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Bank of Canada has it all wrong — this is the real ‘red flag’ to watch for in the economy

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Bank of Canada has it all wrong — this is the real ‘red flag’ to watch for in the economy thumbnail

Record household debt in Canada has stoked concern that the mountain of debt will squeeze economic growth and trigger the next financial crisis. But a new paper from the C.D. Howe Institute suggests such red flags will be accurate only if the ability to service debt is included alongside traditional measures of household debt relative to disposable income and gross domestic product.

Authors Jeremy Kronick and Steve Ambler say including the ability to service debt in the analysis takes into account a growing cushion of assets and net worth that is allowing Canadians to manage their debts.

“In contrast to the Bank of Canada’s financial vulnerability barometer, our index … indicates that financial risks are currently quite low,” they say in the paper, referring to the central bank’s measurement that draws together indicators from households, as well as the banking, corporate and housing sectors.

“Focusing on debt servicing provides a potential clue as to why we have not seen the type of market correction that has been repeatedly predicted for the Canadian housing market.”

The authors note in the report published Thursday that over the past 25 years, the debt-service-to-disposable-income ratio “has largely been flat” with the exception of a recent “mild” increase and a notable increase before the 2008 financial crisis.

Canadians’ net worth – which has been boosted by low interest rates and increased housing prices – has never been higher, according to the paper. And while household debt-to-GDP has increased from around 75 per cent in 2007 to 100 per cent today, household debt-to-net-worth has remained almost identical at around 20 per cent during the period.

This provides context to worrying statistics, such as a recent report from the Office of the Superintendent of Bankruptcy that shows insolvencies were up by 8.9 per cent over the 12-month period ending in November last year, the C.D. Howe report says.

Insofar as their analysis relates to financial stability, the authors say it has implications for monetary policy — the setting and movement of interest rates — and regulation of the financial sector through risk assessment.

“The inclusion of household debt servicing considerably improves the … ability to track financial vulnerability, particularly in advance of recessions,” they write, noting that attention to this metric would result in more accurate risk assessments by regulators.

“Financial sector regulators should look beyond traditional credit-to-GDP measures, which were destined to increase in a low interest rate environment at any rate, and closely monitor the behaviour of debt servicing.”

For the central banks, the authors say, the key implication is how they view financial stability in managing the “trade-off” between short-term positive effects from increased borrowing on output and inflation, and potentially negative effects in the long run in terms of the servicing of that debt.

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