Part 3: BRITISH COLUMBIA ECONOMIC REVIEW AND OUTLOOK¹

Highlights

Following growth of 3.9 per cent in 2004, the British Columbia economy is forecast to grow 3.4 per cent in 2005 and 3.2 per cent in 2006. This is somewhat higher than the economic forecast in the February 15 budget of 3.1 per cent in 2005 and 3.0 per cent in 2006.

The Economic Forecast Council, a group of private sector economists who provide independent advice to the Minister of Finance on the provincial economic outlook, has also upgraded their average outlook for the BC economy in a survey conducted in July 2005. The Council now forecasts growth in British Columbia of 3.6 per cent in 2005 and 3.4 per cent in 2006, compared to 3.3 per cent in 2005 and 3.1 per cent in 2006 in January.

Over the 2007 to 2009 period, the Economic Forecast Council expects the British Columbia economy to grow 3.3 per cent per year while the Ministry of Finance forecast calls for growth averaging 3.1 per cent per year.

Economic Forecast Council members upgraded their forecasts for BC in July for a variety of reasons, including strength in the domestic economy. In particular, retail sales, non-residential investment and employment growth were all performing better than expected in January. Council members also noted that the outlook for net migration to BC had improved since January. Council members also upgraded their outlook for the trade sector since their January surveys. Stronger commodity prices and a less severe than anticipated impact from the high Canadian dollar on BC exports have resulted in higher expectations for net exports over the forecast period.

As has been the practice, the Ministry of Finance forecast is slightly more conservative than that of the Economic Forecast Council (see Table 3.1). A topic box at the end of Part Three reports on the consultation with the Economic Forecast Council.

Recent Developments

The performance of key BC economic indicators in recent quarters is presented in Table 3.2.

Employment in BC has shown continued strong gains over the first two calendar quarters of 2005, increasing 3.2 per cent over the same period last year. The unemployment rate hit 5.7 per cent in May of this year, its lowest point since January of 1981. In June and July the unemployment rate rose, and so far this year has averaged 6.3 per cent.

Supported by continued low interest rates, housing starts remain at high levels, and increased in the April to June quarter after declining in the previous quarter. Over the first six months of this year, housing starts were down 3.0 per cent relative to the same period of 2004. Retail sales posted robust growth in the first quarter, but declined slightly in May and June. For the January to June period, retail sales are up 5.8 per cent compared to the same period last year.

Exports have risen 6.4 per cent during the first six months in 2005, over the same period last year. The negative impact on exports of the high Canadian dollar has been offset by strong commodity prices and a robust U.S. housing sector. Manufacturing shipments fell in both the first and second quarters of 2005 due to large declines in wood shipments. However, shipments are up 4.9 per cent year-to-date to June due to weakness at the beginning of 2004.

Non-residential building permits have increased strongly so far this year, rising 78.8 per cent in the first six months of 2005 relative to the same period a year ago. Growth was seen in all three areas of non-residential building permits, institutional and government, commercial and industrial.

The Outlook for the External Environment

The U.S. economy posted strong growth over the first half of 2005, with real GDP increasing at an annual rate of 3.8 per cent in the first quarter and 3.3 per cent in the second quarter. Real consumer spending continued to be one of the main growth drivers, rising 3.0 per cent on an annualized basis in the second quarter. Investment in both residential and non-residential structures rose in the second quarter with investment increasing an annualized 8.9 per cent overall. The trade sector contributed positively to growth as exports saw substantial growth of 13.2 per cent (annual rate) in the second quarter.

In the second half of this year, many analysts expect U.S. growth to moderate due to the impact of high oil prices, rising interest rates and slowing consumer spending growth. Housing starts have continued to post record levels so far in 2005, with demand sustained by continued low interest rates. Most analysts expect the housing sector to cool later this year and into 2006 due to rising house prices, higher interest rates and saturated demand. Cooling of the housing sector and high debt loads are also expected to moderate consumer spending in the second half of 2005.

After the 4.2 per cent growth seen in 2004, the August Consensus Economics survey of private sector economists expects U.S. real GDP growth of 3.6 per cent in 2005 and 3.3 per cent in 2006. Forecasters have raised their expectations for U.S. growth mainly because of the strong growth seen in the first half of this year. Even with moderating growth for the second half of 2005, the strong start to the year will result in a robust performance overall in 2005 for the U.S. economy.

