European crisis could have substantial impact on Canada, BoC warns

In fact, the bank says the spillover effects on Canada’s financial institutions, such as banks, “would be substantial.”

While the report does not attempt to place odds on the chance of a Europe-centred shock, it judges the risks as “very high,” or the top level in its scale.

The dire warning — not altogether unexpected from the central bank given renewed turbulence in Europe, including a possibility that Greece will exit the euro currency zone after Sunday’s elections — gives some urgency to the G20 summit of leaders in Mexico next week, where Europe will be the main topic.

In Ottawa on Thursday, Finance Minister Jim Flaherty said non-European countries in the G20 need to keep up the pressure on the Europeans to put up sufficient money to “overwhelm” the problem.

In reference to yet another idea being floated — guarantee of bank deposits in Europe — he said the manner of the solution was up to the eurozone.

“It is important that we and the United States as well, and the other non-European G20 countries, continue to exert pressure on the eurozone countries to deal with this matter because it can have unfortunate consequences for the global economy,” he said.

The Bank of Canada report leaves little doubt if the problem is not contained in Europe, Canada would suffer.

In fact, the central bank suggests households here may be in worse position for another shock now than they were in 2008, when the collapse of a prominent U.S. investment banker sparked a cash crunch and recession.

Since that time, the report said, consumers have taken on significant amounts of new debt and real estate prices are also at record highs.

In its financial system review identifying risks to the economy, the bank noted certain segments of the housing market that have a persistent oversupply — such as condos in Toronto — face a higher risk of a price correction.

Using a hypothetical stress test, the bank says a three per cent increase in unemployment — about the same as occurred in the recent recession — would almost triple the proportion of indebted households that would go into arrears.

The current rate is currently about half a per cent and could rise 1.3% under that scenario.

A shock would also cut into net worth of Canadians. The bank points out that 40% of household worth is tied to the value of their real estate holdings, compared to only 34% a decade ago.

The Bank of Canada was careful to point out it wasn’t predicting a global crisis like the one in 2008, but suggested a failure in Europe could not be contained to that region.

The central bank concluded that the risks of a European financial meltdown that could ripple around the world have returned to the elevated levels of last December.

“The key risks to financial stability are highly interdependent and mutually reinforcing,” it states.

“If the sovereign debt crisis in Europe continues to intensify, it would further weaken global economic growth and prompt a general retrenchment from risk. In turn the weaker global outlook would fuel sovereign fiscal strains and impair the credit quality of loan portfolios.

“Together, these factors would increase the probability of an adverse shock to the income of wealth of Canadian households.”

As well, the diminished prospects for economic growth likely lead to a continuation of rock-bottom interest rates in Canada, which would further erode the positions of life insurance companies, pension plans and boost household borrowing.

Economists call the mechanism a “negative feedback-loop,” and what the central bank is describing is almost identical to what occurred after 2008, when the world was plunged into the worst recession since the Great Depression.

In Canada, the slump was mitigated by a sound banking system and strong government fiscal positions that allowed Ottawa and the provinces to inject about $60 billion of stimulus into the economy.

Still, about 430,000 jobs were lost and Canada’s gross domestic product fell by more than three per cent. Some sectors of the economy, in particular manufacturing, have still to recover fully.

The bank’s shock test shows that in some ways Canadians are in a more precarious position today than they were in 2008.

At the time, households in arrears also doubled, but from less than 0.3% to about 0.6%. Now they would almost triple to 1.3% and from a higher starting point, given the record levels of debt.