Lessons from Canada from the International Financial Crisis of 2007-?

1. Lessons from Canada from the International Financial Crisis of 2007-? Pierre L. Siklos BSIA & WLUViessmann European Research Centre A Lecture at the Joint Vienna Institute – April 2012

2. Outline of Talk • The Long Road to Respect: From Zero to Hero • Fiscal Consolidation Canadian Style • Banking and Macro-prudential Regulation: The Canadian Experience • Monetary Policy: Credibility and Effectiveness

3. The Long Road to Respect:From Zero to Hero • In January 2005, the Wall Street Journal called CANADA “an honorary member of the third world”. The Canadian dollar was referred to as the “northern peso”. • What are they saying now?

4. The Long Road to Respect:From Zero to Hero • “Canada has emerged as a favoured destination for investors seeking refuge from the turmoil sweeping the euro zone and the continuing uncertainty over the U.S. fiscal position.” WSJ • “Part of the allure is Canada's sterling fiscal position.” WSJ • “Canada’s ratings are supported by its institutional and structural strengths, underpinned by effective policy response and a history of macroeconomic and social stability. Canada’s macro prudential approach to policymaking has allowed years of economic growth and stable prices in Canada.” Fitch

5. Fiscal Consolidation Canadian Style • 1995, as it turns out, is a pivotal year in Canada’s fiscal policy • It begins with Paul Martin’s budget speech with a crystal clear message: • “The time to reduce deficits is when the economy is growing. So now is the time.” • “Short-term targets are the surest way to get to zero.”

6. Fiscal Consolidation Canadian Style Source: http://www.fin.gc.ca/budget95/speech/speech.pdf

7. Fiscal Consolidation Canadian Style Source: http://www.fin.gc.ca/budget95/speech/speech.pdf

8. Fiscal Consolidation Canadian Style • An extraordinary committee of ‘cuts’ • Cuts in spending NOT tax increases • Transparency and accountability not ‘sugar coating’ • Equivalent to a ‘fiscal rule’

9. Canada’s Net Debt, 1970-1995 Source: T. Macklem (2010), “Fiscal Policy During and Afterthe Crisis”

10. Dramatic Improvementsin Fiscal Policy Source: T. Macklem (2010), “Fiscal Policy During and Afterthe Crisis”

11. Thinking About the Long-term Source: T. Macklem (2010), “Fiscal Policy During and Afterthe Crisis”

12. Fiscal Returns I 2005

13. Fiscal Returns II 2005

14. Fiscal Consolidation & Growth: The Canadian Experience Source: Own calculations from CANSIM II

15. Canada’ Growth VS US Economic Growth Source: Own calculations from CANSIM II

16. Better than the Rest? Source: http://www.theglobeandmail.com/news/politics/budget/infographic-your-2012-federal-budget-explained/article2384109/

17. Learning the Lesson 2012 Style? Source: http://www.theglobeandmail.com/news/politics/budget/infographic-your-2012-federal-budget-explained/article2384109/

18. Banking and Macro-prudential Regulation: The Canadian Experience • Canada’s financial system is regulated by 4 main ‘actors’ • Bank of Canada • Provided liquidity assistance during the crisis • OSFI (Office of the Superintendent of Financial Institutions) • Regulatory arbitrage is kept to a minimum by effective leverage oversight • CDIC (Canada Deposit Insurance Corp.) • FCAC (Financial Consumer Agency of Canada) • Bottom Line? Both entity and activity regulations are in place • There exists a formal mechanism in place for the regulators to communicate & exchange information

19. Banking and Macro-prudential Regulation: The Canadian Experience • Canada’s Banks did not require an injection of public capital during the crisis • Very few sub-prime mortgages and none insurable after 2008 • Canadian banks rely less on repos and securitization • Canada’s banks are expected to EXCEED Basel II Tier I and capital-asset ratios (approx. 10/13%; Basel II is 4/8%) • Canada’s banks have conservative risk appetites