In order to reflect the risks surrounding the U.S. economic outlook, the Ministry of Finance's growth assumptions are somewhat lower than the consensus. In 2005, the Ministry of Finance assumes U.S. economic growth of 3.4 per cent, compared to the current 3.6 per cent consensus. U.S. growth is expected to moderate to 2.9 per cent in the Ministry of Finance forecast for 2006, while the August consensus survey predicts more robust growth of 3.3 per cent for the year. Over the medium-term, the Ministry of Finance assumes that the U.S. economy will grow at a rate of about 3.0 per cent per year. The risks surrounding the U.S. growth outlook include the impact of high oil prices, slowing housing and consumer spending and the fiscal and current account deficits.

Growth in the Canadian economy continues to be dampened by the impacts of the rapid appreciation of the Canadian dollar relative to the U.S. dollar seen in 2003 and 2004. However, the domestic side of the economy has shown robust growth, which has helped to offset weakness in the trade sector. Robust job creation, strong housing prices, low interest rates and rising incomes are driving an expansion in consumer spending and the housing market. Real GDP growth was 2.1 per cent in the first quarter of 2005, strengthening to 3.2 per cent in the second quarter. The main drivers of growth in the Canadian economy so far this year, were consumer spending and both residential and machinery and equipment investment. Export growth, however, remains modest, rising 2.1 per cent over the first two quarters of this year relative to the same period in 2004.

In their July survey, Consensus Economics raised their 2005 Canadian growth expectations after four consecutive months with no change. Recent positive economic data releases such as retail sales, employment and strong April GDP growth were cited as factors in the upgraded outlook. The August survey calls for growth of 2.7 per cent for 2005 and 2.9 per cent for 2006. The Ministry of Finance forecast is somewhat conservative relative to the consensus, and assumes that the Canadian economy will grow by 2.5 per cent in 2005 and 2.6 per cent in 2006.

The economic recovery in Japan has been supported by a turnaround in domestic demand, although consumer activity is still not strong. Japan is a major oil importer and the adverse impact of higher oil prices on the Japanese economy combined with the potential slowing of their trading partners, including China and the U.S., indicates further difficulty for the trade sector. The August Consensus Economics survey predicts economic growth in Japan of 1.6 per cent for 2005 and 1.5 per cent for 2006. The Ministry of Finance is assuming slightly lower growth of 1.2 per cent in 2005, rising to 1.5 per cent in 2006.

Germany's economy has been showing signs of improvement recently with rising business sentiment and stronger foreign demand. However, the outlook for growth prospects for Europe remains muted in the near-term. The Consensus Economics survey in August predicted growth of 1.3 per cent in Europe for 2005 and 1.7 per cent in 2006. The Ministry of Finance forecasts growth of 1.0 per cent in 2005 and 1.5 per cent in 2006 for Europe.

China saw substantial GDP growth in 2004 of 9.5 per cent, driven by strong exports and investment. In July of 2005, China delinked its currency from the U.S. dollar, resulting in a revaluation of 2.1 per cent. The Chinese Yuan now will float within a very narrow band against a basket of currencies from the country's major trading partners. The banking sector remains a key concern in terms of economic stability in China, as the ratio of problem loans has been rising. Blue Chip Economic Indicators, a monthly survey of about 50 leading business economists, was forecasting growth in China of 9.1 per cent in 2005 and 8.0 per cent in 2006 in their August survey.

Financial Markets

The Federal Reserve Board has raised the federal funds rate 25 basis points at each of its' past ten meetings, bringing the key interest rate to 3.50 per cent. The committee stated that monetary policy continues to be accommodative and that this stimulus can be "removed at a measured pace."

The Bank of Canada has left the target overnight rate unchanged at 2.50 per cent since October of 2004. In their July 12th interest rate announcement the Bank of Canada signaled that interest rates might soon be rising since they believe the Canadian economy is operating close to its production capacity. Therefore, some reduction in monetary stimulus will be required in the near-term.

Outlook

The Ministry of Finance assumes that the U.S. federal funds rate will rise at a measured pace in order to remove monetary stimulus from the economy, consistent with the private sector average. The average of private sector forecasts predicts that the Federal Reserve will move to the sidelines in 2006 as inflationary pressures ease and growth moderates.

