Country Report Canada
The budgetary problems of the US government could affect Canada significantly. Furthermore, the continuing strength of the Canadian dollar is weighing on exports. Domestic risks stem from high household indebtedness and a slowing housing market.
Economic growth is slowing down but economy is still well performing
After a rapid recovery following the Great Recession (real GDP grew by 3.2% and 2.6% in 2010 and 2011, respectively), the Canadian economy has started to weaken. The pace of growth is slowing down because of lower export growth amid weaker external demand and a strong appreciation of the Canadian dollar. Furthermore, commodity prices have become less supportive of output growth and domestic demand is softening. For 2012 as a whole, real GDP increased by 1.8%, but this masks the weakness in the second half of the year where growth was particularly poor: output grew by only 0.6% q-o-q (annualized) in 12Q4. Leading indicators, however, suggest that the recovery gathered some momentum in the first quarter of this year. Going forward, economic growth will rely on exports and business investment, since private consumption growth is expected to be modest. Residential investment might drop due to the housing slowdown and the public sector will move forth with its austerity agenda. According to the consensus forecast in February 2013, Canadian growth is expected to be 1.8% in 2013. This estimate might be too optimistic though as the risks to the outlook are firmly tilted to the downside.
External risks: dependence on the US economy and the strong currency
The external sector is facing two major downside risks. First, if the US government would fail to solve its budgetary issues in the first half of this year (amongst others, not raising the debt ceiling), this would have large repercussions for the Canadian economy since 75% of its goods exports are destined for the US. Second, the strength of the Canadian dollar (CAD), which is still close to parity with the US dollar, is weighing on exports. The CAD has been depreciating recently after the Bank of Canada decided to not tighten the policy stance. The strong CAD partly explains the deterioration in the current account balance, which has dipped into the negative territory since 2009 and last year reached its highest deficit as a share of GDP in the past 20 years (-3.7%). Combined with Canada’s low productivity growth (because of its reliance on commodity industries), the strong currency has led to lower competitiveness of the manufacturing sector. Overall, weak external demand and the strong currency can widen external imbalances further and this would put downward pressure on the country’s credit risk metrics.
Domestic risks: high household debt and a slowing housing market
Very low interest rates and abundant supply of credit have fuelled the Canadian housing market in recent years. Recently, however, the Canadian housing market has been showing signs of cooling. Nationwide existing home sales fell by 17.4% y-o-y in 2012. Housing starts are also on a downward trend. House prices have been relatively resilient up to now but we know from past experience that prices often respond to shifts in sales with a considerable time lag. According to the Teranet-National Bank house price index, the annual gain in national house prices was still 2.7% in February 2013, but on a monthly basis house prices actually fell by 0.2%, the sixth consecutive monthly drop.
The recent developments beg the question: is Canada heading for a severe housing downturn or will it experience a soft landing? The country’s housing fundamentals indicate that the housing market is severely overvalued, which points to considerable downside risks. Based on price-to-rent ratio and price-to-income ratios, which were 78% and 34% above their long-term average respectively according to OECD data, Canada’s housing market is even the world’s most overheated. Dynamics have been particularly strong over the past decade with real house prices nearly doubling. A sharp correction can prove painful for home owners given that household debt-to-income ratio amounted to 162% in 12Q3. What’s more, Canadian households are particularly vulnerable to interest rate risk. Although the percentage of new mortgage loans with fixed interest rates has increased to around 90% since the beginning of 2012 (rising from about 55% over the period 2010-2011), still one-third of the total stock of debt is financed at variable rates.
Going forward, the housing market development must be monitored closely. A gradual slowdown is welcome and it would mainly affect the economy through lower consumption and residential investment. Regarding the effects on the banking industry, Moody’s expressed its concerns by downgrading the credit ratings of six Canadian banks in January 2013. As long as interest rates remain at low levels and the unemployment rate does not rise sharply (7% in January 2013), Canadian banks - which continue to report high capital ratios and low non-performing loan ratios (around 1%) - are expected to cope with a moderate housing downturn. There are also good reasons for not immediately expecting the worse. First, Canada has very low rates of non-prime mortgage lending. This can at least be partly explained by the fact that most mortgages are held by the banks that originated the loan, thereby providing incentives for conservative lending practices. Second, housing equity is declining from relatively high levels. Finally, the regulators seem to be aware of the potential risks and are responding appropriately. In recent years they have taken several (macro-prudential) measures to moderate the expansion of mortgage credit. In 2011 and 2012, the government imposed stricter standards for government-backed insured mortgages and forced banks to become more conservative by tightening mortgage rules.
That said, if the housing downturn would accelerate, non-performing loans would rise quicker than currently expected and banks would be hurt more severely. A collapse in residential investment could be a drag on growth since it accounts for about 7% of GDP. Because of the government-backed insurance for mortgages with high loan-to-value ratios, there would also be a risk that the government – which already has a stretched balance sheet – eventually needs to backstop the financial sector.
Limited room for economic stimulus
Since the policy rate has been at a low level (1%) for a couple of years now, there is limited room for monetary easing if economic conditions deteriorate considerably. Moreover, Canada’s high gross public debt-to-GDP ratio (85%) also offers little fiscal space. After a decade of budget surpluses, the government budget has been in the red since 2009. The deficit has narrowed to 2.4% of GDP in 2012 as a result of fiscal consolidation efforts, but this has also taken a toll on economic growth. Going forward, the fiscal authorities are determined to continue with consolidation measures. The plan is to achieve a balanced budget before the next election in 2015. We must note that too rosy growth forecasts and lower than expected inflation could make it challenging to achieve this goal. This will not necessarily lead to a rise in sovereign risk though. Canada has a solid track record of fiscal consolidation in the past, a low net debt to GDP ratio (36%), a high credit rating and a relatively stable domestic investor base. The true risk to the sovereign stems from the private sector needing to be bailed out in the event of a sharp housing market correction. Would this situation occur, Canada’s floating exchange rate regime would, however, provide some relief in offsetting the negative impact on the economy.