Cablegate: Psychology, Reality and Integration: Canada's

DE RUEHOT #1372/01 3021415
R 281415Z OCT 08




E.O. 12958: N/A

C. OTTAWA 1362


1. (SBU) Summary: How Canada fares in the global economic
crisis will be measured as much by its integration with the
U.S. economy as by Canada's own domestic economic policies.
The bottom line is: Canada's solid economic policy
management will only serve to mitigate the impact of the
global financial crisis and the United States, economic
difficulties. Canada,s deep economic integration with the
United States will cause Canada to suffer as much or
potentially more than many of our other large trading
partners, if the U.S. economy enters a prolonged recession.
Of course it could conceivably be hurt less if the United
States in turn suffers less economic hardship than other
countries or pulls out of its economic downturn. End summary.

2. (SBU) Canada's macroeconomic indicators are largely
healthy (the global financial crisis aside) and this
country's history of cautious, highly-regulated financial
operations, now looks "prescient" rather than "outmoded."
Canada,s October year-on-year inflation rate is 2.2 percent;
its 6.1 percent unemployment rate is at historically low
levels (with every province suffering from skilled labor
shortages); and the federal government has enjoyed a budget
surplus each year since 1998. The relative drop in the
Canadian dollar (down 25 percent against the USD since the
beginning of the year) should boost Canada's manufactured
exports, though revenues from priced-in-USD energy have
dropped significantly and Canada,s balanced budget also
provides a macroeconomic cushion. Nevertheless, Canada's
deep integration with the United States leaves Canada
vulnerable to our economic and financial downturn. These
facts are not the only negatives spilling across this long
border; the drop in confidence among Americans is leading a
gloomy cold front that is seriously dampening consumer
confidence and thus markets in Canada. One example: the
drop in the Toronto Stock Exchange aggregate since January 2
and again since September 15, which parallels the fall in the
Dow Jones over the same period. The bottom line is: Canada's
solid economic policy management will at best only serve to
mitigate the impact of the financial crisis, and its
proximity to and interrelationships with the U.S. will cause
it to suffer as much or potentially more than many of our
large trading partners.

3. (SBU) In recent days, we have been talking with a number
of well-placed economic actors ranging from the Deputy
Minster of Finance to Canada's G-8 sous-sherpa to the chief
economist of the Royal Bank of Canada (RBC), and their
staffs, for a picture of what the Canadian economy is facing.
We've been helped by excellent formal and informal reporting
from our Consulates. What follows is a summary of the
consolidated picture of the Canadian macroeconomic situation
and its vulnerabilities.

Canadian banking system healthy but still worried -- housing
market cooling
============================================= ===============

4. (SBU) Canada's banks and investment brokerages have been
Q4. (SBU) Canada's banks and investment brokerages have been
operating for years in a much more conservative regulatory
environment than their U.S. counterparts. Among a host of
different reserve and capital base requirements, Canada never
separated investment banks from retail banking operations in
Canada and thus all brokerages are part of the financial
empires controlled by Canada's five major retail banks. This
means that even investment/brokerage operations must meet the
regulatory requirements pertaining to retail banking
operations. The aggregate leverage of Canadian banks is
markedly smaller than the levels now extant in the United
States and there is only a small sub-prime mortgage
component. Additionally, the collapse of the asset-backed
commercial paper market last year forced Canadian banks to
recognize and deal with certain problematic asset categories.

OTTAWA 00001372 002 OF 004

The World Economic Forum recently ranked Canada's banking
sector as the world's healthiest. Yet this will only
insulate Canada up to a point. Given the interrelationship
of financial markets across the border, the tightness of
credit flows in the United States is having a measurable
impact on Canadian lending, especially within the tighter
capital adequacy ratio requirements that Canadian
institutions must meet. In terms of housing market lending,
Canada is not facing a homegrown mortgage crisis -- the
consumer housing market remains relatively strong compared to
the United States, but consumer confidence is causing a dip
in purchases and housing starts. There are local housing
bubbles (in Vancouver, parts of Ottawa, and Montreal), but
very little of this effect is related to sub-prime mortgages,
rather to rapidly escalating property values. In addition,
the mortgages at risk are a very small percentage of the
loans held by the big five national banks. As the RBC chief
economist noted, "we are facing a cooling rather than a
collapse of our housing sector."

Canadians will maintain their balanced-budget religion; see
their credit actions as "maintaining a level playing field"
============================================= ===============

5. (SBU) It has been a shibboleth of Canadian pol-econ policy
since the mid-1990s (when Canadian Federal deficits
ballooned) that Canada must maintain balanced Federal
budgets. This is a political red-line that will only be
crossed in extremis, and no one here thinks that type of
crisis is near. In Keynesian terms, this limits the ability
of Ottawa to prime the pump during economic downturns. Some
economists have explained to us, however, that they have
enough positive headroom within their budget and off-budget
accounts to try and jumpstart and/or mitigate any approaching
downturn in the economy by increasing spending without
actually going into deficit. At the same time, the Federal
and some Provincial governments are taking measures to ease
the credit crunch here. Finance Minister Flaherty announced
on October 23 a range of actions, including purchases of up
to C$25 billion of insured mortgages and expanding insurance
coverage by the Canadian Lenders Assurance Facility. In
addition, the British Columbia provincial government on
October 24 outlined a 10-point program of tax cuts, budget
cuts and capital outlays to help insulate the province, and
the BC Premier is recalling the provincial Parliament to vote
on this legislation. In Ontario, Canada,s manufacturing
heartland and economic center of gravity, a province that has
been hit hard by the high Canadian dollar over the past year
and declining consumer demand in the U.S., the Premier
recently announced a deficit provincial budget (see ref B),
the first since 2005.