The private sector average expects the Bank of Canada to begin raising the overnight target rate this fall and into 2006. The Bank of Canada's statement that they believe the Canadian economy is operating near capacity supports the view that they will raise interest rates until monetary stimulus is removed.

The Canadian three-month treasury bill rate is expected to average 2.6 per cent in 2005, rising to 3.3 per cent in 2006. Ten-year government of Canada bonds are forecast to average 4.1 per cent this year and 4.6 per cent in 2006. The Ministry of Finance outlook is based on the average of six private sector forecasts as of July 25, 2005.

The Canadian dollar averaged 76.8 cents US in 2004, and appreciated strongly in the second half of the year. So far in 2005, the Canadian dollar has remained at high levels, averaging 81.3 cents US over the January to August period.

Outlook

The U.S. dollar is expected to resume a modest weakening trend in 2006, as the imbalances in the U.S. economy become more of a concern. In addition, high energy prices are expected to provide support to the Canadian dollar. However, gains in the Canadian dollar from U.S. currency weakness could be limited by softening non-energy commodity prices and lower interest rates in Canada relative to the U.S.

The private sector forecast of the Canadian dollar in 2005 averages 81.4 cents US, rising to 83.0 cents US in 2006. The Ministry of Finance exchange rate outlook is based on these private sector averages (see Table 3.5). The Canadian dollar is expected to level out at 83.5 cents US for the 2007 to 2009 period.

The British Columbia Outlook

After strong growth in 2004, the Ministry of Finance expects economic growth in British Columbia, at 3.4 per cent, to outperform Canadian growth in 2005. Over the medium-term, economic growth in BC of 3.1 per cent is expected, reflecting continuing robust investment, consumers spending and export growth.

Table 3.6 summarizes the Ministry of Finance's outlook for key economic indicators relative to the February 15 budget forecast. Additional detail on the current economic forecast can be found in tables 3.8.1 to 3.8.4 at the end of Part 3.

The Labour Market

Employment growth in British Columbia was robust in 2004 averaging 2,059,700 persons employed, an increase of 2.3 per cent from 2003. The British Columbia economy has continued to generate substantial employment opportunities in 2005. Over the first seven months of this year 64,114 jobs were created compared to the same period of 2004. An increase in full-time employment of 69,286 jobs was offset by a decline in part-time employment of 5,200 jobs year-to-date to July. Job growth in British Columbia was broadly based, with both goods and services sectors expanding in the first seven months of 2005.

The unemployment rate in British Columbia averaged 6.3 per cent in the January to July period of 2005, down from 7.5 per cent in the same period of 2004. The drop in the unemployment rate over the first seven months of this year is a result of stronger growth in employment than in the labour force.

Outlook

Employment is forecast to increase by 2.7 per cent in 2005, adding about 55,000 jobs to the BC economy. In 2006, an additional 42,000 jobs are expected to be created in BC, an increase of 2.0 per cent. Job creation is expected to be strong in the construction, energy, mining, transportation and service sectors of the BC economy, while the outlook for job growth in the forest sector continues to be weak.

The labour force is expected to grow at about 1.9 per cent in both 2005 and 2006. As the labour force is expected to grow at a slower pace than employment for 2005 and 2006, the unemployment rate is forecast to fall to 6.5 per cent in 2005 and 6.4 per cent in 2006. Over the medium-term, the unemployment rate is forecast to continue this gradual decline.

Domestic Demand

Consumer Spending and Housing

Retail sales are on track to post another year of strong growth after an increase of 6.3 per cent in 2004. Over the first six months of this year, the value of retail sales has risen 5.8 per cent compared to the same period of last year. The increase has largely being driven by the strong housing market as much of the strength was seen in furniture, home electronics and appliances as well as home improvement stores. In addition to furniture and home-related purchases, the value of fuel sales increased substantially over the first half of 2005, reflecting higher market prices for gasoline.

Low mortgage rates, increased migration and robust job creation continue to support strong housing starts in 2005. British Columbia's housing starts totaled 32,386 units in the first seven months of 2005, a 0.2 per cent increase over the same period the previous year.

