Exports, animal spirits and spaghetti sauce

With Mark Carney succumbing to the charms of UK Chancellor of the Exchequer George Osborne, Canada needed a new central bank governor. Rather than picking the heavily fancied Tiff Macklem, Carney’s senior deputy, the Bank turned to Export Development Canada’s president and chief executive Stephen Poloz. In one of his first interviews since taking on the job in early June, Poloz explains how exports will play an increasingly important role in the post-crisis Canadian economy, why this is an era of creative destruction and renaissance for the Canadian economy, the thinking behind his spaghetti sauce model and just why he is so confident that Keynes’ animal spirits will return. He spoke to EuroWeek’s Ralph Sinclair in early September.

  • By Dariush Hessami
  • 30 Sep 2013
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EUROWEEK: Governor, you’ve spoken about the normalisation of the Canadian economy after what has been described as “a good crisis”, for want of a better phrase. But rather than normalisation, given falling commodity prices, lower emerging market economic growth, domestic wage stagnation, higher mortgage rates and the high level of household debt, are there not major risks to the downside for Canada’s economy? 

Poloz: In the near term, perhaps, and indeed some of those things may be longer term. They’re parts of what I would say is a new normal that we’re converging towards. So when I talk about normalisation, I have in mind a fairly narrow economist’s view of a normal yield curve, inflation on target, a reasonable level of real interest rates, and then behind that consumers are in balance and firms are generating what I would call self-sustained momentum, or self-sustained growth, which really hasn’t started again yet. 

If we go back to pre-crisis when the economy was growing at, say, 2%-3% on trend, we had a population of companies that was growing at about the same rate. So although you have corporate, or company deaths every year, you have more births than deaths. The net growth in the population is small companies that are emerging and they’re the ones that create these big moves in productivity, big moves in employment, and that process is, we think, just getting restarted. It’s the same observation I would make actually for the US economy and there are symptoms similar in the UK.

So, for me, that is the self-sustaining process of Schumpeterian creative destruction. Whereas the net creation is the part that we’re watching to see happen and that takes time. So that’s what I mean by normal but behind that, the Canadian economy will look significantly different than it did pre-crisis and you’ve mentioned some of the things that will matter. There aren’t necessarily downside risks but there are things that we will adjust to.

In the near future, of course, we’re watching emerging markets. It’s an important export market segment for Canada. Companies have done a lot of work during this cycle to diversify out into emerging markets — we pick it up in surveys and we can see it in the numbers. It is still a small piece of our total trade, but a growing piece, and that’s something we wouldn’t want to see a major downside to. 

But behind it you have to be ready for the world to look different. We got used to China growing at, say, 8%-10% at least every year. A lot of that trend line was pumped up by the bubble period in the US and we know that wasn’t sustainable.

But the whole world wasn’t sustainable including China. Everything kind of gears back and for an exporter like Canada, 6%-8% growth in China today is worth a similar amount of new demand every day than it was five years ago when growth there was at 10%. It all works out to something we have to get used to, which is the numbers looking different. 

So I’m not particularly troubled, but in the near term you’re absolutely right. There are downside risks. We’ve got our eyes on those, and not least of which is trade that we’re expecting to be the catalyst to that self-sustaining momentum process that I talked about before — the US is the piece that’s been missing but it’s looking much more encouraging.

EUROWEEK: With rates at 1% and stuck there for the foreseeable future, do you feel that the Bank of Canada has enough wriggle room to adjust for any downturns greater than expected?

Poloz: Well, I think we do have room to manoeuvre. As you suggest, we would prefer not to need to use it given our starting point. 

The household sector is quite indebted and did all the heavy lifting during the weak global growth period and so we wouldn’t want to rely on that, but in fact the household sector seems to be stabilising as opposed to going into a retrenchment, and so it puts a base under things. 

I would guess that if one of those downside risks did materialise, then yes, Canada’s growth would ease back again, but we’d have a pretty good base underneath it. Certainly companies are in good shape, households are indebted and yet showing good promise. 

