Global economy will take $700-billion hit, Bank of Canada predicts

More than $700-billion in global output is expected to be lost to the European financial crisis in 2012, with a $10-billion hit to Canada as demand slows for the country's exports and uncertainty limits investment by companies.

The Bank of Canada quantified the effects of Europe's sovereign-debt woes Wednesday in a forecast predicting the $70-trillion global economy will be held back by 1 per cent this year. Canada's $1.6-trillion economy, already struggling to gain traction, will be restrained by 0.6 per cent due to the crisis. The United States, Canada's chief export market, will suffer a hit of 0.8 per cent, the bank said.

The warning illustrates that Canada's economy is still experiencing blowback from a crisis that policy makers say will see the euro zone in recession for most of the year. It also underscores that even as leaders express rising concern about household debt in Canada, they are widely expected to leave borrowing costs at near-emergency levels until 2013 or even later, to help offset the weight of Europe's problems on the economy.

Bank of Canada Governor Mark Carney and his rate-setting panel say their predictions for growth and inflation over the next two years are based on an assumption that European leaders will manage to contain their problems before they engulf the global financial system and spur a far worse crisis. But this assumption, Mr. Carney and his team acknowledge, is far from guaranteed.

"Failure to contain the crisis in Europe is the most serious risk facing the global and Canadian economies," the central bank said in its quarterly monetary policy report. Even though Canada sends barely 5 per cent of its exports to Europe, the fallout would be felt.

"The effects on Canada through financial, confidence and trade channels would be substantial, given the size and importance of the euro area to the global economy."

Assuming, as the bank does, that such worst-case scenarios are avoided, the problems in the euro zone – which accounts for 16 per cent of the global economy – are still expected to cut into worldwide growth.

The central bank cut its 2012 and 2013 forecasts for the world economy Wednesday, to 2.9 per cent and 3.3 per cent respectively. The World Bank also slashed its outlook for the global economy, citing "significant headwinds" from the European debt crisis.

All of that came on a day when the World Bank's sister institution, the International Monetary Fund, said it will need $1-trillion (U.S.) – more than double the amount the Washington-based emergency lender has at its disposal – to absorb potential defaults in Europe and the poorer countries that could be brought down by a global financial crisis.

Canada's economy will grow 2 per cent this year and 2.8 per cent in 2013, performances that would have been better except for the European situation's "implications for financial conditions, confidence and global commodity prices," the central bank said.

Even as low interest rates spur debt-fuelled spending by households, uncertainty linked to Europe is driving many businesses to hoard cash or delay projects rather than invest at a time when policy makers are counting on private-led consumption to drive the recovery.

At a news conference in Ottawa Wednesday, Mr. Carney urged executives to resist the "natural" tendency to put off investments, reiterating his long-standing argument that they should look past the turmoil in Europe and the U.S. and focus on faster-growing economies such as China's.

"One really wants to think about how important Europe is for the ultimate profitability of those (projects)," he said.

For the most part, economists agree with the central bank's core assumption that European leaders will not allow a full-blown, continent-wide banking crisis to happen on their watch, and say the world will dodge another meltdown similar to the one in 2008, when the failure of Lehman Brothers Inc. rippled through markets and triggered the worst downturn since the Great Depression.

"There's too much to lose out there, so that's why we also think a global financial crisis will be averted," said Krishen Rangasamy, a senior economist with National Bank Financial in Montreal.

"Hopefully, politicians learned enough about the cost of inaction in 2008-2009. That's our 'base case' – that politicians are rational."