Canadians' rising debt worries Bank

Paul Vieira, Financial Post Published: Thursday, December 10, 2009

OTTAWA -- Rising levels of household debt and deteriorating budget balances in a number of countries will emerge as the most prominent risks to the Canadian financial system over the next few years, the Bank of Canada said Thursday.

In its semi-annual review of the Canadian financial system, the central bank said the level of vulnerability to an adverse near-term shock has declined modestly. Furthermore, the likelihood of a renewed global downturn has diminished since the release of its previous assessment in June.

"At the same time," it warned, "several medium-term risks have intensified."

Two were singled out: rising levels of household debt, perhaps spurred in recent months by consumers looking to take advantage of record-low borrowing costs; and an inability to resolve global trade imbalances, which the bank warned could cause a "disorderly" adjustment in exchange rates.

The central bank said the review is meant to provide an assessment of downside risks that could cause stress in financial markets, even if they are low-probability events.

Nevertheless, it acknowledged that ratio of household debt to income has climbed to "historically" high levels, of over 140%.

"The medium-term risk to financial stability arising from the household sector is judged to have increased," it said. "This judgment is predicated on concerns that the sustained growth of household debt in the context of rising interest rates will increase the vulnerability of households to an adverse shock over the medium term."

To illustrate its point, the bank conducted two hypothetical stress tests. In one scenario, interest rates rise to levels consistent with the current fixed-income market; and in the other, rates climb at a quicker pace than currently priced in by traders.

The results, for the period up to the second quarter of 2012, suggest the proportion of households with a debt-service ratio of over 40% -- a threshold the central bank deems vulnerable – would increase, from its present level of 5.9% to a range between 8.5% and 9.6%. (The debt-service ratio measures the amount of income needed to finance loans.)

The percentage of overall debt held by these vulnerable households would increase, from 10.7% now to somewhere between 16% and 19%.

While lenders might be able to absorb these type of losses based on current capital buffers, the central bank warned they should "carefully consider" the risk to their entire household exposure, even if mortgages are insured by the federal government. "A household defaulting on an insured mortgage would likely be unable to meet its other debt obligations, resulting in a deterioration in the quality of the bank's entire household loan portfolio."

The Canadian housing market has been on fire this year, with sales and price levels in the existing home market posting significant double-digit gains, especially in big urban centres.

Meanwhile, the central bank also raised a red flag on efforts to level out current account imbalances – whereby countries with massive deficits, such as the United States, save more while surplus nations, led by China, have to boost domestic consumption.

While there has been progress, the central bank warned that further adjustments in exchange-rate policies are required – a hint aimed at China and other Asian nations, which have intervened in currency markets to keep their currencies from appreciating. Unless that happens, other economies, such as Canada, might be forced to bear more of a cost than they can handle in terms of evening out imbalances.

In addition, dealing with the imbalances might be hindered by the massive budget shortfalls a "number of countries" are running at present, and are expected to continue over the medium term. The central bank didn't cite countries, but it is likely the United States was top of mind.

Should concerns over fiscal sustainability mount, the central bank suggested this could result in higher-than-expected yields on sovereign bonds – which would translate into higher borrowing costs for households and businesses across the board. Moreover, there is likely to be more volatility in currency markets.

"While Canada's fiscal position remains relatively strong, [the country] could be adversely affected if higher borrowing costs facing countries with large deficits were to mute the global recovery, or if there are rapid shifts in exchange rates," the review said.

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