Unsustainable household debt levels drag on growth and leave us vulnerable to financial crisis
By David Rosenberg and Julia Wendling
Canadians have continued to pile on debt at an alarming rate throughout the COVID-19 pandemic, exacerbating the financial vulnerabilities associated with an overburdened economy.
Indeed, despite being among the most indebted of their peers pre-pandemic, Canadian households expanded their liabilities at the fastest rate in nearly a decade — primarily driven by a huge uptick in demand for mortgages as low interest rates prompted a surge in house prices — leading to a surge in the household debt-to-GDP ratio to 119.6 per cent by mid-2020, from 101.3 per cent at the end of 2019. The household debt ratio has come down since the crisis peak, but the reality is that the population’s excessive borrowing habits leading up to and during the pandemic will likely act as a drag on future consumption — and, thus, economic growth — over the longer term.
Why has household debt surged? As mentioned above, the debt bulge was predominantly fuelled by the boom in mortgage loans that accompanied the rapid house price acceleration witnessed since the beginning of the pandemic. As interest rates ventured lower and residential real estate prices across the country skyrocketed by around 40 per cent year over year at their peak in April 2021, mortgage growth followed suit, leaping 9.2 per cent in the second quarter — the fastest pace since the 2007/2008 housing bubble.
As a result, the share of mortgage loans on household balance sheets now sits at the highest level since 1995, at 68.7 per cent (up from 65.9 per cent pre-pandemic), and mortgage debt per capita has reached a record high, further exposing Canadians to any downside housing shock.
Meanwhile, other forms of debt (consumer credit and non-mortgage loans) have actually seen fairly tepid growth. On balance, Canadians exercised some financial prudence as generous government aid and limited spending opportunities joined forces to boost disposable income, giving households the opportunity to pay off more expensive types of debt (including unsecured debt).
The ratio of consumer credit and mortgage liabilities to disposable income fell to its lowest point since 2008, as households cut credit-card spending at the same time that the federal government was beefing up their wallets.
Some relief does come from falling debt-servicing costs, expanding Canadians’ ability to pay for their loans, but the danger here is that this encourages the accumulation of more debt. Consumer credit managed to contract on a year-over-year basis for four quarters in a row (as credit card debt hit a six-year low, according to Equifax Inc.), but it has begun to rise once again (1.3 per cent year over year as of Q2 2021, from -2.2 per cent year over year in Q1). After some brief signs of improvement, overall debt growth seems to be returning to its unstable pre-pandemic trend.
The trade-off between the short-term benefits and long-term costs of high debt levels is well documented: while spending and economic growth may get a brief boost (typically within one year) from the debt burden increase, any potential benefits in the short run are typically reversed (and then some) within three to five years.
According to a study by the International Monetary Fund, higher debt tends to suppress long-term GDP growth, is associated with elevated unemployment levels and considerably increases the odds of a future financial crisis as slower growth could trigger a wave of credit defaults.
Similarly, a separate study from the Bank for International Settlements estimates that an increase of one percentage point in the household debt-to-GDP ratio leads to lower growth in the long run by 0.1 percentage points. What’s even more unsettling, from the perspective of the Canadian economy, is that the BIS found that the negative long-run effects on consumption tend to intensify when the household debt ratio exceeds 60 per cent of GDP. At more than 103 per cent, Canada’s household debt-to-GDP ratio far exceeds this “intensification ratio,” and actually hasn’t been below the 60-per-cent threshold since 2001.
Ultimately, while the debt boom may have some positive effects in the short run, the unsustainable household debt levels across Canada are expected to act as a drag on long-term consumption spending, hindering real GDP growth and leaving the economy more susceptible to a future financial crisis.
Even though balance sheets somewhat improved throughout the pandemic (particularly at the lower end of the income strata) as government aid boosted disposable income and Canadians attempted to pay down expensive non-mortgage debt (even as mortgage debt boomed), the unsustainable trend of rapidly rising overall debt that existed pre-pandemic seems to have taken hold once again.
With mortgage debt accounting for more than two-thirds of liabilities and real estate as a share of disposable income reaching a record high of 501 per cent, Canadians are exceptionally vulnerable to any correction in the housing market, which has already shown signs of cooling off. All in, the long-term fundamentals of the Canadian economy are on shaky footing, further crippled by excessive debt, and we fully expect future economic growth to remain subdued — safe to say we remain highly skeptical of the loonie in the longer term.
Source: Financial Post