November 6, 2017 by Don Curren
It’s been said that debt is like alcohol – a small amount can be a good thing, but too much can be dangerous.
There’s another unfortunate similarity – they both tend to induce hangovers.
We all know that Canadians have binged on debt in recent years. The question now is when the hangover will start – and how bad it will be.
Canadian households are more indebted than ever before. One metric frequently cited as a benchmark for household debt growth, StatsCan’s debt-to-disposable income ratio, reached a record 167.8% in the second quarter, up from 166.6% in the first.
Much of that borrowing has been mortgage debt, and that’s fuelled the stratospheric ascent of housing prices in recent years – an ascent that has many observers warning about a catastrophic correction similar to that the US suffered in 2007-09.
Household debt and the related issue of housing prices have joined the top echelon of Canadians’ go-to conversational topics, along with the weather, the Maple Leafs, the wonders of a Tim Hortons double double – and the weather.
But households haven’t been the only ones bingeing.
According to a report issued by the Canadian Center for Policy Alternatives in June, Canadian non-financial corporations had racked up C$671 billion in new debt since the fourth quarter of 2011. That’s two-thirds of the total accumulation of C$1 trillion private debt in that period.
That new debt drove private sector debt-to-GDP ratio from 182% to 218% over that period, prompting the CCPA to note that “This increase of a fifth in only five years is the fastest growth of any of the world’s 22 advanced economies over that same time frame…Canada has never before led advanced economies in private debt accumulation.”
Canadian households are sometimes reproached for spending most of their borrowed money on housing – either through buying real estate or renovating it – and other assets like cars that don’t increase their productivity.
The CCPA argues the corporate sector has, in effect, been doing the same thing. It says the buildup in corporate debt was spent almost entirely on real estate or mergers and acquisitions. “The value of equity and investment shares rose C$348 billion over the same period, and productive investments in machinery and equipment rose only C$60 billion, half of the amount that corporate cash holdings increased,” the CCPA says. “In other words, little of this corporate debt binge was spent making Canada more productive, but was more akin to speculation.”
There’s a moralistic undercurrent in some of the commentary and conversation about household debt in Canada. It’s sometimes insinuated that Canadians have thrown off their long-standing frugality and embraced a kind of materialistic extravagance more commonly associated with Americans. Or, at the very least, it’s considered a sign of the kind of “financial illiteracy” that should be eliminated through more education on money and finance. There’s an element of truth in both of those observations, although how much they apply varies from household to household – and from company to company.
But there’s another way of looking at it. When interest rates go to the lowest levels on record, as they did in Canada during the financial crisis, and stay there for years, borrowing can be a sign of financial acumen rather than ignorance.
Borrowing when money is almost free isn’t necessarily stupid – in fact it’s a sign of the kind of optimizing behavior that mainstream economics models are built on.
When people have been hearing all their lives about great luxury cars are and how they confer an elite status to their owners – and they suddenly become affordable due to low interest rates and longer term car loans or leases – acquiring one doesn’t seem such an outlandish thing to do.
Nor is it terribly scandalous that Canadians’ saving rates declined in the same period. There’s not much incentive to save when the returns on bank accounts, GICs and other savings vehicles barely make the low-single-digit range. (None of these observations is intended to downplay the need for financial literacy and prudent budgeting among Canadian households – just to point out that strapping on debt during the last several years was not necessarily a crazy thing to do.)
Indeed, encouraging Canadians to borrow money and spend it on big-ticket items is one of the things the Bank of Canada intends to do when it cuts interest rates.
The problem is that when long rates go low on for a long time, the debt really starts to pile up, and the potential for a disaster of some kind escalates. Canada’s record levels of debt represent a vulnerability, as the Bank of Canada has said several times in its semi-annual financial statement – and a rather sizable one.
Some kind of hangover is inevitable. How painful it will be depends on the economic context. A sharp economic downturn or sudden surge in interest rates could make it an excruciating one, but a gentle slowing or gradual increase in rates will make it much more bearable.
Something similar happens with regular, non-metaphorical hangovers. If they happen on Sunday morning, when you can lie in bed and drink coffee for a couple of hours, they don’t seem so bad. But if it’s Monday morning, it’s rather a different story.
The question of how Canada’s big run up in private-sector debt is an increasingly critical one, since one of the phenomena that the Bank of Canada and many others believe could trigger it is already under way: interest rates are moving higher.
Many believe that rate increases will not come quickly, and that their terminal point may be lower than in the past. But how will a private sector that’s more indebted than ever before react to rising interest rates? The Bank of Canada addressed that question in its policy statement on Oct. 25 , saying it will be “guided by incoming data to assess the sensitivity of the economy to interest rates.”
The Bank is like a doctor who has been prescribing a medication that’s helping the patient, but also producing troublesome side effects. He wants to taper the dose he’s giving to the patient, but has admitted that he doesn’t know how the patient will respond. He says he will be guided by how the patient reacts to the reduced dosage – perhaps not the most reassuring methodology for the patient.
But the Canadian Center for Policy Alternatives – and many other observers – believe Canadians might not be able to avoid a sharp, painful correction. The CCPA points out that countries that have accumulated private-sector debt at a rate similar to Canada’s in the past have frequently run into problems. It says Japan recorded five-year growth in its private debt-to-GDP ratio of 28% by 1990, after which its economy remained depressed for a decade. “Five-year private debt-to-GDP growth in Portugal and Spain topped 50% in the 2000s, which ended in calamity following the 2008 financial crisis,” CCPA says.
Considering the risks proliferating on the economic front, they may be right. The sudden termination of the NAFTA trade pact, for instance, could be the kind of economic shock that triggers job losses, and therefore a surge in Canadians having trouble making their debt payments.
That wouldn’t just be a problem for those Canadians and the financial institutions holding their debt. Households that are scaling back debt tend not to contribute much to economic growth, and it’s the household sector that’s been driving growth in Canada in the last few years.
Other observers – notably some economists at Canada’s Big Five banks – expect the housing market and heavily indebted consumers to negotiate a softer landing.
We won’t know until we get there, and making a precise forecast of the outcome of such a complex and fragile situation is a surefire way of making yourself look like an idiot. However, here’s one suggestion in that direction: when pundits are forecasting apocalypse on one hand and a cake walk on the other, the truth is often somewhere in the vast, muddy middle.
In the meantime, we might as well enjoy all those beautifully renovated kitchens, shiny new BMWs and upscale shopping centers that our hard-borrowed dollars have bought.
P.S. This Thursday, November 9, at 2 p.m. EST, my colleague Karl Schamotta and I will be discussing the negotiations for revising NAFTA, one of the factors that could impact Canada’s debt challenges, in our third Cambridge Exchange. Our short webinar is open to all, click here to learn more and register!
About the Author:
Don specializes in developing, writing and editing content at Cambridge Global Payments across multiple platforms, including social media and our blog. He has reported on Canada’s financial markets and economy for the Wall Street Journal, Dow Jones and Reuters. Don also has extensive experience in corporate communications in both the public and private sectors.