Canadians likely haven’t been sufficiently chastened by past deleveraging episodes, so the Bank of Canada is going to have to help reign in our excesses, Scotiabank economists suggest.

In a new report, Scotia economists wonder whether past experience with deleveraging here at home in the early 1990s, and the emergence of deleveraging pressures in other developed countries in the past couple of years, has made Canadian households and firms wise to the dangers of overextended balance sheets, “Or did it facilitate a certain insouciance that resulted in the creation of current imbalances that could expose the country to risks?”

They conclude that its likely the latter — that Canadians have become complacent, and that the Bank of Canada is going to have to lean against that attitude with further monetary policy tightening, “but at a cautious pace that balances too-low-for-too-long against disrupting current imbalances in the Canadian economy.”

Among Canadian businesses, the report suggests that inventories are too large. “The recession hit Canada not just through imported forces, but also because businesses were ill prepared with high inventories,” it says. “That left Canada negatively exposed to the events that followed because the hit to sales emanating from the shocks to US supply chains required even greater cuts to production and employment than would have been necessary had inventories been kept leaner before the crisis.”

“Any perception that inventories are lean and the shelves are bare is simply false,” it adds. Moreover, it says that “The process of adjusting inventories lower relative to sales has halted through rapid production and job gains that may have been premature, thus leaving Canadian businesses with the same relatively high inventory positions they had in the summer of 2008.”

On the household front, home prices have continued their run up. “To say that Canadian house prices have become dear is an understatement,” the report notes, adding that resale, new, and repeat sales measures are at all time highs in Canada, and house prices have roughly doubled over the past 10 years. “We continue to believe that Canadian house prices face further correction risk,” it says.

Moreover, household finances are deteriorating. “Within six months, Canadians will be more heavily indebted than Americans as U.S. households deleverage while Canadians keep on leveraging higher toward debt equaling 150% of after-tax incomes,” it says. And, it observes that borrowing has “become skewed toward revolving debt products that require interest only to be paid on bank lines of credit.”

“Overall, it is indeed possible that Canadian firms and households did not learn much of anything from many of the lessons imposed on firms and households elsewhere,” Scotia concludes. While there are some important factors mitigating the current situation in Canada — such as strong non-financial corporate balance sheets, a well-capitalized banking system, and a much better overall fiscal picture — Scotia finds that the key implication for the Bank of Canada is the current conditions support further monetary policy tightening, including a 25 basis point hike on September 8.

IE