Some good news this week from Canada’s central bank – the risk of economic implosion in our nation is now the lowest it has been since 2011. The Bank of Canada released their December Financial System Review this Tuesday, cutting our perceived exposure rating from “high” to “elevated”.
Such a status may not seem all that reassuring – but it is a sign that economic conditions are looking sunnier than they did in June, when the last Review was released.
The semi-annual report, which compiles the Bank’s efforts to identify and mitigate key risks, states improvements are due to a stabilizing global economy – Europe has taken tentative steps toward recovery, and new global system regulation means the chance of another financial crisis is shrinking.
However, this silver lining comes with a stark reality – global economic improvement is akin to a house of cards – it’s new, fragile and could collapse should there be unforesen economic shock. Here are the biggest risk factors identified by the Bank, and how they’ve changed since the last economic check in.
Key Risk 1: Euro-Area Banks and Sovereigns
The financially embattled Eurozone has been through the wringer since the 2008 financial crisis. Employment has been anemic, banks have been unstable (Cyprus bank account freezes come to mind), and there has been political and social backlash to the austerity measures implemented to help the situation.
European instability causes an “adverse feedback loop” in the global banking sector, affecting trade and liquidity between nations. And the damage has been done – European banks are still in recovery mode and governements – not to mention citizens – are suffering from reform fatigue.
The level of investor trust in some nations has also been deeply undermined – the report points out that yields for Spanish and Italian bonds remain very high, as they have increased their loan-loss provisioning.
But it’s not all doom and gloom for our European neighbours. Euro-area GDP is improving, and the balance sheets of most major banks there are strengthening, and public debt levels being reduced to more sustainable levels. This has led the Governing Council to reduce Euro-area risk from “very high” to “high”.
Risk to Canada: States the report, “The adverse spillover effects to the Canadian financial system through financial, condidence and trade channels could be substantial.”
Key Risk 2: Canadian Household Debt and Housing Market
Some of the biggest threats to the Canadian economy are self inflicted – Canada continues to experience high household debt levels, and a scorching housing market fueled by low interest rates. Despite measures taken over the past four years to curb mortgage borrowing, sales remain persistently strong, and prices remain too hot to handle in some markets – and it’s only gotten worse since the June report. With Canadians continuing to pile on the debt, the Bank warns this leaves us all exposed to big economic shock – especially if interest rates were to rise dramatically.
The report signals out the condo market in Toronto – demand there has lagged, yet mid-construction levels continue to contribute to oversupply. The warning is that if demand does not pick up, the market will experience price and value corrections.
Risk to Canada: Rising interest rates, imposed either by economic shock or natural inflation growth, could spell disastor for some overly indebted homeowners. Those maxed out on their affordability may find their monthly debt repayment to be suddenly out of reach,
Key Risk 3: Financial Behaviour In A Low Interest Rate Environment
Everyone loves a great deal – so it’s only natural that borrowers are clamouring for mortgages, loans and credit while interest rates are at such record lows. The Bank of Canada has kept their benchmark Overnight Lending Rate at an artificial one per cent since September 2010 in efforts to encourage consumer spending and support the post-recession economy. But such efforts are a double-edged sword – such low rates have been a main contributor to be aforementioned consumer debt levels.
And Canada is far from the only nation to employ such methods – central bank rates have been slashed from England to Japan. Says the report, “Low interest rates continue to provide incentives for excessive risk taking by investors as they search for higher yields, and there has been great use of leverage and maturity transformation in some sectors.”
Should there be a sharp increase in long term rates, it could cause massive disruption across financial markets and create losses for investors. The hoopla surrounding the U.S Fed’s “will they or won’t they” taper drama is a perfect example of how the fear of higher rates drives the market haywire.
Risk to Canada: Investor fallout could have global implications once rates do start to rise, especially if markets panic – dumped bonds will in turn push fixed rates in Canada higher, resulting in an even higher cost of borrowing.
Key Risk 4: Financial Vulnerability In Emerging Economies
This is a brand new risk category, created to address the uneven economic progress in rapidly growing economies. States the report, “Strong growth, fueled by rapid credit expansion, aggressive policy stimulus and underdeveloped financial regulation has masked a significant buildup of financial stability risk in some countries.”
Some of these countries are highly dependent on external market-based financing – a shock in the form of rising interest rates could have deep consequences for them. Others are experiencing banking growing pains as they’ve boomed too quickly for efficient regulation to keep up.
Risk to Canada: The danger posed here is mainly through trade with these countries, which could further hurt our exporting industry – an already floundering economic driver, the poor performance of which has contributed to our own nation’s slow GDP growth.