Canada’s “vulnerable” financial system

Canadians should have their financial houses in order. While Canada’s financial system is strong, says the Bank of Canada (BofC) in its December Financial System Review (FSR), it is not immune from the “challenges” that threaten global stability.

“The Canadian financial system,” it reports, “continues to be vulnerable to a number of interrelated and mutually reinforcing risks.”

In its semi-annual FSR, the BofC’s Governing Council weighed the impact of external and domestic conditions on Canada’s financial stability. It notes that risks “remain high” — as they were in June — due mainly to external factors and the interconnectedness of global economies.

The euro area continues to pose the greatest threat to global economic stability, although the U.S. and concerns about the “fiscal cliff” aren’t far behind. The FSR notes that conditions in Europe have improved since June’s FSR, thanks to actions taken by the European Central Bank (ECB). Likewise, actions by the U.S. Federal Reserve, with its third round of quantitative easing, have been positive, boosting credit markets in North America.

But there is still uncertainty ahead. As the FSR notes, it all hangs on whether policy-makers in the euro area and the U.S. have the resolve to put in place lasting solutions. The FSR calls it “implementation risk.”

“The principal threat to financial stability in Canada,” the FSR says, “is that the crisis in the euro area could reintensify.”

Slowing and uneven economic growth in both advanced and developing economies could also upset the fragile global balance. With Europe in recession, the U.S. recovery modest and China’s growth subdued, there is what the FSR calls a “deficiency in global demand.” Should that deepen or entrench the impact would be felt globally — and domestically.

Perhaps the risk factors that strike closest to home are Canadian household finances and the housing market. There is some reason for optimism in that the growth in household credit has continued to slow in the past six months. As of October, household credit grew by a three-month annualized rate of about 4%; in June it was growing at an annual rate of 5.5%. Unfortunately, however household credit is still growing at a faster rate than disposable income. In the second quarter, household debt to disposable income reached 163%.

“The Bank’s stress-test simulations continue to suggest that households are vulnerable to adverse economic shocks,” the FSR concludes.

The strength of the housing market is another risk. Although some markets have slowed recently, there are still concerns about overvaluations and overbuilding. “Housing activity has been elevated relative to historical norms for close to a decade,” notes the FSR. As well, housing starts have exceeded estimated levels of demographic demand. The culprit is multiple-unit dwellings, including condominiums, in major metropolitan areas, led by Toronto.

“Canadian households are vulnerable to two interrated shocks,” says the FSR, “a significant decline in house prices and a sharp deterioration in labour market conditions.”

The FSR drives home the fact that the global recovery remains elusive. The Canadian financial system, too, is vulnerable to economic shock and Canadians will have to tread carefully in 2013.