Ever since the real estate bubble burst in the United States in 2007, observers have pointed to Canada as an example of a well-regulated financial system that has avoided many of the regulatory mistakes that helped lead to an American crash. But Canadians weren’t able to perch on their high horse for very long, as a bubble of their own has been inflating for the past couple years. And now many analysts are watching for that bubble to burst, and soon.
What has so many observers worried? A few things:
- 7.5% of the Canadian workforce is in the construction industry, while 7% of the Canadian economy is based on residential construction — both record highs;
- The latest Canadian jobs report was dismal, as its economy shed 45,000 jobs in December, and the unemployment rate rose from 6.9% to 7.2%; and
- This decline in employment is occurring against a backdrop of unprecedented debt levels. The Canadian debt-to-income ratio has soared to a record 164%, above levels experienced in the US before the financial crisis.
The above chart by Matt Barnes of the research firm BCA illustrates Canada’s debt problem. These huge debt loads could be a pose a serious threat if unemployment continues to rise due to a sharp pullback in the construction spending, or if interest rates begin to rise. Here’s Amna Asaf an economist with the macro research firm Capital Economics:
“Even a modest uptick in mortgage rates will translate into much higher homeownership costs, easily outpacing any expected increase in household incomes. This will price out some prospective home buyers, reinforcing the drop back in existing home sales that is already under way.”
This is the same dynamic that eventually sunk the U.S. economy and triggered a global financial crisis. Canada’s saving grace, however, may end up being its strict housing regulations–which encourage high down payments and government-backed insurance.
While the presence of government insurance means that Canada is unlikely to suffer a financial crisis similar to what we had in the U.S., it doens’t mean Canada will avoid any pain associated with a real estate bubble bursting. It just means the government will end up having to foot the bill. And if a housing bust leads to an uptick in unemployment plus the need for the government to cut back spending in other areas, we could be looking at a serious rough patch for the Canadian economy.