The Bank of Canada intends to raise borrowing costs at a time when private debt levels are at record highs. Recent survey data show Canadians are already feeling the pinch from three interest rate hikes since July, while the projected path for future rates could stretch household budgets to levels last seen during the financial crisis.

Record Debt Levels

Canadian households and businesses each owe about C$2.1 trillion, bringing total private debt to $4.2 trillion or about 215% of GDP. The Bank for International Settlements (BIS) tracks this data for 44 of the largest economies, representing 85% of global GDP. As of 2017, Canada's private debt load was the ninth largest relative to GDP.

But it is the growth of debt – not just the level – that heightens the risk for Canada. Since 2007, Canadian households have taken on an additional $915 billion of debt, nearly doubling their pre-crisis total. At the same time, businesses added over $1.0 trillion, pushing total private debt to GDP up 50 percentage points from its 165% level in 2007. This is likely the largest 10-year expansion of Canadian private debt in at least a century (though data is only available back to 1969), leaving Canadian households and businesses with a record debt loads relative to their respective incomes.

The BIS also tracks each economy's credit-to-GDP gap, a measure of private debt relative to its long-run trend that has been shown to be a useful predictor of banking crises. As of 2017, Canada's credit-to-GDP gap was third largest of the 44 tracked economies. The past decade of Canadian private sector credit growth is exceptional, not just relative to Canadian history, but also in a global context.

Higher Interest Rates

Against this backdrop, the Bank of Canada intends to raise interest rates. According to last week’s statement, "higher interest rates will be warranted over time, although some monetary policy accommodation will still be needed.” Private forecasters have taken this to mean another two hikes in 2018, followed by two or three more in 2019. This could nearly double the current policy interest rate to 2.50% and push up interest rates for Canadian households and businesses to the highest level in a decade.

But recent evidence suggests households have little financial buffer to absorb the higher costs. A recent survey from MNP showed almost half (46%) of all Canadians have less than a $200 cushion to meet each month's expenses, while nearly a third (29%) have already maxed out their monthly budgets. Around 43% of Canadians reported they are already feeling the effects of higher interest rates, while 51% fear still higher rates could hurt their ability to pay debts. By my estimate, higher borrowing costs could push household’s debt service ratio – defined as total debt payments divided by disposable income before interest payments – up to levels last seen in 2007.

Based on this analysis, the Bank of Canada may need to slow its roll. Last week’s policy statement mentioned the Bank is closely watching “the economy’s sensitivity to interest rate movements,” while about half of homeowners are set to refinance their fixed-rate mortgage at higher interest rates this year. Though the full economic impact has yet to be seen, consumers appear cautious with nearly four in five Canadians (78%) saying higher interest rates will cause them to be more careful with how they spend their money.





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