What happened to Canada’s economic miracle?

Stalled growth, rising debt — Canada’s stuck

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Our latest cover story is actually two stories, comparing the state of the Canadian and American economies. View the companion piece to this story, here.

To outsiders looking in, Canada must seem like a potent place. In the midst of a global recession, our banks were profitable, home prices soared and lost jobs were quickly replaced—all feats Ottawa was fond of boasting about. “We have the soundest financial system in the world and that’s a strong point that we can share with others,” Finance Minister Jim Flaherty told reporters in 2008. A few years later, at the World Economic Forum in Davos, Prime Minister Stephen Harper promised to set the stage for a generation of economic growth with changes to immigration and a focus on selling oil and gas to Asia—part of a grand vision to make Canada an “emerging energy superpower.” The country’s new-found reputation for punching above its weight may have also played a role in the U.K.’s decision to hire Bank of Canada governor Mark Carney to run the Bank of England, the first time a foreigner has been sought for the job.

Carney doesn’t start his new gig until July 1. But already the holes in Canada’s narrative of economic exceptionalism are big enough to drive an oil sands dump truck through. Our banks, though still sound, have been downgraded by rating agencies because of their exposure to a potential Canadian housing bubble and high levels of consumer debt. Economists are worried that a pullback in government spending won’t be offset quickly enough by a ramp up in exports. And Alberta’s vaunted oil and gas sector is suddenly in trouble as a glut of new U.S. crude threatens prices and future investment. The stiff headwinds are reflected in GDP forecasts now expected to come in well under the previously anticipated (and already dismal) two per cent growth for 2013.

Canadians previously took pride in the fact that our small, resource-based economy was doing far better than that of our bigger neighbours to the south—Harper reminded CNBC viewers as recently as 2011 that Canada was still “outperforming the average, or the pack, in the industrial world”—but in the space of just few months the tables have seemingly turned. What happened?

Ben Rabidoux, an analyst at M. Hanson Advisers, argues Canada’s economic miracle was more of a mirage all along. “While there’s an element of truth about our banks being more prudent and such, the reason we escaped the recession with very little collateral damage is because we had the capacity to reinvigorate consumer spending by ramping up credit growth,” he says, referring to Ottawa’s decision to buy $69 billion worth of mortgages, beginning in 2008, from banks so they would continue lending. That, in turn, juiced home sales and kept shopping malls buzzing. “We didn’t grow our way out of the recession organically. We just papered over some of the weaknesses in our economy.”

It also added some new risks: a real estate market that appears in danger of collapse and potentially crushing levels of household debt. Now that consumers are tapped out, the best-case scenario is for the global economy to pick up steam just as ours begins to sputter, allowing exporters to take over from home buyers as Canada’s growth engine. But it’s a tall order, given the debt problems in Europe and slowing growth in China, which has raised fears of a global commodities slump. Even the rebound under way in the all-important U.S. economy could be a double-edged sword for Canada. “If interest rates rise because of a U.S. recovery, exports will pick up, but so will [the cost of carrying] consumer debt,” says Rabidoux. “The economy is just not as strong as people think it is.”

A recent report by the Royal Bank of Canada argued that Canada’s economy “cracked” in the second half of 2012. After boasting the strongest performance in the G-7 during the post-recession period, RBC blamed the abysmal 0.6 per cent growth in fourth-quarter GDP on slumping mining, oil and gas production, as well as a slowdown in construction and manufacturing. RBC has since trimmed its GDP growth outlook for 2013 by nearly half a percentage point to 1.8 per cent. Others have gone as low as 1.5 per cent. That’s about half the rate the U.S. economy is expected to grow this year. Moreover, Canada is expected to lag behind the U.S. for the foreseeable future, according to a recent forecast from the Organisation for Economic Co-operation and Development.

The stock market, a leading indicator, continues to lag those of other countries. In fact, the S&P/TSX was one of the worst-performing major indices in the world last year. Investors, the old adage goes, hate uncertainty. And Canada seems to offer nothing but.