Outlook

The forecast for inflation-adjusted consumer spending on goods and services calls for growth of 3.5 per cent in 2005. Increased job opportunities and rising incomes in British Columbia will support consumer demand for goods and services this year. In 2006, further growth of 3.6 per cent is expected in real consumer spending, followed by growth of about 2.9 per cent on average over the medium-term. Retail sales are forecast to rise 5.7 per cent in 2005, followed by growth of 5.2 per cent in 2006.

The outlook for consumer spending growth remains robust over the forecast period. However, higher interest rates, housing starts leveling off and high debt loads of consumers are expected to slow growth in consumer spending over the medium-term.

Rising interest rates, saturated demand and rising house prices are expected to cool housing starts growth in British Columbia over the forecast period, although the level of housing starts will remain high. Housing starts are forecast to total about 32,200 units in 2005, falling to around 30,800 units in 2006. Over the medium-term housing starts are forecast to remain at a robust level of around 30,000 units per year.

External Trade and Commodity Markets

The value of BC's merchandise exports rose 6.4 per cent in the first six months of 2005, relative to the same period of 2004. A jump in the market price for coal and natural gas, combined with higher coal export volumes, has led to strong growth in the energy sector. Energy exports rose 29.3 per cent during the six months of 2005 compared to the same period the previous year. Overall, the value of merchandise exports excluding forestry increased 14.8 per cent year-to-date to June, reflecting strength in other export commodities such as industrial goods.

Lower spruce-pine-fir prices, and the continued effect of a higher Canadian dollar, have contributed to a 3.2 per cent decline in forestry exports year-to-date to June. For the January to August period the spruce-pine-fir price averaged US$367. This compared to an average US$412 observed during the same period of 2004. The price of hemlock baby squares has fallen 14.3 per cent year-to-date to August. The average price of hemlock baby squares over the January to August period was US$538 compared to US$627 during the same period of 2004.

The value of softwood lumber exports to the U.S. has risen 5.7 per cent year-to-date to June, reflecting strength in the Interior of the province. Conversely, softwood lumber exports from the Coastal industry are mainly destined for Japan and have fallen 23.8 per cent over the first half of this year.

Canadian natural gas prices continued to be volatile over the course of 2005, with the highest monthly price of $6.5C/GJ occurring in April shortly after a low of $5.5C/GJ in February. On average through the month of July 2005, the natural gas price has increased 7.5 per cent compared to the first seven months of 2004. The impact of hurricane Katrina on oil and natural gas markets remains unclear. How high oil and natural gas prices reach and how long they stay elevated depends in large part on how quickly refinery production and distribution can get back to normal operations.

Coal prices have been very strong so far this year, driven largely by China's rapid economic growth and resulting import demand. Increased demand for steel in turn raised demand for coal, supporting higher coal prices.

Outlook

Real exports of goods and services are expected to increase 1.1 per cent in 2005. This is somewhat lower growth than the 4.9 per cent seen in 2004, reflecting the higher Canadian dollar and easing external demand. Real export growth is forecast to improve after 2006, consistent with economic growth in BC's trading partners and improving export prices. Over the 2006 to 2009 period, export growth is expected to pick-up, rising 3.8 per cent per year on average. The improvement in export performance over the medium-term is forecast to come largely from the energy and high-tech sectors as well as service exports related to the 2010 Olympics.

The average price of British Columbia goods and services exports is forecast to rise just 0.2 per cent in 2005, as the strength in energy prices are largely offset by a decline in the price of lumber, BC's largest export. Export prices are expected to decline in 2006, led by lumber prices returning to their medium-term levels. Natural gas prices are forecast to decline gradually, reaching C$5.42/GJ by 2009/10. Spruce-pine-fir prices are expected to average US$360 per thousand board feet in 2005 and US$300 through the remainder of the forecast period. The average export price is expected to pick up moderately over the medium-term as commodity prices stabilize and the Canadian dollar remains around 83.5 cents US.

Business and Government

Business investment (including residential) adjusted for inflation expanded by 11.7 per cent in 2004, building on robust growth of 7.4 per cent in 2003. While much of the growth in business investment was driven by strong residential investment, which is estimated to have increased 14.8 per cent in 2004, investment in machinery and equipment also saw robust growth. Business confidence in BC remained strong in 2004, remaining above Canada as a whole.

