The Bank of Canada has warned that household debt levels have worsened over the past year and could lead to problems in the economy as people struggle to make their loan payments as interest rates rise.
The central bank identified high levels of household debt and elevated home prices as the top two vulnerabilities, saying they could even result in a financial crisis.
The cost of borrowing has spiked over the past few months, and the Bank of Canada has said it will continue raising interest rates forcefully to combat high inflation. Monthly mortgage payments for highly indebted households could rise by more than $1,000 over the next three to four years, the bank said.
“Our primary focus is getting inflation back to target. Monetary policy is not housing policy,” Bank of Canada Governor Tiff Macklem said at a news conference after the central bank released its latest Financial System Review.
Higher interest rates have already slowed real estate activity, with sales declining around the country and home prices falling in some of the country’s hottest markets. Several private-sector economists have forecast double-digit declines in prices this year, but the central bank said it was too soon to say whether this was the start of a substantial correction.
At the news conference, Mr. Macklem repeatedly stressed that the central bank’s priority is getting consumer price growth under control, even if that meant a cooldown in the housing market. The bank has raised interest rates at three consec
utive rate decisions and has said it will continue to push borrowing costs higher to cool inflation, which hit a three-decade-high annual rate of 6.8 per cent in April. The bank aims to keep inflation at 2 per cent.
Bank of Canada open to larger rate hikes, more moves if needed, Tiff Macklem says
“Some moderation in housing would be healthy,” Mr. Macklem said. He did not indicate how much moderation that would be, but said higher interest rates are needed to cool the entire economy and bring inflation back down. “Part of that adjustment will no doubt come through the housing market,” he said.
Already, in places like Halton, an affluent region just west of the city of Toronto, the typical home price has dropped 13 per cent over the past three months.
The bank listed several worrisome trends it has observed during the latest real estate boom: Households have increasingly stretched themselves financially to purchase property; homebuyers have made smaller down payments relative to the price in recent quarters; and investors have increasingly leveraged the homes they already own to buy new ones.
The high amounts of household debt could eventually become problematic for the financial system as central banks around the world raise interest rates. The global economy could soon start to slow or slip into a recession. That could lead to job losses and make it harder for mortgage holders to make their loan payments.
A drop in home prices could further restrain the owners’ ability to use the equity in their homes. People might be forced to reduce their spending and/or sell their properties. As well, if investors find themselves financially stressed and flee the market, the bank said, that could “amplify downward pressure” on home prices.
“The likelihood of this risk materializing and its impact on the economy are greater today than in the past,” the report said.
Mr. Macklem said the bank is not projecting a serious economic contraction driven by a real estate downturn. But he said the situation needs to be watched and managed closely.
The central bank is primarily concerned about the highly indebted Canadians who took out mortgages over the past two years. Borrowers with a loan-to-income ratio above 450 per cent account for more than 25 per cent of new mortgages – a record high.
“Those with high debt are more vulnerable to a decline in income and will face more financial strain when they renew their mortgages at higher rates,” the review said.
A five-year fixed-rate mortgage, the most common type of home loan in Canada, climbed to an interest rate of 4.37 per cent at the end of May from 2.99 per cent in early March, before the first rate hike, according to central bank data.
All borrowers will see a significant jump in mortgage payments at renewal time. Bank of Canada economists have calculated that a highly indebted borrower who took out a variable-rate mortgage in 2020 or 2021 would see a median increase of more than $1,000 in their monthly payments at renewal time in 2025 or 2026, the report said. In most variable rate mortgages, the monthly payment stays the same, but the amount that goes toward the principal changes with interest rates.
Despite the growing risks, the central bank said commercial banks remain well-positioned to weather an economic downturn.
In the event of a “severe and prolonged recession,” Canadian banks would experience a significant hit to their capital levels, but would likely be able to continue lending to businesses and households, the bank said. This is supported by sound mortgage underwriting practices, solid capital buffers and a “robust capacity to generate revenues even in times of stress.”
Desjardins Securities chief economist Jimmy Jean said since the 2008-09 global financial crisis and U.S. housing meltdown, policy makers have come far in protecting the financial system against housing risk. “Financial institutions have been subject to quite rigorous stress testing exercises to make sure they are equipped to handle even extreme downside housing scenarios,” he said.
The Bank of Canada offered a relatively upbeat assessment of corporate balance sheets. The ratio of debt to assets for non-financial companies has declined continuously since its peak in the second quarter of 2020. Meanwhile, the ratio of cash to debt has reached an all-time high.
Companies that use bond markets to raise money will face higher borrowing costs as interest rates increase. But the central bank noted that most outstanding bonds are not set to mature in the next five years. Still, companies could face challenges servicing their debts if the economy moves into recession and corporate revenues fall.
The Financial System Review noted a range of other risks that appear to be growing. Russia’s invasion of Ukraine has increased the chance of a state-sponsored cyberattack against Canadian banks, the central bank said.
Meanwhile, financial stability concerns related to climate change remain pressing. The worry is that asset prices and company valuations do not properly account for risks related to a transition to a lower-carbon economy.
The bank also expanded its analysis of cryptocurrencies. It reiterated its view that cryptocurrencies are “not yet of systemic importance” to the Canadian financial system. Although it did note that interest in the asset class is growing rapidly and expanding from retail investors to institutional investors.
In 2021, about 13 per cent of Canadians owned bitcoin, up from 5 per cent in 2020. The median holding was about $500.
The bank’s principal concern is the lack of regulation in the sector. Many cryptocurrency companies function like traditional financial institutions, but with far less oversight.
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Rachelle Younglai
Mark Rendell