U.S. tax changes could hurt Canadian economy more than NAFTA pullout, business groups warn

OTTAWA — Business associations are warning that substantial tax changes in the U.S. could end up inflicting more damage on the Canadian economy than the possible termination of the North American Free Trade Agreement.

Two of the country’s biggest business lobby groups say much of their attention these days is focused on the negatives of the recent U.S. decision to slash corporate taxes to levels comparable to those in Canada.

The warning follows on the heels of the Bank of Canada’s first public estimate on the impact of the U.S. tax changes on the economy north of the border.

The bank predicts NAFTA uncertainty and the tax reforms will encourage firms to divert more of their planned investments from Canada to the U.S., trimming half a percentage point off Canadian investment by the end of next year.

Business Council of Canada president John Manley says he believes the fallout from the U.S. tax changes on the Canadian economy could be even bigger than the negatives associated with the potential demise of the NAFTA.

Canadian Chamber of Commerce president Perrin Beatty says the U.S. tax reforms should be a wake-up call to spur Canada into finding ways to make the country more attractive for both domestic and foreign investors.

Bank of Canada’s pledge to raise rates gradually may prolong nation’s debt binge

OTTAWA — It will take longer than expected for Canadian rate hikes to discourage consumer spending or spark deleveraging as most homeowners are sheltered from mortgage renewal risk until 2019 – and cheap loans are still available, economists said on Thursday.

The Bank of Canada raised interest rates on Wednesday, taking borrowing costs to their highest level since 2009.

But the overnight rate is just 1.25 per cent and the most popular mortgage, the five-year fixed term, only costs about 3 per cent, about the same as in 2012.

“Most people can absorb 100 basis points of rate hikes. When we start talking 150 to 200 basis points, it’s a different story,” said Rob McLister, founder of mortgage rate comparison website RateSpy.com.

About 70 per cent of Canadian mortgages have a fixed interest rate, but most reset several times within their 25- or 30-year amortization period. Some 47 per cent of outstanding mortgages will renew within the next year – meaning the bulk of borrowers will be locking in current rates, near historic lows.

“(That’s why) we think it is going to take a little bit longer than people are anticipating to feed through, and it will be more meaningful next year,” said Mark Chandler, head of Canadian fixed income and currency strategy at Royal Bank of Canada.

Canadian consumers have powered the country’s economic growth for years, pouring so much money into the housing market that there are fears of a bubble, and racking up a record debt-to-income ratio of 171 per cent – meaning households owe $1.71 for every $1 they earn in disposable income.

Having already hiked interest rates three times in the past seven months, the Bank of Canada expects consumption to cool as debt costs force consumers to shut their wallets. But the bank’s pledge to raise rates only gradually may prolong the debt binge.

“They are banking on consumption moderating going forward, but there’s a risk that consumers are used to the big houses, the big cars … so consumers may be more resilient than anyone is expecting,” said Jean-Paul Lam, an economics professor at the University of Waterloo.

“As long as we live in an environment where credit is cheap and the economy is doing well, I don’t see households retrenching a lot in terms of debt.”
© Thomson Reuters 2018

Trump administration losing patience with NAFTA talks, serious about threat to withdraw: sources

The U.S. is running out of patience with Canadian and Mexican resistance to key American proposals ahead of talks next week on a new North American Free Trade Agreement, two people familiar with the matter said.

The U.S. is serious about its threat to withdraw from the North American Free Trade Agreement if there’s no breakthrough on proposals the Trump administration has made that are intended to rebalance trade, said one of the people, who spoke on condition of anonymity because the negotiations aren’t public. The Trump administration wants to see serious counteroffers to U.S. demands like tightening content requirements for cars.

U.S. negotiators also want tangible signs of movement from its trading partners on issues such as Mexican labour conditions, which the U.S. says keeps the nation’s wages artificially low, and a “sunset clause” that would cause the agreement to expire in five years unless the countries agree to renew it.

U.S. officials are particularly frustrated with what they see as Canada’s intransigence at the table, according to the two people. While Mexico has shown some flexibility on the U.S. proposals, Canadian officials are more reluctant to give ground, preferring to promote Prime Minister Justin Trudeau’s concept of a “progressive” trade agenda based on improving gender equality and the environment, among other things, one of the people said.

Lingering Tensions

The tension between the U.S. and its trading partners, especially Canada, sets up a pivotal round of talks in Montreal that begin Tuesday and wrap up Jan. 29. With the negotiations on home turf, Trudeau’s Liberal government will want to be seen standing up to Canada’s bigger neighbour and its Republican president. For its part, the U.S. won’t be happy with merely procedural discussions on how to address the administration’s toughest demands.

