January 3rd - 2011

ON THE MARKETS: Canadians wary of household debt risks

Canadians are very cognizant of the dangers of excessive debt leverage, according to a special report by Scotia Economics.

Canadians are very cognizant of the dangers of excessive debt leverage, according to a special report by Scotia Economics. After witnessing the effects of the global credit crisis on other countries and living through the painful deleveraging of the 1990s at home, our citizens are understandably concerned, says the report, titled Canada's Balance Sheet & Economic Advantages Mitigate Household Debt Risk. However, the rapid rise in borrowing and the buoyant housing market in particular have pushed Canadian household debt leverage to new records.

The report nevertheless suggests that the odds of the current household debt leverage triggering a full-blown relapse -- either in the housing market or in the economy -- are relatively low.

“Today's situation is much different than the early 1990s when corporate, household and government balance sheets were simultaneously imperilled and monetary policy was much more restrictive,” says Warren Jestin, Chief Economist at Scotiabank. “Canada entered the recent downturn with close to two decades of government fiscal repair, strong corporate balance sheets, and a world-class banking sector." Jestin adds that "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."

Households - Preparing for balance sheet repair
Canadian borrowers are establishing record levels of indebtedness well above the euro zone average and approaching other high-debt advanced nations, including the U.S., U.K. and Australia, the report states. "By mid-2010, household credit market liabilities as a share of disposable income totalled 144 per cent, just shy of a high of 146 per cent in March."

However, the rising trend in borrowing is not new, since debt-to-income ratios have increased steadily since the mid-1980s. Relatively stable inflation and interest rates -- especially since the adoption of inflation targeting by the Bank of Canada in the early 1990s -- have helped Canadians successfully manage financial risk and contributed to the decline in risk aversion.

"A reassuring note is recent evidence that Canadians are already beginning to trim back the pace of borrowing while boosting their precautionary savings," he adds. "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 levelling out in the aggregate debt-to-income ratio."

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," states Jestin. This is the opposite of the early 1990s, when strained corporate balance sheets magnified the downside risks to jobs, investment and the overall economy.

Canada's non-financial corporate sector began strengthening its balance sheets in the early 1990s and remained on course even after companies in other nations adopted a re-leveraging strategy, the report notes. As a result, Canadian corporations now enjoy 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.

Banking regulation and mortgage market structure
The structural features of Canada's financial sector -- and, more specifically, its mortgage market -- operate as a last line of defence behind Canada's other advantages, says the report.

For instance, although the U.S. banking system remains fragmented, 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 bank failures that have plagued the U.S. system.

This nationwide banking and branching approach prevented the emergence of a shadow banking system in Canada like that of the U.S., according to the report. The U.S. shadow banking system developed partly as a by-product of decades of unregulated or lightly regulated classes of financial institutions that circumvented restrictions on nationwide activities of regulated institutions.

These structural differences have meant the funding model of Canadian financial institutions is inherently more stable. Adverse incentives between different classes of financial institutions are less acute and more diversified in nature, and government-sponsored enterprises do not wield the same degree of influence over the Canadian market, Jestin notes.

Canada’s banking system has been ranked the soundest in the world by the World Economic Forum for the third consecutive year, the report highlights. Former U.S. Federal Reserve Chairman Paul Volcker repeatedly acknowledges inherent strengths in the Canadian banking system and touts it as a model for the U.S. As well, Canada was one of the few countries to avoid bank failures in the recent global banking crisis. To see the full report, go to www.scotiabank.com, type “special reports” in the search window and click on the recent report.

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