For the 70 per cent of Canadians who are homeowners, the biggest worry so far has been the dramatic cooling of the housing market. In Vancouver, home sales were down nearly 30 per cent in February compared to the same month a year earlier, while prices have dropped 5.6 per cent since their peak, according to the local real estate board. In Toronto, where concerns are mounting about 144-odd condo towers still under construction, sales were down nearly 15 per cent in February and 12 per cent during the first two weeks of March. Montreal, too, saw a steep decline in housing activity in February, with overall sales down nearly one-third.

Some have warned about the possibility of an economy-killing housing crash, with prices dropping as much as 25 per cent. But most economists have settled on a marginally more palatable outcome: an extended period of little or no growth. A recent report by the Toronto-Dominion Bank forecast a brief correction, followed by a rebound and then price gains of just two per cent per year until 2023—a flat performance once inflation is factored into the equation. But that would still act as a drag on the Canadian economy considering that housing and related industries account for as much as 27 per cent of Canada’s GDP, which is more than the U.S. before the crash. An equally big concern is Canada’s household debt-to-income ratio, which now stands at a record 165 per cent—again, higher than in pre-crash America. Ottawa’s recent budget calls “exposure of Canadian households to elevated levels of debt” the “main risk” to its domestic forecast.

So where will future growth come from? “The baton was always thought to be handed off to exports and investment,” says Craig Wright, RBC’s chief economist. “But in the second half of last year the baton—I won’t say it was dropped—was fumbled so that exchange just hasn’t happened yet.”

A recovering U.S. economy promises to provide a lift for manufacturers and exporters, which could help offset rising interest rates by adding jobs. But risks remain. Canada’s huge resource sector, which accounts for nearly one-fifth of GDP, is increasingly vulnerable to events on the other side of the world. The Harper government’s first budget in 2006 touted higher commodity prices, driven by emerging economies, as a major factor in “robust corporate profit growth.” But now such bullish views are being called into question as China’s GDP growth slows from around 10 per cent annually to 7.5 per cent. In his annual newsletter to investors, Prem Watsa, the CEO of Fairfax Financial and Canada’s answer to Warren Buffett, suggested the top of the commodity cycle may have been reached when miner Rio Tinto bought Montreal-based aluminum giant Alcan for $38 billion back in 2007. Six years later, the company has written off nearly $20 billion amid cost increases and investor uncertainty. “If commodity prices come down after their parabolic increase, Canada will not be spared,” Watsa warned. Similarly, François Dupuis, the chief economist at Desjardins, wrote in a recent report that “the loonie’s drop to US$0.97 and a stock market that is underperforming the U.S. markets are both reminders that the rush for our commodities has waned.”

One only needs to look to Alberta to see what a more serious commodity slump might look like. Though global oil prices remain high, at around $108 a barrel, the province’s oil producers are currently receiving far less because a lack of pipeline capacity and a glut of U.S. oil from sources like the Bakken shale deposit have driven down local prices. Oil-rich Alberta now faces an estimated $6-billion shortfall in oil revenues this year.

More worrying, says RBC’s Wright, is rapidly deteriorating sentiment among Canadian businesses. A recent Statistics Canada survey revealed the slowest non-recession pace of growth in private and public sector investment intentions since 1995. “In an environment where corporate balance sheets are in pretty good shape, you would likely expect a bit more investment,” Wright says.

Yet even if the all-stars line up for Canada—the global economy roars back to life just as ours stumbles—don’t expect to hear more stories about our impressive performance. Unlike the U.S., Canada’s economy has very little room to grow due to our small, aging population and less dynamic workforce. Already the Conference Board of Canada and several economists have identified a looming skills shortage as a major threat to the country’s long-term outlook. Meanwhile, Canada continues to lag behind the U.S. and others when it comes to innovation and productivity, which are key to boosting competitiveness and raising per capita incomes. “Our speed limit is going to be constrained,” says Wright. “I think that’s why policy-makers, having dealt with the financial crisis, are back focused on competitiveness and prosperity.”

Canada did admirably while the rest of the world struggled back in 2009. But four years later the best it can hope for is a merely mediocre performance, even as the good times return elsewhere. And the spectre of another recession still haunts us. None of which is anything to brag about.