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OTTAWA (Reuters) - Finance Minister Jim Flaherty warned on Friday that Canadian economic growth may be set to weaken and undermine his budget projections even though second-quarter GDP data exceeded market expectations and was the strongest in the G7.
Solid business investment in plant and equipment, along with inventory build-ups, helped Canada register annualized real growth of 1.8 percent in gross domestic product in the second quarter, data on Friday showed. That matched a recent Bank of Canada forecast and beat a market forecast of 1.6 percent.
Canada now has had four straight quarters of expansion, Flaherty said. He added that though the growth rate was modest, it was better than any of the others in the G7, the Group of Seven leading industrialized nations.
But he said the global economy was fragile, and while the federal budget deficit had been halved in the first three months of the fiscal year, April-June, to C$1.98 billion ($2.00 billion), there was "downward risk to the fiscal track presented in budget 2012 (in March)".
The government did include an adjustment for risk in preparing the budget, he said. "However, further slowing of the global economic situation can be expected to have an impact on Canada," he added.
Flaherty, a long-time critic of what he sees as Europe's reluctance to deal with its problems, said he had talked to his European counterparts this week and they had expressed optimism about dealing with the euro-zone debt crisis later this year.
"I'll believe it when I see it, because this has been going on for a long time," he added.
"(The European crisis) is affecting the level of economic growth in the emerging economies including China ... this is a drag on the world economy," he said.
Any hit to the Canadian budget deficit would pale in comparison with the trillion-dollar gap faced by Washington. For the whole fiscal year, Canada's March budget predicted a deficit of C$21.1 billion.
The Bank of Canada's most recent projection, in July, is for economic growth to accelerate to 2.0 percent this quarter and to keep rising to 2.7 percent in the fourth quarter of 2013.
Scotiabank economist Derek Holt said that while Canada's second quarter growth was better than expected, it was still very soft and did not merit hawkish monetary policy talk. He noted that inventory build-up contributed 1.7 percentage points of growth.
"The fact that so much...is coming from inventories signals that there is unanticipated inventory building in a soft economy. It is not a good form of growth."
Nonetheless, businesses also boosted spending on plant and equipment by an annualized 9.4 percent from the first quarter, and Flaherty said real business investment was now above pre-recession levels.
Bank of Canada Governor Mark Carney pointedly criticized corporations last week, suggesting they should invest their hefty holdings of cash or return it to shareholders.
Flaherty said he would like to see more investment in machinery and equipment as it boosts productivity.
Overnight index swaps, which trade based on expectations for the central bank's key policy rate, showed that traders increased bets on a rate hike in 2013 after the GDP data was released.
They have now priced in a greater than 50 percent chance of a rate hike by July 2013.
Canada's dollar climbed against its U.S. counterpart after the GDP figures, and was further boosted by remarks by Fed Chairman Ben Bernanke that the stagnation of the U.S. labor market was of grave concern and the Fed would act as needed.
At midday, the currency had strengthened to C$0.9863 versus the greenback, or $1.0139, from around C$0.9903, or $1.0100, immediately before the release of the data.
Additional reporting by Claire Sibonney in Toronto and David Ljunggren in Ottawa; Editing by Peter Galloway