In a tweet Thursday, U.S. President Donald Trump called NAFTA a “bad joke,” and reaffirmed his plan to build a wall with Mexico.

Canada has said it will present new ideas in the upcoming round of talks.

“We’re continuing to work diligently with our Mexican partners and with our American partners to make progress,” Canadian Finance Minister Bill Morneau told reporters Thursday in Toronto. “We’ve said that we have some constructive ideas on how to make a difference in terms of moving forward the NAFTA discussions.”

‘Bad Joke’

U.S. President Donald Trump has repeatedly threatened to pull out of the deal, which he blames for America’s US$63-billion deficit in goods and services with Mexico. In a tweet Thursday, the president called NAFTA a “bad joke,” and reaffirmed his plan to build a wall with Mexico.

Mexico and Canada are casting the talks in a different light. Mexico’s Ambassador to the U.S. Geronimo Gutierrez said Thursday that differences are narrowing in the talks, while last week Canadian officials said the chances are rising that Trump will exit the deal.

At a negotiating round in November in Mexico City, U.S. officials were flabbergasted when Canadian negotiators delivered a presentation suggesting the U.S. proposal on autos is misguided, an approach the U.S. considered to be more of a lecture than a counteroffer, one of the people said. Gutierrez said Thursday Mexico may be able to accept an increase in the regional content requirement for vehicles traded under the deal.

NAFTA requires a vehicle to have a minimum of 62.5 per cent North American content in order to benefit from tariff exemptions for autos assembled and traded in the region. The Trump administration has proposed raising the so-called auto rules of origin requirement to 85 per cent North American content and add a new 50 per cent U.S. content minimum.


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Ottawa planning for strengthened tri-party NAFTA, but runs models for a Plan B

Federal Finance Minister Bill Morneau suggested Thursday his department is running internal scenarios that include what would happen if NAFTA talks were to falter. But he said Ottawa remains heavily focused on “Plan A,” which is strengthening the tri-country North American Free Trade Agreement between Canada, the United States, and Mexico.

“My job … is to think about how we can ensure the economy is successful in the long term, so we do look at the economic impacts of any NAFTA discussion in order both (to determine) how do we improve and also to think about the challenges that the long discussion might present,” Morneau said following a meeting in Toronto with his counterpart from Mexico, José Antonio González Anaya.

Morneau said model scenarios are “a confidential part” of Ottawa’s NAFTA analysis and declined to discuss the potential impact on the economy or any specific sector if the trade agreement were to fall apart. He stressed that the focus remains on strengthening the deal.

The five rounds of talks, which pick up again next week in Montreal, have been contentious due to some extreme rhetoric from U.S. President Donald Trump.

“The job of the Department of Finance is to run models on everything … so we have an understanding of sector-by-sector impact on how we can make a positive impact on our economy and jobs, and that will continue to be our approach to this analysis,” Morneau said. “Be prepared, be ready to have constructive discussions, and understand the impacts, potentially both positive and challenging.”

He added that the federal government remains “very focussed on Plan A, on making sure that NAFTA continues to provide great jobs that it’s done for the last generation or two.”

On Wednesday, the Bank of Canada’s senior deputy governor, Carolyn Wilkins, warned that the country’s economic growth outlook “remains clouded by uncertainty related to the future of the North American Free Trade Agreement.” Her remarks came even as the central bank raised the benchmark overnight interest rate by one-quarter of a percentage point to 1.25 per cent.

Avery Shenfeld, chief economist at CIBC World Markets, said if NAFTA were to fail, the most likely scenario would be for Canada to “pull out all the stops to launch bilateral talks with the U.S.”

Forging a separate bi-lateral agreement with Mexico “would not be much help for Canada, as we don’t have much in the way of exports to Mexico,” Shenfeld said. “Moreover, it might interfere with working on a new bilateral pact with the U.S., which might not want, for example, to give free trade access to Canadian goods with a lot of Mexican content.”

Morneau said in an interview Ottawa is committed to a three-country deal on NAFTA.

“We’re working very closely together,” he said, standing next to González, who was recently appointed Mexico’s secretary of finance and public credit.

“I think we share a view that NAFTA is better with three countries, and so we’re moving toward a solution that works for all three of us, and so that’s the goal,” Morneau said.

