Economic analysis

What worries the Bank of Canada even more than housing? China.

Kevin Carmichael on what might be keeping Canada’s central bank governor up at night
Stephen Poloz
Bank of Canada Governor Stephen Poloz speaks about the Financial System Review during a news conference in Ottawa, Thursday,June 9, 2016. THE CANADIAN PRESS/Adrian Wyld

This story, by Kevin Carmichael, first appeared at Canadian Business.

Unlike many central banks, Canada’s monetary authority has little regulatory power over the banking system. It does have a bully pulpit, however.

In 2001, the Bank of Canada introduced the Financial System Review (FSR) as an outlet for its views on lenders and credit markets. For years, only the most dedicated of the Bank of Canada’s professional observers read the FSR. Yet it was always there—twice a year, in June and December—to send a message if policy makers felt the need to do so.

Last week, Bank of Canada Governor Stephen Poloz felt such a need.

You will have read by now that Poloz used the Bank of Canada’s latest FSR to try to stop home shoppers in Vancouver and Toronto from doing something stupid. “Fundamental factors underpinning housing demand in the greater Vancouver and Toronto areas are strong, but the rapid pace of price increases seen over the past year raises the possibility that prices are also being supported by self-reinforcing price expectations,” the central bank wrote in the FSR, which was published June 9. Poloz was more to the point in a press conference: “In these two areas we see a rate of price increase that would be very difficult to match up with any definition of fundamentals that you could point to.”

Maclean’s senior editor Jason Kirby brilliantly described the Bank of Canada’s use of behavioural economics to warn of irrational exuberance in Vancouver and Toronto. Average home prices grew at double-digit rates in those markets over the past year, compared with single-digit increases in cities such as Montreal and Ottawa. Poloz’s approach to now had been a series of gentle nudges; raising housing prices and record household debt as concerns, but at the same time accepting that buyers and their lenders likely knew what they were doing. But something changed between the previous FSR in December and now. To borrow Kirby’s phrase, the governor switched to “central banking by sledge hammer.” Poloz slammed through the wall of noise that stands between the Vancouver and Toronto housing markets and anyone who might want to have a calm discussion about the situation. The Bank of Canada has created a baseline: there is something wrong with this picture:


What is to be done? Poloz wouldn’t say. He is a member of the Senior Advisory Committee, a secretive group of senior technocrats that advises the finance minister on financial policy. Poloz told reporters that any advice he had for Finance Minister Bill Morneau would be delivered through that committee, not the press.

That was another way of saying that Vancouver and Toronto are not the Bank of Canada’s problems. It is important to be clear about what the central bank did last week: it provided a public service announcement, not a warning that it is contemplating higher interest rates. The Bank of Canada describes excessive home prices in some big markets as a “vulnerability,” a vulnerability that has gotten worse over the past six months. But to become a problem, a weakness must be exposed—in the case of Canada’s frothy housing markets, by a recession or a spike in unemployment that triggered a wave of defaults. Poloz and his advisers actually have become more confident that they have steered Canada away from such a tragedy. They are generally satisfied that ultra-low interest rates, a weak dollar and stronger U.S. demand has put Canada on a better track. The banks likely could manage a bust in either city; they would feel it, but their capital cushion is bigger than it was before the 2008 crisis and they are among the most profitable financial institutions in the world.

So what might keep Canada’s central bank governor up at night? George Soros’s decision to end his retirement, perhaps. According to various reports, the 85-year-old Soros is spending more time with the managers of his family fortune because he dislikes what he sees in global financial markets. He is selling equities and buying gold and the shares of gold miners, including Canada’s Barrick Gold Corp. Earlier this year, Soros said China’s debt-fuelled economy reminds him of the United States ahead of the financial crisis. An extended period of negative interest rates in Europe and Japan is another reason to be nervous. In theory, the policy should work, but has never been tried. There is no way to be certain about how negative rates have altered behaviour.

The Bank of Canada isn’t comfortable with what is going on in financial markets, either. It used the FSR to report that traders and investors in Canada say that it is taking longer to complete trades in fixed-income markets and that larger trades that used to go through easily now must be broken up into smaller bites, especially when moving corporate bonds. There could be a number of explanations: new regulations, negative interest rates in Europe and Japan, a shift in risk tolerance are a few possibilities. Regardless, the Bank of Canada is worried about liquidity in debt markets. That matters, because if investors are becoming less willing to hold debt, interest rates could speak in the event of a shock such as another bout of worry about the state of China’s economy and financial markets.

Financial markets are worried about China because its debt has surged to a record 237 per cent of gross domestic product, according to the Financial Times. For every Soros, there is an analyst who will tell you that China is fine—that its high savings rates and relatively strong growth will allow it to easily manage its debts. Yet to achieve its growth target of an annual rate of 6.5 per cent, the Chinese government is borrowing heavily to fund investment. “The question from a financial stability point of view is whether or not those measures, to the extent they encourage more credit and more investment, may not buy some more growth today, but increase the risk of some disruption in growth further down the road,” Carolyn Wilkins, the Bank of Canada’s senior deputy governor, said at least week’s press conference.

The Bank of Canada rates the probability of a financial crisis caused by sharp correction in housing prices as low. The likelihood that something could go wrong in China that would cause financial pain: medium.