Canada as an emerging economy

On Monday, Merrill Lynch investor conference made interesting comment about Canada:  It behaves more like an emerging than a developed economy.  Although it was not talking of corruption or weak administrative institutions or laws, rather it was talking about Canada as a “capital destination” with the same problems (and opportunities) that emerging economies face.  In ML's universe Canada faces stronger inflation pressures than does America, but nowhere the same level as the emerging economies.

Like all analogies, comparing Canada to an emerging economy can be carried to far, but ML did make a few valid points, insomuch that the tools available to the central banks are muted because of the foreign investors huge appetite for Canadian 30 year sovereign debt (pricing at an historically unprecedented 88 bps discount to similar T-bonds issued by the U.S. government).  I mentioned in earlier posts that the BoC had four main tools at its disposal (see here), but that the only tool currently available was moral suasion; since late November, the BoC governor and deputy governors have been “shouting from the roof top” about the risks to the Canadian economy.  In fact, Canada appears to be moving to a position of a flat yield curve (e.g. where the short term and long term pay the same yield – usually long term debt have higher interest rates), and there is nothing that the BoC can do!  Interest rate policy will be ineffective as long as foreign cash continues to stream into the economy (in 2010 it represented nearly 10% of GDP – an unprecedented amount).

ML, like many other economic commentators, also made the comment that the BoC miscalculated the supply destruction which occurred during the recession.  While this is true, especially in the auto sector which is today operating around 75% of capacity I think that ML missed the boat and is underestimating the impact of capital investments.  In 2010 Canadian companies undertook massive capital investments (more than 9% of GDP -- far beyond what it had done over many years), that would have two main consequence:  First increase demand for labor [December labor numbers would seem to prove this], and Second increase labor productivity – higher capital expenditure leads to more efficient use of labor, which translates into higher wages and higher productivity. As a side note it would be amusing of the largest upgap in Canadian productivity occurred when government policy was neutral on productivity increase…which would confirm one of my own pet theory that there are no policies mix that can induce capital investments which target productivity improvements.

Although inflation pressures in Canada are higher than in the U.S. it is important to note that in 2010 Canadian corporation already recognized that they were hitting thresholds in production capacity and have taken remedial measures.  Of course, the strong Canadian dollar helps in muting some inflation pressures, but it remains that current inflation levels are well within the BoC’s acceptable band.