Canada: Policy issues remain - HSBC

In coming quarters, both fiscal and monetary policy will attempt to navigate the ongoing moderation of the Canadian housing market, while avoiding measures that could magnify stress on the financial system, explains David Watt, Chief Economist at HSBC.

Key Quotes

“Measures by the British Columbia and Ontario governments have slowed housing market activity, but have done little to bring valuations to more reasonable levels. Meantime, the Federal financial regulator, the Office for the Superintendent of Financial Institutions, is slated to implement several measures to tighten mortgage lending toward year end. These measures will include more rigorous stress tests for uninsured mortgages, home equity lines of credit, and restrict some riskier lending practices, such as a regulated mortgage provider bundling a loan with an unregulated lender.”    

“The Bank of Canada has, meantime, begun the process of removing some of the considerable monetary policy stimulus. The 50 basis points of rate hikes have lifted the policy rate to 1.0%.  We expect one more 25 basis point increase in December, but believe that household vulnerabilities and subdued price pressures will result in the Bank leaving rates at 1.25% through 2018. The market, however, has almost two more rate hikes priced in for 2018.”

“Risks

Overvalued housing markets and excessive leverage in the household sector remain the most notable risks to the economic outlook. Work by the BIS has shown that if interest rates rise by 250 basis points, household debt service ratios could rise to levels that could be disruptive to the economy and to financial stability. 2-year bond yields have already increased by 80 basis points since mid-June, which was when Bank of Canada officials began to prepare the market for rates to rise. The combination of higher rates and regulatory tightening measures could result in either a controlled slowdown in housing (our base case), or a potentially more sudden correction. 

Canada is also more vulnerable to global financial market turbulence than prior to the 2008 financial market crisis. This reflects the current account deficit that remains 3% of GDP. The funding on that deficit has required significant inflows of foreign investment. Much of that has been in the form of portfolio flows into Canadian debt products given that FDI outflows dominate inflows. While higher rates continue to bolster the attractiveness of portfolio investment in Canada, the reliance on portfolio investment is a vulnerability.”