Canada has distinguished itself through the debt super cycle (Chart 10), though there are some recent trends that bear watching. Over the past twenty years, our non-financial debt increased less than any other G-7 country. In particular, government indebtedness fell sharply, and corporate leverage is currently at a record low (Chart 11).
In the run-up to the crisis, Canada’s historically large reliance on foreign financing was also reduced to such an extent that our net external indebtedness was virtually eliminated.
Over the same period, Canadian households increased their borrowing significantly. Canadians have now collectively run a net financial deficit for more than a decade, in effect, demanding funds from the rest of the economy, rather than providing them, as had been the case since the Leafs last won the Cup.
Developments since 2008 have reduced our margin of manoeuvre. In an environment of low interest rates and a well functioning financial system, household debt has risen by another 13 percentage points, relative to income. Canadians are now more indebted than the Americans or the British. Our current account has also returned to deficit, meaning that foreign debt has begun to creep back up.
The funding for these current account deficits has been coming largely from foreign purchases of Canadian portfolio securities, particularly bonds. Moreover, much of the proceeds of these capital inflows seem to be largely, on net, going to fund Canadian household expenditures, rather than to build productive capacity in the real economy. If we can take one lesson from the crisis, it is the reminder that channelling cheap and easy capital into unsustainable increases in consumption is at best unwise.
Canada’s relative virtue throughout the debt super cycle affords us a privileged position now that the cycle has turned. Unlike many others, we still have a risk-free rate and a well-functioning financial system to support our economy. It is imperative that we maintain these advantages. Fortunately, this means largely doing what we have been doing—individuals and institutions acting responsibly and policy-makers executing against sound fiscal, monetary and regulatory frameworks.
It cannot entirely be business as usual. Our strong position gives us a window of opportunity to make the adjustments needed to continue to prosper in a deleveraging world. But opportunities are only valuable if seized.
First and foremost, that means reducing our economy’s reliance on debt-fuelled household expenditures. To this end, since 2008, the federal government has taken a series of prudent and timely measures to tighten mortgage insurance requirements in order to support the long-term stability of the Canadian housing market. Banks are also raising capital to comply with new regulations. Canadian authorities are co-operating closely and will continue to monitor the financial situation of the household sector.
To eliminate the household sector’s net financial deficit would leave a noticeable gap in the economy. Canadian households would need to reduce their net financing needs by about $37 billion per year, in aggregate. To compensate for such a reduction over two years could require an additional 3 percentage points of export growth, 4 percentage points of government spending growth or 7 percentage points of business investment growth.
Any of these, in isolation, would be a tall order. Export markets will remain challenging. Government cannot be expected to fill the gap on a sustained basis.
But Canadian companies, with their balance sheets in historically rude health, have the means to act—and the incentives. Canadian firms should recognize four realities: they are not as productive as they could be; they are under-exposed to fast-growing emerging markets; those in the commodity sector can expect relatively elevated prices for some time; and they can all benefit from one of the most resilient financial systems in the world. In a world where deleveraging holds back demand in our traditional foreign markets, the imperative is for Canadian companies to invest in improving their productivity and to access fast-growing emerging markets.
This would be good for Canadian companies and good for Canada. Indeed, it is the only sustainable option available. A virtuous circle of increased investment and increased productivity would increase the debt-carrying capacity of all, through higher wages, greater profits and higher government revenues. This should be our common focus.
The Bank of Canada is doing its part by fulfilling its mandate to keep inflation low, stable and predictable so that Canadian households and firms can invest and plan for the future with confidence. It is also assisting the federal government in ensuring that Canada’s world-leading financial system will be there for Canadians in bad times as well as good and in pushing the G-20 Action Plan because it is in Canada’s interests.
Conclusion
It makes sense to step back and consider current challenges through the longer arc of financial history. Today’s venue is an appropriate place to do so. A century ago, when the Empire Club and the Canadian Club of Toronto would meet, the first great leveraging of the Canadian economy was well under way. During the three decades before the First World War, Canada ran current account deficits averaging 7 per cent of GDP. These deficits were largely for investment and were principally financed by long-term debt and foreign direct investment.
On the eve of the Great War, our net foreign liabilities reached 140 per cent of GDP, but our productive capacity built over the decades helped to pay them off over time. Our obligations would again swell in the Great Depression. But in the ensuing boom, we were again able to shrink our net liabilities.
When we found ourselves in fiscal trouble in the 1990s, Canadians made tough decisions, so that on the eve of Lehman’s demise, Canada was in the best fiscal shape in the G-7.
We must be careful, however, not to take too much comfort from these experiences. Past is not always prologue. In the past, demographics and productivity trends were more favourable than they are today. In the past, we deleveraged during times of strong global growth. In the past, our exchange rate acted as a valuable shock absorber, helping to smooth the rebuilding of competitiveness that can only sustainably be attained through productivity growth.
Today, our demographics have turned, our productivity growth has slowed and the world is undergoing a competitive deleveraging.
We might appear to prosper for a while by consuming beyond our means. Markets may let us do so for longer than we should. But if we yield to this temptation, eventually we, too, will face painful adjustments.
It is better to rebalance now from a position of strength; to build the competitiveness and prosperity worthy of our nation.
