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Canadian economy 'vulnerable' to overheated housing market, IMF warns Add to ...

Canada’s average home price is about 10 per cent higher than models suggest it should be, posing a “vulnerability” to the country’s economic outlook, the International Monetary Fund warns in a new report.

A drop in prices would be a blow to already highly indebted consumers. With household debt at record levels of about 150 per cent of disposable income, the domestic spending boom that helped Canada weather the financial crisis already is at its limits.

The IMF, in its annual report on Canada’s economy, estimates that a 10-per-cent decline in housing prices could result in a 1.1-per-cent drop in personal consumption, excluding durable goods, which would correspond to a 0.5-per-cent loss in gross domestic product.

At another time, Canada would be better able to withstand such a blow. But with the U.S. economy struggling, Europe on the cusp of a recession and China cooling after years of red-hot growth, there is limited demand for exports. That means Canada’s economy must continue to lean on domestic demand and investment for growth for the next couple of years.

“Adverse macroeconomic shocks, such as a faltering global environment and declining commodity prices, could result in significant job losses, tighter lending standards, and declines in house prices, triggering a protracted period of weak private consumption as households reduce their debt,” the IMF says in the report, released Thursday in Washington.

“The effects on economic growth could be exacerbated by weaker external demand and slowing construction activity.”

As the world braces for a fourth year of economic turmoil rooted in poor financial regulation and excessive sovereign debt, Canada stands out for being strong on both. The economy grew 3.2 per cent in 2010, an impressive rally from a 2.8-per-cent decline in 2009.

But Canada’s economy has failed to keep up that pace. Growth likely will average about 2 per cent in 2011 and 2012 because of weak demand for exports. Unemployment in the United States, Canada’s primary export market, remains elevated, crimping household spending. Europe, hobbled by its debt crisis, sits on the cusp of a recession.

While the state of the U.S. and European economies are out of the control of Canadian policy makers and executives, the IMF report makes clear that Canada bears some responsibility for its predicament.

Canada’s position in world trade has weakened, the primary evidence being a persistent trade deficit after years of enjoying a trade surplus. This is mostly the result of weaker demand for automobiles and lumber in the United States, but the country also is paying the price for doing too little to enhance productivity and seek out new markets, the IMF said. Canada’s growth prospects over the near term are limited as a result.

“While the 2008 crisis has triggered a sharp deterioration in the external trade balance, Canada’s export growth had been weak for over a decade,” the IMF said. “The authorities pointed out that exchange rate appreciation had played a key role in constraining export growth, but lagging productivity growth and increased competition from emerging economies in the U.S. market also contributed.”

The Harper government is now aggressively seeking new free-trade agreements, and the IMF said the Canadian dollar’s value is on the “strong side” of what fundamentals suggest it should be.

But neither of these factors will change Canada’s trade position markedly in the short term.

That will depend on demand from abroad, especially the United States, where there are indications the economy is perking up. A government report Thursday showed that the number of first-time claims for unemployment benefits dropped by 4,000 to 364,000 in the week ended Dec. 17, the lowest since April, 2008.

Still, the U.S. economy has a long way to go. Another government report showed GDP grew at an annual rate of 1.8 per cent in the third quarter, barely half the rate necessary to significantly lower the country’s unemployment rate of 8.6 per cent.

The IMF’s warnings on the housing market and household debt echo those of the Bank of Canada. The fund’s report amplifies the stakes by quantifying what could go wrong if the housing market slips. An external shock such as an abrupt drop in commodity prices that triggered a decline in house prices by 15 per cent, accompanied by a severe downturn in construction, could result in a 2.5-per-cent loss in GDP over two years, the IMF said.

Policy makers should continue to watch developments in the mortgage market closely, the fund said. Lending for homes has slowed, but still is growing at a “robust” pace of almost 7 per cent, the report said. Finance should be ready to take steps to slow borrowing further if home lending continues to expand excessively, such as larger down-payment requirements for mortgages and demanding lower debt service-to-income ratios, the IMF said.

Follow on Twitter: @CarmichaelKevin

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