A soft or crash landing for Canada?

2015 is shaping up to be the year the national housing bubble pops and Canada loses its international bragging rights to financial sobriety. We won those rights during the global financial crisis when the housing market wobbled but did not crash and Canadian banks remained solvent, with only a modest amount of government support. But instead of learning lessons from the U.S. and other countries exposed to the brunt of the crisis, Canada patted itself on the back and reassured itself that it couldn’t happen here.

That’s just wishful thinking. Canada suffered two housing busts in the recent past – one that began in 1981 when house prices fell 30 percent and a milder one starting in 1990 when prices dropped 17 percent. And the elements are in place for a painful reprisal, or what the central bank refers to as a disorderly unwinding of imbalances in the household sector. We are poised on the precipice and all it would take to push us over is a sudden shock to the economy, which doesn’t have to originate in Canada. If you look around the world you will see plenty of possibilities looming on the horizon.

A key element for a housing bust is prices that are well above what could normally be expected given population growth and demand. Aside from a brief dip during the 2008-09 recession, average house prices have risen more or less steadily since the late 1990s. The Bank of Canada reckons that Canadian housing could be as much as 30 percent over-valued. More ominously, an internal research paper at the bank that looked at 43 housing corrections in 18 countries, found house prices were about 21 percent over-valued on average when a correction started.

Canada is in the danger zone.

Another element is levels of debt so high that homeowners struggle to pay the mortgage when interest rates rise or their income drops. Encouraged by interest rates that have remained near rock bottom since the global crisis, Canadians have ignored what happened in the U.S. and piled up record amounts of debt, the bulk of it in mortgages. The household-debt-to-income ratio, a popular measure of debt, rose to record 162.6 percent in the autumn of 2014, up from 161.5 percent earlier in the year.

High housing prices and record levels of consumer debt do not in themselves make a housing bust. Something more is needed. The bank’s internal research said an increase in interest rates by the central bank appeared to trigger the 43 housing corrections it studied. Will that happen in Canada? The central bank maintains it is primarily interested in controlling inflation, so what happens to the inflation rate in the coming months is key. The recent drastic drop in oil prices is putting downward pressure on inflation because people are paying less for fuel. But the related drop in the value of the Canadian dollar, which fell around 10 percent against the U.S. currency in 2014, exerts upward pressure because it makes all the goods and services Canadian import more expensive. If the dollar falls further, as some economists anticipate, that will push inflation higher and prompt the Bank of Canada to act. So too could rising interest rates in the U.S. as the American economy heats up.

The trigger could also come from the income side. The expectation that the oil price will remain low or even drop further has already prompted the major oil companies to cut pay to skilled contractors working on projects in the North Sea off Britain. There is no reason to think they will stop there. And if salaries drop in Canada’s oil areas in Alberta, Saskatchewan and Newfoundland, it won’t be long before local house prices dive. The soft landing the Bank of Canada still hopes for would become a crash landing instead.

The shock that pushes Canada over the edge doesn’t have to be a domestic one. There are fears that Russia, stumbling under the burden of low oil prices and western sanctions, could default on its sovereign debt payments or that key Russian banks will fail. Either could send the kind of shock waves through the international financial system that inflict damage far from the epicentre. A sovereign debt default is also possible in Greece if the left-wing Syriza party wins the upcoming elections on Jan. 25. With the European Union still not recovered from the last crisis, this could have unexpectedly large consequences. There is China’s slowing economy to consider. Given its importance to world trade, too sudden a deceleration will have a ripple effect across the world. These are the potential shocks that are already visible. More with the potential to rock the world economy — and Canada — will undoubtedly emerge throughout the year.

When the global financial crisis hit Canada was in good shape to withstand the hardest blows. But since then we have made ourselves more vulnerable. Admittedly a housing bust in 2015 is a worst-case scenario. But a good case can be made that it will happen this year. The banks are largely insulated from the fallout because the government stands behind most mortgages with public insurance. It is taxpayers and homeowners who will be hardest hit. If we are lucky, the housing collapse won’t be like the one in Japan, which lasted 15 years, or even those in Spain, Germany and Italy, which went on for just over six years. But even a short housing bust will be small consolation to those who have to walk away from their homes or who enter retirement with a much reduced nest-egg.