OTTAWA—The Bank of Canada continues to warn that the high level of household debt and overvalued real estate in this country have left the economy vulnerable if a financial shock erupts in Europe.

The central bank’s said Thursday that Canadian households generally have too much of their net worth tied to real estate values, which it says are overvalued.

In its financial system review identifying risks to the economy, the bank noted certain segments of the housing market that have a persistent oversupply — such as condos in Toronto — face a higher risk of a price correction.

Using a hypothetical stress test, the bank says a three per cent increase in unemployment — about the same as occurred in the recent recession — would almost triple the proportion of indebted households that would go into arrears.

The current rate is currently about half a per cent and could rise 1.3 per cent under that scenario.

A shock would also cut into net worth of Canadians. The bank points out that 40 per cent of household worth is tied to the value of their real estate holdings, compared to only 34 per cent a decade ago.

The report comes ahead of a key meeting of G20 leaders in Mexico next week.

The Bank of Canada was careful to point out it wasn’t predicting a global crisis like the one in 2008, but suggested a failure in Europe could not be contained.

The central bank concluded that the risks of a European financial meltdown that could ripple around the world have returned to the elevated levels of last December.

“The key risks to financial stability are highly interdependent and mutually reinforcing,” it states.

“If the sovereign debt crisis in Europe continues to intensify, it would further weaken global economic growth and prompt a general retrenchment from risk. In turn the weaker global outlook would fuel sovereign fiscal strains and impair the credit quality of loan portfolios.

“Together, these factors would increase the probability of an adverse shock to the income of wealth of Canadian households.”

As well, the diminished prospects for economic growth likely lead to a continuation of rock-bottom interest rates in Canada, which would further erode the positions of life insurance companies, pension plans and boost household borrowing.

Economists call the mechanism a “negative feedback-loop,” and what the central bank is describing is almost identical to what occurred after 2008, when the world was plunged into the worst recession since the Great Depression.

In Canada, the slump was mitigated by a sound banking system and strong government fiscal positions that allowed Ottawa and the provinces to inject about $60 billion of stimulus into the economy.

Still, about 430,000 jobs were lost and Canada’s gross domestic product fell by more than three per cent. Some sectors of the economy, in particular manufacturing and exports, have still to recover fully.

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The bank’s shock test shows that in some ways Canadians are in a more precarious position today than they were in 2008.

At the time, households in arrears also doubled, but from less than 0.3 per cent to about 0.6 per cent. Now they would almost triple to 1.3 per cent and from a higher starting point, given the record levels of debt.

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