The following is the feature article in BMO’s weekly financial digest for the week of June 24, 2011.
Canadian Household Debt: Slowing, But Still Growing
Douglas Porter and Sal Guatier
Canadian households can’t fully resist the lure of interest rates at persistently rock-bottom levels. With overnight rates unchanged since last September, household credit market debt has climbed to a fresh all-time high of $1.524 trillion in Q1, or a record 147.3% of disposable income. Canadian debt
ratios are now leaving their U.S. counterparts in the rearview mirror (Chart 1), despite the repeated exhortations bydomestic policymakers to rein in borrowing. It seems that (interest rate) actions speak louder than words.
Chart 1.
Although household debt growth has cooled notably in recent months—April’s 5.5% y/y was the slowest pace since early 2002—the plain fact remains that it continues to outstrip income growth. In Q1, credit market debt rose 6.4% y/y
(Chart 2), with consumer credit (5.2%) showing a more noticeable slowing trend than mortgages (7.4%). The latter was likely boosted by activity pulled ahead of tighter mortgage insurance rules that took effect in March, though demand remains solid in some regional markets.
Chart 2.
Alongside rising household debts are two other noteworthy trends: higher debt service costs and lower homeowners’ equity (Chart 3). Interest payments consume 7.6% of disposable income, just above the 10-year mean (of 7.4%).
Chart 3.
While far from high, the muted figure is solely because of current low interest rates. Interest payments will absorb a larger share of household budgets when rates increase. Similarly, while homeowners still have a nice equity cushion in the event of a house price correction, it’s a concern that the cushion is losing some padding even in the face of rising house prices (as was the case before the
U.S. boom turned to bust). The ratio to real estate values has slid to 67.3% from a peak of 71.1% in 2007Q2.
We have been much less alarmist than others on the buildup of debt, as in many cases there are solid assets on the other side of household balance sheets.
In fact, because of higher house prices and equity markets in Q1, households are wealthier despite rising debts, with net financial assets hitting fresh peaks (Chart 4). Importantly, the increase in debt ratios has slowed in the past year after soaring 35 percentage points in the previous eight years. Moreover, Canadian debt ratios remain well below peak U.S. levels (164% in 2007), and the gap is even starker when compared against before-tax income (Chart 1; American families pay more of their health care costs out of pocket rather than through higher taxes).
Chart 4
That said, household debt remains elevated relative to assets (Chart 5).
Chart 5.
Moreover, since the end of Q1, equity markets have slid 10% into correction territory, and more than a few analysts have warned about a possible housing
correction in some regions.
As Governor Carney says, “while asset prices can rise and fall, debt endures”.
The risk to Canada’s financial stability and economy arising from high household debt remains “elevated” according to the Bank of Canada’s recent Financial System Review. The Bank suggested that a “further moderation in the pace of debt accumulation” is needed to contain this risk. The report also said that this risk was “broadly unchanged since December”, despite the further build-up in household debt ratios over the past two quarters. Ironically, the same report cites an increase in risks stemming from the current
low interest rate environment in advanced economies— the same low rates that are sustaining household credit growth (and keeping the economy moving forward in the face of a strong dollar and soft U.S. demand).
Bottom Line: While we maintain that a singular focus on debt to gauge the strength of household finances is not entirely appropriate, the prolonged period of ultra-low interest rates runs the risk of pumping a debt/housing
bubble. We are encouraged by the recent slowing in consumer debt growth, though some further cooling, especially on the mortgage side, will be required to stabilize household debt ratios. This should occur when (or if) interest rates climb moderately in the year ahead. If debt growth doesn’t slow further, look for Governor Carney to become more vocal in his warnings to households and financial institutions, to potentially push for another round of regulatory moves to curb credit growth, and to possibly raise interest rates more aggressively than he (or the economy) would like.
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