Machinery and equipment investment benefited from the higher Canadian dollar, rising an estimated 20.0 per cent in 2004, as costs were lower for industries importing equipment from the U.S. Non-residential construction saw a decline of 4.2 per cent compared to the level achieved in 2003. Over the first six months of 2005, non-residential building permits have increased strongly, indicating a pick-up in non-residential construction for this year. Corporate profits in British Columbia jumped 32.9 per cent in 2004, following a strong 11.2 per cent gain in 2003. The strong growth in corporate profits provides further momentum to reinvest in plant and equipment.

Local, provincial and federal government combined spending in BC is estimated to have increased 1.1 per cent in 2004 in inflation-adjusted terms.

Outlook

Total investment in British Columbia is forecast to grow 6.7 per cent in 2005 and 5.2 per cent in 2006. This growth reflects public sector investment in capital projects as well as strength in machinery and equipment and non-residential investment. Over the medium-term, total investment in British Columbia is expected to grow around 4.2 per cent per year on average. Strong investment in non-residential construction is expected to be a significant growth driver over the medium-term, rising 7.1 per cent per year on average from 2007 to 2009. Investment in machinery and equipment is also forecast to post strong growth over the medium-term, as firms take advantage of the higher Canadian dollar to import equipment from the U.S. at a lower cost and re-invest profits.

Combined spending by the three levels of government in inflation-adjusted terms is expected to grow 5.9 per cent in 2005 as the provincial government increases spending commitments for health care, education, and priority initiatives for children, communities, safety, economic development, culture and the environment. Over the medium-term, inflation-adjusted government spending is forecast to rise 2.3 per cent on average per year.

Inflation

Consumer price inflation in both BC and Canada began 2004 quite low, but rising fuel prices drove up inflation over the summer months and into the winter before falling in December. In Canada, overall consumer price inflation averaged 1.9 per cent in 2004, a significant decrease from the 2.8 per cent rate of inflation seen in 2003. The slowdown in the average annual rate of inflation in 2004 was due mainly to a much smaller increase in automotive vehicle insurance premiums during the year, as well as a decline in natural gas and computer equipment and supplies prices. British Columbia experienced similar consumer price inflation to Canada as a whole in 2004; inflation averaged 2.0 per cent for the year.

So far in 2005, Canadian consumer price inflation has averaged 2.0 per cent, while in BC the rate is slightly lower at 1.9 per cent. Higher gasoline and other energy prices have been a leading factor in inflation so far this year. Removing the energy component of the index, consumer prices in BC are up by 1.6 per cent when compared to the first half of 2004.

Outlook

Consumer price inflation in British Columbia and Canada is expected to continue to average 2.0 per cent per year over the forecast period, in line with the Bank of Canada's inflation target.

Risks to the Economic Outlook

The economic outlook has risks on both the upside and downside. The most significant risks to the British Columbia outlook remain the volatility of the Canadian dollar and sustainability of the U.S. economic recovery.

The British Columbia economy could grow faster than forecast if:

• The Canadian dollar falls significantly below the current forecast.
• The U.S. economy resumes a higher growth path.
• A lasting resolution to the softwood lumber dispute is reached; alongside growing U.S. demand, this would provide an opportunity for further growth in British Columbia's forest industry.
• British Columbia business confidence and investment strengthen further; this would provide a base for stronger economic growth in the province.
• Interprovincial net in-migration strengthens further; this would generate additional demand for goods and services and boost economic growth.
• Visitors to BC increase more than expected as Vancouver gains further international recognition as a tourism destination through promotion of the 2010 Winter Olympics.

Alternatively, the British Columbia economy could grow slower than forecast if:

• The Canadian dollar movements become increasingly volatile or the dollar appreciates rapidly above the current forecast.
• Oil prices rise and are sustained at a high level, dampening North American growth prospects.
• Interest rates in the U.S. and Canada rise more quickly than forecast.
• Commodity prices decline more sharply than forecast or become more volatile.
• The recent monetary tightening, as well as the effects of high oil prices on China, slows the Chinese economy significantly.
• Geopolitical uncertainty accelerates due to events in the Middle East or further terrorist attacks.