Globe and Mail February 26, 2008

WASHINGTON — Canada’s growing reliance on U.S. capital markets is playing a greater role than cross-border trade in importing American economic woes to Canada, according to a report by the International Monetary Fund.

More vital than Canada’s massive trade ties, financial markets have become the primary conduit for the faltering U.S. economy to infect its northern neighbour. And that’s why Canada can’t easily escape the economic headwinds now buffeting the United States, the report concluded.

Financial conditions are now “the largest source of U.S. spillovers to Canada,” according to a 20-page staff report, released yesterday along with the Washington-based agency’s annual review of the Canadian economy. “These results suggest that the Canadian economy is unlikely to decouple from the U.S. downturn,” the report said.

A growing number of analysts say the U.S. is already in a recession or headed for one. As the slump in the U.S. extends beyond housing, the impact on Canada will accelerate, the fund warned.

Financial linkages between the two countries are far more extensive than most people realize, with Canadian firms tapping U.S. markets for roughly a quarter of all their equity, bank and bond financing.

“Capital markets are much more integrated than in past economic cycles,” said Clément Gignac, chief economist and strategist at National Bank Financial in Montreal. The result is that even Canadian companies that are completely isolated from trade, including broadcasters and cable companies, are being affected because their cost of capital has gone up, he said. And that has exacerbated the impact in Canada, Mr. Gignac added.

The IMF found the spillover effect has been “remarkably stable over time” - every 1-per-cent drop in U.S. economic output lops three-quarters of a percentage point off Canadian gross domestic product within two years.

Likewise, households feel the pain because Canadians hold U.S. securities worth 13 per cent of Canada’s annual GDP, the report pointed out.

There are also indirect effects as tighter U.S. financial conditions spread quickly to Canada. So even companies that rely solely on Canadian banks and financial markets feel the pain of a U.S. credit crunch.

As U.S. bond yields widen, equity prices fall and short-term interest rates rise on both sides of the border.

Even though Canada has not experienced a major real estate correction, Canadian banks have still been hit by steep losses on their various structured investments, including asset-backed commercial paper and collateralized debt obligations that have been hammered because of the U.S. credit crunch.

Interestingly, the report argued that even as Canada’s economy has become much more dependent on U.S. trade since the Canada-U.S. free-trade deal, more than half of the measurable economic spillover effect is due to financial conditions.

Canada-U.S. trade represents 49 per cent of GDP, up from 37 per cent in 1988.

But the value of cross-border financial holdings, meanwhile has shot up to 90 per cent of GDP from 53 per cent before the trade pact.

In a separate annual review of the Canadian economy, the IMF downgraded its forecast of Canadian growth to 1.8 per cent in 2008 from 2 per cent - matching the consensus forecast of private sector economists in February. Growth of 1.8 per cent would match Canada’s performance in 2001, when the United States suffered a mild recession.

“Canada is facing some very interesting times,” said Tamim Bayoumi, who headed this year’s IMF mission to Canada. “Growth is slowing because of problems in the United States.”

The IMF also lowered it 2009 forecast to 2.4 per cent, down from 2.7 per cent, or slightly more pessimistic that than the consensus. It blamed the downgrade on slowing exports, tighter credit conditions and the deteriorating U.S. outlook.

“With the U.S. downturn now expected to be more severe than earlier assumed and last year’s upward momentum in the Canadian dollar, the drag from real net export will intensify,” the IMF said.

The IMF pointed out that Canada has enjoyed “enviable macroeconomic performance over the past decade.”

But it warned that the balance of risks is now on the downside.

This article was posted on Tuesday, February 26th, 2008 and is filed under Canada-USA, Deep Integration, Economy. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.