Government restraint will exert major drag on growth in 2011: CIBC World
Markets Inc.

End of stimulus spending, belt-tightening will necessitate slowing of rate hikes

TORONTO, April 29 /CNW/ - After engineering a massive fiscal offensive in 2009, and keeping up the fight against recession in 2010, Canadian governments will soon be pulling back on spending, putting a drag on growth in 2011, finds a new report from CIBC World Markets Inc.

"With the lightest net debt burden in the G7, Canada has greater flexibility to go slow on deficit reduction," says Warren Lovely, government strategist with CIBC's Macro Strategy Group and author of the report. "But the country's fiscal discipline is surpassed by few, and Canada looks to be one of the most aggressive countries when it comes to tackling a structural deficit. More than simply letting stimulus measures run their course, governments will swing to outright restraint. Notably, Canada is the only G7 nation on track to eliminate its deficit by 2015."

The report notes that 2009 saw a record one-year deterioration in the combined federal-provincial budget balance, equivalent to more than five percentage-points of GDP. Having seen the combined deficit explode to $88 billion, most governments are now setting their sights on a return to balance within 3-5 years. Given a commitment to stimulus, official projections suggest little progress on deficits in 2010/11. Canadian governments are targeting a combined $30 billion cut in the deficit for 2011/12 - equivalent to 1.8 percentage-points of GDP-the biggest one-year improvement since the mid-1990s era of ultra-restraint.

"The expiration of temporary stimulus programs will go a long way towards correcting imbalances, accounting for 40 per cent of Ottawa's back-to-balance strategy," says Mr. Lovely. "Extraordinary federal stimulus, and related provincial programs, provided a $62 billion boost to the economy, the majority of which was accounted for in fiscal 2009/10."

Mr. Lovely estimates that, on a calendar year basis, a little less than $20 billion of the stimulus was spent in 2009, providing a roughly one per cent contribution to GDP growth. With outlays ramping up in 2010, he expects that contribution to reach 1.3 per cent of GDP. However, turning the stimulus taps off will take roughly two percentage-points out of GDP growth in 2011, removing the fuel that has seen today's economic fire burn so brightly.

After languishing in the 2 - 2 1/2 per cent range for much of last year, the consensus forecast for 2010 real GDP growth has moved up in recent months. CIBC currently anticipates 3.1 per cent real growth for Canada this year, and the Bank of Canada is even more bullish, at 3.7 per cent. Budget projections imply a 2 1/2 per cent national growth pace in 2010, which is increasingly conservative relative to the new and improved outlook for real GDP.

"Should Canada's economy perform more in-line with our thinking, sensitivity analysis suggests federal-provincial governments could see roughly $7-10 billion in fiscal upside relative to plan," notes Mr. Lovely. "That would allow for swifter progress on deficits but still leave a cyclically-adjusted shortfall to be corrected."

To address this shortfall, governments are proposing a reduction in program spending growth. After a decade of growing program outlays at a seven per cent average rate, Ottawa's five-year fiscal plan hinges on a slowdown in spending growth to less than two per cent. With provincial transfers slated for four per cent growth, the plan banks on reduced employment insurance outlays and a roughly flat profile for "other" programs - national defence and other discretionary spending which currently comprise one-half of all program outlays.

Provincial governments aim to limit total spending growth to less than two per cent over the three-year period starting in 2011/12. That's barely a third of the five per cent-plus pace averaged during the pre-recession period, when provinces were flush with cash. Substantial spending restraint could be tough to achieve, given provincial responsibility for health and education.

Expenditure reviews, efficiencies and the consolidation of organizations will achieve savings. But in most cases, serious progress requires taking a tough line on wages and sizeable reductions in public sector headcount - as much as 10 per cent. Public sector workers will be asked to do more for a declining real wage rate, raising the prospect of union backlash and potential service disruptions.

"During the 2000s, government spending contributed an average 0.8 percentage-points to annualized GDP growth, accounting for fully 40 per cent of the country's growth," adds Mr. Lovely. "That direct contribution soared to 1.5 percentage-points in the past year, the biggest public sector push since the 1970s when Canada's social fabric was being built.

"But all that is about to change. With stimulus expiring, real program spending flat to falling, and public sector jobs being cut, the Canadian economy will be losing an important driver of growth. The fiscal restraint won't be as severe as that witnessed in the mid-1990s, but nonetheless signals downside risk to growth in 2011 and reduced prospects thereafter. Fiscal tightening also means (Bank of Canada Governor Mark) Carney et al will be going slower on rate hikes in 2011 than the market currently expects."

The complete CIBC World Markets report is available at: http://research.cibcwm.com/economic_public/download/sapr10.pdf.

CIBC's wholesale banking business provides a range of integrated credit and capital markets products, investment banking, and merchant banking to clients in key financial markets in North America and around the world. We provide innovative capital solutions and advisory expertise across a wide range of industries as well as top-ranked research for our corporate, government and institutional clients.

SOURCE CIBC World Markets

For further information: For further information: please contact Warren Lovely, Macro Strategy Group, CIBC World Markets Inc. at (416) 594-8041, warren.lovely@cibc.ca; or Kevin Dove, Communications and Public Affairs at (416) 980-8835, kevin.dove@cibc.ca


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