Is the Canadian economy in big trouble?

By Paul Gambles

Deutsche Bank’s chief international economist, Torsten Slok recently warned that Canada “is in serious trouble.” But is he right?

I tend to apply a heavy dose of skepticism to such bold statements, particularly when they come from a) an economist and b) Deutsche Bank. That’s especially the case with Slok, who has a reputation for talking down the Canadian economy.

However, I have to admit that he probably had a point in 2013, when he suggested that house prices could be overvalued by up to 60%. Not only that, if we look beneath the sub-editor’s headline for his latest analysis, there´s more than a grain of truth in what he’s saying.

There are many causes of recessions and depressions. But the main factor apparent in most of the major downturns of the last hundred years has been debt. By debt, I don’t mean those fantastical figures that often get quoted about how much the federal government ‘owes’ through public spending. No-one has yet been able to explain to me to whom governments owe all of this debt. The reality is that it is that ‘government debt’ isn’t actually debt. It’s money that has been put into the economy to pay for public services, such as education and healthcare. Once paid out, that money flows around the economy as public-sector employees, and the companies that have public sector contracts, spend parts of their income.

To meet its obligation to public services and other costs, the federal government asks the Bank of Canada to print loonies. If Ottawa decides to spend more on, say, education and healthcare, it asks the BoC to print more money. On the other hand, if the government actually tries to slow down spending/money printing (a.k.a. reducing debt), it is, in fact, putting a brake on the economy by reducing the amount of money flowing around.

The debt that really counts is, in fact, private debt, which has rocketed exponentially since the 1970s – as you can see in the chart.

Source: BIS

At the last count, 47% of this debt was household debt, roughly C$2.127 trillion. Putting that in to some sort of context, it is (according to 2016 figures) Canada has the highest debt-to-GDP ratio among all OECD members. What’s more, for every dollar a Canadian earned in 1990, she/he owed (on average) just under 80 cents. By 2016, that figure had gone up to C$1.62.

The jump in household debt between 1990 and 2016 can be partially explained by the fivefold rise in credit card debt and the eightfold increase in personal lines of credit. The amount of home loan debt only multiplied by four during this time, but it is still the dominant force – representing just under 62% of total household debt in 2017. House prices – particularly in Vancouver and Toronto – have undoubtedly been the main driver of the boom. After all, the cost of buying property certainly hasn’t been replicated in people’s salaries! So, if you want to take a step up the ladder, it’s more than likely that you’ll need to borrow money: more now than ever before, or at least more than since 1992.

Low-interest rates have meant that the mortgage debt service ratio (DSR) for Q1 2018 (i.e. affordability of mortgage repayments) was at a 26-year high in Q1 2018. However, interest rates are now beginning to rise again,

Statistics Canada’s debt service ratio (DSR) figures prove that, at the end of Q1 2018, loan unaffordability was at its lowest point in the last 26 years. But interest rates are rising, and the debt is concentrated – the Bank of Canada (BoC) warned about the debt concentration in May. They estimate 8% of households hold more than 20% of all household debt in the country and that these households are “vulnerable” in the coming years, as rates continue to normalize.” DSR is the amount of pre-tax income that goes on paying mortgages, but it doesn’t include other payments such as property tax. Therefore, DSRs superficially often look relatively innocuous but it’s over a quarter of a century since affordability was so stretched.

One of the main reasons the price boom has had such momentum appears to be the popularity of buying newly-constructed condos to rent out. Slok and his colleagues drew that conclusion because the rate at which detached houses are being built is pretty much where it was in the pre-boom-and-bust 1990s. Yet multi-family condo construction has shot up from around 4,000 units a year in 1996, to around 17,000 in 2015. As you might expect, the percentage of the workforce employed in construction has followed this trend as well: under 5% in 1996 to around 7% today.

With all that in mind, it could be argued that there is a good side to the property boom: somebody gets richer and more people find jobs. But the 2008 crisis wasn’t the only event in history that made us realize that sharp rises can often mean sharp drops later on. Good news for those hanging on before buying can be catastrophic for others who bought at the top of the market in the expectation that the market was still on its way up. After all, there are no alarm bells to signal the top or bottom of a market.

Debt service levels help give a general overview of the economy. The more money that goes towards paying debts, the less money there is to spend on consumer goods and services, meaning it’s difficult for an economy to expand. That’s why a sudden boom in housing leads o a bust in the rest of the economy.

There are already signs that the bubble could be bursting. In May this year, average year-on-year prices in the Greater Toronto area, one of the two juggernauts (Argonauts?!?) of the boom, dropped for the sixth time in seven months. The sample size remains relatively small and could well be the market coming back to a price range more in line with real value.

However, if the drop continues and spreads to Vancouver and Montreal, amongst other cities, lenders will start to get nervous. The 2008 crisis showed us that, when we talk about lenders, we’re not only talking about the banks who leant homeowners the money. Nowadays, the pyramid is far more complex, with Main Street banks repackaging customers’ home loans into leveraged products. This breaks up the lender-to-borrower relationship that, under traditional circumstances, would often allow for loan renegotiation during hard times. Instead, borrowers become mere book-keeping entries and the prospect of default makes financial institutions exceptionally nervous that those huge numbers will suddenly turn into minuses.

As a consequence, the bottom can fall quickly out of the market, directly affecting investors, construction workers, sub-contractors; and indirectly the rest of the economy. And when that happens, we all know who will ultimately pay for the mess… it certainly won’t be the banks.

Paul Gambles is co-founder of MBMG Group

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