There’s a nagging, uneasy undercurrent running through the Bank of Canada’s retreat from rate hikes and its downgraded economic outlook. Canada has a business-investment problem. And it’s not just weighing on near-term growth prospects; it threatens the economy’s long-term capacity to grow.
Indeed, business investment is taking shape as the biggest challenge for government policy if the country is to avert a deeper and longer-lasting growth stagnation.
In the central bank’s decision Wednesday to maintain its key rate at 1.75 per cent, the bank highlighted that global trade uncertainties are hurting exports and “undermining” business confidence – translating into a slowdown in investment. That investment slowdown is the biggest factor in the bank’s downgrade of its GDP growth call for this year, to 1.2 per cent from 1.7 per cent.
Bank of Canada Governor Stephen Poloz argued the slowdown is a “detour,” saying the economy may already be bouncing back and better growth can certainly be expected in the second half of the year. But another important estimate released by the central bank Wednesday suggested the effects of sluggish business investment could linger much longer than that: its annual revision to its estimate for potential output growth.
"Potential output” refers to what the economy is capable of producing – all its goods and services – if all its capital and labour were being fully used. The growth of potential output from year to year speaks to how much capacity an economy has to grow.
The new potential output growth estimate shows the Bank of Canada has become less optimistic about the pace at which the Canadian economy will add new capacity to produce goods and services in the future. The forecast hasn’t declined by much – no change at all for this year, and one-tenth of a percentage point annually in 2020 and 2021. But it’s the composition of the growth that points a worrisome finger at business investment as a sputtering growth engine.
Potential output of an economy can grow in two ways: You can increase the amount of labour available (more workers, and/or more hours per worker), or you can increase labour productivity (the amount each worker is capable of producing). The biggest source of productivity growth is through investment by businesses in more/newer/better/more efficient facilities, machinery and equipment.
The Bank of Canada’s new estimates indicate that while future growth in labour will be hampered by the country’s aging demographics and the retirement of more of the huge baby boomer generation, the outlook over the next few years has actually improved thanks to the federal government’s substantial increase to Canada’s immigration intake.
But the gains on the labour side are being outweighed by deepening declines in business investment, which prompted the bank to slash its labour-productivity growth forecasts. And although the bank believes business investment will increase its growth beyond 2020, the forecast contribution pales in comparison to what businesses were contributing in the first decade of this century – or even in the years after the Great Recession.
Put simply, capital investment by businesses isn’t expected to deliver anywhere near as much to Canada’s economic growth potential as it used to. It’s a big reason why a slow-growth economy looms in the country’s future – and one that hasn’t gotten nearly as much attention as the looming demographic crunch.
The big reason is the downturn in the oil sector. Earlier in the decade, it was a massive contributor to the country’s business investment. But since the 2014-15 oil slump, investment in the sector has never recovered. Indeed, in its latest potential output estimates, the Bank of Canada acknowledges that the impact has been “more pronounced and persistent” than it previously believed.
Much of this slowdown in oil and gas investment may be more or less permanent, even once the more recent oil slowdown of late 2018 dissipates. Meanwhile, expansion of global trade no longer looks like the reliable driver of Canadian economic growth that it once was.
There are other ways to increase productivity besides business investment. You can improve training and skills development to produce a more efficient and productive labour force. You can improve infrastructure to enhance efficiency in delivering goods and services. You can increase trade liberalization to expand markets. You can grow labour supply.
The federal government has already made strides in all these areas – in immigration, in trade deals, in infrastructure investment and most recently in a skills-heavy focus to last month’s budget. What it hasn’t done yet is present any coherent strategy for stimulating business investment over the long term. While its plan for accelerated expensing of capital investments, introduced late last year, is a move in that direction, it’s just one small step in addressing a much deeper problem.
The solution may lie in a long-overdue overhaul of Canada’s tax code, built a half-century ago and no longer well designed for the fast-evolving 21st-century economy. So far, the Trudeau government has resisted such calls. But as business investment looms larger as the weak link in Canada’s economic growth potential, this is something Ottawa can no longer afford to sweep under the rug.