OTTAWA—The Bank of Canada broke its tone of pessimism on May 29, saying that the economy is improving as expected but that trade tensions between the United States and China and with China directly are the primary concerns for the outlook.
The economy has not really strengthened, but it has not deteriorated further as it had when the BoC released its April 24 statement and quarterly projections. As widely expected, Canada’s central bank left its overnight rate target at 1.75 percent.
“The recent escalation of trade conflicts is heightening uncertainty about economic prospects,” said the bank in a short press release.
The biggest development since the bank’s prior interest rate decision is the renewal in early May of the United States taking China to task for unfair trade practices by raising tariffs to 25 percent from 10 percent on US$200 billion worth of Chinese imports. China refuses to back down and its latest retaliation threatens exports of rare earth minerals used in electronics.
The Bank of Canada’s position on the U.S.–China trade war has been that it is a two-sided risk. Its escalation is hurting the global economy, but if it gets resolved, that would represent a risk to the upside. The United States getting a trade deal done in which China stops taking advantage of other countries through stealing intellectual property (IP) and forcing technology transfers in joint ventures would be a part of the expected boost for the global economy.
But for now, these trade tensions have indirect effects on the Canadian economy through channels like commodity prices and business confidence.
University of Waterloo economics professor Jean-Paul Lam says these downside risks are heightened now and Canada is likely to get caught in the crossfire.
“If we’re going to see a more sustained and bigger slowdown in the U.S. economy … that’s the most direct impact for us going forward,” he said in an interview.
But short-term pain could pay off in the long run for both the U.S. and Canadian economies.
“If we get a lot of things in order with China, stopping China from playing easy on IP and other things, definitely,” Lam said.
Bloomberg economists estimate Canada’s output exposed to China’s exports to the U.S. at 0.09 percent and U.S. exports to China at 0.21 percent of GDP. The vulnerable Canadian energy sector’s products are more exposed to U.S. exports to China than any other Canadian industry.
Oxford Economics estimates that the impact on the Canadian GDP from the U.S.–China trade war appears to be little more than a rounding error—0.1 percent in 2019 and 2020.
Gregory Daco, chief U.S. economist at Oxford Economics, says that the confidence effects could be much larger should tariffs be imposed on all imports. In this case, the hit to U.S., Chinese, and Canadian GDP would be significantly higher.
But in addition, the Bank of Canada specifically singled out China’s recent actions against Canadian exports—the highest profile of which is canola.
“Trade restrictions introduced by China are having direct effects on Canadian exports,” said the bank.
But Lam says the indirect effects coming through the United States are more material than the direct ones, as the Canadian economy is more dependent on the United States than it is on China.
“The danger is really trade uncertainty going to impact investment decisions and financial markets in the United States,” Lam said. “That effect is going to be much more important for Canada than China continuing to impose tariffs on Canadian goods.”
Positive Signs
Exports are off to a slow start in 2019, but the BoC says the removal of steel and aluminum tariffs and the improving prospects for ratification of the Canada-United States-Mexico Agreement “will have positive implications for Canadian exports and investment.”
Financial markets in Canada aren’t pricing in as dire an outlook as are the financial markets in the United States. Canadian bond yields and equities have not fallen as much as their U.S. counterparts, and the Canadian dollar is roughly unchanged since the last BoC meeting in which a neutral stance toward interest rate changes was adopted and the currency shifted lower.
The BoC remains focused on household spending, oil markets, and global trade—of which the first two support the hypothesis that the second quarter of 2019 is seeing a pickup in economic activity after the slowdown of late 2018 and early 2019.
There is no sign of inflation picking up and the bank remained neutral regarding the next move in interest rates.
The strongest component of the Canadian economy continues to be the labour market, which has added 222,000 jobs through the first four months of 2019 and is growing much faster than GDP. The bank suggested that businesses thus see the weakness in the last six months as temporary.
TD Securities said in a note that first-quarter GDP is tracking at 0.4 percent, which is in line with the bank’s 0.3 percent forecast from April.
“The [Bank of Canada’s] tone was extremely optimistic about the economy,” Lam said.
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