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clément gignac

Over the past decade, Canadian economic prosperity has been anchored upon two factors: elevated commodity prices and a housing boom. It can easily be argued that these two factors are connected and have contributed to attracting qualified labour from around the world to Western Canada, pushing housing prices to ever new highs.

Interestingly enough, the IMF highlighted back in 2011 a significant relationship between commodity prices and housing, with an estimate that a 1-per-cent variation in the price of commodities results, on average, in a 0.3-per-cent shift in housing prices in the same direction.

We have made the case in a previous column that demographic flows (along with our well-capitalized financial institutions) are most likely one of the main reasons why our country came out of the Great Recession in such great shape. The shining employment prospects of Alberta were a major element of this attractiveness and, with crumbling commodity prices, it is now vital to ask ourselves: Where do we go from here?

A real-world stress test

The Canadian economy is clearly entering a period of stress. Commodity prices are falling all around, led of course by the price of oil, which is down by more than 55 per cent since last June. In fact, the Bank of Canada's aggregate commodity price index shows that price levels are now back to the 2008-09 lows and, this time, nothing suggests that the fall is about to end.

The words "stress testing" are commonly used in economic analysis when we run a theoretical shock through an economic model in order to evaluate the potential impacts on the economy. In 2015, this shock will not be theoretical, but very real.

The Canadian economy is more dependent than ever on its energy exports. In the past 10 years, the share of oil in total nominal exports went to 18 per cent from 6 per cent. In fact, the latest data regarding Canada's trade balance, showing a $600-million deficit last November, are hiding a $6.9-billion deficit in the trade of non-energy goods. Falling energy prices mean a significant deterioration in Canada's terms of trade (the ratio of the average price of our exports to the average price of our imports), which in turn results in a worsening of the country's standard of living.

Alberta, in particular, will clearly suffer, and the Conference Board of Canada is now forecasting a full-fledged recession in the province. Businesses are already changing their plans, with news of job cuts (Suncor), capital expenditure plans being revised lower (Suncor, Canadian Natural Resources), and this is only the beginning. Premier Jim Prentice clearly articulated that his government will have to react, as the province may reach a deficit of $7-billion to $10-billion in 2015, which is not trivial for a $40-billion budget. The implementation of a new sales tax has also not been turned down, so we are looking at a profound shock to Canada's richest province.

For those keeping score, Canadian housing data are also hiding a significant fact: Home prices are only really booming westward of Toronto. What could happen if employment opportunities begin to fade in the west? The latest figures from the Calgary housing market already show a fall of 7.5 per cent in home sales on an annual basis in December, as well as a whopping 42-per-cent surge in new listings from a year earlier, signs that many homeowners are not feeling as confident about the value of their homes going forward.

Housing prices are still growing at a strong pace, but cracks seem to be appearing. The same phenomenon can be seen in commercial real estate, with vacancy rates going up in the past few quarters. Since Canadian mortgages are in large part backed by the Canada Mortgage and Housing Corp., any transmission of the shock to the inflated housing market could quickly create a domino effect and become a burden to taxpayers.

Of course, there are some caveats to this scenario. The fall of the loonie will cushion some of the effects and Eastern Canada will most likely be more competitive on the export market. Still, with Ontario and Quebec on the receiving end of transfer payments, we could expect the burden to end up being spread across the country as, in a few years, lower revenue from royalties will mean less equalization money to be shared among the "poorer" provinces.

A necessary shift of the Canadian model?

Commodities and, specifically, oil, have for over a decade been at the core of Canadian economic growth. If the world is heading for a few years of depressed prices, with the Organization of Petroleum Exporting Countries fighting to protect its market share and China engineering a financial slowdown, then we must act to diversify our country's sources of growth through innovation and limit the propagation of an inherent housing shock coming from the west.

As we have highlighted in past columns, Canada's competitiveness as measured by the World Economic Forum slipped to the 15th spot from the 10th between 2008 and 2014 and the falling loonie gives us a golden opportunity to capitalize and reverse the trend.

The good news is that, historically, our currency trades sustainably below its intrinsic value (what we economists call purchase power parity, or PPP). Canada should be looking to quickly rebuild lost capacity in its manufacturing provinces as, using history as a guide, the loonie should trade for some time below its PPP value, which is currently estimated at about 81 to 84 cents (U.S.).

Clément Gignac is senior vice-president and chief economist at Industrial Alliance Insurance and Financial Services Inc., vice-chairman of the World Economic Forum Council on Competitiveness and a former cabinet minister in the Quebec government. This article was written in collaboration with Sébastien McMahon, economist, Industrial Alliance.