06/27/2017 12:57 EDT | Updated 06/27/2017 13:02 EDT

Canadian Debt Crisis Risk Eases, But Still Among World’s Worst

The Bank of Canada may want to think twice before starting to raise interest rates.

Bank of Canada governor Stephen Poloz says ultra-low interest rates have "done their work" and he's signalling that rate hikes could be on their way sooner than expected.

But a new report from the world's top central bank watchdog should give Poloz pause. Canada's economy is one of the most at risk of a debt-fueled financial crisis if interest rates were to rise, according to data from the Bank for International Settlements (BIS).

Chris Wattie / Reuters
Bank of Canada Governor Stephen Poloz speaks during a news conference upon the release of the Monetary Policy Report in Ottawa, July 17, 2013.

The BIS, a Swiss-based "central bank of central banks," found that a key early-warning indicator of financial crises is flashing red in Canada.

The ratio of private debt to GDP in Canada is 14.1 per cent higher than its long-run average. That's down from 17.3 per cent the last time the BIS compiled this data earlier this year. But any number above 10 per cent indicates an elevated risk of a financial crisis caused by excessive debt.

By this measure, only China and Hong Kong have a higher risk of financial crisis.

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It's little surprise that private debt in Canada is out of control. A report from the Canadian Centre for Policy Alternatives, released last week, estimated that private debt (essentially business and consumer debt, excluding government and financial-sector debt) has been growing in Canada at the fastest pace of any developed country.

That makes Canadian borrowers particularly vulnerable to a downturn in the economy, or an upturn in interest rates.

The BIS report found Canada's economy is one of the least capable of handling an increase in borrowing costs. A 2.5-percentage-point increase in interest rates would more than double the share of income Canadian households and businesses would need to spend to pay off their debts.

Only China and Hong Kong, again, would face bigger problems if interest rates were to rise, the BIS report estimates.

A 2.5-percentage-point increase in interest rates would more than double the share of income Canadian households and businesses would need to spend to pay off their debts.

The bank notes that these numbers do not make it inevitable that Canada will face a financial crisis.

But "these indicators have often successfully captured financial overheating and signaled banking distress over medium-term horizons in the past," the bank noted.

They're not the only ones to worry about "banking distress" hitting Canada's economy. Moody's rating service downgraded Canada's six largest banks last month, on concerns that Canadians have taken on too much debt.

"Continued growth in Canadian consumer debt and elevated housing prices leaves consumers, and Canadian banks, more vulnerable to downside risks facing the Canadian economy than in the past," Moody's said.

Chris Helgren / Reuters
The site of a new condominium complex off Redpath Avenue in Toronto, Ontario, Canada April 1, 2017. Toronto's red-hot housing market and high mortgage debt levels have some observers worried about a financial crisis hitting Canada.

The Bank of Canada (BoC) has itself downplayed the possibility of a widespread financial crisis in Canada — but it too has been sounding the alarm about Canada's debt.

Its primary focus has been Toronto's housing market, which saw price growth of as much as 33 per cent over the past year, before cooling this spring. Affordability in Canada's largest housing market is the worst it's been in at least a quarter-century.

In a recent financial review, the BoC said it sees signs of "extrapolative expectations," or speculation, in the Toronto market.

It warned the market could face a slowdown if those speculators were to exit the market.

"When expectations reverse and prices recede, investors may quickly sell their assets, possibly leading to fire sales with adverse consequences for the rest of the market," the bank warned.

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