News & Analysis

Is Canadian capitalism heading for a crisis? Part 5: Debt limits

Coal Harbour, Vancouver

Canadian capitalism has stagnated for a decade. Businesses won’t invest because they don’t expect to make a profit. Instead, they’re sitting on a growing pile of “dead money.” And when businesses don’t invest, people don’t work. So, employment is low, and wages are stagnant.

Over this long period of stagnation, the mainstay of the Canadian economy has been the housing boom. Money has been flowing from the banks and private lenders to households. Growing mortgages have been pumping up house prices, making construction highly profitable. And with profit margins in the order of 26%, real estate agents have been making a pretty penny in the process.

But the housing boom is premised upon growing household debt.

If households start missing monthly payments, this could spell trouble for the banks. Canadian banks aren’t that stable. They are highly leveraged — and mortgages are their biggest asset. As the old saying goes, if you owe the bank $100, that’s your problem. If you owe the bank $100 million, that’s the bank’s problem. The stability of the Canadian financial system depends upon reliable and timely mortgage payments.

If the housing boom goes bust, Canadian capitalism may have to contend with deeper stagnation and a financial crisis.

So far, stagnating incomes and rising debt levels have not translated into missed mortgage payments or bankruptcies. But there are signs the housing boom has reached its limit.

Household debt may be peaking. The poorest 60% of households hold half of all mortgages. But they only have a third of the country’s income at their disposal. And wage stagnation isn’t helping. According to a recent poll, 46% of Canadians are $200 or less away from insolvency.

Figure 1 – Mortgage debt service ratio

Figure 1 shows the mortgage debt service ratio. It measures mortgage payments as a share of disposable income. The higher the ratio, the more difficult it is for households to meet their financial obligations.

In 2018, the debt service ratio reached a level we haven’t seen in over a quarter century (just before the Great Canadian Slump of 1990-92). It is highest in British Columbia and Ontario, the centers of the housing boom. In these provinces, interest payments alone make up 7.3% and 7.1% of disposable income, respectively.

It seems home prices have maxed out, too. These grew by 12% and 13% in 2016 and 2017. But they only grew by 3% in 2018. And things have only gotten worse. This year, house prices started falling. According to the Canadian Real Estate Association, the home price index posted its biggest year over year drop in March of 2019. The last time house prices fell by as much was in September 2009.

Figure 2. Home price index

Figure 2 shows the home price index, which measures the annual change in home prices since 2007. Over the last two years, home prices have fallen by 4% and 4.5% in Vancouver and Toronto, respectively.

The countrywide price drop began in September 2017 and was felt immediately in the construction industry, whose profit rate fell below the Canadian average for the first time since 2005.

Over the last decade, the housing boom has propped up an otherwise stagnant economy. Premised upon growing debt, it appears it may have reached its limit. Deeper stagnation and financial instability could be just around the corner.

In my next post, I will look at some of the factors that could push Canadian capitalism over the brink.

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