Financial System Review – December 2010

Twice a year the Bank of Canada undertakes a review of the major risks facing Canada’s financial system, being the arbiter between a small open economy and the rest of the world, the Bank looks at where the “trouble” could emerge.  The December commentary (here) makes for somewhat disturbing reading.

The BoC has three main concerns:  First, Europe’s debt market disintegration, second the growing “imbalances” across the world.  Finally, the Bank is concerned with the level of personal debt in Canada.  Their fear is that any one of these three elements could cause a demand shock in Canada, that these risks are more important today then they were six months ago, and that this could have consequences for the stability of Canada’s financial system.

The instability which the BoC refers to is driven first by America’s decision to follow Keynesian “pump priming” fiscal and monetary policies, which at best are only delaying the inevitable, and a worse make the situation even more precarious and difficult to resolve.  Specifically, the BoC suggest that America needs to reduce consumption (increase savings) and that China & Germany (biggest surplus countries) need to implement policies that encourage domestic consumption (Every surplus is a deficit elsewhere).  The Bank’s blunt assessment arises from Canada’s fear (as the U.S. largest trade partner) that it will be caught in the cross-fire of a trade war brewing between the U.S. and China.

Ireland and Greece are already beyond redemption with debt/GDP at levels that will eventually require write offs (ok the BoC doesn’t actually say that, because they cannot). More debt will not resolve the problem of excessive debt!  For those who though the problems would only have to be addressed in 2013 (when the ECB credit facilities expire) as of this morning 100% of the Irish, and Greek bond market’s bids are from the ECB, no one else is buying (see here).  The question is what happens if Belgium and Spain get sucked under (each accounting for more than 10% of Europe GDP – and with bond markets beyond the ability of the ECB to intervene).

The third element of the Bank’s worries gravitated over the level of Canadians’ indebtedness.  It has been widely reported that Canadians continue to borrow more quickly than their incomes are rising (partly fueling a very “healthy” housing market).  This is the one puzzle piece over which the Bank has some ability to affect changes.  I would not be surprised; following discreet conversation between the Bank and Canada’s banking executives, if there was not some tightening of lending standards. If this doesn’t work, the bank can always force Canadian banks to increase reserves.  Their final tool, and the bluntest, would be for the Bank of Canada to raise interest rates, although in view of the global weakness, this tool is probably off the table until March 2011.