It’s always hard to put a pin on what is truly a sustainable level of debt for the household sector. It’s so complicated now. Just thinking of the demographics, we’ve got this post-war baby boom generation moving through the system and their parents are living longer than ever before and they’re very old! 

As a consumer what’s guiding you through all that? If you’re going to get money from parents someday, well, that’s OK, you don’t have to be retiring in perfection perhaps. There are a lot of complicating factors and I don’t pretend to understand them. Just now indebtedness is rolling over in the consumer sector and that’s what we like to see, or at least a stabilisation of that. 

EUROWEEK: So stabilisation rather than continued growth?

Poloz: That’s it.

EUROWEEK: But you do not seeing it going down at all?

Poloz: At the moment it’s rolled over. It does appear that income growth is sufficiently strong that it’s leading to a flattening, or a slight diminution, of our debt ratios and I think that’s a positive development. Provided that good context is maintained, then I don’t think we see anything major happening there, just a gradual healing process, or consolidation process. That’s good for everybody while maintaining that base in growth.

EUROWEEK: I want to return to that image of the new normal Canadian economy and how different that looks. What do you see as the main drivers of growth? Presumably growth will be export-led businesses rather than domestic demand?

Poloz: Yes.

EUROWEEK: And what is the way for exporting firms to attract that sort of investment into their business with rates low and growth also low? How does Canada remain a place to attract that sort of investment?

Poloz: Well the part that’s fallen short so far has been the demand side and it’s probably best to distinguish here between the resource sector and manufacturing — and that’s not a very clean distinction. But for the sake of exposition those are the two ends of the story. 

During the downturn, commodity markets did pretty well because we kept pretty good growth rates as did economies in the emerging market world, and so we had an unusual cycle from Canada’s perspective. Normally commodities would be weaker and often the Canadian dollar would track downwards with that and act as a buffer for the manufacturing sector. 

In this case what happened was the opposite. The Canadian dollar strengthened. It didn’t just maintain itself, it strengthened giving the manufacturing sector a harder cycle than has historically been the case. 

When we came out of the other end, what we discovered was that it’s been such a long a cycle that it’s not like in your text book where you have a recession where companies cut back on production, cut back on employment, and then nine months, or a year later, they start putting that production back up to where it was and bring the workers back. The companies have permanently downsized or in lots of cases that you can name, they’ve exited, they’ve gone. 

As the upturn gets into its higher momentum phase — and we seem to be entering that phase now — you bump up against capacity constraints much sooner than you otherwise would expect.

So our measures of what we call output gaps are not that large. They’re important but they’re not as big as what you see if you look at labour market indicators of capacity. That distinction is because of this destruction phase of the cycle. So as we come out of the destructive phase, what happens is companies that are in business see that they’re tapped out and it’s time to invest in more capacity. 

That investment decision takes into account all the uncertainty that we see and so it may take a little longer for companies to be certain enough to make it, but it’s a natural part of that return to normality. 

In addition, beneath those firms are all the budding entrepreneurs that are ready to enter markets and so their decision is perhaps an even bigger one to make because they have to start afresh. 

Both of those groups’ decisions are primarily investment decisions and require maybe a little more certainty than we have right now. If we’re sitting around the boardroom table, all it takes is a couple of board members to say ‘what if Europe has more problems?’ or ‘what if this China thing really is a slowdown?’ 

Then the CEO has got to admit that it is going to take them longer to overcome their hurdles and they say ‘we’ll wait a little longer before making the decision to jump’. But the firepower is there, they’re ready to go. 

So growth is going to come from a capacity constraint with a clear sight that the orders are there, people want to buy things, and so that’s where the US economy is so key.

EUROWEEK: And are the conditions for accessing that capital for Canadian firms conducive enough for that growth? With mortgage rates up it looks as if banks are more cautious about lending. 