20. Why Conservative Risk Appetite? • Insurance is mandatory if loan-to-value ratio is > 80% (largest insurer is CMHC, a Federal agency) • CMHC does not insure sub-prime mortgages • Securitization is largely limited to meet liquidity needs and NOT risk transfer

21. Canadian Banks’ ROR

22. Spreads and the Financial Crisis

23. Liquidity & the Crisis

24. Canada’s Financial System: Some Challenges • Poorly structured non-bank asset-backed commercial paper • “Because liquidity for this paper was guaranteed only in the event of a "general market disruption," liquidity providers – most of whom are international banks – declined to step in as this paper has come due.” (Dodge Sept 2007) • Household Debt levels are rising quickly as MP continues to be relatively ‘easy’ • Counter-cyclical buffers are necessary • Off-balance sheet items should be included in capital ratio calculations • Regulation is shared with the Provinces & there are too many securities regulators (in each Province) • Although a ‘passport’ system is in place (except Ontario)

25. Source: Author’scalculations

26. Canada’s Financial System: Some Challenges • Poorly structured non-bank asset-backed commercial paper • “Because liquidity for this paper was guaranteed only in the event of a "general market disruption," liquidity providers – most of whom are international banks – declined to step in as this paper has come due.” (Dodge Sept 2007) • Household Debt levels are rising quickly as MP continues to be relatively ‘easy’ • Counter-cyclical buffers are necessary • Off-balance sheet items should be included in capital ratio calculations • Regulation is shared with the Provinces & there are too many securities regulators (in each Province) • Although a ‘passport’ system is in place (except Ontario)

27. Monetary Policy: Credibility and Effectiveness • IT regime has remained in place with relatively few changes since the early 1990s • The 2% target was renewed in the Fall of 2011 for another 5 years • Inflation and inflation expectations have remained stable • A concern for financial system stability may cloud the issues (Tinbergen’s principle) • Where to next? • Price level targeting? • More transparency?

29. Source: Author’s calculations

30. Monetary Policy: Credibility and Effectiveness • IT regime has remained in place with relatively few changes since the early 1990s • The 2% target was renewed in the Fall of 2011 for another 5 years • Inflation and inflation expectations have remained stable • A concern for financial system stability may cloud the issues (Tinbergen’s principle) • Where to next? • Price level targeting? • More transparency? Success and Failure

31. Source: Author’s calculations

32. Monetary Policy: Credibility and Effectiveness • IT regime has remained in place with relatively few changes since the early 1990s • The 2% target was renewed in the Fall of 2011 for another 5 years • Inflation and inflation expectations have remained stable • A concern for financial system stability may cloud the issues (Tinbergen’s principle) • Where to next? • Price level targeting? • More transparency? Success and Failure

33. Inflation Targeting: The Communications Challenge “Conditional on the outlook for inflation, the target overnight rate can be expected to remain at its current level until the end of the second quarter of 2010 in order to achieve the inflation target. The Bank will continue to provide guidance in its scheduled interest rate announcements as long as the overnight rate is at the effective lower bound.” BOC MP Report, April 2009, p.2

36. IT and ‘Headwinds’ VS ‘Tailwinds’ I Source: BoC MPR July 2011

37. The Message? • Figure 2-A and Figure 2-B plot the hypothetical responses of inflation, the output gap and the target overnight rate to a negative foreign demand shock. • Figure 2-A illustrates the case of a simple Taylor-type rule where the overnight rate mechanically responds to deviations of current inflation from the target. In this scenario, inflation returns to target, output returns to its potential and the overnight rate returns to its 2 A Taylor-type rule specifies policy in terms of current inflation and the estimated current level of the output gap. long-run level, all at the same time, after the effects of the headwinds have fully dissipated. • Figure 2-B illustrates the more desirable case where the central bank takes better account of the expected headwinds from the sustained decline in foreign demand. The central bank leans more heavily into the headwinds by maintaining interest rates further below their long-run level, which more fully offsets the effects of weaker foreign demand on the domestic economy. This allows inflation to return more quickly to the target (and stay there) and output to potential, before the policy rate returns to its long-run level, as illustrated.

39. The End!