Finance minister of the year 2009: Jim Flaherty, Canada


Helen Avery
Published on:

The finance minister has enhanced his country’s reputation for sound fiscal policy that takes full account of social justice, while a strong regulatory regime has kept the financial sector out of the chaos. Helen Avery reports.

Editor’s note

Finance minister of the year: Jim Flaherty, Canada
WHEN JIM FLAHERTY, Canada’s minister of finance, visited China in January 2007, his reception was tepid. The visit was overshadowed by human rights debates, and each country’s commitment to invest in the other was questioned. "I was told that the Canadian banks were too hesitant," says the minister. Fast forward two and a half years and a worldwide banking crisis, and the minister’s welcome in China in August was significantly warmer. Indeed, Canadian exports to China increased 6.8% during the first five months of this year. Canada, with its resource-rich economy, is a key trading partner of China, and Flaherty is credited with improving international trade relationships.

Sherry Cooper, global economic strategist at BMO Financial Group, says: "No sooner had the minister encouraged China’s state-run companies to invest in Canadian resource companies [during his August visit] than state-controlled Jilin Jien Nickel Industry made a surprise $148.5 million unsolicited takeover bid for Canadian Royalties, which is developing the Nunavik nickel project in northern Quebec."

Canada’s ability to weather the banking crisis while its neighbour, the US, has struggled, has further boosted the country’s reputation on the global stage. Other countries’ big financial institutions have had to cut credit or withdraw from markets such as China to rebuild capital domestically but Canada’s banks suffered no such setbacks. Not one bank in Canada has failed. Indeed, the World Bank has ranked Canada’s banking system the soundest in the world. If anything, says Flaherty, Canadian companies have become more global still. China is keen to learn from Canada’s financial regulatory system, as are the UK and the US. During the G7 talks in Washington in October 2008, Canada’s input was essential in rewriting the way markets should be viewed, and Flaherty was a key contributor to the five-point plan presented to former US president George W Bush, the G20 leaders and the IMF.

The steps that went to creating Canada’s solid regulatory system were in place before Flaherty was appointed to his role in 2006. Since the late 1980s, investment banks have been subject to the same rules as commercial banks, so leverage was much lower than elsewhere. While the Department of Finance has kept a watchful eye over financial regulatory issues, it is the Office of the Superintendent of Financial Institutions (Osfi) that has been largely credited with keeping the banks on the straight and narrow. Julie Dickson, head of Osfi, has stayed firm on capital and leverage ratios despite strong opposition.

Canadian banks have also had tighter lending requirements than many of their international peers. They securitized only about 25% of their mortgages, compared with more than 50% in the US. And the sub-prime market is less than 5% of the total mortgage market; in the US sub-prime mortgages accounted for nearly two-thirds of all new mortgages granted between 2003 and 2004.

Thanks to the foresight of regulation, one could argue that the Canadian government has had an easier job than those of many other countries during the crisis.

Where Flaherty and his government, headed by prime minister Stephen Harper, must take credit during the crisis is for their fast handling of potential problems. Early in 2007 the government increased the down-payment requirements on mortgages to prevent people buying houses with too little equity. Then in October 2008 during an election campaign, Harper and Flaherty guaranteed Canada’s banks and agreed to buy C$25 billion ($22.8 billion) of insured mortgage pools from them to improve liquidity. "Taking drastic action is not normal during an election campaign, but it was becoming increasingly apparent that steps needed to be taken to prevent Canada’s banks from being at a competitive disadvantage because other countries were guaranteeing their banks," says Flaherty.

A clever win-win

The agreement to buy up the mortgages "set the stage to get the economy moving again and avoid an infusion of taxpayers’ money," says a senior executive at Scotiabank.

Because of the crises at banks around the world, the Canadian banks were having to pay as much as 300 basis points above the Government of Canada rate to borrow in the open market for 10-year maturities, when they had been paying barely over the sovereign rate previously.

"The first few Canada Mortgage and Housing Corporation [CMHC] auctions saw the banks get the bonds at around 135 basis points above the government rate, and there was really no risk to the government because the banks gave secured/insured top-class mortgages in return," says Don Drummond, chief economist at TD Bank. "It was a clever win-win. Banks got 135bp premium instead of 300bp. And the government made a 135bp profit over their borrowing costs, which could generate a profit of several billions of dollars."

Flaherty, while indicating that the Department of Finance has a key role in watching over the markets (discussions with Osfi’s Dickson take place every Friday), credits the cohesiveness of several overseeing bodies – the Bank of Canada, the Canadian Insurance Deposit Corporation and the Financial Consumer Agency of Canada, as well as Osfi and the Department of Finance. "We have regulations as did other countries. But our markets were well regulated. Regulation means little when it is not effective."

