The debts of Canadian households rose once again in the second quarter of this year, to the astonishment of the Bank of Canada. Finance Minister Jim Flaherty and Bank of Canada Governor Steven Poloz should heed the warning and head off the looming credit crunch while they still have time.
Statistics Canada reported last week that the credit market debt of Canadian households, measured against their disposable income, rose to 163.4 per cent of income in the second quarter from 162.1 per cent in the first quarter. Mr. Flaherty and the Bank of Canada had been worried about this level of debt last year when the debt-to-income ratio reached 162.8 per cent. Mr. Flaherty took a series of steps to restrict mortgage insurance eligibility and discourage mortgage interest rate discounting. These measures appeared to be working when the debt ratio fell to 162.6 per cent in the fourth quarter and then to 162.1 per cent in the first quarter of this year. The authorities patted themselves on the back. The sudden increase to 163.4 per cent in the second quarter, therefore, appeared to be both a shift in the trend and a setback for Mr. Flaherty's efforts.
The Bank of Canada was also caught off-guard. The bank said in its Sept. 4 rate-setting statement: "While the housing sector has been slightly stronger than anticipated, household credit growth has continued to slow and mortgage interest rates are higher, pointing to a continued constructive evolution of household imbalances." The household-debt report nine days later showed this was no longer the case.
To set that ratio in context, working people in their 30s, with maybe 30 years of slowly rising income ahead of them, might logically buy a house and borrow an amount two or three times their annual income with a mortgage loan from the bank. A few will get into trouble but most will be able to make their monthly payments. As they approach retirement, however, their income should rise and their debt should decline because they have only a few years left to pay off the bank. For all Canadian households in aggregate, debt should not exceed annual income -- or not for long. At the moment, debt is 163.4 per cent of income and climbing.
Lately, Canadian banks have found a new group of borrowers among empty-nesters whose house values have shot up. They are reluctant to sell their house but the bank can help them cash in on the rising value through a mortgage loan. The bank will get its money back when the house is sold, either by the couple or by their children. It's a way of making the next generation pay for their parents' declining years.
The banks' success in issuing these home-equity loans is reflected in the stellar level of bank profits reported in August and in the high level of household debt relative to income. The practical effect is that the heirs of home-equity borrowers will inherit family homes encumbered with debts. This was once rare but may soon become common. That is when deleveraging will set in -- when the next generation has to repay their parents' debts.
For the moment, Canada and some of its retirees and empty-nesters are able to live well and spend freely. This credit-fuelled prosperity looks like robust economic health while it lasts. But house prices will not go on rising forever and interest rates will not remain low forever.
If Mr. Flaherty is lucky, the deleveraging will not take hold before the 2015 election. Mr. Poloz, however, will still be in office and answerable for the results of his policy. He should recognize household imbalances are not evolving as constructively as they seemed on Sept. 4. He should slow the growth of household debt. He should touch the brake pedal while he can. He should avoid the fate of that Spanish train driver who took the curve too fast near Santiago de Compostela in July and then saw his train spin off the rails.