Canada’s net worth rises

In the third quarter, Canada’s Net Worth rose by 2.7% -- this is almost entirely due to the strength of the Canadian stock market – which is up 9.5% for the year (small percentage due to the increase in the value of the housing stock).  Kind of a boring week for economic data, thank God our southern neighbors are providing such entertainment (e.g. healthcare reform unconstitutional, renewal of Bush tax cuts). 

Following the BoC financial strength review (last Thursday) the Bank of Canada’s Governor further pressed the issue of Canadians excessive private borrowing, especially in an environment of ultra low interest rates -- rates may change and there is a strong likelihood that they will rise above the prevailing inflation rate.  Personal indebtedness is the only endogenous risk factors identified by the BoC -- the only area where policy may have an impact.  Canada is, in fact, the only OECD country encouraging its citizen to borrow less and save more.  The question is will be the Bank back these statements with action?

The bank has five tools in its arsenal:

(1)               Interest rates

(2)               Open market operations

(3)               Reserves

(4)               Capital adequacy rules

(5)               Moral suasion.

Right now the Bank is emphasizing moral suasion, because the other tools are mostly unavailable:  Interest rate policy is locked-in at 1% until then of spring 2011. Money market intervention trough the Repo market (where the Bank sells government bonds, to soak up available liquidity), has been actively used, but with heavy foreign demand for Canadian sovereign bonds, it has limited impact on the money supply. Reserves and capital adequacy rules can be used, but they are almost “nuclear options”, moreover, after two excellent years the banks’ capital adequacy is well beyond the “policy level” as for reserves the banks tend to maintain excess reserves with the Bank.

Above is a table showing the growth of M1, M2 and M3 (Source: StatsCan & Bank of Canada).  In early 2009, the BoC began removing the excess liquidity it had introduced following the  capital markets freezing   following the Lehman bankruptcy.  This operation was completed in late 2009, since then M2 & M3 have grown at similar levels. 

Thankfully, the BoC has allies in its quest to reduce personal credit; OSFI has been a willing tool of monetary policy by requiring Canada’s banks to increase their Tier 1 capital (reducing the banks ability to issue Tier 2 capital in the form of subordinated debt).  Requiring high minimum down payments on mortgages, reducing the term of loans from 35 years to 25 years, and employing stricter “interest rate” test on income.

Will all this work?  The BoC instruments are relatively blunt, and like the pilot of a supertanker, must allow for time lag between policy change and impact on the economy.  The housing market cooled this year, but it’s not entirely clear if this is the result of the over-build during 2009 and early 2010 or a result of the shift in lending requirements (which were introduced during the summer).