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Is Canada on the brink of a financial crisis?

Is Canada close to a financial crisis?
[File photo of a foreclosed home in Detroit/CNBC]

Ever since the U.S. financial crisis in the late 2000s, there have been questions about whether there might be a Canadian version coming down the pipe. The fact that it hasn’t happened has been taken by some as proof that Canada’s financial system is a better machine than its U.S. counterpart, and by others as a combination of luck and low interest rates.

This week the Bank of International Settlements (BIS) pegged Canada as one of a small group of countries vulnerable to a crisis. The BIS, a sort of global bank for central banks, based its verdict on a combination of credit levels, housing prices, and the potential for higher interest rates.

The BIS said Canada’s credit-to-GDP gap – a measure of private sector debt levels – is at 17.4 percent, trailing only China in the study, and well above the BIS threshold of 10 percent.

“In the past, two thirds of banking crises were preceded by credit-to-GDP gaps breaching this threshold during the three years before the event,” the report says.

The bank noted that the level has been rising for Canada since September 2016.
It also raised a red flag with Canada’s real estate market, noting a property price gap – a measure of prices deviations from long-term trends – of 11.6, among the highest of the surveyed countries.

It didn’t find major fault with Canada’s debt service ratio at 3.6, but said Canada was particularly vulnerable to a rise in interest rates. If rates rose by 2.5 percentage point, that ratio — a key measure of how much income is needed to service debt – would rise to 7.9 percent. While a 2.5 percentage point rate hike is not expected, economists do expect rates to eventually begin to rise from their current rock-bottom levels.

The BIS is hardly the first entity to point out worrying signs in Canada’s debt levels and home prices.

The Bank of Canada has been warning about the rise in consumer debt levels for years, and it its 2016 year-end financial review, the BoC highlighted consumer indebtedness and out-of-whack real estate prices as key vulnerabilities for Canadian households.

And a quick look at the rapid rise of housing prices in Toronto and Vancouver suggests that some sort of pullback is inevitable.

“There is some concern that household credit has risen relatively fast compared to person disposable income,” says Earl Sweet, head of economic risk at BMO Capital Markets.

But few see the same conditions in Canada as there were in the U.S. before its financial crisis, which was stoked by widespread bad lending practices on the part of banks and weak regulation. On the contrary, Canadian lenders are well capitalized and uninsured mortgages have relatively low loan to valuation.

“We don’t want to downplay the fact that households are exposed to a lot of debt, and if there was a rapid increasing interest rates, some families would be facing difficulties,” says Sweet. “(But) we don’t think there’s meaningful chance of a financial crisis in Canada right now.”

Sweet also called into question how the BIS calculated corporate debt in the study, suggesting that it may have double-counted some debt for Canadian companies with subsidiaries.

“What I think they’ve got there just isn’t representative at all of what the Canadian private non financial corporate situation really is,” he says.

Sweet says the issues of debt and housing are certainly cause for concern in Canada, because they leave the country vulnerable to an external shock to the economy, such as a credit crisis in China, or a breakup of the euro. In that situation, the Canadian debt levels would make the result of that external shock more severe. But he doesn’t see a Canada-specific crisis in the offing.

“I’m not saying we can’t have a housing price correction over the next couple of years, because prices have gone up quite a lot in certain markets,” he says. “But we’re not looking at the type of implosion that occurred in the United States.”

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