On the causes of an eventual Canadian recession

I was planning on writing this post a bit later, but since several good points have already been made in the comments over here, I'm going to start a discussion on the mechanics of how the Canadian economy might go into recession in the next few months.

The decline in exports to the US. About 25% of Canadian GDP is exported to the US, so you'd expect that a 1% decline in US aggregate demand would reduce the demand for Canadian output by about one-quarter of a percentage point. Clearly, this story is not enough, since it doesn't generate the sort of reduction consistent with what we'd call a recession. Moreover, exports to the US actually increased during the 1982 and 1991 recessions, and have been increasing during 2008.

Financial contagion. One way that the US financial markets could affect the Canadian real economy is financial contagion: falling prices for US assets held by Canadian banks would reduce their value and lead to tightening credit conditions. But again, this doesn't seem to be happening: the Asset-Backed Corporate Paper agreement has more or less dealt with the subprime toxic waste, and if there were anything else that would be hitting Canadian banks' balance sheets, we should have seen it by now.

Housing markets. There are two things to think about here. The first is the wealth effect of falling housing prices. For a variety of reasons (enumerated by Nick Rowe in the comments over here) we're not going to see the wave of foreclosures the US is going through. But to the extent that people are basing their spending decisions on the assumption that house prices will increase, then we can expect a slowdown in consumption expenditures. The other is the effect on employment in the construction sector: a reduction in the demand for housing will hit a sector that has been an important source of employment growth.

Consumer confidence. After several weeks of being bombarded with Scary Headlines Announcing Impending Doom, households may decide to cut back on spending, even if there is no objective reason to do so. For example, this is by no means good news.

I'm pretty sure that this list is not exhaustive, but I'm going to stop here anyway. I'll be pleased to add suggestions made in the comments.

Comments

[MattYoung]

Canada, having some better management, has the luxury of planning for their recession, while we fools in the USA just await the next random shock to initiate the recession.

[marmico]

Are we already not in a per capita GDP recession? Final domestic demand is still holding up, though.

It appears that residential investment peaked at almost 7%* of GDP (and is 6.7% as of Q2.08) and has been declining for three or four quarters. I would echo Nick's comment, look out below and expect it to return to, if not overshoot, it's long run trend line. Does anyone know what the trend line is?

Personal expenditure on consumer goods and services is about 55% of GDP so we should expect to see some decline there as well due to housing and stock market negative wealth effects. It will be interesting to note the resiliency of the Canadian consumer going forward. For instance, September auto sales were gangbusters.

Investment in non-residential construction and machinery and equipment is about 12% of GDP and we should also expect to see some decline as the consumer becomes more docile.

Government is 23% of GDP and we should expect that to be ramped up sharply. The deficits will roar back, but we are in good enough shape that sovereign credit will not be downgraded as in 1995.

The recent carnage in the $Can ought to impact the final component of GDP, by reducing imports and increasing exports, after the one-off effect of the Q3.08 rout in commodity prices.

My prognostication: A repeat of the 1990-91 recession, with a lower peak unemployment rate as government is in a superior position to mitigate the recession.

*GDP component estimates from the Canadian Economics Account Quarterly Review

[westslope]

May I toss my caribou shoulder blades into the sand?

Apparently, the stylized facts of housing/financial sector-lead recessions point to longer, deeper recessions.

The financial contagion will not affect just the Canadian financial sector but investment throughout the Canadian economy. There is no new investment money for new projects outside of internally generated cash flow. Regions of Canada were booming on new projects just not so long ago.

One needs to look bottom up starting at the levels of sub-sectors and sectors to get a full handle on how this recession will develop.

- Most junior resource explorers and developers will have run out of cash by late 2008, early 2009, even if they possess "world class", enormously rich deposits. Meagre new financing will likely target keeping the front office open.
- commodity prices have corrected and appear likely to continue to further soften to that threshold where many in-development projects are suspended even if sufficient internally-generated cash is available.
- expect machinery and equipment (M&E) sales to resource companies to plummet
- recovery in the softwood lumber and pulp & paper sectors looks to be farther down the road than ever before.
- auto exports are likely to continue to shrink.
- overseas shipping of grains and forest products that relied on short-term credit market financing is faltering and causing potentially expensive inventory problems.

The weaker Canadian dollar will help offset some of these negative effects but the time lag would be substantial.

[Stephen Gordon]

That's a good point. I meant to mention that the effects of lower oil and commodity prices mixed with the financial crisis would slow down investment spending.

I wonder how much inertia there is in those projects: many are already underway, and it's unlikely that they'll be canceled outright. But it's likely that we'll see fewer new projects.

[Brendon]

From what i've read and heard - many new oil sands projects require oil to be around $75-80 due to increased labour and materials costs. That level has already been breached and so capex could slow dramatically (perhaps a bad time for Alberta to implement a new royalty regime?)

There was an excellent IMF paper regarding the impact of shocks transmitted via financial channels from the US to Canada. I believe a structural VAR showed a 1% US GDP shock translated to 0.4-0.6% in Canada.

[westslope]

SG: I've been reading a steady stream of headlines just like this one below for quite some time now. It is hard to imagine how a company like First Nickel would have risk-managed for an event like this. Earlier in the cycle senior companies such as Teck were stopping large development projects because of escalating capital and labour costs.

Headline: First Nickel shares fall 36 per cent after company suspends operation of Lockerby mine

21 October 2008

By The Canadian Press

TORONTO - First Nickel Inc. (TSX:FNI) shares fell more than a third Monday after the company suspended production and initiating a care and maintenance program at its wholly owned Lockerby mine near Sudbury due to low metal prices and the "challenging financial environment."

Full CP article

edited to make it possible to click through to the link

[Stephen Gordon]

Yikes. That's not good.

Curiously enough, I was just looking at the Bank of Canada's commodity price indices. I was thinking that they're pretty much where they were a year ago (and prices weren't low then), so maybe all that had happened was that the craziness in commodity prices over the the first part of 2008 was over and things may not be so bad after all.

But then again, maybe they will.

ETA: I just found a source for nickel prices. In the last three years, prices had increased by a factor of 5 and then came back down to where they were.