12/09/2014 11:39 EST | Updated 12/09/2014 11:59 EST

Canada's Catch-22: Bankruptcies Could Soar If Economy Improves


There is a Catch-22 in Canada’s economy, which is this: When things get good again, it will cause things to go bad.

That’s because Canadians have taken on so much debt that a rise in interest rates could tip many borrowers at the margins into insolvency.

Many market observers expect interest rates in Canada and the U.S. to start rising next year, with the U.S. Federal Reserve leading the way as the U.S. economy enjoys a widespread recovery.

CIBC economist Benjamin Tal issued a report last week noting that interest rates typically rise when the economy improves, so bankruptcies tend to come down when interest rates go up.

But after five years of rock-bottom interest rates, Canadians have taken on record levels of debt that have pushed house prices to record highs and spurred large increases in auto sales.

That makes Canadian consumers very sensitive to changes in interest rates. “We might see bankruptcies rising alongside interest rates,” Tal concluded.

In other words, when the economy is strong enough that interest rates have to rise, those interest rates will send some fraction of Canadian households into financial trouble.

Just what sort of impact are we talking about? Economist Will Dunning, who often carries out research for Canada’s mortgage industry group, estimated last year that a one-percentage-point increase in interest rates would result in a 15.3-per-cent drop in home sales in Toronto, while prices would drop 6 per cent.

That’s bad enough to be a serious drag on the economy, especially given Canada’s economy is more reliant on real estate and construction today than it has been in recent memory.

And that’s the sort of problem that can keep the governor of a central bank up at night.

Recently, the Bank of Canada's Stephen Poloz has been musing about ways to delay a hike to the bank’s key lending rate. Officials at the bank have suggested it could raise its inflation target, essentially raising the bar for when the BoC hikes rates.

Currently, the bank’s inflation target is 2 per cent, and if inflation runs hotter than that, in theory it raises rates. But after inflation hit 2.4 per cent in the latest StatsCan report, there was no talk of raising rates, just talk of changing the standards for raising rates.

That is a clear sign the bank is worried about the impact even a modest interest rate hike would have on the economy.

Officially, Poloz is worried about "slack" in the economy, hence his desire to keep rates low. But recent economic data are challenging that notion, and in any case Poloz wouldn't come out and blithely declare that the housing and auto markets would tank if rates rose.

But there is a serious risk they would. According to the CIBC report, household debt in Canada is back on the rise. Growth in borrowing had been slowing for several years, but Tal’s report shows it’s now growing at the fastest pace in nearly two years.

The upside is borrowing is still not growing as fast as it had been in the years prior to the economic crisis, and thanks to those low rates, the cost of paying interest on loans is at a record low (7.2 per cent of disposable income).

That's probably why consumers still feel comfortable taking on more debt. Stripping out mortgages, consumer credit is growing at the fastest pace in nearly two years, driven by auto loans (up 8 per cent in the past year) and by credit card debt (up 5 per cent).

There is “a significant supply push by credit providers,” CIBC's Tal writes. “Accordingly, the recent improvement in retail sales might be more leveraged than perceived.”

In other words, Canada’s economy is still being fuelled by larger and larger debt loads. And that in turn makes the Catch-22 even harder to resolve.

There is one element that could delay any improvement in Canada's economy, and therefore the inevitable interest rate rise: Falling oil prices. They're down by about 40 per cent since the summer, putting serious pressure on the economies of the resource-exporting provinces. That could create some downward pressure in the economy, which would (ironically) delay that possible wave of bankruptices as interest rates stand pat.

Between falling oil prices and rising house prices, unustainable debt levels and a job market that continues to struggle, it's really anyone's guess what the right monetary policy should be. Stephen Poloz has a tough job ahead of him.

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