Canadian Household Debt: What’s Next?

July 2017

Canada turned 150 years old this month. Over this century-and-a-half, the country’s GDP has grown from under $400 million to over $2 trillion. From beaver pelts and codfish to bitumen and car parts, the face of Canada’s economic growth has changed considerably over the last 150 years.

In the last few years, the face of Canada’s economic growth has become a lot more familiar. We now see it anytime we look in a mirror. Figure 1 shows how important consumer spending and residential investment has become for the economy. Figure 2 shows that RBC Economics expects consumer spending to become an even more important part of GDP growth in the coming years, given that oil prices are expected to remain depressed.

Figure 1

Figure 2

That’s all well and good. Consumer spending is usually expected to drive the bulk of GDP growth. Hence, someone could argue that there’s nothing more to see here.

Digging below the surface, though, we are concerned with what has been facilitating consumers’ ability to consume more: debt. Figure 3 plots private-sector debt as a percentage of GDP for developed countries around the world. It shows that Canada has exhibited the highest growth in this ratio over the last five years. The chart’s author (who may or may not be Kenny Loggins) says that this rapid growth has put Canada in the debt Danger Zone.

Figure 3

Figure 4 illustrates the impact that this rapid growth has had on Canadians’ debt service ratios (interest and principal payments as a percentage of income). Canada’s ratio is the highest in the G7. Additionally, while most other countries worked to bring this ratio down after the recession, Canadians kept theirs near all-time highs.

Figure 4 - Source: Bank for International Settlements

It is telling to look at the components of debt service payments. Figure 5 shows that as interest rates have decreased steadily since the recession, Canadians have chosen to simply offset their lower interest payments by taking on more loan principal.

Figure 5

It’s not just mortgages that have driven the growth in loan principal either. Figure 6 shows that non-mortgage debt has grown to such a point that the interest paid on it is now equal to the interest paid on mortgage debt. This non-mortgage debt includes things like credit card loans, auto loans, and home equity lines of credit (“HELOCs”). While a proportion of HELOCs are undoubtedly used for home renovations, a great deal of this non-mortgage debt has been used simply to consume depreciating goods.

Figure 6

Figure 7 shows that delinquencies on credit card debt have been creeping up in recent periods. Whether or not this is the start of a long-term trend is not for us to predict. But we do find it to be an interesting data point that suggests Canadians are nearing their indebtedness limit.

Figure 7

That sums up where we are today: consumer spending and residential investment have been the driving forces behind economic growth and we believe this type of growth has largely been debt-fueled. It’s where the economy goes from here that has us worried.

Economist Richard Koo coined the term “balance sheet recession” based on what he saw happen in Japan in the 1990s. This type of recession occurs when borrowers all focus on using their disposable income to pay down debt instead of consuming goods and services. This type of recession can happen even when interest rates are low, but could be triggered by something like a rate increase or falling asset prices.

From the preceding discussion, you can see why we think that a balance sheet recession is a risk for the Canadian economy. Richard Koo himself has even said as much: “…if something should happen to house prices, if they should start falling, then suddenly some of the people who bought these houses realize their balance sheets are underwater. And if they all start paying down debt or increasing savings, Canada could fall into a balance sheet recession.”

Figure 8 quantifies why Koo’s concerns about housing prices are so applicable to Canada. Compared to the U.S., real estate represents a much larger proportion of a citizen’s total assets. Thus, if housing prices were to fall, it would affect a Canadian’s net worth much more severely.

Figure 8

One final thought. Figure 9 shows that an extraordinary percentage of Canadians are employed in the construction sector. If housing prices were to fall, causing a slowdown in construction activity, a great number of these workers would find themselves unemployed. Figure 10 shows that there has been a strong historic relationship between the national unemployment rate and mortgages in arrears. This makes sense as it is difficult to pay your mortgage if you don’t have a job. Thus, we could envision a scenario where house price declines lead to a vicious cycle of layoffs, unpaid mortgages, deleveraging, reduced consumption, and more layoffs. We certainly hope this isn’t the case, but it is one worth paying very close attention to.

Figure 9

Figure 10

In sum, the deleveraging process for Canadian consumers is going to be a delicate balancing act. If it proceeds too slowly there is the potential for a debt-fuelled overheating of the economy. If it proceeds too quickly there is the potential for a rapid slowdown in consumption leading to a balance sheet recession. With the Bank of Canada now openly suggesting a rate hike is on the horizon, it appears that there is concern among policymakers that the deleveraging process is going too slowly. Historically, markets and economies have not reacted well to rising rates, so only time will tell whether Canada is the exception to the rule.