Canada’s economy, the world’s 10th-largest, looks to be chugging along nicely. Though low oil prices slowed it down in 2014-2015, it grew by 3 percent last year, with help from each of the country’s provinces. But this growth has come at a cost: debt. Canada’s debt is piling up, creating vulnerabilities that could make recovery more difficult for the country in the event of another recession. This Deep Dive will investigate the scale of Canadian debt, with an emphasis on consumer debt, and whether its associated risks could spread beyond Canada.

Warning Signs

That Canada was accumulating more debt was no secret. But the extent of the risk that debt has created became more apparent earlier this year when the Bank for International Settlements published the latest edition of its report “Early warning indicators of banking crises.” The paper lays out several metrics that have a statistically significant effect on predicting future banking crises, while minimizing the chance of a false positive, or a crisis that was forecast but doesn’t happen. The metrics include the difference between current and historical ratios of private, nonfinancial debt to gross domestic product – the credit-to-GDP gap – and the ratio of outstanding debt to income, known as the debt service ratio, at the national and household levels. When these early warning indicators cross a certain threshold, the BIS highlights them in amber. When they cross a higher threshold, indicating an even greater likelihood of a banking crisis, it turns them red. All of Canada’s indicators are red or orange, meaning conditions in the country’s banking system are favorable for a crisis within the next three years.

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Household debt is a big part of this equation. Canada currently has roughly 2.5 trillion Canadian dollars (or about $2 trillion) in household debt – the equivalent of approximately 170 percent of Canadian disposable income. In other words, for every dollar earned, the average household owes C$1.70 in debt. And that’s just the average; about 8 percent of Canadian households have debt equivalent to 3.5 times their gross income, making up about 20 percent of Canada’s total household debt.

Most of Canada’s household debt comes from mortgages. Since the end of 2008, low interest rates in the country have made credit more available and less expensive. Demand for housing has, in turn, increased – and with it, housing prices. At the end of last year, the Organization for Economic Cooperation and Development estimated that Canada’s housing prices were overvalued by approximately 50 percent relative to prevailing rental rates. Higher housing prices, and, by extension, higher collateral value, justified larger loans, while low interest rates made bigger debts easier for borrowers to service. The result was a kind of feedback loop. Meanwhile, Chinese capital flooded the Canadian real estate market as investors in China looked for hard assets to acquire abroad. These buyers helped drive up housing prices in Canadian cities such as Vancouver, and they could drive them back down just as quickly if Beijing were to clamp down on its capital outflows. The resulting dearth of capital and the collapse of housing prices would put some homeowners in Canada underwater.

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Mortgages, however, are only part of the problem. Many Canadians, like countless Americans in the runup to the 2008 financial crisis, have also taken out home equity lines of credit, or HELOCs – lines of credit secured against the value of a house. Unlike a traditional mortgage, in which a bank extends a fixed amount of credit at once for the purchase of a home, a HELOC is a guarantee that a bank will lend up to a certain amount of money as needed over a given time frame. The loans became more popular as lending increased overall, and since HELOCs often allow for interest-only payments – or at least lower principal payments – many Canadians have opted for higher HELOC interest rates than for traditional mortgages. The interest-only or lower-principal model means borrowers pay less each month than they would for a traditional mortgage, the higher interest rate notwithstanding. So lenders get more in interest, while borrowers have more cash on hand to spend elsewhere. It’s a win-win – until, of course, the principal comes due. Once a loan reaches maturity, borrowers must either pay off what’s left of their debt or refinance it. In some instances, borrowers wind up owing more on a HELOC than the value of their homes, a particular danger in inflated housing markets like those in most Canadian cities.

