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The Effect of European Debt Crisis on Canadian Business

We live in an interconnected world where a financial crisis spreads like wild fire and markets in different continents move up and down in tandem. So it is no surprise that the European debt crisis is causing anxiety thousands of kilometres away from its source on this side of the ocean in North America.

In January 2012, the Bank of Canada for the first time attempted to put a hard number to the effect of the European debt crisis on Canada. According to the bank’s estimates, the loss to economic output this year could amount to 0.6 per cent, or about $10 billion.

The Bank estimates that the costs to the global and American economies are even greater, at more than one per cent of gross domestic product and 0.8 percent respectively.

In its winter quarterly outlook, the Bank of Canada policy council, headed by Governor Mark Carney, stated that “Thus far, the impact on global financial conditions from the strains in Europe has consisted mostly of a general retrenchment from risk taking… Over the projection period, the impact is expected to become more widespread, however, and to take the form of increased funding pressures, adverse confidence effects and reduced availability of credit. In particular, deteriorating funding conditions are projected to push banks to restrict access to credit for households and businesses in Europe and the United States, adding to the drag on economic growth.”

On the positive side, because Canadian banks have had much less exposure to European banks and sovereign debt and are financially sound and have healthy lending practices, Canada has been affected less by the European debt crisis than the U.S. and the rest of the world in general.

However, Canada can still be affected through lower consumer and business confidence and lower commodity prices.  Given the fact that commodities are one of the main sources of export for Canada and a major component of the Canadian market, lower commodity prices can have a ripple effect on many parts of the Canadian economy.

Bank of Canada has predicted that the economic impact of the European debt crisis will limit economic growth in Canada in 2012 to a modest pace and the economy is unlikely to return to full capacity until the third quarter of 2013.

Interest rates have stayed low in Canada mainly due to worries about the negative impact that the European debt crisis could have on the Canadian economy. This low interest rate policy is encouraging more Canadians to take on greater debt, particularly to purchase homes and this has been a cause of worry for the governor of Bank of Canada as well as the Minister of Finance.

However, there is an upside to the sky-high household debt levels feared by the central bankers. It is largely due to the strong demand from consumers continuing to purchase everything from clothes to cars and homes that the economy is not doing worse than it is now. Housing and consumption account for 70 per cent of this year’s growth. The low mortgage interest rates and favourable mortgage financing conditions bode well for the housing market and it is likely that the momentum will continue in terms of investment in residential properties. Given the fact that the housing market supports so many industries, a strong housing market bodes well for the economy as a whole.

With double dip recession in Europe and deceleration of growth in China and the dampening effects of the European debt crisis on world economic growth, the demand for commodities has decreased and the prices of most commodities have suffered declines in the past few months. This has also caused the Canadian dollar to weaken (even though it is still relatively strong) as its fortunes are closely correlated to the price of energy in particular. A weak Canadian dollar can be a boon for Canadian exports and can partially offset the effect of the decline in the price of commodities. Also, lower energy prices will cause transportation costs to drop and profitability of companies to improve and can help stimulate the U.S. economy.  This in turn will help boost the Canadian economy and help offset some of the lost profits in the energy sector in Canada.

Despite the debt worries in Europe, recent economic numbers out of the US have been encouraging. According to the Globe and Mail (Friday May 11, 2012, pageB5), “real or after-inflation imports surged nearly 6 percent in the United States in March. And imports of consumer goods were even better – up 8 percent. US consumers who make up 70 percent of the economy, are clearly feeling more confident.”  Also, according to the latest economic forecast released by the Federal Reserve Board in the U.S. in April, GDP growth rate expectations have been increased to 2.4 per cent to 2.9 per cent range, which paints a rosier picture compared to the figures released in January 2012.

This is good news for Canada as 70 per cent of our exports are to the United States. The fact that the world’s largest economy is healthy bodes well for the global economy as a whole.

Another encouraging sign in Canada is that over the first three months of 2012, imports of machinery and equipment increased at an annual rate of 3.4 per cent, suggesting businesses are taking advantage of the high dollar to retool their plants and invest in technology.

Another testament to the strength of the Canadian economy is the fact that over 58,000 jobs were created in April, far exceeding the forecast of 10,000 jobs and following the stunning 82,000 jobs that were created in March. With most of these jobs being full time jobs, this represented the best two month gain in job numbers in three decades.  The jobs created were mostly in the construction, manufacturing, natural resources and agriculture industries.  A surge in activity in the mining and energy sectors has caused a boost in the recruitment efforts of many companies in Western Canada. In addition, some factories in Central Canada are ramping up production as demand increases in the U.S.

Therefore, while worry about European debt woes will rule the markets in 2012, and recession in Europe can have a dampening effect on world economic growth, the current strengthening trend in the U.S. economy bodes well for Canada as the bulk of our exports are to the U.S.

The strong housing market in Canada and healthy levels of consumer spending are keeping the Canadian economy buoyant for the time being.

What may be more worrisome than the European debt crisis is the “fiscal cliff” in the U.S. This refers to the fact that an estimated half a trillion dollars worth of stimulus to the U.S. economy in the form of tax cuts and government spending is scheduled to disappear at the end of 2012.

While this may seem like a U.S. problem, the fact of the matter is that the Canadian and U.S. economies are so intertwined that this will inevitably have an impact on Canada.

Some of the programs set to expire towards the end of this year include: The Bush-era tax cuts; the 2 percent payroll tax holiday; extended unemployment compensation; and the end of temporary spending and tax cuts agreed to last year as part of the deal to raise the U.S. debt ceiling.

It is estimated that the withdrawal of all these stimulative measures can drain $500 billion or 3.5% of gross domestic product (GDP) out of the U.S. economy, causing growth to come to a standstill and possibly push the U.S. into recession.

The International Monetary Fund (IMF) has compared the threat posed by the fiscal cliff to the European debt crisis and even the Bank of Canada has factored it into its projections. A slowdown in the economy of our major trading partner can cause the volume of our exports to shrink.

With the help of politicians in Washington, crisis can be averted by deferring at least some of the cuts. However, it is an election year in the U.S. and congress can easily get log jammed with Democrats insisting on raising taxes on the rich and the Republicans intent on cutting social programs.

The fate of the European Union and resolution of the European debt crisis also lies in the hands of the politicians. As with most political solutions, patience is key as things take much longer to come to fruition in the political arena than they do in the business arena. With new leaders at the helm in France and Greece, there is even more uncertainty about the future in Europe.

For the time being, despite the worrisome situation in Europe, the economic recovery in the U.S. and Canada seems to be intact and even though it is not robust it is on track. 

Tina Tehranchian, MA, CFP, CLU, CHFC, is a senior financial planner and branch manager at Assante Capital Management Ltd. (member of the Canadian Investor Protection Fund and IIROC).In Richmond Hill Ontario and can be reached at (905) 707-5220 or through her web site at www.tinatehranchian.com.

Please contact a professional advisor to discuss your particular circumstances prior to acting on the information above. 

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