The International Monetary Fund cautions that although Canada’s economic performance looks strong, it is very dependent on machinations of the global economy.

The warning came in the statement of the IMF Mission to Canada, which was released today by the Department of Finance.

“The outlook appears favorable, buoyed by the boom in world commodity prices, but Canada remains highly dependent on global economic developments,” the IMF said. It predicts GDP will increase by about 3% this year and next, “as the support to activity from high commodity prices balances the pressures on noncommodity exporters from currency appreciation, with inflation returning close to the 2% target by end-2006.”

“While the low household saving rate remains a concern, the key risks are external. In particular, Canada’s openness to foreign trade, exposure to commodity prices, and close ties to the U.S. economy have brought enormous benefits, but also leave it especially vulnerable to a disorderly resolution of global external imbalances,” it noted.

The IMF said that the key economic challenge remains to improve the economy’s flexibility and to support long-term growth. It noted that Canada’s productivity performance has been disappointing in recent years, “and an improvement will be needed to help cope with the effects of the coming retirement of the baby boom generation on the labor supply and social programs. Economic flexibility remains key to maximizing the benefits from Canada’s plentiful natural resources in the face of recent commodity price increases, and to enabling the economy to respond to the uncertainties that surround the global environment and prospects.”

“These challenges underline the importance of continuing to pursue sound macroeconomic policies while intensifying the focus on policies to improve economic efficiency,” it added, noting that it agrees with the Bank of Canada that a further withdrawal of stimulus will be required in coming months.

The organization lauds the 2005 federal budget and subsequent Fiscal Update as providing, “a welcome reaffirmation of the commitment to fiscal transparency, prudence, and continued debt reduction.”

It suggests that after the significant boost to social spending that has occurred in recent years, it is appropriate to shift the policy emphasis toward improving economic efficiency. “In this respect, the focus on reducing the tax burden and supporting education, innovation, and immigration proposed in the Update is welcome. Planned cuts in corporate rates and the early elimination of the federal capital tax are particularly appropriate given the relatively high level of Canada’s marginal effective tax rates,” it said.

The IMF stressed that health care reforms are still needed to ensure the sustainability of the public health care system. It called for improving incentives to invest and save, including further reducing top marginal income tax rates and increasing RRSP limits; reducing labor market rigidities; reducing barriers to competition; liberalizing trade; delivering a clearer bank merger policy; and, establishing a national securities regulator; among other things.