Canada's Fortunes:
17 April 2009
In the space of three short months, almost every single factor that has been driving Canada's dream economy has slipped into reverse. Oil prices have plunged, the loonie plummeted, house prices dropped and $215 billion was wiped off the S&P/TSX composite index.
It has been a lightening paced change in fortunes for a country that entered into the new millennium on a river of black gold, With the chance of a 1929 type depression now a real possibility and with federal budget surpluses already on razor thin ice, Canada is on shaky ground.
However a recent study by the World Economic Forum ranks Canada first in the world for the soundness of its banking system. Risks of defaulting or declaring bankruptcy are extremely low in Canada, and this is reflected in part by a business model that is different from that of USA banks. Major Canadian banks have an average asset to capital ratio of 18. The higher the ratio, the more the assets owned by a bank were acquired through indebtedness rather than through an influx of equity. In effect, it is a measure of a financial institution�s indebtedness level and its exposure to the leverage effect. Bear in mind that the Canadian regulatory system requires that banks have no more than a multiple of 20.
The equivalent ratio among American investment banks is over 25, while that of European banks is approximately 30 and the ratio of the largest banks in the world is over 40. This position benefits Canadian financial institutions and minimizes capitalization risks, which lessens the threat that access to credit be restricted. All the same, Canadian financial institutions are not completely immunized against the effects of the financial crisis.
The impact of the financial crisis in Canada is not limited to financial institutions. And the overall economy will be affected. The tightening of credit terms will trigger slower growth in consumer spending and investment.
The Canadian economy like most is driven by domestic demand, so a significant slow down in consumer spending and investment will take its toll on the country's economic outlook. But it is the full scale retreat in commodity prices that will undoubtedly cause the most concern. The stream of commodity earnings and the resulting boost in the loonie has helped send Canada's terms of trade (the prices we get for our exports compared with the prices we pay for our imports) soaring up 29% since 2001.
But recent surveys of global purchasing managers show new orders have collapsed at their fastest pace in 28 years, and for a country such as Canada that makes about a third of its GDP from selling goods abroad, a global slow down will hit hard.
Governments for some time have run a pro cyclical type of fiscal policy, which means budget conservatively, enjoy upside surprises on revenues and then push those upside surprises back out into the economy in the form of higher spending and tax cuts, while previous Liberal governments have favored spending increases, the Conservatives have announced tax relief totaling $21 billion and they have increased spending more than 7% per year.
The problems in the USA financial institutions should lead to an even greater tightening of credit conditions South of the border. This will lead to a sharp slow down in consumer spending by Americans. The risks of a depression have incidentally increased significantly over the last few weeks in the USA. For instance, the ISM manufacturing index has dropped to 43.5 in September 2008. In these circumstances. The problems of Canadian exporters will worsen, simply because around 80% of all export commodity earnings involve trade with the USA.
And to add more fuel to the fire Canadians are now more indebted than Americans.
(1) The debt to disposable income ratio in Canada currently stands at 132%, higher than the USA ratio of 122%, according to Bank of Canada. Canada has pulled ahead because USA indebtedness has fallen against disposable income since mid 2007 while Canada,s continues to rise.
(2) Many Canadian credit card issuers loosened standards in recent years. Their credit card balances have increased almost 40% since 2004.
(3) A survey of credit card executives in Canada revealed a 5% to 10% jump in delinquencies beginning last fall, which translates into annualized industry losses of more than $800 million.
(4) Credit card companies in Canada have traditionally seen loss rates of less than 4%, a figure much lower than that of their American counterparts (6% and growing), but with Canadian consumers increasing their debt to disposable income ratios to more than 130%, Canadian issuers could see losses similar to those of their USA counterparts.
(5) Financial institutions see credit card losses as the canary in the coal mine. In Canada customers will likely default first on cards rather than on mortgages or car payments. This is converse to what has been happening in the USA where fairly lax mortgage default legislation has meant that people have been walking away from their houses before they have missed payments on their credit cards.
Belt tightening should be paramount, if you're going to spend up to your income when times are very good, you've got to spend down to it when times are bad. A key difference between Canada and the USA, and perhaps a difference that will have meaningful implications for longer term recovery, is that at the time the crisis hit, Canada had a much stronger budget and trade balance.
