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Defusing Canada’s debt bomb

While many economies around the world are staggering under huge public and private debt burdens, Canadians are likely feeling sanguine. Our governments' net debt burdens remain well below international norms, and we have not experienced anything like the housing meltdown in the United States, which has put more than one-third of that country's mortgages "under water" - a scenario in which the amount owed exceeds the market value of a home.

Still, rapidly rising household debt amounts to a "Canadian debt bomb" that has been ticking more loudly. Canadians will have to slow their debt accumulation or it will explode. Moreover, many Canadians will need to save more to achieve their desired standard of living in retirement.

Much of the alarm about the indebtedness of Canadian households focuses on the sector's debt being 146 per cent of personal disposable income. This is up from 90 per cent just 20 years ago. And two decades before that, indebtedness was less than 80 per cent of after-tax income. This rise in household indebtedness is a sociological as well as economic and financial phenomenon.

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Each generation seems to move further away from the notion of saving before making major purchases. The culture has shifted to borrowing so that the purchase can be made immediately. Financial innovations, such as home-equity lines of credit, have facilitated the shift.

A trend rise in household indebtedness is not necessarily troubling. Much of this debt is long-term, so it does not need to be paid out of just one year's income. In good part, the debt was acquired to build assets, principally in housing but also in equity markets. With strong asset rates of return until the Great Recession struck, net household worth had been rising despite the growing debt. And with record low interest rates, the cost of carrying that debt is low.

The soundness of the Canadian financial industry provides some security not found in other countries. Most Canadian institutions have strict conditions for lending and are well capitalized to cover any defaults. Mortgages with less than 20-per-cent equity must be insured.

The overall trend toward greater household indebtedness may not be very troubling, but the recent acceleration is. For many years, debt was rising about 2.5 percentage points faster per year than income. The gap had widened to 4 to 5 percentage points by 2005 and blew even wider during the recession. Despite a softening in incomes, housing returned to its boom after a brief pullback as Canadians embraced the allure of low interest rates.

Some telltale signs of stress are already appearing. In 2008, the value of household assets experienced its first decline, falling 2.7 per cent. On the other hand, liability growth continued, unabated by the Great Recession, rising by 9 per cent in that same year. And while assets recovered somewhat in 2009, the asset-to-liability ratio hit an all-time low as liabilities again grew faster than assets. The Bank of Canada estimates that, despite the record low interest rates, debt servicing charges put 6 per cent of Canadian households in a vulnerable financial position.

That will surely rise as interest rates inevitably rise. TD Economics expects short-term interest rates to rise to around 4 per cent and longer-term government bond rates to be closer to 5 per cent within the next few years. That will push the portion of household income going to interest charges to a 20-year high.

In a similar interest-rate scenario with continued strong growth in credit, the Bank of Canada estimates that the percentage of vulnerable households will rise to 8.5 per cent. Another percentage point's increase on top of our interest-rate projection, and the portion would be almost 10 per cent. The hurt to Canadian households and the economy would be palpable. But even this scenario would not bring about a financial meltdown of the type we have seen elsewhere, due to the strong capital positions of Canadian financial institutions.

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The path forward is clear. Defusing the debt bomb requires Canadian households to slow the pace of debt accumulation. It must come down from the recent annual growth of almost 9 per cent to no more than 6 per cent. Consumption can still rise, but at a more restrained pace. Some things households want will have to be forgotten or deferred until some money has been saved.

This is all the more necessary because household balance sheets are unlikely to be skated back onside by huge capital gains from housing and equities of the kind that occurred throughout the 2000s, when housing-price gains averaged 8 per cent per annum. TD Economics expects future rates of return to be much lower than past averages. So, achieving a desired income stream in retirement will require amassing a larger pool of savings. Instead of 8-per-cent average house-price gains, in the future they are unlikely to exceed 4 per cent. In a 2-per-cent inflation world, a fixed-income portfolio is unlikely to return more than 4 per cent a year, and equity markets (including dividend returns) will turn in about 7 to 8 per cent.

This means that a household's entire portfolio will be providing a return that is 2.5 percentage points less every year, relative to what households have become accustomed to in the past decade. Consequently, household consumption must rise at a slower pace than in the past decade. Spending on the back of asset appreciation will become harder to do.

The need for Canadians to save more will be a lingering issue for many years to come. Several recent studies have concluded that Canada's retirement-income system is reasonably sound, in that most Canadians have enough savings to preserve their standard of living in retirement. But they do identify a significant group, concentrated in the middle and upper-middle income classes, that is vulnerable because they do not have employer-sponsored pension plans and have not been putting enough aside on their own.

This comparatively hopeful view is largely backward-looking. The question of the adequacy of retirement savings is shrouded in financial literacy challenges. Almost one-third of respondents to a Statistics Canada survey acknowledged they had no plans for their financial needs in retirement.

Moreover, some recent trends are rather ominous. The coverage of employer-sponsored pension plans continues to dwindle, especially for the gold-plated defined-benefit plans. Work is increasingly shifting to self-employment, contract and part-time positions where there are few benefits and greater income fluctuations.

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Demographics and workplace changes are collapsing the period available to amass savings. With more education, people enter the work force later. Until recently, they were retiring earlier. And couples are older when they have children, so this additional expense continues into what used to be savings years. The median age for first-time mothers in Canada has risen to 30. So right into their 50s, parents are incurring postsecondary education bills for their children. In previous generations, these were out-of-pocket expenses for parents or covered by students' part-time earnings. The cost of a BA for a child born today will be almost $100,000 in today's dollars if the student does not reside at home. With two children, it doubles to practically $200,000. That's a game-changer for lifelong savings requirements. And again, in contrast to the past, Canadians shouldn't count on extraordinary savings being furnished from sustained, outsized gains from housing and equity markets. The savings will have to come the hard way: out of earned income after taxes.

Canadians can take some comfort that they are not yet facing a financial disaster sparked by excessive debt - although that could happen. For instance, double-digit interest rates would bring down household balance sheets like a cheap deck of cards. The threat of really high rates would come from monetary policy authorities letting inflation get out of hand and fiscal policy authorities not curbing debt burdens. There is little danger of hyperinflation now, but central banks around the world will need to mop up liquidity as economies recover. Canadian governments are setting out programs to return to fiscal balance. But the same cannot be said for many other countries.

In case we had forgotten, the Great Recession reminded us that Canada is highly vulnerable to financial shocks emanating from outside the country, especially the United States. Of course, sharply higher interest rates could be a catalyst for a plunge in housing prices. The extent of any decline would depend in part on whether we are now in a housing bubble. TD Economics does not believe we are in a bubble and barring the disaster scenario painted above, predicts housing prices will see a sharp moderation in the pace of increase rather than a level decline.

All Canadians had better hope that Canadian policy-makers and regulators are on their game to avoid these catastrophes. The rest is up to Canadian households. Many of them will need to save more today and save more tomorrow. It may not be the end of a party, but an earlier bedtime is recommended.

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