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External risks to economy rising, Bank of Canada warns Add to ...

The European crisis and the United States' high debt and sputtering rebound are straining the global financial system and complicating Canada's recovery, showing that the chief risks to the economy lie outside Canadian borders.

Top policy makers indicated Wednesday that they are on heightened alert for a deeper crisis in Europe that spreads beyond Greece and, potentially, hurts Canadian banks or the wider economy. Though the direct exposure of Canadian banks to countries such as Greece is low, the Bank of Canada warned that Canada's financial institutions are vulnerable through links to the United States and other countries that are much more exposed.

Europe's leaders are trying desperately to keep the debt problems of smaller economies such as Greece from rippling through the international financial system - in a worst-case scenario contaminating banks in countries with little direct exposure to Greek debt - just as the crucial U.S. economy is muddling through an ominous rough patch.

The rebound from the global downturn is expected to continue, but there is clearly more concern among policy makers than a few weeks ago. That helps explain why the Bank of Canada has held interest rates steady even as it frets about households using ultracheap credit to pile up unprecedented levels of debt. Canada is already suffering from the effects of the Japanese earthquake, which is squeezing North American supply chains, and economists say growth in the current quarter will slow to an annual pace of little more than 1 per cent from 3.9 per cent in the first three months of 2011, before picking up again in the second half.

Adding another wrinkle, the Bank of Canada said Wednesday in a semi-annual assessment of risks to the financial system that the low interest rates needed to keep recoveries in advanced economies intact are pushing some yield-hungry investors to engage in riskier behaviour.

"All of these risks - if they are borne out - could have significant consequences on Canada's economy and financial system," economist Diana Petramala of Toronto-Dominion Bank said in a report to clients. "In addition, they are medium-term (rather than short-term) in nature, suggesting they are unlikely to disappear any time soon.''

Adding his voice, Finance Minister Jim Flaherty told reporters in Ottawa that Europe needs to somehow build a "firewall" around Greece to keep its problems from spreading. Already, Canada's financial system is at greater risk than it was six months ago in part because European governments have been unable to convince markets that they will get the debt crisis under control, Bank of Canada Governor Mark Carney and his policy team said in their report.

Separately, the Federal Reserve's policy committee said Wednesday that the current slowdown in the United States will be temporary, but acknowledged that growth in Canada's No. 1 export market has chugged along "somewhat more slowly" than the Fed was expecting.

In a press conference after the Fed's policy meeting in Washington, chairman Ben Bernanke not only indicated he won't be moving from near-zero interest rates any time soon, but also said the Greek debt crisis could threaten the world's biggest economy and the stability of the global financial system if a solution isn't found.

The warnings about Europe came as governments in France, Germany, the Netherlands and other key countries were reportedly meeting with banks and insurers to urge them to share in the burden of Greece's second bailout, something the private bondholders have been reluctant to do. The trickiness of those talks underscores why few outside the halls of government in Athens were ready to pop the champagne corks after Prime Minister George Papandreou narrowly survived a confidence vote on Tuesday night.

"Whether or not a [default or restructuring]occurs," the Bank of Canada report said, "strains could trigger a sharp repricing of credit risk for other governments with high debt burdens, as well as a generalized retrenchment from risk-taking in global markets. If this happened, it would cause losses at financial institutions and increase the funding costs of banks around the world, including those in Canada."

Moreover, policy makers noted that although Canadian financial institutions' total exposure to Greek, Irish, Portuguese and Spanish debt amounts to a mere $8-billion, banks in countries with which Canada has deeper financial ties - namely, the U.S., the United Kingdom, France and Germany - are far more exposed.

"The high degree of interconnectedness in the international banking system can thus amplify shocks," the central bank warned.

And it doesn't end there. In addition to the "acute fiscal strains" in Europe that could have severe ramifications throughout the global banking system if mishandled, countries like the United States and Japan must also come up with credible debt-reduction plans, Mr. Carney and his deputies said. Furthermore, efforts to beef up international banking standards must continue apace, he said.

"If the significant fragilities that still burden the financial system are not addressed in a timely manner, the progress achieved to date could be derailed.''

With files from our wire services

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