Risks to Canada's economy remain high as household debt levels continue to grow

Aled ab Iorwerth
Deputy Chief Economist

As Deputy Chief Economist, Aled ab Iorwerth is part of a team of housing economists and researchers striving to improve Canada’s understanding of drivers and barriers in housing markets and how they impact affordability. Aled is also part of a diverse national team of researchers and analysts who are investigating impediments to housing supply and potential solutions.

With the highest level of debt among G7 countries, three quarters are mortgages

Economies around the world have had some rough years recently. From a global pandemic, a bout of inflation, a disruption in supply chains, coping with a European war and ongoing concern about global financial stability. The Canadian economy has weathered these storms as well, if not better than other economies.

Unfortunately, Canada’s very high levels of household debt — and the highest in the G7 — makes the economy vulnerable to any global economic crisis.

It's important to understand that not all debt is bad. It can be a valuable tool that allows households to purchase more costly items, such as cars and houses. It also enables people to carry things over if they have a temporary drop in income. The financial system has all sorts of products that make it easier for households to purchase items involving large-scale expenditures by distributing payments over time.

Debt, however, comes with significant risks. The burden of servicing debt does not go away when people lose their jobs; the burden continues until the debt is paid off. This is a key problem when there are widespread job losses in the economy because of the global economic downturn and because of people’s inability to pay off their debts when they have no income. And when many households in an economy are heavily indebted, the situation can quickly deteriorate, such as what was witnessed in the U.S. in 2007 and 2008.  

Canada’s increasing household debt burdens households with high interest rates

Household debt in Canada has been rising inexorably. At the time of the recession in 2008, it stood at about 80% of the size of the economy, in 2010 it rose to 95%, and by 2021 debt exceeded its size.

By contrast, household debt in the U.S. fell from 100% of GDP in 2008 to about 75% in 2021. While U.S. households reduced debt, Canadians increased theirs and this will likely continue to increase unless we address affordability in the housing market.

The chart below shows these figures, and how debt burdens have increased for countries on the right of the chart while decreasing for countries on the left. Australia, New Zealand and Canada have seen household debt increase from already high levels.

Currently around three-quarters of household debt comes from mortgages in Canada

So as house prices increase in Canada, households take on debt leading to a rise in the total amount of debt in the economy. Longer term, reestablishing housing affordability in Canada will be key to reducing household debt if they want to become homeowners.

Over the last year, interest rates have increased as the Bank of Canada battles inflation. Over time, these higher interest rates translate into higher mortgage payments for households when those on fixed 5-year terms renew at higher rates. Those facing the most challenges are those with variable rate mortgages who see higher interest rates immediately. Risks are reduced by policy changes introduced a few years ago that required mortgage holders to qualify for mortgages at a higher rate. 

Our upcoming Residential Mortgage Industry Report will be revealing further information on how homeowners are trying to adjust to higher rates. We see early warning signs that more and more consumers are getting into financial difficulties.

Other consequences of high household debt in Canada

High levels of debt do most damage when a significantly negative external economic event happens — such as a global economic crisis - which leads to widespread job losses, as discussed above. It becomes difficult, if not impossible, for many mortgage holders to service their debt.

Although the Canadian financial system has been stress-tested for significant losses — which will stop an economic downturn from being amplified through a Canadian financial crisis — widespread job losses in an economy where debt levels are high will make any recession more severe.

Longer term, more debt today enables more products and assets to be purchased. However, the cost of servicing and repaying that debt slows economic growth over time. This outcome is more likely when this debt is incurred to finance house purchases that do not meaningfully improve the economy’s potential. In the U.S., households’ focus on repaying debts likely contributed to subdued U.S. economic growth over the last decade.

Our concern about debt is exacerbated by concerns over interest rate levels in the long term. Although the last decade was characterized by historically low interest rates — and slow economic growth that some economists called ‘secular stagnation’ — there is no guarantee that we will return to such a pattern after currently high inflation is addressed and interest rates start to decline.

Some argue that with increased demands for investment to address an ageing population, infrastructure needs, reshoring of manufacturing and so forth, interest rates may have to remain high by recent historical standards to ensure sufficient savings. Structurally higher interest rates with Canada’s household debt burden would further lower economic growth.

There are also significant distributional concerns from the fallout from high debt. Households with less income tend to be more highly indebted. They rely on having jobs to service that debt and are disproportionately vulnerable to economic downturns. Now, they are facing real pressure from higher housing costs.

CMHC’s Market Outlook

Recently, CMHC released its forecast for the economy and housing in Canada. We were pessimistic about the near term, but our baseline forecast had the Canadian economy growing into 2024 and beyond.

In this forecast, we also produced an alternative scenario that captured some of the risks talked about in this note. In the face of higher interest rates, if inflation proves more difficult to tackle, growth will be lower. In this alternative scenario, we suggest that the economy would shrink by 2% in 2024.

But this scenario does not consider all the risks related to an unanticipated economic downturn, causing widespread job losses and that would be made more severe by excessive debt. So, the scenario we produced was not a worst-case scenario. 

Improved housing affordability will lead to lower household debt over time

Canada is safeguarded by a sound institutional framework and prudent financial regulation. This ensures that most Canadian borrowers would be able to withstand currently elevated mortgage rates. But, in the event of a severe global economic downturn, Canada’s high household debt will be a vulnerability. And the need to repay this debt will damage Canada’s long-term growth prospects.

Reestablishing affordability means less debt will need to be taken on by first-time homebuyers. By lowering the share of income spent on housing and creating more options, increased housing supply is key in this respect. Renewing and rebuilding Canada’s rental stock to be modern and attractive will help prevent Canadians from being compelled to be homeowners.