High household debt a threat to economic recovery, says Bank of Canada

OTTAWA _ The Bank of Canada warned Monday it is keeping a close watch on household debt, and repeated its plea for both individuals and lenders to act responsibly when it comes to loans.

In her maiden speech as a deputy governor of Canada’s central bank, Agathe Cote told a business luncheon in Kingston, Ont., that restraining household debt is a key to the economic recovery.

“Sound household finances are a key element of a balanced economy,” Cote said in speech notes released in Ottawa.

“They are essential to keep household spending and overall economic growth on a sustainable track and to maintain the stability of our financial system.”

The fear is that if a shock occurs or interest rates rise, Canadians saddled with high debt payments will need to curtail spending on other areas.

That’s a problem for the economy, since about 60 per cent of aggregate demand comes from household spending.

Cote concedes that a low interest rate _ in part because of Bank of Canada policy _ is a principal contributing factor in Canadians’ piling on of debt at record levels, even in uncertain economic times.

But she says the central bank’s primary responsibility is to keep inflation on target _ not to address economic bubbles _ although she hinted it is possible that could change in the future.

She made clear the main line of defence against excessive borrowing should be Canadians themselves and those that lend them money _ the banks.

Failing that, the federal government can intervene by tightening up rules for borrowing, as it has twice before in the past two years.

The central bank has been warning about excessive borrowing by Canadians for at least the better part of a year, but with little effect. In fact, the situation has gotten worse.

According to data released in the fall, household debt to disposable income rose to a record 148 per cent in the third quarter of last year, even higher than what exists in the U.S.

It’s not just Canadians taking out mortgages to buy homes, she said. A big part of the rising indebtedness is caused by homeowners using their house collateral to borrow for other purposes, including renovations, consumer goods purchases and paying off other kinds of debt.

The volume of home-equity loans as a share of overall household credit has risen by 170 per cent in the last decade, she said, twice as fast as mortgage debt. That’s a problem, she says, if home prices fall.

“If there were a sudden weakening in the Canadian housing sector, it could have sizable spillover effects on other areas of the economy, such as consumption,” she said.

In a recent interview, Finance Minister Jim Flaherty also expressed concern about the speed of growth in home-equity loans, hinting he is prepared to take action if necessary. One option is to raise the threshold on how much equity owners must retain on their homes.

Cote said households and lenders should show “prudence” over taking and extending additional debt.

“As part of our research for the renewal later this year of our inflation-control agreement… the bank is examining whether there may be cases in the future where monetary policy should play a supporting role,” she added.

TD Bank economist Pascal Gauthier said by his calculations, household debt ratios are already at unsustainable levels.

“The Bank of Canada can only hope that its message is not being lost on deaf ears,” he said. “At 148 per cent and rising, the debt-to-income ratio is but one measure underscoring the need to pay close attention. By our calculations, economic and financial fundamentals suggest that a more sustainable debt-to-income ratio would lie around 138-140 per cent.”

Cote noted that the central bank could slow credit by raising interest rates, but hinted that the bank has bigger concerns given the still fragile economic recovery. The bank is next scheduled to pronounce on interest rates next week, but most analysts expect it will keep the policy rate at one per cent for a few months longer.

According to its own projections, the bank forecasts Canada’s recovery will remain muted, growing by a tepid 2.3 per cent, this year.

“Canadian monetary policy is set for overall macroeconomic conditions in Canada,” Cote said.