Cautious Canada has avoided the financial pitfalls of the U.S. - for now
Yet there are signs that the banks’ balance sheets don’t look quite as strong anymore. Canadian households have rushed to get mortgages and refinance at record low rates; the average mortgage rate was well under 5.0 per cent in September 2009. Banks were more than happy to extend loans, particularly after the government’s purchases of the already-insured long-term mortgages helped unlock long-term capital for the banks.
Although Canadian housing markets weakened in late 2008 and early 2009, particularly in the overheated western Canadian cities, low interest rates, capital inflows, increased liquidity and a reduction in bank lending standards have helped reverse the trajectory. Housing starts, prices and sales have rebounded, despite remaining below their 2008 highs. This improvement is both a trigger and a symptom of the strong domestic demand that has helped Canada exit the recession. The fact that Canada had less excess housing stock than the U.S. is a further support. But recent moves could be overly optimistic.
There are a few differences between Canada’s housing spree of 2009 and what happened in the U.S. earlier this decade that mostly end up in Canada’s favor. First, Canadian mortgages are recourse loans, meaning that the cost of default is higher than in the United States. In Canada, mortgage interest is not tax deductible, an incentive to reduce balances that are owed. Canada also has less excess housing stock. Moreover, most Canadians still have much more equity in their homes than their southern neighbors. Canadian homeowners own about 74 per cent of the equity in their homes, close to double that of the U.S. (43 per cent as of September 2009). As a result, very few homeowners were ever in negative equity.
But there are some reasons to be concerned. The share of Canadian households that owe over 80 per cent of their homes’ value has climbed in the recent years. In addition to lower down payments (many as low as 5.0 per cent), the loans are amortized for a longer period. When the loans are reset after several years, interest rates could climb. Canadian policymakers are rightly starting to worry about the property market rebound and have emphasized the tools available to avoid a property bubble. Some regulatory changes, including an increase in the minimum down payment, are expected, and banks may already be starting to tighten lending standards.
Canada’s financial strength and timely monetary easing resulted in a milder recession (the net output loss was lower than in the previous postwar recessions), but its recovery has been sluggish.
The improvement in Canadian housing markets has helped fuel domestic demand, continuing a decade-long trend. Incentives including a tax credit on renovation have also helped. Strong domestic demand, supported by ample credit, asset-price inflation and the increased consumer purchasing power from a strengthening loonie, has boosted the service sector even as exports remain weak. The labor market data clearly shows this split.
As of November 2009, the service sector had about the same number of jobs it did at the October 2008 labor market peak, while the goods producing sector had lost 324,000 jobs (roughly equivalent to the country’s net job losses). The reduced hours and slower wage gains of some of these jobs are a constraint to consumption, but clearly, domestic demand has been strong, supported by the increase in purchasing power. However, businesses may be slow to start investing and productivity might continue to decline.
The real question is how strong Canadian growth can be with a weak external environment. Canada still relies on the U.S. to absorb over 70 per cent of its exports, despite efforts to diversify its export base. Trade with the EU and China has increased, along with China's interest in Canadian resources and dollar assets. Even Canada’s commodity exports have yet to expand significantly in recent years.
Canada’s financial strength and timely monetary easing resulted in a milder recession (the net output loss was lower than in the previous postwar recessions), but its recovery has been sluggish. Like much of the global economy, Canada exited recession in mid-2009 and has good momentum going into 2010. But the recovery could continue to be slow with below-potential growth as the external sector drags and the stimulus wanes. Moreover, Canada’s twin surpluses (fiscal and current account) have shifted to a deficit. Given our concerns about the strength of the U.S. and G3 recovery, Canada’s private investment may also be slow to recover.
The role of the property market and related tax incentives in financing Canada’s return to growth is something to watch. If it doesn’t lead to a positive feedback loop with private investment, Canada runs the risk of being yet another host nation suffering the Olympic economic curse.
Nouriel Roubini, a professor at the Stern Business School at New York University and chairman of Roubini Global Economics (RGE), is a weekly columnist for Forbes. Rachel Ziemba is a senior research analyst at RGE for China and oil-exporting economies.