Watch out for rising debt levels, bank warns

By Michael Lewis | Thu Dec 9 2010

As shoppers cram the malls this holiday season, the Bank of Canada has a Scrooge-like warning for consumers: Step away from the credit card and think about your ability to pay if borrowing costs rise or you lose your job.

In its twice-a-year economic assessment Thursday, the bank warned that heavily indebted consumers are in the danger zone as the uneven global recovery makes them vulnerable to financial shocks.

In its Financial System Review, the bank said economic risks have increased over the summer on worries about European sovereign debt, the widening global trade imbalance and consumer credit levels that surged during the recession and the early stage of recovery.

It said household debt has risen to 145 per cent of disposable income, with Canadians taking advantage of record low interest rates to buy homes and consumer goods on credit.

Issued two days after the bank held its key interest rate unchanged at 1 per cent, and after Ottawa said the economy contracted in September, the report urged institutions to use caution in issuing loans to Canadian consumers.

The bank said that while there has been moderation in the pace of debt accumulation since June, credit continues to grow faster than incomes.

And while the household sector’s debt-service ratio edged down in the second quarter and remains below the historical average thanks to low borrowing rates, the bank said mortgage and credit card loans in arrears were well above pre-credit crisis levels in the quarter.

Sal Guatieri, senior economist at BMO capital markets, noted that consumer spending has propelled growth in Canada this year, but debt levels will force spending to cool in 2011.

He said households could face the prospect of selling assets to meet credit obligations if interest rates rise and employment falls, a development that would hurt Canada’s finance sector as consumers struggle to make payments.

In a report earlier this month, however, BMO Capital Markets said it does not expect consumers to cut off spending entirely to focus on reducing debt.

It said savings levels remain healthy, while a 12 per cent gain in the value of the TSX main index this year and increased home values, have lifted household net worth to about six times disposable income, up from five times in the 1990s.

“While we are not blasé, we think the singular focus on debt portrays an overly negative picture and therefore an overly negative take on consumer spending,” BMO deputy chief economist Doug Porter said in a roundtable discussion last week.

“We think households can boost spending by 3 per cent next year and while we see a mild slowdown, the emphasis is on mild.”

The central bank review, however, said that “the risk of a system-wide disturbance arising from financial stress in the household sector is elevated and has edged higher since June. This vulnerability is unlikely to decline quickly, given projections of subdued growth in income.”

The central bank also cited threats from trade imbalances that fuel protectionism, arguing that a trade war could not be ruled out, and said sovereign debt impacts may spill over into Canada. It said market concerns over the debt could force countries to reduce deficits more rapidly, resulting in slower global growth.

“A key concern is that acute fiscal strains in peripheral Europe and weaknesses in the European financial system could reinforce each other and have adverse effects on other countries,” the bank said.

Despite its assessment that the domestic financial system remains comparatively sound, the bank said “global financial stability could be undermined by an adverse feedback loop between weak economic activity, fiscal strains and the financial system.”

It said progress was made to ease trade imbalances between consumer and producing nations during the recession, but the gap is widening again as China and other emerging economies continue to fix their currencies at depressed values to encourage exports and discourage consumption of foreign goods.

The bank said governments can reduce risks by acting on plans to rein in deficits, by moving to floating currency exchange rates and by closely monitoring consumer debt.