Poloz: Everything we see suggests that credit is well available. Obviously larger firms have no problems whatsoever. They’ve got plenty of cash. They have very strong balance sheets and the credit markets for high rated credits have been very strong. 

For the small or medium sized firms I see no indication that anything’s different from normal. It may be slightly more expensive to borrow, in terms of spreads, but they will also still get a good deal relative to historical borrowing costs. 

Our banks are in very good solid situations. The market has performed very well. So it’s more a question of when is the borrower ready to borrow and make that decision, as opposed to whether or not the lending capacity is available. 

Some will say there’s a problem with small firms that can’t get this or that access to capital but that’s always a bit of a problem. It’s not a complete and perfect market. However, I don’t see anything unusual there. Things seem to be functioning quite well.

EUROWEEK: The Canadian economy has always exported, particularly to the US, and you’re saying that’s set to increase. Is there not a risk of becoming over-reliant upon the US economy?

Poloz: I’m not sure what that would look like. There is a lot of integration between the Canadian and US economies, which is perfectly natural. It’s mutual reliance as opposed to dependence.

We did come through a period where people were concerned about being overly dependent on demand from the US. That gave rise to extra impetus to diversify. The crisis forced some of that and the result is a lot more diversification, according to Export Development Canada figures. That’s a positive thing because you’re attaching your trade to faster growing economies for the next 10-20 years. 

All of that is a positive thing, but an extra two or three or five percentage points of market share for the US is not going to hurt or improve Canadian trade. The US is the biggest and most dynamic economy in the world and a lot of the trade between Canada and the US is in intermediate goods, which are destined for the international market anyway. So if you’re a supplier to a GE factory in the US, you may think you are exporting to the US and that’s what the data will record, but GE has got that end product going to 120 countries. If your component is part of GE making a jet engine, it goes into aeroplanes all around the world even though your product was shipped to the US.

EUROWEEK: You are plugging into a bigger grid.

Poloz: Exactly. The United States is a highly globalised economy, so I think of trading with the US as trading with the world.

EUROWEEK: And where can growth come from domestically given household debt, rising mortgage rates and stagnant wages?

Poloz: It’s clearly going to come from the investment side. We think that in many areas of the economy, capacity constraints are not that far away, so as long as the US continues on its healing trend and the rest of the world remains where it is or continues to heal, which would be my forecast, then investment is almost inevitable. 

The uncertainty drives a wedge between those investment decisions and their outcomes. That just means you have a bit more of a hurdle to jump. But everything we do that’s constructive is likely to reduce that uncertainty hurdle. 

It goes back to Keynes and his animal spirits. Today I talk about uncertainty or risk, but it really is just the flipside of positive animal spirits. There’s no doubt about it — the experience we’ve had crushed animal spirits and has made people much more cautious to make sure that the light at the end of tunnel’s not an oncoming train before they make their decision. That’s fine. But once we get across a certain undefined threshold, what we know is that the other side of animal spirits will kick in. It usually kicks in earlier in the cycle but has been lacking this time so far. 

That’s the immeasurable. I used to do the forecasting here back in my first career at the Bank of Canada, and I know this is exactly where we always underestimate what can happen, because you can’t put a quantifier around it and I suppose no one really criticises you for under-predicting a massive upturn. It’s always the other way around.

But when animal spirits get crushed, then they become this weight that holds you back. So just imagine if that weight is dissipating at the same time that the fundamentals are improving. I don’t want to be the one predicting it, but in a way it’s almost inevitable at some point that animal spirits will return. It could just take the form of companies deciding we’re in a world where lower rates of return world are the new normal, our earlier rate was too high. 

I don’t know what they will be, but they will at some point be unleashed. 

EUROWEEK: Canada’s taken a very conservative approach towards its banks implementing Basel III, higher capital requirements and so on. Has that made it harder for Canadian banks to compete internationally?

Is there a risk of over-regulation or do you hear from the banks that they’re happy with the approach and this conservative approach is a better long term strategy?

