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Canadian households are more indebted than they have ever been (Catherine Yeulet)
Canadian households are more indebted than they have ever been (Catherine Yeulet)

The Great Debate

Is household debt threatening Canada's economy? 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 opening arguments defending and opposing the motion: Canada's household debt is a major threat to our economy.

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

Over the past 10 years, household debt in Canada has risen by 135 per cent, while disposable income and nominal GDP have risen by 54 per cent. Household debt growth over the past decade has risen nearly three times as fast as income growth, a trend that is clearly unsustainable. The average Canadian now has a record-high debt load equal to 154 per cent of their disposable income. This rise in household debt has led to our central bank warning that household debt levels are the most significant risk to the economy.

Yet despite this rapid growth in credit, it appears at first blush that it poses little risk to the economy. Interest rates and hence the interest portion of debt-servicing costs remain low (although total debt-servicing costs remain very elevated), arrears rates are minimal, unemployment is relatively stable, and the percentage of at-risk households as measured by debt-servicing ratio, while rising, still remains reasonably low.

However, in order to believe that household debt levels pose little risk to the economy, you must hold some assumptions about the future: Interest rates must remain low and any rise in rates must be gradual; there must be no shocks to the economy that result in a significant rise in unemployment; most importantly, households must be able to slow their pace of unsustainable borrowing and begin to pay off their debt burdens without adversely affecting the economy.

It ought to be clear that high debt levels increase the risk families face during times of rising interest rates or employment shocks. And while we can’t predict these, we do have a fairly good understanding of how developed economies, which tend to be reliant on domestic consumer spending to drive growth, behave in an era of consumer deleveraging.

During a credit boom such as we’ve experienced in Canada, the demand for goods and services rises above what might be considered an equilibrium point as purchases are increasingly funded via credit and not constrained solely to income growth. In turn, industries adapt to this higher level of demand, resulting in an artificially strong economic expansion accompanied by artificially low unemployment.

Yet this credit-driven expansion serves to pull demand forward: What would have been purchased next year out of saved capital is instead purchased today on credit.  And discretionary income that would have been used to purchase goods and services next year is instead diverted towards debt repayment. What results is a demand gap that must eventually be contended with and what we call a “consumer deleveraging.”

This consumer deleveraging increasingly becomes a necessity as debt burdens rise relative to incomes, and it tends to be a significant drag on the economy and labour market unless offset in another part of the economy such as growth in business investment or exports. 

While this is possible, the reality remains that rising debt burdens do pose a risk to the economy from a number of potential fronts. The economic and labour market growth of the past decade has to some degree been driven by an unsustainable expansion in consumer credit. 

In short, high household indebtedness most certainly does make households more at risk. And while there are a number of reasons to be concerned about consumer debt levels in Canada, it’s this tendency of credit booms to masquerade as economic booms that concerns me the most.

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

We’ve all seen the worrying headlines: Canadian household debt continues to rise, exceeding U.S. levels. Home prices have soared. Canadian households are vulnerable to rising interest rates.

Every bit of it is true. Canadian household debt accumulation and home prices have indeed proceeded further than I’d like. Recent regulatory efforts are already beginning to deflate the housing market. The unvarnished truth is that Canada probably has a lean year or two in its future as these excesses unwind.

And yet I don’t believe Canada’s household debt constitutes a “major threat” to our economy. A major threat is one of two things: a recession or a financial crisis. Neither is likely for Canada.

Canada’s household debt-to-income ratio has risen from below 100 per cent in the mid-1990s to 151 per cent today. But this is less meaningful than it seems. First, the fact that debt now exceeds annual income is a red herring. No one demands that Canadians repay all of their debt in a single year. It could just as easily be framed as 4 per cent of their lifetime income.

Second, household debt hasn’t increased in a vacuum. To the contrary, it has been spurred higher by a structural decline in interest rates over the past 30 years. Canadians logically gear their borrowing to what they can afford. Lower interest rates mean that Canadians spend less today servicing their debts than usual.

Third, do not neglect the asset side of the ledger. Canadian households have also enjoyed sizeable asset growth, and assets outweigh debt by a factor of five.

What about those with higher-than-average debt? A young couple earning $80,000 after taxes with a $300,000 mortgage has a debt ratio that is more than twice the national average. Yet this is probably manageable for them. Fortunately, Canadians tend to exercise fairly good judgement. Lenders and CMHC also vet applicants. For the most part, this works. Seniors hold less debt than younger people. The poor carry far less debt than the rich.

Housing has driven a disproportionate share of the borrowing boom. Several affordability measures now argue home prices have gone too far. But the affordability measure that matters most – what share of household resources is commanded by mortgage payments – still generates very ordinary readings. Canadians are not unusually burdened by their mortgage.

Of course, the government is now tightening regulations, and interest rates must eventually rise. These changes will sting, and prompt Canadians to scale back their borrowing. A complete normalization of interest rates would put home prices as much as 15-20 per cent offside. This would certainly crimp residential construction and consumer spending, and lead to a materially weaker rate of economic growth. The effects would be palpable, but not outright recessionary.

Moreover, the risk of financial crisis is slight. Mortgage delinquencies will undoubtedly rise, but systemic risks are low: the financial sector is well protected since the most vulnerable borrowers must insure their mortgages and CMHC is backed by the full faith and credit of the Canadian government.

Also, the Canadian mortgage market functions very differently than in the U.S. Canada’s sub-prime mortgage market is miniscule, the uninsured securitization of mortgages is minimal and most Canadian mortgage markets have “recourse,” ensuring that borrowers make mortgage payments even if their home price is underwater.

The bottom line is that Canadian household debt poses a moderate – but not a major – threat to our economy.

Who won Day 1 of the Great Debate? Cast your vote here.

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