Morneau and González spent the day in meetings that included discussions with representatives of businesses in the mining and financial sectors, including banks and pension funds.

A statement released Thursday by the Department of Finance said the commercial relationship between Canada and Mexico is “strong and growing.” It noted that Mexico is Canada’s third-largest business partner, with bilateral merchandise trade reaching a “milestone” of $40.8 billion in 2016. The same year, Canadian direct investing in Mexico reached about $17 billion, while Mexican direct investment in Canada totalled nearly $2 billion.


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Canadians’ unprecedented debt levels prompts Macquarie to warn on rate hikes

The unprecedented rise in consumer debt means the Bank of Canada’s rate-hiking cycle is already the most severe in 20 years and further increases will have far graver consequences than conventional analysis shows, Macquarie Capital Markets Canada Ltd. said.

Assuming just one further rate rise, the impact would be 65 per cent to 80 per cent as severe as the 1987 to 1990 cycle, according to Macquarie, which took into account five-year bond yields, household debt and home buying. Canada’s housing market slumped in the early 1990s after that rate-hike cycle and a recession.

“The Canadian economy has experienced an unprecedented period of hyper-leveraging,” analysts including David Doyle wrote in the note released Thursday. According to Macquarie, this is underlined by the fact that:

About 30 per cent of nominal GDP growth has come from residential investment and auto sales over the past three years. This is about 50 per cent greater than what has been experienced in similar prior periods. The wealth effect from rising home prices has driven nearly 40 per cent of nominal growth in gross domestic product over the past three years, about two to four times the amount experienced previously when the BoC was hiking rates. Even as this has occurred, fixed business investment and exports have struggled, limiting the ability for a virtuous domestic growth cycle to unfold. This again is in sharp contrast to similar periods in the past when these were accelerating.

Bank of Canada Senior Deputy Governor Carolyn Wilkins and Bank of Canada Governor Stephen Poloz listen to a question during a news conference in Ottawa, Wednesday January 17, 2018.

New mortgage stress-test rules will also have a larger impact than estimated, Macquarie said. The new rules in isolation are expected to reduce buyers’ maximum purchasing power by as much as 17 per cent. That jumps to about 23 per cent after incorporating the rise in mortgage rates since mid-2017, according to the note.

Governor Stephen Poloz has indicated high household debt could make the slowing impact of rate hikes harsher, and that the impact of 2017’s increases will not be fully clear for 18 months, Doyle said.

“When taken together, these observations mean the Bank of Canada is proceeding with hikes despite uncertainty surrounding the severity of tightening performed so far,” Macquarie writes. “This elevates the risk of policy error.”

Macquarie expects only one more rate hike in either April or July.


It would be wrong to assume NAFTA’s death would only be a small shock to economy: Poloz

NAFTA’s about more than tariffs, Bank of Canada Governor Stephen Poloz says in a warning to avoid low-balling the impact of a potential collapse of the trade pact.

Poloz, speaking in a news conference in Ottawa on Wednesday, said the North American Free Trade Agreement “channel” he’s most focused on is the impact on business investment. He alluded to other reports that, focusing on a change in tariff rates, have predicted the death of NAFTA would have only a modest impact.

Tariff-based trade models alone show a death wouldn’t “be that large of a shock to the economy, and one that would be a bit gradual,” Poloz said, calling it a useful exercise but only part of the picture. “We can’t just relax and assume it would be a small shock.”

The sixth round of NAFTA negotiations between Canada, the U.S. and Mexico get underway next week in Montreal. President Donald Trump has repeatedly threatened to withdraw.

Poloz said it’s very difficult to quantify NAFTA’s impact because it varies not only by sector, but also from firm to firm. “So we’ve chosen not to get buried in all of that,” he said. The immediate impact — already being felt — is a chill on business investment in Canada, as it’s either deferred or simply made in the U.S. instead. “That’s the sort of effect that could be bigger, in a binary sense, if an announcement is made that NAFTA is no longer to be. But again, even then, it would take time.”

The U.S. could also layer on additional trade actions that would worsen the blow, he said, citing ongoing actions in the aerospace and lumber sectors. “The analyses that you’re looking at do not consider the channel that I’m trying to emphasize the most,” he said, adding the shock of a NAFTA collapse is difficult to analyze. He contrasted it to the 2014 collapse in oil prices, whose effects were easier to predict.

“You will need the benefit of time and data to understand this as it all unfolds, and so markets should not think of it as a binary event, and I’m hopeful that they’ll appreciate the conversation we just had,” Poloz said.