Canada likely faces slower economic growth even if the United States manages to avoid default on its debt or a credit rating downgrade, economists said Wednesday.
The U.S. government's need to cut spending by between US$2 trillion and US$4 trillion over a decade would delay its recovery and drag down Canada's rebound because the two economies are so closely linked.
"The short-run effect of these changes is going to be to slow the recovery even further," says Christopher Ragan, an associate economics professor at McGill University.
"But at the same time they need to put themselves onto a fiscal track that is credible and show they are not going to be hitting the debt wall."
The U.S. government has been grappling since May with more than $14 trillion in debt – the borrowing ceiling set by Congress – and may not be able to pay its bills after Aug. 2.
That means Washington could be forced to cut its spending by almost half, threatening social security benefits, defence outlays, or even the wages of civil servants.
Ragan said a slower recovery by Canada's largest trading partner would have a ripple effect on export sectors such as automotive and forest products that have been struggling to return to pre-recession levels of a few years ago.
"Our exports still have a way to go before they get back to a pre-crisis levels, so we've got a lot of recovery to go in the export sector and that's going to slow it down."
Sluggish growth in the United States cuts demand for many Canadian exports – from oil and gas, cars and auto parts to newsprint, lumber, fertilizer, industrial chemicals, metals and machinery.
That eventually leads to fewer jobs in those sectors and far slower growth than is healthy for the national economy.
A one per cent hit to U.S. growth translates into a 0.5 per cent drop in Canada, said RBC Capital Markets chief economist Craig Wright.
He said financial restraint could prompt forecasters to ratchet down their growth forecasts in both countries.
"It does leave the economy more vulnerable and any further bad news may be in and of itself not enough to knock the economy significantly lower but you start wondering about the cumulative effect of all these negative shocks when the economy is sort of struggling," he said in an interview.
Potentially offsetting the decreases, however, could be a decision by corporations to spend their hordes of cash in the face of more financial certainty, he added.
Many believe U.S. politicians will eventually cobble together some sort of deal that avoids a default.
Prime Minister Stephen Harper said Wednesday that he was confident the U.S. government would find a way to deal with the situation and avert an economic disaster.
He called the situation in Canada "significantly" better than that south of the border but said Ottawa would remain vigilant and act as needed to mitigate any spillover effects.
"Part of the reason that the Americans are having such trouble dealing with this is that the U.S. debt and fiscal situation is extremely difficult," Harper said in Brampton, Ont.
"It is very bad."
Ragan said U.S. debt is not a crisis and levels are relatively lower than when Canada hit the debt wall in 1995.
Then Liberal finance minister Paul Martin tackled the problem by cutting $7 in spending for every $1 raised in taxes. But the impact on Canada's economic growth was shielded because the American economy was booming.
As the world's largest economy, the U.S. doesn't have that advantage.
The impact of a potential default are unclear.
U.S. interest rates would spike in such a scenario but those in Canada may actually decrease. That's because the Canadian dollar has soared in recent days – as the U.S. greenback weakened over the debt impasse – keeping downward pressure on Canadian rates.
The high Canadian dollar has squeezed the export sector and manufacturers in Central Canada. But if a U.S. economic slowdown cuts demand for energy, minerals and metals, it could drag down the loonie in the long term because of lower global commodity prices.
Wright said the worst case could be a U.S. recession, which would have a spillover effect in Canada.
More likely, a soft patch in the United States gets even softer for a bit longer, he said.
The United States may still face a downgrade even if a political deal is reached. Standard & Poor's said it wants to see a commitment for $4 trillion in spending cuts.
The impact of that would be less significant than a default and would likely be short term since ratings agencies might provide targets the U.S. would have to meet to regain its top credit rating, said Ragan.
The situation could be in some ways similar to 1998 when Moody's downgraded Japan's sovereign rating, said a report by Barclays Capital Research.
"We believe fundamentals will drive assets rather than the ratings revision," said the report.
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