The final addition to the committee of financial markets overseers is hoped to be a national securities and exchange commission. At present, Canada’s 10 provinces and three territories each have an individual commission. Several governments have tried to replace the fractured system with one national commission but Flaherty is the closest to success. He says his wife compares him to "a dog with a bone" with the proposal. "I will not give up on this," he says. "It is the missing pillar in the financial regulatory framework, and it will help Canadians. Global firms that want to do an IPO in Canada look at all the different provinces, with all their fees and paperwork, and weigh that up with the fact that Canada has a population of only 34 million. It discourages them." A taskforce is now in place and several provinces have expressed an interest.

"You have to admire minister Flaherty’s tenacity," says TD’s Drummond, who served 23 years in the Department of Finance. "He hits a brick wall, and he comes back at it time and again to get things done. Others, including myself, gave up on a national securities and exchange commission, thinking it was hopeless. But he just keeps on kicking."

Provinces on board

This drive to solve problems that have been plaguing Canadian finance ministers for years is also evident in his success in trying to harmonize value-added tax across the provinces. Ontario and British Columbia have signed up this year and only three provinces remain in need of convincing. "It’s a good long-term policy, but with any tax change there is a negative reaction. I’ve put the plan in four budgets so far and, to my delight, the provinces are now joining us in this venture," says Flaherty.

"You have to admire minister
Flaherty’s tenacity. He hits a brick wall,
and he comes back at it time and again
to get things done. Others, including myself, gave up on a national
securities and exchange commission, thinking it was hopeless. But he just keeps on kicking"

Don Drummond, TD Bank

It’s a similar story with corporation taxes in the provinces. Flaherty has battled to ensure that by 2012 federal/provincial corporation tax will be lower. In October 2007 (in anticipation of a slowing economy) he announced that the federal government would be lowering its corporate tax rate from 22% to 15% by 2012. He encouraged the provinces to lower their rates to 10%, which would create a 25% corporate tax band for Canada. Most have signalled their intention to do so. "It started to come down with a Liberal government but Flaherty has kept on and on at the provinces during his role to make sure it happens," says Drummond.

Flaherty’s decisions have not always made him popular. The surprise announcement to end tax benefits for most income trusts in 2006 caused much upset. So much so that one man is now in prison for threatening the lives of the minister and his family because of the move. An increasing number of corporations had been converting to income trusts in order to take advantage of tax deductions, which threatened to cut billions of dollars in taxes payable to the government.

"The tax rule was not created to erode taxes. Large banks were going to become income trusts, and something needed to be done urgently for the sake of the Canadian economy," says Flaherty. "Warning could not be given as it would have fundamentally affected the markets. The role of government is not to make everyone happy but to do what is right."

Flaherty’s plan for Canada’s economy is one of long-term goals that will have positive effects for its citizens. Putting the fiscal house in order has been essential. Up to this year, Canada had been running a surplus, which has acted as a cushion going into the recession.

"We knew one was on the way, so we made sure we were prepared and started paying down debt in 2006," says Flaherty. A fiscal conservative, Flaherty introduced a January budget that will put Canada into a deficit of C$35 billion. It has been received with scepticism. GDP growth forecasts going into the election had been flat to positive but by January had been revised down so that Canadian GDP for this year is now forecast to contract by 2.7%.

It has concerned some that the budget promises were premature. Added to the worries has been the C$7 billion bailout of General Motors and Chrysler’s Canadian operations in May, which caused the government to increase the deficit estimate to C$50 billion.

Flaherty, however, says it is necessary to act boldly. "Running a deficit was not an easy choice to make, but half measures in a recession would have been a mistake," he says. "By 2013, Canada will be back in surplus, and the country will be in great shape from the investments made now."

Budget commitments to infrastructure, innovation and technology will be important for the longer-term positioning of Canada, which cannot rely solely on its natural resources. C$12 billion was committed to these sectors in the January budget.

A decision to set up tax-free savings accounts of up to C$5,000 annually will also ensure long-term changes to the way Canadians view savings, says Flaherty, as well as benefiting older people, as the plan allows for withdrawals at any time.

One of the most popular budget commitments has been that of raising the lower two tax brackets, which particularly helps low-income earners. The government has also raised the personal tax allowance, again a particular benefit to low-income earners.

Leave no one behind

"Flaherty takes a comprehensive approach to economic policy," says Drummond. "It’s not just about fiscal balances."

Combining fiscal sense with a firm eye on social policy is a characteristic that Canada is known for, and Flaherty says building on this tradition has made him proud. "We have implemented good fundamental economic policy, but we have not forgotten those that need our help. When the recession is over, and longer-term investments have come to fruition, we don’t want anyone to have been left behind. That is truly Canadian." 

World Bank/IMF special focus: Global economic outlook and financial stability