Rate hikes okay for most but a ‘financial shock’ for many

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Michael Babad
Globe and Mail Update
Last updated Wednesday, Jun. 01, 2011 8:39AM EDT

Canadians cut back, but trouble ahead for some
Most Canadians should be able to handle higher interest rates expected later this year, but many will still see a "financial shock," Toronto-Dominion Bank economists say.

Their comments come as Bank of Canada Governor Mark Carney primes markets for that inevitable hike, which economists believe will now come in September.

"The main question is how households will respond to the eventual rebalancing of monetary policy, TD economists Craig Alexander and Diana Petramala write in a new report that looks at indebtedness among Canadian households.

"In our opinion, many Canadians will experience a financial shock when interest rates eventually rise, but the vast majority of households should be able to cope so long as interest rates rise only gradually. The worst scenario would be one where interest rates are left too low for too long, which necessitates a more rapid tightening of monetary policy that would pose a greater shock to personal finances."

Yesterday, the Bank of Canada held its benchmark overnight rate steady at just 1 per cent, citing global uncertainty and the impact of the strong Canadian dollar, but said rates must eventually rise. Mr. Carney has warned borrowers to get ready, pointing to high personal debt levels, and consumers have started to heed the call.

Mr. Alexander and Ms. Petramala note that households are cutting back. Annual personal credit growth slowed to a year-over-year pace of 6.4 per cent in April, compared to an average 10.9 per cent in a period spanning 2004 to 2008.

Both secured and unsecured lending has moderated, they say, the former a sign of the real estate sector's "soft landing," and the latter an indication that consumers "have responded to the calls for greater prudence in managing their debt."

Those are good signs, the economists add, but household budgets are still stretched and, thus, at risk.

"The moderation in credit growth has been evident in all measures of debt," according to the report's authors.

"However, the brunt of the cooling in debt accumulation is being experienced in non-mortgage lending products, such as credit card borrowing and personal lines of credit (predominately home equity lines of credit) ... The debt obligation on these instruments is typically very flexible, meaning that outside of interest payments, consumers are not limited to how much principal they wish to pay off in any given month or year. This is in contrast to mortgages where monthly payments are generally fixed, and one’s ability to pay down principal is often limited by the terms of contract. This provides some evidence that households are trying to work down high debt levels."

And, they warn, while credit growth may be cooling, consumers aren't "deleveraging." Families are still borrowing more than they're saving. And amid that cooling, debt costs are climbing.

"The debt-service ratio, the interest households must pay on their debt each month as a share of personal disposable income, climbed to a two-year high of 7.6 per cent in [the first quarter of] 2011, despite still record low interest rates. Over the next year and a half, the expectation is that a future rise in interest rates will lift this ratio to the highest level in more than a decade."

As others have also suggested - and evidence this week highlighted - the TD economists note that consumers are tapped out and won't be the main driver of the rebound after "spending like gangbusters" over the past five to 10 years.