Canadian Economy Headed for a Wake-Up Call?

The Canadian dollar, commonly known as the loonie, derives its nickname from the North American loon, an aquatic bird known for diving to great depths. Similarly, the currency has taken a plunge since the start of 2013, falling 10 percent against its American counterpart from parity to C$ 1.1.

The period marks a sharp reversal for the Canadian dollar, which enjoyed a strong rally in the aftermath of the global financial crisis. Last month the loonie declined to its weakest in nearly five years, reflecting an increasingly fragile economy.

Canada proved an attractive safe haven for investors in the post-crisis years, with the currency being viewed as a reliable alternative to the uncertainty surrounding the US dollar and euro. A stable environment underscored by relatively robust banks and a global commodity boom allowed the central bank maintain higher interest rates than the US for much of the past five years, meaning that holders of Canadian assets could obtain a greater yield.

However, in recent years the commodity rally has stalled and despite a pickup over the last few months, prices remain far from the lofty levels of 2010. While a focus on commodities once gave Canada an advantage over other nations, it could now prove a detriment. Too much reliance on exporting its natural resources has resulted in reduced investment in the manufacturing sector.

Over the past decade the number of Canadian manufacturing firms has fallen by 20% and the sector’s share of GDP has shrunk from 16% to 12%. It is a worry trend, possibly indicating that the commodity boom has masked vulnerabilities in the core economy; something that could be painfully highlighted if food and energy prices tumble.

Improving US growth should boost demand for Canadian goods (it takes in about 70% of Canada’s exports) but the central bank recently warned that Canada’s non-commodity exports were becoming uncompetitive, even at C$1.1. The country’s growth outlook isn’t particularly encouraging either, with real GDP expected to increase 2.4% this year after rising 2% in 2013, marking a third straight year of slowing growth.

Canadian policymakers face a difficult challenge in supporting the economy while trying to manage an overheating housing sector. House values have ballooned, with the average price of a home more than doubling since 2002. Moreover, household debt has climbed to record levels of about 100% of GDP, on par with the US at the peak of its housing bubble. Similarly, at 7% of GDP, residential investment has become an unhealthily large part of the economy, outdoing the pre-crash US and rising much faster than population growth. The sector is undoubtedly on an unsustainable trajectory.

While interest rates were kept at 1% last year, the central bank had a tightening bias, intimating that it would raise rates in the near future to cool excessive spending. But new governor Stephen Poloz adopted a neutral stance in October, recognizing weakness in the broader economy. His dilemma is that low rates could add fuel to the housing boom, encouraging indebted households to increase borrowing, while higher rates could strangle business activity.

Inflation pressures are minimal at present, with the consumer price index rising 1.1% in February from a year earlier, well below the central bank’s 3% upper target. This has built up expectations that rates will be maintained at 1% until at least mid-2015. The prospect of no rate hikes should keep the Canadian dollar at relatively weak levels, helping boost the competitiveness of exporters.

This will help with a necessary longer-term goal of shifting the economy’s growth drivers, which have been imbalanced over the past decade. A transition is needed from reliance on debt-driven household consumption and residential construction to an export-led economy boosted by strong manufacturing investment.

Such a goal involves discouraging housing speculation through tighter mortgage conditions and limits on residential investment, hopefully resulting in a gradual stabilization of house prices. Policies targeted at revamping the much-neglected manufacturing sector will also help provide sustainable growth, effectively sheltering the economy from fluctuating commodity prices.

The deleveraging from an excessively indebted economy will take time and be somewhat painful, but that is the consequence of years of largess. Action now can prevent a severe hemorrhage later. For inspiration, policymakers just need to remember what happened to the housing market south of the border.