Bank of Canada sees risks easing

In many respects, the Bank of Canada's Financial System Review, published today, offers more of the same.  The Bank still believes that the greatest risks to financial system stability are posed by the interlinked problems of household indebtedness and an unbalance housing market, with cyber threats not far behind.  However, the Bank now sees signs that these risks are beginning to moderate, although it will take some time for them to disappear completely.

In recent months, the vertiginous climb in household debt has slowed, in response to both rising interest rates and new regulations aimed at curbing excessive mortgage borrowing.  At the same time, the burden that the debt represents has eased somewhat as the strong economy and labour market lift household incomes. House prices have fallen, notably in the key Toronto market, but there has been no sudden collapse in the market, which could have led to widespread problems for both borrowers and lenders.  The Bank sees these developments as "encouraging", while noting that the sheer size of the accumulated debt means that the vulnerability will persist for some time to come.

As for the cyber threat, the Bank reports that it has been working with the major banks to ensure that the payments system can recover quickly in the event of a successful cyber attack.  The recent brief chaos caused across Europe by the sudden failure of the Visa payments system, together with the speed with which the system was brought back online, underlines the importance of such efforts.

What could go wrong?  The Bank identifies the same three key risks as in its last Review, published in November 2017:  a sudden collapse of overheated housing markets; a sharp increase in global long-term interest rates; and a severe Canada-wide recession.  The Bank sees little change in the probability of any of these events, which is a little surprising.  The likelihood of a sudden collapse in the housing market has surely diminished in recent months, as the Bank notes elsewhere in the Review.  In contrast, the risk of a sharp increase in long-term interest rates may have increased, in light of the fiscal irresponsibility of the Trump administration in an economy that is already dangerously close to overheating.

As for the risk of a severe Canada-wide recession, the possibility that a downturn could be triggered by US withdrawal from NAFTA or by a trade war has undoubtedly increased.  In this context there may be some reassurance to be found in the latest IMF assessment of Canada's economy, published earlier this week.   The Fund sees GDP growth slowing from 2017's 3 percent pace to just above 2 percent this year and next.  However, it notes that a collapse of NAFTA and its replacement by "WTO rules" would cut the growth rate by at least 0.4 percent.  That doesn't sound too scary, until you recall that the Trump administration has clearly signalled in the last few weeks that it has no intention of following WTO rules.  In light of that, the IMF's assessment looks very much like a best case; things could turn out very much worse.