Canada might seem at first glace to be well insulated from Greek's economic turmoil, but a messy exit by the country from the euro zone could pack a big hit on the Canadian economy, worse than the downturn during the financial panic.
That's the analysis of what a worst case scenario in Europe might mean for Canada by economists at TD Bank. In a note to clients on Wednesday, they said a systemic crisis would lead to a “severe recession” in Canada, with the decline being “substantially worse than that experienced during the 2008/2009 recession.” They called the potential for Greece to destabilize Europe “the number one risk to Canada's economic outlook.”
The bank cites several reasons for Canada's vulnerability, among them the country's overheated housing market and high levels of household debt, which “leave the economy more vulnerable to a negative external shock than it has been in the past.” Housing prices are probably 10 per cent to 15 per cent overvalued and a global financial crisis could be the trigger for a sharp housing market correction and a move by households to cut their debts.
As well, the bank worries that a major downturn in Europe would be accompanied by tumbling resource prices, delivering another blow to Canada.
Bank economists usually shy away from using the R word, but they issued their gloomy assessment after being overwhelmed by questions from clients on how a potential Greek exit from the euro might play out on financial markets.
Although the worst case outlook is for hitting the panic button, the bank's most likely scenario is for Canada to continue posting moderate growth and for policy makers in Europe to contain any contagion risks from Greece, if it leaves the euro.
All bets are off, however, in a severe financial crisis due to the problems in Greece spreading to other countries. Events in Europe would then start to hit Canada hard through the fall in resource prices and reduced economic confidence.
“If Greece does adopt a new currency, it will be a major financial shock. Financial markets will immediately start to speculate that other countries will follow suit,” the bank said.
In this kind of environment, one casualty would be the Canadian dollar, which would fall in value. But the bank says the depreciation of the currency would lessen some of the blows emanating from Europe by raising manufacturing export competitiveness and by reducing the impact of falling commodity prices denominated in U.S. dollars.
The Toronto stock market would likely plunge too, according to the bank. “With Canada's heavy focus on commodities, the S&P/TSX would likely be hit particularly hard in the aftermath of a disorderly Greek exit from the euro zone,” it forecast.
About the only investment that would rally would be super safe government of Canada bonds, which would benefit as investors bought them to flee risky assets, according to the bank.