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Paying the Piper

The possibility of interest-rate hikes adds to the risks facing borrowers. In Canada, one-quarter of all mortgages have a variable interest rate and reset more often than fixed-rate mortgages. But even fixed-rate mortgages reset every five years, compared with the 30-year fixed-rate arrangement familiar to U.S. homebuyers. The more debt a household carries, the lower its chances of being able to repay its obligations when interest rates increase. As fewer borrowers can afford to repay their debts, more loans will be at risk of becoming nonperforming, putting strain on the Canadian financial system.

Put simply, rising interest rates will have an outsize effect on Canada’s consumer spending. But as the central bank boosts interest rates – as it has already done five times since May, bringing them from 0.5 percent to 1.75 percent – it will add to the stress on borrowers. A recent poll by the Canadian Broadcasting Company showed that nearly 60 percent of Canadians could not afford to pay C$100 more a month toward their debt (or any other expense) without changing their spending habits. That means three more interest rate hikes of 0.25 percent are all it would take to drive households with $200,000 or more in mortgage and HELOC debt to modify their spending. Considering the average household debt in nearly all of Canada’s major metropolitan areas is at least that high, a large share of Canadians may soon have to curb their spending.

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Interest Rates and External Debt: A Tricky Situation

That’s troubling news, not only for the average Canadian citizen, but also for the government.  As the U.S. Federal Reserve continues its monetary tightening, the Canada is facing the conundrum that plenty of other states around the world are: try to keep up with the Fed’s rate hikes and risk overcorrection, or take it more slowly and risk currency depreciation. (If interest rates climb faster in the U.S. than elsewhere, capital will flow there in search of greater returns.) Canada stands to take a hit either way. Although it is a major energy exporter, consumption and residential investment have accounted for more than 90 percent of its economic growth since 2009. Boosting interest rates could dampen consumer spending by increasing household expenses and decreasing disposable income. On the other hand, if the central bank doesn’t keep raising interest rates, or doesn’t raise them quickly enough, the differential with U.S. interest rates will cause the Canadian dollar to depreciate.

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The substantial debt burden of the average Canadian household could also complicate the Bank of Canada’s efforts to keep inflation between 1 and 3 percent, and preferably right around 2 percent. Its previous interest rate hikes aimed to lower inflation, which has hovered above 2 percent for most of the year. But because the average household has so little wiggle room in its finances, even small interest rate increases can affect consumer behavior. That reality will constrain the central bank as it considers bumping up the interest rates in the future, and Canada’s rates may well wind up trailing those of the U.S.

On both counts, the result would be a higher price tag on Canada’s external debt. Currency depreciation makes external obligations denominated in foreign currencies more expensive for a country to service. And Canada’s external debt isn’t trivial, at $1.9 trillion total, of which $1.33 trillion – a sum equivalent to 80 percent of Canada’s GDP – is in non-Canadian currencies. The government will have to decide whether to raise interest rates at the expense of consumers and economic growth or hold off and pay more to service its external debt.

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Risk of Infection?

The situation looks foreboding for Canada, but what about for other countries? How vulnerable another state would be to a prospective Canadian recession depends in large part on how exposed its banking system is to that of Canada. The top five countries with claims on Canada’s banking system – The United States, the United Kingdom, Japan, Germany and France – don’t have much exposure to Canadian banks. For example, the United States has $125.1 billion in claims on Canada, an amount that may seem formidable but comes to just under three-quarters of a percent of the total assets in U.S. commercial banks. These holdings are modest enough that even if Canada fell into a banking crisis on the scale of Italy’s meltdown – in which the ratio of nonperforming loans neared 15 percent – only 0.1 percent of U.S. banking assets would face a greater repayment risk. (Canada’s gross nonperforming loan ratio is in fact very low, at only about a half of a percent.)

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Canada, on the other hand, is not quite as insulated from other countries. A full 25 percent of Canada’s financial system has cross-border claims on the U.S., in part because of the large trade volume between the two countries. So while the U.S. would be more or less safe from a Canadian recession, the same would not be true for Canada in the event of a U.S. recession. That Canada derives about one-fifth of its GDP from trade with the U.S. makes it all the more susceptible to fluctuations in the American economy. Its vulnerability to the United States has become more apparent than usual since Washington reopened negotiations on the North American Free Trade Agreement.