Poloz: Well, this is the Office of the Superintendent of Financial Institutions’s area, of course. We work with them on all these things, and so my observations are not from a practitioner but from an observer. 

First of all, yes, Canada’s banks have always been relatively conservative in that sense. I don’t think it’s a product of regulation per se, but a product of how they’ve conducted their business. And I mean that in a positive way as opposed to a judgemental way. It’s how they do business and the result has always been a well performing corporate and household sector, so I’m not one to argue with that. It stood us well over the course of the crisis, something that is well appreciated. 

When you look at the world, we didn’t really have what you might call a level playing field 10 years ago. The whole Basel process is an attempt to strengthen the system, and it is much stronger today than it was back then. 

And we’re building it in a collegial and co-ordinated way so that we do have the next best thing to a level playing field when we’re done. 

I do expect the Canadian banks will be as competitive as they ever were in both domestic and international markets. I don’t see this as a major issue, but of course we have to continue to participate and work on it, and that regulatory architecture is not complete yet. 

I wouldn’t want to predict it. It’s very complicated and it’s a major negotiation with lots of people involved. The Financial Stability Board has done an absolutely superb job of bringing the issues right to the front, harnessing all that energy, getting that sense of common purpose on the table, and setting an agenda that is very rhythmic.

There is always something due. I’m very impressed with how rapidly the system has evolved in a positive direction.

If you ask any random audience if they think the banking system is more secure today than it was before, everybody is going to say yes it is. There’s more capital and more awareness. It’s all good. 

EUROWEEK: So perhaps it is the case that even if Canadian banks had stood still from a regulatory point of view, they’d still be in a stronger position than a lot of their international counterparts.

Poloz: Well, they’re all done with complying to the new regulations way ahead of time, of course. There are still plenty of issues floating around and they take a direct interest in those issues. That’s good. That’s part of collegial fact finding and a consolidating process. 

I have good relationships with all the CEOs of Canadian banks and they’re all sounding pretty upbeat about things. They’re proud of how things went.

The key to a really good international banking architecture is that you don’t see it as the regulator versus the organisations. It’s more a case of financial institutions wanting to be part of the system because there are obvious benefits to them to doing so.

When it first happens banks can feel regulators are forcing them to do something. But that’s really not it. We all have a major stake in the fundamental properties of the system, so I think it has to be an enlightened conversation. 

Most banks would see that as a positive for everybody and as long as somebody else isn’t getting away with something much easier, that makes them uncompetitive, then they’re going to be fine with it.

EUROWEEK: Will the Bank of Canada’s job change at all in the Canadian banking sector? Will there be a central clearing counterparty?

Poloz: We have our repo system as a way of working as a central counterparty for the derivatives market in general, but the architecture itself is the responsibility of the Minister of Finance.

We’re primarily seen as a key system adviser. We do our financial stability studies and monitoring. That’s a key part of the monetary policy process — to have a key input to those conversations.

EUROWEEK: What can people expect from your governorship that might be different to Governor Carney? 

Poloz: The organisation did exceptionally well under Governor Carney’s leadership. If someday somebody said that I did as good a job as Governor Carney did, that would be pretty high praise to me. 

I don’t come to the job hoping to change things of that sort. There’s no question about the pillars of what the Bank does. They remain what they are. The inflation target is sacred to us and we’re doing everything we can in the sense of strengthening, or investing in, our analytics so we understand it better. 

‘Why is inflation as high as it is given what we’ve been through?’ is a simple question. But it’s not an easy one to answer. It was one of the subjects at Jackson Hole this year. If you can’t really put a pin on that with precision, that’s just an illustrator of how complex this is. 

So over time we want to strengthen that side of the Bank’s work and provide something that is even more understandable for people even with all the problems of financial stability that we’ve gone through in the last few years.

To just talk about inflation a bit would be a positive evolution — central banking getting back to its core work. 

