Hilliard MacBeth is an Edmonton-based portfolio manager and the author of When the Bubble Bursts: Surviving the Canadian Real Estate Crash.
A recent review has singled out Canada, along with six others, as the most indebted countries in the world. Our inclusion in this list isn't based on government (public) debt, the type that gets all the attention at federal budget time, but private-sector debt that accumulates year after year and hides in plain sight.
Public-sector deficits were debated at length after the recent Liberal budget, but more immediate risks associated with private-sector borrowing – household debt and non-financial corporate debt – failed to generate discussion.
Steve Keen, a professor of economics, politics and history at England's Kingston University and author of the 2011 book Debunking Economics, believes that the 2007 U.S. financial crisis was caused by banks lending too much to finance speculation, rather than investment. In an article for Forbes published a few days ago, he says seven countries are most likely to suffer an economic crisis in the next one to three years: China, Australia, Sweden, Hong Kong, South Korea, Canada and Norway.
It was shocking to see Canada on this list. But Richard Vague, author of The Next Economic Disaster: Why It's Coming and How to Avoid It, did the basic research that Prof. Keen references and makes a convincing argument.
Mr. Vague says that any country whose private-debt-to-GDP ratio goes beyond 150 per cent and that has a five-year rate of growth of 18 per cent or greater in that ratio experiences a financial crisis at some point. (The data comes from the Bank for International Settlements.) These two milestones were surpassed during Canada's recent borrowing binge. Canadians collectively owe more than 208 per cent of GDP and private debt to GDP grew more rapidly than the guideline between 2011 and 2016. Private debt grew from 182 per cent of GDP to 208 per cent, well above the benchmark rate of growth for five years.
Canada nearly qualified between 1985 and 1990, when Canada's private-debt-GDP ratio experienced rapid growth from 112 per cent to 140 per cent. But the debt-GDP ratio stayed below 150 per cent and so Canada barely stayed below the standard. In the early 1990s, even though private debt stayed below the threshold, Canada still experienced a financial crisis when large companies failed and house prices declined by more than 20 per cent.
In 2016, Canada qualifies for a private-debt crisis without caveat.
When will the crisis hit? Exact timing is difficult, but it could arrive when Canadians decide to stop borrowing more. Or, more likely, when lenders restrict the availability of new credit, since aggregate demand depends on households and businesses going deeper into debt.
With Canadian private debt growing at more than 5 per cent a year and GDP growing at 2 per cent, it will get ever more difficult to manage the debt burden.
First, existing debt must be rolled over and interest on that debt paid. Second, for the economy to keep growing, borrowers must add new debt to finance an expansion in consumption, business investment, real estate, automobiles and speculation. At more than $4-trillion, Canadian private debt has become a leviathan that must be fed.
The coming crisis can be delayed but not averted. For example, in 2006, a change in government policy accelerated the incipient borrowing boom when 40-year amortization and zero-down payment guidelines were introduced for housing loans.
The debt burden was lightened when interest rates fell to extremely low levels not experienced for many decades. Lenders relaxed their standards by allowing loans on easier terms. And borrowing continued to grow when "shadow lenders" provided loans to marginal borrowers rejected by banks. But these factors can provide only temporary relief while adding fuel to the fire for the eventual crisis.
When the crisis nears, a warning sign will appear as a drop in the rate of private-debt growth. This ebbing of new money flow will reduce demand and, if it persists, will bring on recession. Lenders will pull back, worsening the recession, leading to an increase in bankruptcies and even more caution among lenders. Elected officials will become alarmed and take action.
Canada and Norway are fortunate to have a relatively small amount of public debt and a triple-A credit rating and therefore are in good position to mitigate the severity of the crisis.
Prof. Keen points out that the countries on the list are at different stages in this cycle, with Hong Kong in the lead. In that region, a decline in the growth of private debt began in 2014. If the rate of growth continues to decline, Hong Kong could be the first to reach a crisis. If you want a preview of what could happen in Canada, keep an eye on what happens there.