On Unequal Footing

To better buffer itself from the vagaries of U.S. economic policy in the long term, Canada, like Mexico, will look for ways to diversify its trade partners. Doing so won’t be easy. Much of Canada’s trade with the United States is in energy, which requires extensive (and expensive) transport infrastructure, such as pipelines. Building new pipelines to send Canadian energy exports to new markets will take too much time and money for it to be a quick fix. Even so, Canada will need to find new energy buyers sooner or later; as the U.S. oil and natural gas industry becomes more self-sufficient, the United States will need less and less Canadian energy.

Canada isn’t totally at the whim of the United States, however. Ottawa has proved willing to push back against U.S. policies that challenge Canadian businesses. For instance, despite the inclusion in the United States-Mexico-Canada Agreement of a clause requiring all members to review any bilateral trade negotiations between a signatory state and a “non-market” economy, Canada says it nevertheless plans to pursue further trade agreements with China, the obvious, if tacit, object of the provision. It even helped China place four deep-sea monitoring devices in the Pacific Ocean late last month and connect them to its system of marine observatories. The sensors, which provide real-time data to the Chinese Academy of Sciences, are ostensibly for research purposes, though their proximity to two U.S. naval bases – one is the only West Coast base that can support dry-docking of Nimitz-class aircraft carriers, and the other houses nuclear submarines – adds a shadow of doubt to that claim.

It’s hard not to read Canada’s cooperation with China on these marine sensors as a message to the United States. What’s more, it’s easy enough to imagine that if Washington stands firm on its trade agenda, a nationalist party could take power in Canada and more aggressively pursue alternative trade partners to distance it from the United States. (The odds of it happening in the 2019 federal elections are slim, since Canadian consumers would probably need to experience a fair amount of financial discomfort before they move in that direction.) China would make a poor substitute – it’s far away, it’s not nearly as integrated with the Canadian economy as the U.S. is, and its consumer base isn’t as strong. But it may still be better than nothing, especially given Canada’s need for leverage in its trade dealings with the U.S. The transition won’t happen overnight, if it happens at all; Canada’s deep, structural economic reliance on the United States. would take years to break.

In the meantime, Canada has more immediate economic problems to contend with. The early warning indicators identified may not portend certain doom for the Canadian economy, but they don’t paint a picture of perfect health, either. And if Canada’s financial issues do trigger a crisis, its dependency on the United States could add fuel to the fire.

Xander Snyder
Xander Snyder is an analyst at Geopolitical Futures. He has a diverse theoretical and practical background in economics, finance and entrepreneurship. As an investment banker, Mr. Snyder worked in corporate debt origination and later in a consumer-retail industry group at Guggenheim Securities, participating in transactions ranging from mergers and acquisitions, equity and debt capital raises, spin-offs and split-offs to principal investing and fairness opinions. He has worked on more than $4 billion worth of transactions. He subsequently co-founded and served as CFO for Persistent Efficiency, an energy efficiency company that used cutting-edge technology to create a new type of electricity sensor for circuit breakers and related data services. In his role, he was responsible for raising more than $1.5 million in seed capital and presented to some 70 venture capital and angel investors in the process. He also signed four Fortune 500 companies as customers, managed all aspects of company accounting, budgeting and cash flow, investor relations, and supply chain and inventory management. In addition to setting corporate strategy, he helped grow the company from two people to a 12-person team. As an independent financial consultant, Mr. Snyder wrote an economics publication for a financial firm that went out to more than 10,000 individuals and assisted in deal sourcing for a real estate private equity fund. He is an active real estate investor and an occasional angel investor. Mr. Snyder received his bachelor’s degree, summa cum laude, in economics and classical music composition from Cornell University.