Market Growth Helps Canada’s Debt Problem

There are two things that could impede Bank of Canada Governor Stephen Poloz from raising interest rates further in the coming months: worries about the financial system’s ability to cope with higher borrowing costs and concern that plenty of slack remains in the economy.

By the end of this week, the picture should be at least a little clearer on both fronts. On Tuesday, the central bank’s semi-annual report on financial stability will reveal its thinking about risks such as how vulnerable are highly indebted households to a major housing correction. That’s followed Friday by Statistics Canada’s GDP numbers for the third quarter and October jobs data that will show the extent to which the economy continues to eat into its spare capacity, Bloomberg reported.

The reports are widely seen reinforcing market expectations for continued interest rate increases, but only gradually as the Bank of Canada tiptoes its way to more normal levels.

Poloz’s main message at his last Financial System Review in June—which came just before his first rate increase in seven years—was that despite an unsustainable jump in Toronto home prices earlier this year and the consequent rise in debt levels, the financial system’s resilience was actually strengthening on the back of an improving economy. And since then, Canada’s economy has done even better than Poloz had thought at the time.

While economists expect Statistics Canada to report a slowdown to 1.8% annualized growth in the third quarter, growth in the second quarter turned out to be a much stronger 4.5% and the economy is on pace for 3% growth for all of 2017.

Toronto’s housing market meanwhile is cooling after Ontario imposed a foreign-buyer tax and the country’s main financial regulator tightened mortgage-qualification rules. Stronger economic growth and cooler housing should mean—in the eyes of policy makers—the financial system has only become more resilient over the past six months.

Of course, what has changed since June is that Poloz raised the central bank’s key interest rate twice, and the Bank of Canada has said it’s monitoring closely how the higher borrowing costs will impact the economy. It’s one of the reasons the central bank claims it will remain cautious on future hikes.

Soft Landing

But the initial signs should be comforting. A soft landing seems to be playing out in Toronto’s housing market and households are hardly slowing their credit growth.

Year-over-year benchmark home price gains in Toronto averaged 27% in the first six months of 2017, according to the city’s realtor board. Since June, that average has halved to 13.6%. Vancouver’s housing market underwent a similar slowdown after a foreign-buyer tax was imposed in August 2016, and is now recovering.

Stronger demand and tighter supply mean the Toronto and Vancouver markets are “still on an upward trajectory, but it’s on a more stable upward trajectory,” said Royce Mendes, an economist at CIBC World Markets. New regulations in places like Toronto and Vancouver “will be more like a bump in the road than a car driving into a sink hole.”

Household credit—the latest data were released Friday—show year-over-year growth still hovering at the 5.5% range it’s averaged over the past 18 months, with consumer credit gains offsetting slowing residential loan borrowing.

Household Debt

The Bank of Canada sometimes comes under criticism for its role in fueling the household debt, with some suggesting the central bank should stop worrying about the impact of raising interest rates and hike more aggressively in order to curb borrowing more quickly.

This month, the OECD flagged Canada as leading the advanced and developed world in household borrowing, and how that poses a risk to growth. Canada currently has the second-highest gross debt to income ratio in the Group of 20, the IMF reported in October.

Canada’s debt addiction is frequently the subject of such warnings, yet CIBC’s Mendes says they’re misleading. He says although household debt in Canada is elevated, the quality of that debt is higher than in many countries which have less debt.

For example, the risks are nowhere near where they were in the US before the financial crisis, according to Mendes. He says the proportion of non-prime mortgage origination is about 10% of the total, compared with 33% in the US before the crash.