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The household debt conundrum facing the Bank of Canada

The stereotype that Canadians are financially more conservative than their American cousins may no longer apply.

The stereotype that Canadians are financially more conservative than their American cousins may no longer apply. Data released last week by Statistics Canada showed that, for the first time in nearly two decades, the Canadian household debt to income ratio surpassed U.S. levels, at 148 per cent.

Governor of the Bank of Canada, Mark Carney, has highlighted on various occasions over the last year that this is a risky trend . . . but stopping the binge carries risks too.

What worries the Bank of Canada is whether or not households will be able to service their debts once interest rates normalize or if a negative income shock occurs. For the December Financial System Review (FSR), economists at the central bank conducted a stress test using micro lending data that projected current debt and income trends forward a couple years and then imposed a shock to the model, increasing unemployment by three per cent. The result: arrears at banks increased from 0.6 per cent of loans in Q2 2010 to 1.4 per cent in Q4 2012. September’s FSR report looked at hypothetical situations in which interest rates spiked - showing that a return to pre-recession interest rates would increase the proportion of vulnerable households from 6.1 per cent to 7.5 per cent in 2012.

Extraordinarily low interest rates are obviously playing a part in the debt binge, a lever partly controlled by Carney and his staff. However, the Bank of Canada has proven extremely reluctant to use interest rates to deter households from taking on more debt given that other aspects of the Canadian economy need low rates. Instead, the Central Bank would prefer the Finance Department use its control over mortgage insurance rules, such as minimum down payment requirements and maximum amortization periods, to cool the mortgage market. Earlier this year, small changes were introduced, but apparently this did little to significantly dampen Canadian appetite for mortgage credit.

When Canadian mortgage insurance rules started to be relaxed in 2003, it drastically increased the number of households that could enter the market and the qualifying amounts. It was a democratization of credit and many households took advantage, spurred on by other key fundamentals, such as strong income growth and high household formation rates. New home investment has contributed significantly to the economy and, given the current situation, no one wants to put the economy in peril by restricting the availability of credit too much.

A strong residential real estate market affects the economy through another indirect channel, known as the wealth effect. Household consumption patterns are obviously impacted by income, but studies show asset price changes also impact current spending. Furthermore, with access to home equity becoming more available over the past decade, the effect may have increased. The reverse can also occur, such as what is happening currently in the U.S. This has important impacts for industrialized countries, whose economies depend anywhere between 65 and 70 per cent on consumption spending.

It's a balancing act. Drawing down equity and taking on excessively large mortgages can leave the economy very vulnerable to negative economic shocks, but stopping the party full stop before other segments of the economy strengthen would also be painful - especially if it resulted in a housing price correction. Convincing households to act more prudently on their own without restricting credit for all homebuyers might carry the least risk, but that strategy hasn’t had a lot of success so it wouldn’t be surprising to see some regulatory action in the coming months.

Will Van’t Veld is an economist with ATB Financial.

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