Volatility and regional differences in growth complicate
Federal economic and energy policy
============================================= ===============

6. (SBU) As a corporate chief economist told us this week,
"it is the volatility of both exchange rates and energy
prices that is killing us, not the actual levels of either."
Several of our contacts have opined that an exchange rate of
QSeveral of our contacts have opined that an exchange rate of
US 80-85 cents to C$ 1 is probably the long-term
purchasing-power parity level and the level that balances
Canada's export engine with its import needs. Yet the
movements from US 95 cents to US 80 cents to the C$ during
the last two months (and from US 1.10 a year ago) are making
decisions, predictions, and hedging very difficult. The rise
of the US$ is also introducing a sardonic factor -- a senior
bank economist told EMIN that "you guys have the best of both
worlds; you can tank the world economy and then increase your
currency's strength as it serves as a store of value when
problems become global."

7. (SBU) Another area of uncertainty for policymakers is the
large differences in economic performance across the
provinces. Many of the western provinces (BC, Alberta and
Saskatchewan) with a largely resource extraction economic
base call themselves the "have" provinces with high
employment rates and healthy bottom lines, while Ontario,
Quebec and Atlantic Canada are suffering from the demise of

OTTAWA 00001372 003 OF 004

the manufacturing sector. In fact, the huge demand for labor
in the energy bubbles of Alberta and Saskatchewan have eased
unemployment in Canada,s eastern provinces.

8. (SBU) Canada faces a complicated nexus between exchange
rates, trade, and energy prices at the best of times. A
major contributor to the value of the Canadian dollar is the
price of oil, as Canada is a major oil exporter, supplying
the United States with 17 percent of our oil needs. In
particular, the capital and labor-intensive oil sands sector
in Alberta is watching oil prices and exchange rates closely;
there is a fair amount of disagreement here about the
"break-even level" below which continued extraction would be
unprofitable. Yet trade for Canada is a major national
engine of growth and the lower exchange rate will have a
positive effect (as long as domestic and U.S. demand keep up)
on manufacturers, who have taken a hammering over the last
five years due in part to the rising C$.

9. (SBU) We defer to CG Calgary, but pass on that the
emerging consensus position in Ottawa is that technology
developments and growing productivity levels are lowering the
oil market break-even point to somewhere in the US$ 50 per
barrel range. Yet while Ottawa policy makers may be talking
about the break-even point for oil sands production, that
figure is actually less relevant, since producers must only
cover their variable costs to make continued production
worthwhile. A number of factors suggest they will continue
to do so. The general slowdown in the U.S. and Canadian
economies may work to lower some costs, especially labor, and
the flip in exchange rates may support continued production
and export. In-country costs are in C$, while export
revenues are in US$, making it that much cheaper to meet
those costs. While Canada does import energy from the United
States, imports are much smaller than exports. On the whole,
Canada,s energy sector is probably benefiting from the
reversal of exchange rates.

10. (SBU) The situation with capital investment is different,
however. Imported material costs are higher in C$ terms, and
financing decisions may be different (balance sheet vs.
credit). Even though oil companies are normally very
conservative on price forecasts made in support of investment
decisions, we are seeing companies slow down major projects,
which also eases pressure on material and labor markets.

Consumer and corporate psychology a key factor
============================================= =

11. (SBU) One of the main factors that will determine how
Canada rides out the United States, perfect economic and
financial storm is psychological. The interrelationship
between our two real economies is so massive as to tie Canada
largely to developments in the United States no matter what
their policy choices; but industrial and consumer gloom could
lead to a self-fulfilling prophecy in both countries. There
has been over the last decade "less excess" in consumer
spending and indebtedness in Canada than in the United
States, and thus less vulnerability. But Canadians have long
experience with having the U.S. economic dog wagging their
Qexperience with having the U.S. economic dog wagging their
northern tail, and they are already slowing down their
purchasing and borrowing levels in a manner which will, like
a vicious circle, contribute to their own national slowdown.
Businesses will focus on cutting costs and jobs in
preparation for what they fear will be a deflationary spiral.
Credit is not as tight here as in the States, and the
housing markets are healthier, but the exposure of Canadian
citizens, firms, and banks to the U.S. markets writ large
(and not to mention to American media and to our overall
economic zeitgeist) will have a major impact both on reality
and in psychological terms.

12. (SBU) For those reasons, it is perhaps not a surprise
that the Canadian Government is very supportive of the
Administration's coordination over recent weeks with the G-7
and now with the G-20 on a global approach to the global
crisis. Senior Canadians are participating actively in these
discussions and have praised the speed and "multilateral
nature" of the USG response so far.

OTTAWA 00001372 004 OF 004

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