UPDATE 1-Bank of Canada should raise rates in late 2013-IMF

Wed Dec 19, 2012 2:40pm EST

* IMF says BoC should resume modest tightening in late 2013

* Projects growth of 1.8 pct in 2013, 2.25 pct in 2014

* Says U.S. fiscal cliff, European crisis biggest threats

* Warns on household debt, says tighter policies may be needed

* Says Canadian dollar overvalued

By Claire Sibonney

TORONTO, Dec 19 (Reuters) - Canada's economy should start ramping up in the second half of next year following a couple years of sluggish growth, allowing the Bank of Canada to resume raising interest rates by the end of 2013, the International Monetary Fund said on Wednesday.

In a report that warned about the threat to the Canadian economy from the U.S. "fiscal cliff," a worsening euro zone debt crisis, and high levels of household debt, the multinational agency said real economic growth likely slowed to 2 percent this year. It expects growth of just 1.8 percent in 2013.

But it said the economy will start accelerating part way through next year, paving the way for growth of 2.25 percent in 2014. The IMF's World Economic Outlook in October had forecast Canadian real GDP growth of 1.9 percent in 2012 and 2 percent in 2013.

"(If) a shock hits the economy, (households) already have a lot of debt and cannot smooth consumption by borrowing, cannot really borrow their way out of the crisis, and this is where Canada is right now," Roberto Cardarelli, the IMF's mission chief to Canada, said in a briefing to reporters.

"The challenge for policy in this context is to support growth, to make sure that the support to growth is not going to disappear over the next few quarters and to make sure that this gradual unwinding of excesses in the housing sector is ... gradual."

SEES C$ AS OVERVALUED

The IMF expects stronger exports and business investment to contribute to the pickup in growth in the second half of 2013, helped by more certainty in the United States, Canada's largest trading partner.

Exports have struggled because of the relatively strong Canadian dollar, which the IMF saw as 5 to 15 percent overvalued given the country's wide current account deficit.

The currency has been supported by heavy flows of foreign investment, attracted partly by the Canada's comparatively strong economic fundamentals. Canada's safe-haven appeal has been further boosted by an IMF plan to have big players such as central banks detail their holdings of Canadian dollars.

The multinational agency approved of the Bank of Canada's current accommodative stance - its key interest rate sits at a below-inflation 1 percent - and said the next gradual monetary tightening should start in late 2013.

The IMF's recommendation is similar to the median view of forecasters in a recent Reuters poll, which was that the Bank of Canada - still the most hawkish Group of Seven central bank - will resume raising interest rates in the fourth quarter of 2013.

Cardarelli said he expected Canada's output gap - excess slack in the economy - to be absorbed by the end of 2015.

The IMF cautioned, however, on Canada's high level of household debt. "If household imbalances continue to build up in the context of modest growth, further macro-prudential measures should be taken into account before considering an earlier start of monetary tightening," the report said.

HOUSE PRICES RICH, NO CRASH SEEN

The agency welcomed tighter government mortgage rules introduced this year and said that if the economy were to weaken significantly, there was still room for further monetary easing.

If the U.S. "fiscal cliff" remains unresolved - which many economists say could push the United States back into recession - the IMF estimates that the impact on Canada would be around 75 percent of the effect on the U.S. economy.

On the domestic front, the IMF noted a cooling housing sector and cautioned that economic headwinds would be exacerbated by the high levels of household debt, which could force households to spend less and save more.

It said, however, Canada should be able to avoid a housing crash like the one experienced by the United States. It said the housing market is currently about 10 percent overvalued in real terms overall, and that prices should flatten out over the next five years, taking inflation into account.

While praising a sound banking system that helped Canada weather the global recession better than many of its peers, the IMF noted that Canadian banks are not immune to troubles abroad.

It said that the low interest rate environment would make profit growth challenging, prompting banks to rely more on volatile capital markets and expand abroad.

The IMF called for further steps to strengthen the financial system, and supported efforts to establish a single securities regulator.

The agency also warned that the low interest rate environment would weigh on non-bank sectors such as pension funds, which may require higher contributions.

The report said the government should continue to address long-term spending pressures.

While Ottawa's plans to balance the budget by 2015 are "well within reach," it said deficit-cutting may prove more difficult for some of Canada's largest provinces. In the event of big negative shocks from abroad, the IMF recommended that the federal government consider more fiscal stimulus.

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