TORONTO: For years, the global community praised Canadian financial conservatism and the country’s success in skirting the global financial crisis. Canadian banks were seen as among the world’s finest, appropriately capitalized, and well-run. They still are. Globalization and interdependency, however, are perniciously eating away at the fortress of stability that Canada once was.

The country is today one of the world’s most vulnerable large economies, and there are three key reasons for this precarious position: First, Canadian household debt levels are extremely high by almost any measure. Second, housing prices are elevated and continue to rise, driven by both confident Canadians and foreigners. More debt accompanies these higher prices, further escalating the vulnerability. Lastly, the proverbial straw that may break the Canadian camel’s back is the recent collapse of crude oil prices. Lower crude oil prices are rippling through the energy-exporting economy and will adversely affect employment, the federal budget, consumer confidence and ultimately real estate. The virtuous cycle appears poised to turn vicious.

Let’s begin by looking at Canadian household debt. According to the McKinsey Global Institute’s February 2015 report “Debt and (Not Much) Deleveraging,” Canada’s household debt-to-income ratio grew by a staggering 22 percentage points between 2007 and mid-2014, matching household credit growth in China and lagging that of Greece (30 percent). Meanwhile, US household credit actually shrank by 26 percent as risk aversion led to rapid deleveraging. Related: A Plot To Hold Down Oil Prices Or Just A Happy Coincidence?

Total household debt, C$1.82 trillion, now exceeds GDP, C$1.6 trillion, approximately C$1.3 trillion of which was for residential mortgages. Further, household debt is now more than 160 percent of disposable income – meaning it would take about 20 months for a family to pay off its debt if interest rates were 0 percent and they spent their entire disposable income to do so. The Bank of Canada highlighted “elevated levels” of household indebtedness as one of the key vulnerabilities of the Canadian economy.

Subprime redux? As Canadian housing prices rise, uninsured mortgages outpace those that are insured (International Monetary Fund)

Click Image To Enlarge

And then there’s the Canadian shadow-banking sector that is booming. As a result of regulatory efforts to contain the housing froth, mortgages insured by the Canadian government are no longer growing. Uninsured private mortgages are filling the void. This includes creditworthy, gainfully-employed and seemingly responsible homeowners tapping home-equity lines. Such loans cost the banks about 3.5 percent, which then lend the money to a homebuyer who doesn’t qualify for an insured loan at 12 percent. This private uninsured mortgage market is a booming subprime industry, similar to the one that brought down US financial system in 2006-7. The graph from a recent International Monetary Fund report shows the continued growth of this lending as traditional insured lending slows.

It’s only a matter of time before this shadow mortgage banking market implodes and the impact of such a development will go beyond Canada. As incremental credit evaporates, housing prices are likely to fall and drag the Canadian dollar and Canada’s debt rating with them. Might this result in a greater flight of capital to US treasuries, forcing yields lower in the United States and an incrementally stronger US dollar? Might this stronger dollar further weaken crude prices, thereby hurting crude exporters such as Venezuela, Iran and Russia while helping crude-importers like India and China?

Given that 70 percent of household debt is associated with residential real estate, there is a tight connection between mortgage debt and real estate prices. Unlike the US real estate markets, which corrected during the financial crisis, Canadian prices continue an uninterrupted rise that began in the mid-late 1990s. Detached single-family homes in Toronto now average more than C$1 million, and Vancouver is now deemed the second least affordable city in the world – thanks in large part to Chinese buyers who are also facing a slower economy. The Economist magazine recently noted that Canada's housing markets might be overvalued by as much as 35 percent. Related: Oil Prices Won’t Recover Anytime Soon Says Exxon CEO

One of the main reasons that Canada weathered the last financial storm was due to a strong oil price and the corresponding jobs created for Canadian workers. Collapsing oil prices have dramatically altered the situation. Consider the chart prepared by University of Calgary Professor Ron Kneebone that evaluates Canada’s unemployment rate as cited and then removing the impact of Alberta’s boom:

Impact of Alberta Oilfields on Canada's Unemployment Rates

Oil and Jobs: Western Canada Select oil prices went from near $80 per barrel in February 2014 to below $30 in March; the graph shows the impact of jobs in the Alberta oilfields on Canada's unemployment rate (Ron Kneebone, University of Calgary) Click Image To Enlarge

A Statistics Canada report issued in March highlighted that Alberta was responsible for almost 90 percent of all new jobs created in Canada in 2014. That trend is now in reverse. According to construction industry association BuildForce, Alberta is likely to see sustained job losses for the next three years at a minimum. Further, because Alberta drew workers from all over the country, any slowdown will have national impact on unemployment. Not surprisingly, Calgary and Edmonton real estate markets have been rapidly weakening.

Sadly, Canadian leaders have very little in their control at this point. The global credit and crude markets defy local control. Even housing in Canada is more global than traditionally assumed – just ask any Vancouver real estate agent. Dan Scarrow of Macdonald Realty last month bluntly described the impact of Chinese buyers: “Our analysis last year indicated that roughly one-third of buyers in Vancouver had some connection to mainland China.”

Excessive household debt, an overvalued housing market, lower oil prices and a weak employment outlook have Canada teetering on the verge of an economic bust. In fact, it may not take a home price drop for chaos to ensue. Individual debt levels now need growth in prices to keep the system working. Prices plateauing may be sufficient for the house of cards to collapse. Related: A Closer Look At The World’s 5 Biggest Oil Companies

China’s economic slowdown and the strong US dollar have affected crude oil and other commodity prices negatively. Bank of Canada Governor Stephen Poloz reduced interest rates this January, clinging to a global trend of government stimulus spending, in a quest to mitigate the negative economic impact of plummeting oil prices. Lower interest rates fuel uninsured lending, but higher rates would crush the consumer and make debt unmanageable.

Housing prices, too, are largely out of Canada’s control. Vancouver and Toronto are highly international cities, proving popular with emerging market investors looking to park money. How much of Chinese buying pressure is because of a desire to get money out of China? One suspects that Chinese President Xi Jinping’s anti-corruption effort is spurring more Chinese money into Canadian housing. More than 20 percent of those in Canada are foreign born. The insidious effect of rising housing prices with incessant foreign-buying pressure is that it generates local fears of being priced out of the market. Canadians scramble to participate, and that drives additional credit.

And lastly, the immediate catalyst of forthcoming economic pain with lower crude oil prices is being driven by dynamics outside of Canada. Whether it’s Saudi Arabia pumping more oil in the face of overcapacity for political reasons or technological developments in the United States allowing the shale boom to continue, Canada has little control over the oil market. And yet crude prices directly impact the federal budget. The best Canada can do is to hope for higher oil prices.

The Canadian consumer reminds one of the cartoon character Wile E. Coyote who has run off the cliff, his feet still moving. Suspended in air, he has yet to look down, and it’s only a matter of time until gravity exerts its force.

By Vikram Mansharamani

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