By several measures, Canada has been sailing through the financial crisis in better shape than much of the rest of the world. Indeed, many Canadian households have been carrying on as if they are hardly noticing the biggest economic downturn since the Great Depression. But a new report warns that our spendthrift ways could catch up with us yet.

So far, the global economy has done a surprisingly effective job of pulling itself up off the mat. The International Monetary Fund recently raised its outlook for global gross domestic product growth this year to 3.9%, up from its October forecast of 3.1%, noting that the recovery is off to a stronger start than expected.

The Bank of Canada’s latest Monetary Policy Report indicates that domestic growth had resumed in the third quarter of last year, and likely gained momentum in the fourth quarter. For the year ahead, the BofC foresees GDP growth of 2.9%, rising to 3.5% in 2011.

But both the BofC and the IMF stress that extraordinary dollops of fiscal and monetary policy stimulus are still supporting much of the current economic activity. The re-emergence of independent private demand is not yet evident. Also, plenty of challenges remain. These include the tricky task of withdrawing all of that stimulus without undermining the recovery.

Underlying the dilemma of figuring out when to curb government stimulus, there remains a big question about the health of balance sheets — both corporate and household — and whether they are robust enough to revive demand once the supports are pulled away. In particular, some analysts fear that the amount of debt being carried by businesses and individuals will have to be sharply reduced before either business investment or household consumption can be expected to replace government stimulus measures.

Indeed, some new research from the U.S.-based McKinsey Global Institute argues that plenty of balance-sheet repair still has to occur — in several countries. This process isn’t destined to be a one- or two-quarter event, or even a one- or two-year phenomenon. Rather, the McKinsey report suggests that the sort of deleveraging that’s necessary could take many years to play out.

The McKinsey report finds that, historically, periods of deleveraging that follow a financial crisis last for six or seven years. This time around, however, the report predicts that debt/GDP ratios are likely to “decline more slowly and over a longer period than the historical average, creating severe headwinds on economic growth.”

While the obvious candidates for deleveraging, such as the U.S. and Britain, are singled out in the report, it also identifies Canada as a country where deleveraging is “highly likely.” In particular, the report points to Canadian households as a probable participant in the deleveraging to come.

The McKinsey report examines debt and leverage levels in 10 developed economies and four emerging markets, looking at trends in various segments of these economies (households, corporations, commercial real estate, governments and financial institutions), and assesses the sustainability of such debt. The report concludes that five of these countries — Canada, South Korea, Spain, the U.S. and Britain — “will very probably experience deleveraging” in some segments of their economies, with the household sector seen as a likely candidate for deleveraging in each of those countries.

But that hasn’t been the case in Canada so far. While consumers in some of the world’s more damaged economies are already cutting back in their borrowing, Canadian households continue to pile on the debt. According to the latest data from the BofC, household debt continued to grow, almost without a pause, throughout the financial crisis and the recession. Debt growth dipped briefly in November 2008 — at the height of the crisis — but has resumed its upward march since.

The BofC has flagged this issue in the most recent edition of its Financial System Review, pointing out that the household debt/income ratio has continued to rise in Canada, reaching a new high in the second quarter of 2009 (the latest period for which the BofC has data). While that still isn’t as high as the same ratios in the U.S. or Britain, it is heading into similar territory. That has led the BofC to caution that the ratio’s “upward trend implies that households have a growing vulnerability to additional adverse shocks.”

@page_break@The big question mark is the pace of the global recovery. If unemployment rises or incomes drop, the increased stress on household balance sheets is likely to feed back into the economy, the BofC notes in the latest FSR: “The risk is that a shock to economic conditions could be transmitted to the broader financial system through a deterioration in the credit quality of loans to households.”

That said, even if the economic recovery continues without suffering a major negative shock, the rise in household indebtedness remains one of the primary risks facing the financial system. This is because interest rates will surely rise as the recovery proceeds, hampering households’ ability to service their high debt levels.

The McKinsey report takes a somewhat different view, saying that the influence of deleveraging on the financial system could be a greater concern when it comes to economic recovery: “The deleveraging process may just be getting underway and is likely to exert a significant drag on GDP growth.”

That report found that, historically, most major financial crises are followed by a prolonged period of deleveraging, with one of four basic outcomes: high inflation; massive defaults; a lengthy period of slow growth; or, in some cases, economies that “grow” out of debt, driven by a significant stimulative event, such as a war.

Of these, a “prolonged period of austerity” is the most common result, occurring about half the time. The McKinsey report suggests austerity is the outcome “that seems most relevant today.” And while the ratio of debt to GDP usually declines to about 25%, getting there is typically a painful process. Credit growth slows dramatically and real GDP tends to fall in the first two or three years of deleveraging then typically rebounds for the next couple of years, as the deleveraging plays out.

This time around, however, the McKinsey report warns that the process may start later and take longer, pointing to a variety of factors that may hinder countries that need to deleverage. Many face demographic realities (aging populations and falling labour-force participation rates), “which will make it more difficult than usual to jump-start and sustain GDP growth.”

In addition, rising government debt levels could offset much of the deleveraging that takes place in the private sector. Governments, policy-makers, central banks, regulators and firms are likely to face some serious challenges as they grapple with the long-term fallout of this latest financial crisis.

Managing the provision of government stimulus so that GDP growth gets a boost, without sparking inflation or creating crushing public debt, will be particularly tricky. The McKinsey report recommends that banks and regulators monitor leverage more closely. But the report also warns against raising capital adequacy requirements too high, too fast, for fear of choking credit growth and stalling the recovery.

The investment implications of this gloomy outlook are driving some money managers to focus on emerging markets that don’t face these sorts of challenges. Bill Gross, managing director at Newport Beach, Calif.-based Pacific Investment Management Co. LLC, makes the point in a recent commentary. As the developed economies reduce debt, he notes, they are losing their positions as “drivers of the global economy.” Instead, he favours emerging markets such as China, India and Brazil.

Although Canada is certainly part of the old guard, and an apparent candidate for deleveraging in the years ahead, Gross points out that it is probably the best bet among the developed economies. For one, the domestic banks have been relatively conservative.

Indeed, the BofC’s stress tests indicate that the domestic banks have enough capital to absorb the sorts of rising loan losses that the BofC says could be triggered by a rising interest rate environment.

Canada’s fiscal situation is also better than most of its counterparts, Gross notes. This is significant because the government’s financial health directly affects its policy flexibility.

Ironically, this situation reflects the hard-won benefits of a different sort of deleveraging — the fight against the deficit that was led by former finance minister Paul Martin back in the 1990s — one of the few examples of deleveraging that didn’t occur as the result of a financial crisis, according to the McKinsey report. It points out that this episode provides a model for countries with heavy government debt loads today. The key, the report says, was the political will to force through unpopular spending cuts.

And that episode shows that while deleveraging is often painful, there are valuable payoffs. IE