But I don’t see any of this as my personal mission; it’s more about the economic context evolving. When Governor Carney came to the job he may have thought something was up, but he certainly didn’t expect what we saw. The context changed dramatically during that time and the organisation responded wonderfully, so a lot of new processes and new rigour and new models, which were not there before the crisis, are investments that we’ll use over and over. 

EUROWEEK: So it is about moving towards a frank conversation about the inflationary outlook. Being able to say what the limitations are on people’s insight into that debate, and a more honest acceptance of them rather than, if I think about, Federal Reserve chairman Alan Greenspan’s era where his every word was being interpreted as if it were some magical code.

Poloz: I always say there won’t be a market for that kind of role with my guidance because I’m more likely to be blunt and try to simplify, make it clear. 

But if you look at the historical context of the last five years, we had to be very dramatic in our policy response and for the next I don’t know how many years, but two, three or possibly as long as five years, we’ll be rebuilding all that. 

From the private sector standpoint I have likened it to a reconstruction process because you’ve taken capacity out of the economy and now it’s time for it to be rebuilt. 

We are in a position to help nurture that and, of course, to explain to people how it is we’re getting there. 

I spoke to the Bank’s forecasters at the beginning of our last interest rate cycle, and I said ‘someday you’ll be able to sit with your grandkids and say, I worked at the Bank of Canada during this era and it will be like when the Norsemen started looking for the New World’. They were looking at the stars when one night, they were blown into the southern hemisphere and then all the stars were different. 

We really are in uncharted territory. The models have failed us in certain ways, but we don’t need new models or new understanding. 

I said to our forecasters to use their models not to answer the questions, but to use them to help ask more questions and form judgements. That’s going to help us guide the way.

For me to be able to go out and say to people that it’s complicated, it’s different, but this is what it looks like, that extra dialogue — hearing back from companies about what it actually feels like in the trenches — will help us narrow that margin of uncertainty. That’s what I see as my job.

EUROWEEK: The tail wagged the dog for a few years as far as forecasting models were concerned.

Poloz: As a modeller — an old modeller — it must be awfully frustrating. But if you start back, around 2000 or even before, the models couldn’t really explain that bubble. They certainly couldn’t explain what happened after 9/ll. 

We had way more spending and it was obviously some sort of a spending binge that created the makings of the bubble. 

My model is a simple one. I call it the spaghetti sauce model. If you look closely when a bubble pops in the spaghetti sauce, there’s a crater underneath it and it’s exactly the same size. It’s not a very complicated model, but I can’t believe that the distortions that were built up over seven years can be fixed in less than seven years.

We are set up for a multi-year crater and we have to get used to the fact that the healing process is going to take longer and needs nurturing. It needs people who understand that and we have a role to play in helping them understand it.  

  • By Dariush Hessami
  • 30 Sep 2013

All International Bonds

Rank Lead Manager Amount $m No of issues Share %
  • Last updated
  • 24 Oct 2016
1 JPMorgan 317,793.98 1355 8.72%
2 Citi 301,114.13 1092 8.26%
3 Barclays 259,580.63 846 7.12%
4 Bank of America Merrill Lynch 258,842.43 934 7.10%
5 HSBC 224,273.23 905 6.15%

Bookrunners of All Syndicated Loans EMEA

Rank Lead Manager Amount $m No of issues Share %
  • Last updated
  • 18 Oct 2016
1 JPMorgan 29,669.98 55 6.95%
2 UniCredit 28,692.62 136 6.73%
3 BNP Paribas 28,431.90 139 6.66%
4 HSBC 22,935.49 112 5.38%
5 ING 18,645.88 118 4.37%

Bookrunners of all EMEA ECM Issuance

Rank Lead Manager Amount $m No of issues Share %
  • Last updated
  • 18 Oct 2016
1 JPMorgan 14,593.71 79 10.38%
2 Goldman Sachs 11,713.19 63 8.33%
3 Morgan Stanley 9,435.23 48 6.71%
4 Bank of America Merrill Lynch 9,019.27 40 6.41%
5 UBS 8,763.73 42 6.23%