Canada’s Vulnerability to Potential Eurozone Turmoil

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March 5, 2014 – The continuing possibility that things could take a turn for the worse in the eurozone ought to be a concern for Canadian policymakers, according to a report released today by the C.D. Howe Institute. In “The Ill Wind that Blows from Europe: Implications for Canada’s Economy,” author Pierre Siklos explores the linkages between the Canadian and eurozone economies and the extent to which contagion from European financial shocks would negatively affect Canada’s economy.

“The eurozone area is not out of the woods yet. An economic downturn or financial shock there cannot be ruled out,” noted Siklos. “I find the effect of setbacks in the eurozone on Canada’s economy could be significant.”

Speculation about the consequences of a break-up of the eurozone, a worsening sovereign debt crisis or a prolonged recession in the European Union have all in recent years made the headlines, notes the author.

Considerable risks remain, he adds. Eurozone unemployment stands at near record high levels, economic growth rates are modest, and deflation remains a concern. As well, wider global economic uncertainty including, now, the spillover effects of turmoil in Ukraine, provides a less than reassuring context.

“The continued uncertain outlook for the global and US economy also suggests that there is a real danger of another ‘perfect storm’ such as the one that affected the world economy in 2008 and 2009,” said Siklos.  “Canada might not escape next time around with only a short-lived recession, nor is it a given that its financial sector would emerge largely unscathed, notwithstanding Canada’s reputation for the quality of its financial regulation and supervision.”

While most scholars have focused on the linkages between the US and Canadian economies, Siklos breaks new ground by focusing on the Canada-eurozone relationship, which will be of growing importance as the Canada-EU trade agreement develops.

The author estimates a small macroeconomic model for Canada that explicitly incorporates financial sector influences. Then, he adds foreign shocks with real and financial elements from the eurozone and the United States to investigate the potential for spillover effects. The study also considers some counterfactuals, by imagining a large, negative and permanent economic shock from the eurozone, and compares the results with estimates based on observed data.

Siklos concludes that negative shocks from the real and financial sectors of the US and eurozone economies do spillover into the Canadian economy. “Clearly, US shocks dominate, but eurozone shocks cannot be ignored,” said Siklos.  “Under eurozone worst-case scenarios, such as a credit-related shock on the scale of the Greek experience, Canada’s economy would suffer a substantial drop of almost 8 percent in real GDP after two and a half years.”

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