Decades of low interest rates and strong demand for housing have resulted in high levels of debt for Canadian households, and the current rise in interest rates is increasing the cost of servicing that debt.
But economists believe that the degree of risk posed by debt depends on the ability of the central bank to slow inflation without causing a major economic shock. “If there is no economic shock of a very large magnitude, it is quite possible that Canadians can afford this higher (debt) service,” noted economist Maria Solovieva, of the TD Bank.
Statistics Canada recently reported that Canadian households owed $1.85 for every dollar of disposable income in the first quarter of 2023, as higher interest rates worked their way into an economy already struggling with inflation. And Canada has the highest level of household debt in the G7, according to the Canada Mortgage and Housing Corporation (CMHC), with mortgages accounting for about three-quarters of that debt.
However, high levels of indebtedness among Canadians are not a new phenomenon. The amount owed relative to income has been rising for decades, said Nathan Janzen, deputy chief economist at the Royal Bank. Strong population growth has boosted demand for homes, helping to drive up prices in a market where debt has been inexpensive for buyers, Janzen said.
As the economy accelerated on the heels of post-pandemic reopenings, annual inflation topped 4% in mid-2021 and peaked at 8.1% in June 2022. In a bid to curb inflation , the Bank of Canada raised its key rate, which it had reduced to almost nothing at the start of the pandemic. Its target for the overnight rate has increased from 0.25% at the start of 2022 to 4.75% currently.
Rate hikes by the central bank have in turn pushed up prime rates at major banks and helped drive up the cost of other loans.
“As these debt payments increase, it eats up a growing share of household after-tax income and leaves less to spend on everything else,” Janzen said. It’s kind of part of the plan from the Bank of Canada’s perspective to absorb purchasing power and allow demand…to slow to a point where inflationary pressures come under control.”
However, as interest rates take time to work their way through the economy, the Bank of Canada is playing “a bit of a guessing game,” Janzen said. The cracks are starting to show for some households, he said, but the central bank’s rate hikes have yet to show their full impact. “There’s a fairly wide distribution of debt levels, income levels and savings levels,” he asserted, meaning the effects of higher interest rates won’t play out. feel evenly.
Statistics Canada reported earlier this month that the household debt-service ratio, calculated as the total obligatory payments of principal and interest on credit market debt as a proportion of household disposable income, had been 14.9% in the first quarter of 2023, compared to 14.4% in the fourth quarter of 2022.
Not a perfect science
David Macdonald, senior economist at the Canadian Center for Policy Alternatives, noted that for homeowners with fixed-rate mortgages, the effect would be delayed until their loan renewal. Meanwhile, potential buyers today are feeling the pinch of rate hikes, leading to a slowdown in new mortgage lending.
But it is not a perfect science. Because house prices aren’t falling enough to offset interest rate hikes, the higher cost of housing overall may actually be contributing to inflation, Macdonald pointed out. And while higher rates are weighing on some sectors of the economy, they are also contributing to lower new home construction amid a housing crisis, he added.
The central bank is trying to avoid an “1980s-style slowdown,” Janzen observed, referring to a period when dramatic interest rate hikes weighed heavily on the economy. Royal Bank currently expects a slight slowdown, Janzen said, noting that Canada’s financial system is strong and healthy. And while more Canadians will fall behind in paying off their debts, a recent Royal report says most households will get by.
TD’s Solovieva said the labor market had proven resilient so far, and said she believed the country could avoid a major shock. “That’s not to say some Canadians won’t struggle,” she warned.
Over time, Canadians will adjust their behaviors and, in many cases, extend the duration of their debts, which will weigh on longer-term consumption and growth. “It will be a gradual process,” Ms. Solovieva explained.
Mr Macdonald said he did not expect to see huge spikes in defaults or bankruptcies like those seen during the financial crisis, but added that “we should be reasonably concerned”. “The biggest problem isn’t so much seeing everyone go bankrupt, the biggest problem is everyone paying so much interest that no one is spending money on anything else, and you’re seeing an impact important to economic growth, he said. This, in my opinion, is the real danger.”