

Europe:

The arrival of a closer unity in Europe in the early 90s and the creation of the Euro was seen as a catalyst to faster pace economic growth. Unfortunately most European government have been living beyond their means. In 1990, an agreement was forged that imposed a strict limit on the size of each government’s deficit (3%). Almost immediately France broke the agreement, as a core European country it gave license to others to emulate its irresponsible behavior. At the same time, an agreement was struck that total government deficit could not exceed 60% of GDP. As as of January 31st 2010 only Finland and Spain are still below this threshold.


In fact, Spain has like Portugal, Ireland Greece, very serious problems because their annual deficit is growing as such high rates. Looking at all government liabilities the picture in Europe becomes depressing (although the U.S. are not looking so hot).

I’m not sure that anybody believes that the Greek “solution” will last the year. First, reducing the budget deficit from 12.5% of GDP to 3% is the right direction, but it is far from clear that Greece will be able to stay the course. It would not be the first time that government “hard line” on expenses is derailed by public opinion (already strikes are growing by the day). By the way for those who wonder how France got to be the king of the hill in terms of total net liabilities, it is because among European countries, none of its public sector pension obligations are funded (also partially true for Germany). In fact, Germany's problem is even more severe, since most company’s pension funds are unfunded…

These are the factors which will influence the Bank of Canada’s decision on the direction of interest rates in particular and monetary policy in general. The odds that all three aspects of "Canada's economic drivers" remain positive is slight. The U.S. economy seems to be heading for a double dip recession as housing continues to be a problem. According the figures released yesterday, vacant house at 18 million unites is the higher number ever (average is around 10 million) this shadow inventory is equal to two times the current "homes available for sale" number. The Chinese government seems to realize that they have a potential real estate bubble problem, the elegance of a command economy is that they can easily change the rules of the game. The impact on prices for natural resources could be dramatic on Canada's economy. Finally, Europe seems to be between a rock and a hard place; support Greece, and moral hazard grows for Portugal, Ireland and Spain, play hard ball, and there is the possibility that the edge of the Euro zone may start to disintegrate. Canada's economy thrives when its partners are doing well. The European situation seems precarious.

Note: To give a sense of proportion, Manhattan Island is 22 square miles, which translates into 14,720 acres. 30 billion square feet translates into 688,705 acres, so the current projects under construction in China is the equivalent of covering Manhattan Island with a single 46 story building, which covers the entire Island... makes you think!


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