Bank of Canada Governor Stresses Caution to Canadian Households

The Governor of the Bank of Canada, Mark Carney, gave a speech in Toronto today regarding the Current Issues in Household Finances.

Here are some of the highlights:

Overview

1. Feedback between financial markets and the real economy has reversed direction
2. The inventory cycle has turned and housing sectors are stabilizing.
3. Considerable fiscal expansion and monetary stimulus are supporting domestic demand.

• The global economic outlook has improved: due to:
• While the Canadian economy will likely grow faster than the other G-7 countries next year, the Bank expects our recovery to be more protracted and more reliant on domestic demand than usual
• In the near term, Canada will grow despite – not because of – the pace of external activity.

Canadian households

• Canadian household finances were in better shape going into the crisis than those of Americans. The Canadian personal savings rate was higher and household debt was lower.

• The ratio of consumer spending to GDP, at 55%, was below the longer-term average in Canada making Canadian households less vulnerable when the crisis struck
• Canadian labour and housing markets have held up better than the US
• The personal savings rate in this country rose to an eight-year high of 5.5% in Q2 2009.
• As the economy begins to grow again and confidence is gradually restored, we expect that some of these precautionary savings will be unwound, and that some consumers will take further advantage of unusually low borrowing rates. Our current stimulative monetary policy is meant, in part, to encourage such behaviour.
• Going forward, there are risks, on both the upside and the downside, to this outlook for the Canadian personal savings rate.
• Canadian households could remain more cautious, chastened by the recent financial and economic trauma, leading to more durably elevated savings. Some of the issues brought to the fore by the crisis, such as retirement funding, could also alter household savings behaviour over the nearer term.
• On the other hand, there is a risk that, as growth returns, the resilience of Canadian households through the crisis could lead to declines in the savings rate that are sharper, and increases in household borrowing that are larger, than the Bank has projected.

Households and Financial Stability in Canada

• Canadian household balance sheets have increased further, meaning we've taken on more debt due to the low current interest rates.
• The vulnerability of Canadian households to adverse wealth and income shocks has grown in recent years as aggregate debt levels have risen sharply relative to income.
• For some households, this additional indebtedness has translated into increased financial stress. Personal bankruptcies in Canada rose 41% in the third quarter from the same period a year ago, leaving the number of bankruptcies as a proportion of the population at its highest level since 1991.
• Delinquency rates on loans have risen as well, with the proportion of mortgages with payments in arrears three months or more having increased by half over the past year.

Stress Testing the Canadian Household Sector

• The Bank believes that overall risks to financial stability arising from the household sector have continued to increase.
• In particular, the combination of sustained growth of household debt relative to income and a rising interest rate environment could increase the vulnerability of households to an adverse shock.
• In the current FSR, the Bank conducts stress-test scenarios to examine the potential impact of growing debt and rising interest rates on the debt-service ratio of Canadian households (Table 1). We look at scenarios such as these, not because we think they are the most likely outcome, but rather to provide an assessment of downside risks that could potentially generate stress in the Canadian financial system.
• Our stress-test simulation on the debt-service ratio of Canadian households generates a scenario indicating that, by the middle of 2012, almost one in ten (9.6%) Canadian households would have a debt-service ratio greater than 40%, the threshold above which households are considered financially vulnerable

As you can see in the table above the Bank's stress test involves the major interest rate (the target for the overnight rate) rising as follows:

Scenario 1

1 year (Q4 2010) = + 1.25% 2 year (Q4 2011) = + 2.85%

Scenario 2

1 year (Q4 2010) = + 1.25% 2 year (Q4 2011) = + 3.75%

• Moreover, the percentage of debt owed by these vulnerable households would almost double. Both of these metrics are well above their recent peaks.
• While these simulation results are purely illustrative, they give pause for reflection. It would not be healthy to have almost 20% of household debt extended to vulnerable households. Nor is it necessary to secure our recovery.

Conclusion

• At present, the risks arising from the Canadian household sector are relatively low.
• The current rate of mortgage arrears, for example, remains more than 1/3 below its peak in the early 1990s. Going into the crisis, Canadian households carried considerably less debt than their American counterparts.
• Our advice to Canadians has been consistent: We have weathered a severe crisis – Ordinary times will eventually return and, with them, more normal interest rates and costs of borrowing. It is the responsibility of households now to ensure that in the future when the recovery takes hold and extraordinary measures are unwound, they can still service their debts.
• So in closing Mark Carney believes that we've help up through the storm, he isn't too worried about a "housing bubble" and re-itereated the Bank's conditional commitment to keep current interest rates low until Summer 2010 as long as inflation stays within 2%. We are enjoying a time of extremely low interest rates and households need to plan an increase of up to 3-4% over the next couple of years to ensure they don't get into trouble.