After witnessing the experiences of other countries during the global credit crisis, and living through the painful deleveraging here in the 1990s, Canadians are very cognizant of the dangers of excessive debt leverage, according to a special report released today by Scotia Economics, entitled Canada’s Balance Sheet & Economic Advantages Mitigate Household Debt Risks.
“There is understandable concern about the rapid rise in borrowing, and the buoyant housing market in particular, that has pushed Canadian household debt leverage to new records,” said Warren Jestin, Chief Economist, Scotiabank. “However, our analysis suggests that the odds that current household debt leverage will trigger a full-blown relapse – either in the housing market, or more generally in the economy – are relatively low.”
According to Mr. Jestin, “today’s situation is much different than the early 1990s when corporate, household and government balance sheets were simultaneously imperiled and monetary policy was much more restrictive. Canada entered the recent downturn with close to two decades of government fiscal repair, strong corporate balance sheets, and a world-class banking sector.” He goes on to say, “even with the continuation of low borrowing costs, existing debt burdens coupled with reduced employment gains point to a cooling of consumer spending and housing activity in the year ahead.”
Canadian Corporations – Financial Strength For Growth
“Canadian companies entered the economic downturn with among the strongest balance sheets in the developed world, giving the business sector greater stamina to deal with the global financial crisis,” stated Mr. Jestin. This is the opposite performance of the early 1990s when strained corporate balance sheets magnified the downside risks to jobs, investment and the overall economy.
“Today, Canadian businesses also have a number of other advantages that support increased capital investment for the long-term,” added Mr. Jestin. “These include the removal of tariffs for industrial manufacturers, the cheapening effects of dollar strength on imported business equipment, low borrowing costs, high cash balances, and accelerated rates of depreciation.”
The report also states that Canada’s non-financial corporate sector began to strengthen its balance sheets in the early 1990s and remained on course even after companies in other nations adopted a re-leveraging strategy. As a result, Canadian corporations now have among the lowest debt-to-equity ratios in the developed world. The leverage ratio (debt-equity) for Canadian non-financial corporations has fallen to less than 70 per cent, from a peak of 117 per cent in late 1993, and 100 per cent as recently as a decade ago.
Governments – Moving Towards Fiscal Restraint
“Mirroring Canada’s corporate balance sheet transformation, government balance sheets, incorporating far-reaching accounting reforms, have strengthened substantially since the early 1990s,” said Mr. Jestin. “As households curtail their debt acquisition, federal and provincial deficit elimination this time around should be generally less drastic than the 1990s experience.”
Canadian governments’ setback following the recent global downturn amounts to only a fraction of their prior fiscal repair, despite revenue erosion and a substantial two-year stimulus effort through March 2011. On a general government basis that includes all levels of government, Canada posted a solid pre-recession budget balance of 1.5 per cent of Gross Domestic Product (GDP) in 2007 that slid to a deficit slightly wider than 5 per cent in 2009.
Mr. Jestin indicates that “Canada also has the advantage of significant financial assets that currently offset about 60 per cent of our gross debt, lowering our estimated net debt this year to less than one-third of GDP. Contributing to Canada’s low net debt are the Canada and Quebec Pension Plans – a social security framework fully funded for the foreseeable future.”
In contrast, Congressional Budget Office projections indicate that U.S. Social Security revenues will only match outlays to 2015, and the combined Old Age & Survivors’ Insurance and Disability Insurance trust funds will be exhausted by 2039.
According to Mr. Jestin, remedial action is now required by Canadian governments to restore the longer-term fiscal flexibility required to address future hurdles, most notably the retirement of the large baby boom cohort. Encouraging are the multi-year deficit reduction plans already laid out by most Canadian governments.
Households – Preparing For Balance Sheet Repair
“By one common measure – debt-to-income – Canadian borrowers are establishing new record levels of indebtedness, well above the euro zone average and closing in on other high-debt advanced nations, including the U.S., the U.K. and Australia”, said Mr. Jestin. “By mid-2010, household credit market liabilities as a share of disposable income totaled 144 per cent, just shy of a high of 146 per cent in March.”
However, the rising trend in borrowing is not new, as debt-to-income ratios have been increasing steadily since the mid-1980s. A relatively stable inflation and interest rate environment, especially since the adoption of inflation targeting by the Bank of Canada in the early 1990s, has helped Canadians to successfully manage financial risk and has contributed to the decline in risk aversion. Meanwhile, financial product innovation has created new and/or more flexible vehicles for managing household finances on both sides of the balance sheet.
The steady rise in household debt mirrors rising household wealth. Average household net worth (i.e. assets minus liabilities) is still close to record highs. Households today are comfortable carrying a higher debt load relative to their annual income flow in part because they have greater wealth.
Notable, however, has been the continuing ramp-up of Canadian household borrowing over the past year and a half when many other advanced nations, the U.S. and the U.K. included, were deleveraging.
Mr. Jestin reports that “many households in Canada emerged from the recent global downturn less damaged than their G7 counterparts in terms of job losses and wealth declines, and more confident to take on additional debt. Unprecedented low interest rates, unsettled equity markets and the home renovation tax credit all helped to spur an increase in housing investment. Meanwhile, Canada’s solid financial sector resulted in less credit tightening than occurred among many of its counterparts.”
“A reassuring note is recent evidence that Canadians are already beginning to trim back the pace of borrowing while boosting their precautionary savings,” added Mr. Jestin. “Home sales have cooled sharply this year, consumer discretionary spending is slowing, and the personal savings rate is moving up. We expect credit growth to slow more in line with underlying income trends over the next year, suggesting a leveling out in the aggregate debt-to-income ratio.”
Banking Regulation & Mortgage Market Structure
The report notes that the structural features of Canada’s financial sector – and, more specifically, its mortgage market – operate as a last line of defense behind Canada’s other advantages.
For instance, while the U.S. remains a fragmented unit banking system, Canada has always adhered to the principles of nationwide banking and branching. This has created a safer and sounder system in which diversification of loans and funding sources has protected against the bank failures that have tended to plague the U.S. system.
According to the report, nationwide banking and branching is also one major reason why Canada never really saw the emergence of a shadow banking system like that which exists in the United States. The U.S. shadow banking system emerged partly as the by-product of decades spent by unregulated or lightly regulated classes of financial institutions circumventing restrictions on nationwide activities of regulated institutions.
As a result of such structural differences, the funding model of Canadian financial institutions is inherently more stable, the adverse incentives between different classes of financial institutions are less acute, they are more diversified in nature, and, government-sponsored enterprises do not wield the same degree of influence over the Canadian market.
The report highlights that, for the third consecutive year, the World Economic Forum has ranked Canada’s banking system as the soundest in the world. Former Federal Reserve Chairman Paul Volcker repeatedly acknowledges inherent strengths in the Canadian banking system and touts it as a model for the United States. Canada was one of the few countries that did not experience bank failures in the recent global banking crisis.
Scotia Economics provides clients with in-depth research into the factors shaping the outlook for Canada and the global economy, including macroeconomic developments, currency and capital market trends, commodity and industry performance, as well as monetary, fiscal and public policy issues.
For further information: