Let’s address the outlook for each of these areas

Weaker economy could impact SME cash flow

The main challenge from a cash flow and uncertain economy perspective will come from weaker revenue growth. The economic outlook is consistent will only meagre gains in profits. While large-scale businesses make up the lion’s share of national profits, small and medium enterprises are found in virtually every sector of the Canadian economy and they will be affected by the same revenue trends. SMEs do tend to be less export-oriented than large enterprises, and exports are expected to be the greatest source of weakness. At face value this could mean that small businesses outperform their larger export-oriented brethren. But, this likely overstates the case, since many SMEs sell to exporters or sell to local economies that are heavily reliant upon to fortunes of local export-oriented firms. And, the weakness will not be solely on the export front, as the domestically-oriented firms will feel the impact of the softer growth in domestic demand. On a national average basis, SMEs are likely to experience modest income growth of around 3% in the coming year.

In the TD survey, currency fluctuations were tied to economic prospects and foreign exchange movements are a concern for many small businesses. In the September CFIB survey, 30% of SMEs reported that they prefer a lower Canadian dollar and 27% prefer a stronger Canadian dollar – so the impact on the SME sector is largely a wash, but for individual firms it could be very important. TD Economics expects that loonie to return to above 90 U.S. cents next year. The Canadian dollar fell sharply in the fall of 2008 in reaction to the correction in commodity prices and in response to a global flight to U.S. dollars during a period of financial turmoil. Commodity prices will not recover their losses in the months ahead, but the U.S. dollar is likely to decline when financial conditions stabilize, providing renewed support to the loonie.

Credit conditions tighten

One of the recent concerns raised by small businesses has been access to credit. This is natural given the extreme distress present in the global financial system and the stories about the dramatic decline in banking lending in the United States. In Canada, there is some evidence that credit conditions have tightened. The Bank of Canada Senior Loan Officer Survey showed that 47% of respondents reported tighter pricing and 53% indicated tougher non-pricing aspects of lending. It is critical to recognize the difference, however, between the U.S. and the Canadian experience. In many cases credit is not available in the U.S. at any price, which is why there had been a massive government intervention in the banking sector, with the U.S. Treasury injecting more than US$1 trillion to get lending flowing again. In contrast, credit is available in Canada to businesses, although the cost of funds may not be as attractive as in the early part of this decade. This is why the Canadian government response has been far more subdued. For lenders that pursued prudent practices in the past there has been no need to dramatically tighten up on loan conditions. And, this can be observed from the fact that tightening observed in the Bank survey is only slightly greater than the experience in 2001.

The reason for the tighter pricing and availability has to do with an increase in the cost of borrowing to financial institutions. The accompanying chart shows the spread between the Prime lending rate and the 1-month Bankers Acceptance (BA) rate. The Prime lending rate is the benchmark for many loans. The BA rate is the cost to financial institutions of raising cash. In recent months, the Prime lending rate has declined as the Bank of Canada cut rates, but the BA rate has not fallen in tandem. Canada’s largest lenders take in deposits and make loans, but the loans are greater than the deposits. The difference must be financed in international markets, which are currently demanding elevated interest rates and impairing profitability. Policy makers in the U.S., Europe and Canada have introduced significant measures to address this problem in an effort to lower interbank lending rates. These actions are likely to be successful eventually, but it won’t happen overnight. When the financial strains do subside, businesses should find that credit pricing and availability improves. However, given that the excess credit was the root of the recent financial problems, the availability and price will not return to the lows in the early part of this decade.

Energy prices plummet, but remain high

Despite all of the difficulties, it is noteworthy that some of the past challenges for SMEs are becoming less pressing. Energy prices have fallen sharply in recent months. Over the past several years a dramatic run up in energy prices caused many businesses considerable distress and boosted production/delivery costs. However, the prospects of weaker global energy demand have now led to a dramatic correction in energy prices, with oil and natural gas falling substantially, and much of the decline will be sustained. The commodity price correction has also not been limited to energy, as base metal and forest product prices have retreated. It should be noted that while the commodity price correction may take some of the pressure off input costs in selected industries, the outturn will hamper profit growth in commodity-related industries or businesses that sell to the commodity sector. Moreover, the level of prices remains elevated – as evidenced by the fact that the pullback in crude oil prices in early October still left the level higher than the average in 2007.

Labour markets to become less tight

Another major concern in recent years has been the excessively tight conditions in Canadian labour markets. Many businesses have encountered difficulty finding and retaining skilled staff at a time that unemployment was at, or near, a 30-year low. Looking forward, Canada’s labour markets will slacken. Employment growth is expected to slow from the 2.1% average pace over the last decade to 1.5% in 2008 and a mere 0.3% in 2009, with the pace of job creation cooling across the country. Meanwhile, the national unemployment rate is poised to rise from 6% in 2007 to 6.7% in 2009, and all of the provinces will experience this trend. It should be stressed that this still represents a low rate of unemployment and is supportive to the domestic economy, but it does suggest that businesses may find that hiring and retention will be less of a problem. Corresponding to the labour market moderation, wage and salary growth is also expected to cool to a 3% pace in the coming year – which will still provide workers with income growth slightly above the rate of inflation.

The bottom line is that 2009 will likely prove to be a challenging year for many firms. However, it is also important to stress that this is a cyclical event. The external shock from the global economic slump and global financial turmoil will dampen Canada’s economic prospects in the coming year. More subdued domestic consumption and a weaker real estate market will also be a headwind in the near-term. Notwithstanding these transitory negative forces, the Canadian economy is fundamentally sound and it will recovery when the depressing factors abate. The Canadian financial system is also stronger than its international counterparts and the Government of Canada has superior fiscal balances than many other nations. When the global economy stages a recovery in 2010 and when the improvement of domestic housing affordability brings buyers back into the market, the Canadian economic cycle will turn, leading to improved fortunes for small and medium-sized enterprises.

Craig Alexander, VP & Deputy Chief Economist
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