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Worried about debt. (Photos.com)

Worried about debt.

(Photos.com)

Great Debate

Is Canada sitting on a household debt land mine? Add to ...

Welcome to the Great Debate, in which Globe Investor invites two experts to debate one of the big questions facing the business and investing world.

This month, we look at Canadian household debt levels. Today, our debaters present their final arguments defending and opposing the motion: Canada's household debt is a major threat to our economy.

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(Click here to read Day 1's opening statements and Day 2's rebuttals.)

For the motion: Ben Rabidoux, analyst and strategist at M Hanson Advisors

There’s a saying that perhaps illustrates my concerns with current debt levels in Canada and the pace of debt accumulation over the past decade:

“It’s not the fall that kills you. It’s the sudden stop at the end.”

While Mr. Lascelles and I agree that household debt poses a risk to the economy, and the pace of borrowing over the past decade is unsustainable, we seem to disagree in two key areas: The likelihood of a hard stop in borrowing and the economic implications of such a hard landing.

My belief is that a hard landing in borrowing is likely, and that such a hard landing would likely cause a recession. This concern is framed by one key issue: Housing.

To understand why housing is such a driver of current debt loads, we need to look at the composition of credit growth over the past decade.

There is currently roughly $1.65-trillion in household debt in Canada. Roughly $1.15-trillion, or 70 per cent of this, is in the form of mortgage debt. The remaining $495-billion is in non-mortgage consumer debt such as lines of credit, credit cards, etc.  But within this total, we find that home equity lines of credit account for roughly $225-billion after accounting for the $206-billion reported by chartered banks and making conservative estimates of HELOC originations by other lenders such as credit unions.

So in other words, $1.38-billion or nearly 85 per cent of the total household debt burden is tied directly to housing.  It’s the HELOC component of this debt that has grown most dramatically – up 700 per cent since 2000. In fact, it was the flow of this very credit that I believe provided an enormous and temporary boost to the economies of certain provinces coming out of the recession.  For example, in B.C., annual line of credit growth coming out of the last recession amounted to over 4 per cent of provincial GDP. That’s one heck of a stimulus.

So significant has this home equity withdrawal been, that it has been estimated by the Bank of Canada to currently amount to over 8 per cent of aggregate personal disposable income in the country – or roughly where the U.S. peaked in 2005.  

No matter how we slice it, economic growth has been goosed by the additional spending power provided by home equity extraction while mortgage debt has also provided a significant economic tailwind.

To put all of this in perspective, if we separate credit-driven industries like residential construction and the FIRE groups (finance, insurance, real estate) from all other components of GDP, we find that real GDP growth generated by all other industries are essentially unchanged since 2007 while real GDP growth from these credit-driven industries are up over 10 per cent in the same time frame.

The question then becomes one of sustainability. I don’t have the space to outline my views on the likelihood of a Canadian housing correction, but needless to say, I would suggest that there is a very high likelihood of a “hard landing.” We have a pretty clear example south of the border of how the flow of mortgage debt and home equity withdrawal reacts to a housing correction. It is most certainly what I would call a “hard stop.”

I’m not predicting a U.S.-style correction, but I also don’t believe we need such a severe correction to significantly crimp demand for mortgage and consumer credit. And if that happens over a short time frame, as I worry it could, the economy looks vastly different than it does at present.

Against the motion: Eric Lascelles, chief economist at RBC Global Asset Management

Household debt deserves our respect, but not our fear. Debt is just as acceptable – and even useful – on a household balance sheet as on a business balance sheet.

Illustrating this argument, expenses tend to be greatest for young families (student loans, buying a home, paying for childcare), yet household income peaks much later. Credit allows households to draw their future income forward, when it is needed most.

As with a corporation, Canadian household debt must be evaluated in the context of its source (mostly domestic funding, suggesting reasonable stability), its carrying cost (low), the purpose it achieves (supplanting home rental/car lease payments), and the vulnerability it creates (fairly low: each dollar of debt is offset by four dollars in assets).

Strictly speaking, Canadians have not actually become more indebted on a net basis: after all, one person’s debt is another’s savings. Rather, Canadians have just become more levered: their assets and their debts are both rising relative to their income. It is natural that household assets should rise over time due to household savings and asset appreciation. It is equally natural that Canadians elect to hold a proportionate amount of debt against this asset base, just as a well-structured corporation would. The rise in assets and debt can best be understood in this context.

Around the world, the trend is almost universal: assets and debt rise more quickly than income.

It is not clear what constitutes too much household leverage. Although Canadian household debt now surpasses the U.S., it remains well shy of Denmark and the Netherlands, which have survived for years with far greater household debt than Canada.

The threat of higher borrowing costs is real, but smaller than it seems. Interest rates simply aren’t likely to rise very soon, or very far. Most Canadians have fixed rate mortgages that shield them from the immediate impact of higher rates. Those with variable rate mortgages have either owned their home for a while (thus enjoying a buffer of positive owner’s equity), or have been shielded by recent rule changes mandating a protective crumple zone between what borrowers pay and what they can afford.

Moreover, as the Globe’s own Rob Carrick recently noted, people can usually handle higher rates via adjustments like tapping their savings, reducing their RRSP payments or selling their second car. The proof is in the pudding: disaster was even avoided in 1982 when mortgage rates peaked at 19 per cent.

The more severe threat to household debt might be rising unemployment, which instantly snuffs out the ability to pay. But virtually no one forecasts this for Canada, and stress testing argues the mortgage delinquency rate would nonetheless remain many times lower than the U.S.

To conclude, household debt constitutes a threat to Canada, but not necessarily a “major” one. The great majority of Canadian households will be only minimally scathed by a housing correction. An economic slowdown is probable, but a recession or financial crisis is unlikely. We can all breathe a little easier.

Who won Day 3 of the Great Debate? Cast your vote here.

 

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