Canada's Housing Bubble

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Jun 09, 2010 Benjamin Tal Troy Media

No one should be surprised by the Bank of Canada's decision to raise interest rates by a quarter percentage point last week. What we should be more surprised about is that bank governor Mark Carney didn't commit to further rate hikes, saying such moves would have to be "weighed carefully against domestic and global economic developments."

The likely scenario is that the timing of future rate hikes will be determined by the situation in Europe - and the global economy generally. But it will be the health of the consumer that will determine how high rates will go.

The bank's strategy of low interest rates to pull us out of the recession worked as planned in Canada. Economic growth was up 6.1 per cent in the first quarter of the year, building on a nearly five per cent jump the quarter before. Most areas of the economy are contributing to this growth - consumer spending has rocketed ahead and residential construction put in its second consecutive quarter at more than 20 per cent annualized growth.

In fact, if we look back at the 2008-09 recession, we find that it was the first economic contraction on record where real household borrowing actually grew. Normally in recessions, consumers worry about job losses and start to tighten the purse strings by cutting back on discretionary spending.

It hasn't happened this time in Canada because consumer confidence did not fall that far during the recession. In fact, consumer confidence here is now only 20 per cent below the level seen during the happy days of 2007. By contrast, in the United States confidence is down by 60 per cent.

As a result, low interest rate policy proved much more effective in Canada than in the U.S. American consumers have been far more concerned about losing their jobs, so when offered an extremely low-interest loan to buy a new house or car, they aren't likely to take it. In Canada, as we've seen, consumers have jumped on the low interest rate bandwagon. Record-low rates did the job in lifting the Canadian economy out of the recession faster than most of the rest of the world.

However, consumer confidence in Canada has exceeded our capacity to spend. Incomes in Canada have not seen a similar rebound post-recession. Growth in real disposable income has been trending downward over the past year and to a certain extent debt is replacing income as a major driver of consumer purchases.

While we are taking advantage of cheap loans and mortgages to spend more, payments on that debt have left us little to put in the bank. As a result, the savings rate has dropped from 5.1 per cent in the second quarter of 2009 to only 2.8 per cent in the latest quarter. Huge job gains over the past couple of months should help replenish bank accounts, but record debt levels and now rising interest rates will see a slowdown in both consumer spending and housing starts.

The household debt-to-income ratio in Canada set an all-time record of 147 per cent last December. More troubling is the fact that this ratio is accelerating at a rate not seen since the mid-1990s.

That said, households are not relying much on credit for day-to-day consumption. After all, roughly 70 per cent of the increase in household debt over the past year has been mortgage debt due to a strong revival in housing activity. Of the other 30 per cent, roughly one-fifth of the increase in non-mortgage consumer credit is used to finance daily purchases. Furthermore, despite rising debt loads, ultra-low interest rates kept the Canadian debt-service ratio falling throughout this latest recession.

While this ratio is only back to the level seen in the third quarter of 2006, back then the effective interest rate on household debt was 1.1 percentage points higher than it is now. With interest rates already beginning to rise, this relatively elevated debt-service ratio suggests some Canadians will be feeling a debt-service squeeze in the coming months.

A further negative for household spending is the fact that household debt is also rising faster than assets. The debt-to-asset ratio (as reported in Statistics Canada's National Balance Sheet Account) trended upwards during the recession.

Despite the rebound in stock valuations and the recent surge in home prices, over the past two years Canadians have seen their liabilities rising twice as fast as their assets. With housing prices expected to drop by five to 10 per cent in a year or so, this ratio is likely to get worse before it gets better.

As we found in a study earlier this year, Canadian consumer fundamentals are weaker than they have been in almost 15 years. While our heads have told us we can afford to spend, our wallets are increasingly telling us we can't.

With many Canadians already sitting on debt loads that are eating up a big piece of their paycheques, this week's rate hike leaves us even less money to spend at the mall. As a result, the Bank of Canada needs to take into consideration the health of the consumer when deciding how much it will increase rates.

Record-low rates achieved their goal of getting consumers spending again -- pushing rates up too high and too quickly could send us back to where we started.

Benjamin Tal is a senior economist at CIBC.