Is Canada’s high debt a worry? With its household debt-to-GDP ratio remaining the highest in G7 and with its large current account deficit, Canada looks more vulnerable to disruptions to global capital flows than when it was leading up to the financial crisis of 2007-08, notes HSBC. In his October 7 research piece titled “Owe Canada: the air is getting thin,” David Watt said he believes the low rate backdrop should be leveraged to trim the vulnerability of households.

Canada’s high debt: Bank for International Settlements sounds warning bell on Canada’s debt

Watt points out that Canada’s non-financial sector debt has shot up to 294% of GDP in 2016 Q2, up from 288% in Q1. Mirroring Canada’s non-financial private sector borrowing heavily in recent years, Canada’s over-leveraged household sector has been identified by the IMF, OECD, credit rating agencies, and the Bank of Canada as a downside risk to financial stability.

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Though at the household level, Canada’s debt-to-GDP ratio in Q2 was below that of Australia, Switzerland, and the Netherlands, it was the highest among the G7 nations. However, Canada has the lowest government debt-to-GDP ratio in the G7.

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As can be deduced from the last two columns of the above table, there is limited scope for the private sector (comprising households and non-financial firms) to add to debt levels at the pace witnessed over the last few years. The HSBC analyst highlights that the BIS has singled out Canada among the developed nations, as the gap between Canada’s credit-to-GDP ratio in 2016 Q1 and its long-term trend was highest among the industrialized nations, at 12.1 percentage points. Watt points out that the BIS uses the gap as one of the early warning signs of stress in the domestic banking sector:

As HSBC notes, citing BIS concerns:

“The BIS is not alone in its concerns about debt levels in Canada. In fact, the high level of household debt has led to warnings from the IMF, the OECD, credit ratings agencies, and the Bank of Canada about downside risks to financial stability.

“We are concerned about the debt situation in its own right. However, we have additional concerns given that the recent widening of global imbalances has echoes of the financial crisis of 2007-08. The high level of debt might make Canada more accident prone in the event of another global crisis.
That is, Canada might not be spared the serious fallout that was avoided in 2007-08. We draw this conclusion in part owing to the vulnerability of the over-leveraged household sector. Another factor leading to heightened caution is the significant shortfall of domestic savings relative to investment. This has led to Canada now running a historically elevated current account deficit of 3% of GDP. The large current account deficit at present compares to surpluses in the lead up to the financial crisis.

“The recent increases in debt levels that have drawn much attention are thus funded by importing capital from abroad. In addition, short-term funds have become a more prominent source of foreign capital in recent years. This potentially leaves Canada vulnerable to disruptions to global capital flows and to capital flight.

Canada’s high debt: federal government has room to enhance debt

Watt argues that the recent increases in debt levels in Canada are funded by importing capital from abroad, with short-term funds becoming a more prominent source of foreign capital in recent years. He cautions that this trend may leave Canada vulnerable to disruptions to global capital flows and to capital flight.

However, despite its over-leveraged household sector, the analyst points out that there is room to expand government debt, particularly at the federal level. As set forth in the following graph, federal government debt stands historically moderate at 38% of GDP, while the debt-to-GDP ratio of other levels of government has increased to a record high of 41%:

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The HSBC analyst believes stimulus exercises from the Canadian government should focus on infrastructure and “crowding in” business investment. He highlights that even though corporate indebtedness continues to rise, business investment has dropped since mid-2014. Watt points out that with corporate profits still weak through mid-2016 and imports of machinery and equipment having continued to drop through August 2016, business investment looks set to remain soft for the next few quarters.

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Canada’s High Debt

Watt believes that amidst its savings shortfall, funding Canada’s large current account deficit would require foreign capital inflows of 4% of GDP. He highlights that recent measures to limit the impact of non-resident investors in the real estate market need to ensure that Canada remains an attractive destination for foreign investment. The HSBC analyst believes with Canada’s current deficits expected to persist for the next few years, policies should be tuned to attract more foreign investment rather than impeding cross-border investment.