Housing Headed for Soft Landing, Says Bank of Canada

Overall risk picture to Canadian economy unchanged in last six months

OTTAWA—Bank of Canada governor Stephen Poloz still believes the housing market is due for a soft landing but warns: Look out if it crashes.

The central banker made the assessment after release of the latest semiannual financial system review, a kind of stress test on financial weak spots that suggests a crash in Canada’s real estate market would have devastating impact on the economy.

And such a crash could be triggered by a number of events—a recession that causes widespread unemployment, rising interest rates, and even global shocks like failures in China’s opaque shadow banking system. All such events would dampen growth and cut demand and prices for Canadian resource exports.

Still, Poloz told reporters at a news conference following release of the report on June 12 that he believes the worst won’t happen.

“We still are pretty confident … that we will achieve a soft landing in housing,” he said. “It’s vulnerable but not risky.”

Senior deputy governor Carolyn Wilkins says data backing the soft landing scenario includes a slowdown in housing starts, cooling in the construction of condos, and the plateauing of household debt ratios, although at levels near those that existed prior to the U.S. meltdown in 2008.

A crash would have system-wide implications, the report makes clear, affecting highly indebted households, the economy generally, and some financial institutions, such as credit unions, which may be more vulnerable to defaults.

In particular, the central bank worries that house prices continue to rise faster than incomes and that certain hot spots like Toronto’s condominium market are over-built.

That trend was confirmed by the latest Teranet-National Bank composite house index, which showed overall prices increasing 0.8 percent in May over April.

On June 11, the Paris-based Organisation for Economic Co-operation and Development (OECD) also warned about Canada’s housing market and suggested that Ottawa limit its vulnerability to defaults by reducing the guarantee on mortgage loans. 

The federal government, through the Canada Mortgage and Housing Corp. (CMHC), insures 100 percent of high-risk mortgages issued by banks, whereas the OECD says most other industrialized countries guarantee only 10 to 30 percent.

Poloz would not directly comment on the OECD recommendation, but noted that the government had already announced its “intention over time to reduce its overall exposure to housing sector risk.”

Recently, several large Canadian banks have lowered their five-year fixed rates below 3 percent, although Finance Minister Joe Oliver says he does not see that as a major problem.

Other Risks

In the financial review, the bank said the risk of a Chinese “hard landing” had increased somewhat in the past six months, while conditions in the eurozone had improved.

Although regarded as unlikely, a sharp increase in U.S. long-term interest rates, which affect Canadian rates, would also cause problems in the housing sector, it said.

“High household debt-to-asset ratios and debt-service ratios would increase the likelihood of bankruptcy if their debt burdens become unsustainable following an increase in interest rates or if their homeowner equity was eliminated by a decline in house prices,” the report said.

Particularly vulnerable to a housing correction may be smaller financial entities, such as credit unions, which may not have the resources of big banks to withstand a reversal and have taken on higher-risk mortgages without government-backed insurance.

Overall, the Bank of Canada sees the risks to the financial system as basically unchanged from December, the last time it reported on the issue, with three out of the four key vulnerabilities coming from outside the country.

With this report, the central bank is also changing the way it reports on financial system risk by stressing each vulnerability separately without giving an overall rating. But Poloz said in an accompanying statement that the bank’s “level of comfort as policy-makers remains roughly what it was six months ago.”