High levels of global debt could create a ‘perfect storm’ of financial risk in economic slump: BoC

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Bloated global debts could feed a “perfect storm” of financial risk in the event of a trade-war-induced global economic slump, making the downturn “deeper than usual and fraught with financial stresses,” Bank of Canada Senior Deputy Governor Carolyn Wilkins said.

In a speech in Montreal on Tuesday, Ms. Wilkins said that the central bank still doesn’t think that a global recession is likely. But she warned that in such a downturn – perhaps triggered by a deepening of the U.S.-China trade dispute – the impact could be made much worse by the heightened levels of worldwide debt.

“The global context has worsened, increasing risks to the global expansion and the chances of financial stress that could spill over into Canada,” Ms. Wilkins said.

The speech served as the central bank’s six-month update on Canada’s financial-system stability. Ms. Wilkins also used the speech to unveil a new research plan focusing on the role of climate-change issues in interest-rate policy and financial stability.

While Ms. Wilkins warned of rising global risks, she said that the Canadian economy remains relatively healthy, and regulatory improvements have made the financial sector more resilient to shocks than it was a decade ago.

“Should a storm arrive, the Canadian economy and financial system are in a good position to weather it,” she said.

A new Bank of Canada survey of senior financial risk-management professionals, conducted in September and October and published this week, showed rising concern over the risks of a significant financial-system disruption over the next one to three years. However, most respondents remain confident in the resilience of Canada’s financial sector to withstand the impact.

Still, Ms. Wilkins said that total global government, corporate and household debts are now more than triple the world’s annual gross domestic product – higher than they were before the financial crisis and Great Recession of 2008-09.

“This leaves many households, businesses and governments exposed should their financial situations deteriorate,” she said.

She added that widely held financial products tied to increasingly risky corporate debt – such as collateralized loan obligations and exchange-traded funds – have further spread the exposure to debt risk among investors.

“The dynamics in an unwind of any of these more complex instruments could look a lot like a case of déjà vu,” Ms. Wilkins said, referring to similarities with mortgage-backed investment products that fuelled the last financial crisis.

She said that while Canadian household debt remains high, the debt-to-disposable-income ratio – a key measure of debt load – has stabilized, and new regulatory restrictions such as the mortgage stress test have substantially slowed mortgage borrowing by the highest-risk borrowers. However, recent declines in mortgage rates have rekindled mortgage growth and house prices.

Concern about adding more fuel to household debts was a key reason behind the Bank of Canada’s decision at the end of October to keep its key interest rate steady at 1.75 per cent, despite the rising global economic risks that have prompted many other central banks to cut rates.

“Lowering interest rates could provide some insurance against downside risks to inflation. However, this insurance would come at a cost, in terms of higher household vulnerabilities down the road,” Ms. Wilkins said. “We said at our most recent interest-rate decision that taking out insurance wasn’t worth the cost at that time.”

“We also said that in considering the appropriate path for policy, we’d watch how the trade situation and household vulnerabilities evolve, as well as fiscal policy developments.”

On climate change, Ms. Wilkins said the central bank has begun a “multiyear” research project “to understand how climate risks are shaping the macroeconomy and financial system.”

In the next few weeks, the bank plans to publish preliminary findings from new mathematical models it is developing, to test how various scenarios of climate change and carbon policies might play out in the economy and the financial system.

“To do our job, we need to understand the economic impact of more frequent and severe weather events,” Ms. Wilkins said. “At the same time, we’re also thinking through how different sectors of the economy and the jobs that go with them could change as we reduce our carbon footprint.”

She said the bank needs to better understand the implications of climate change and climate policy on financial system stability. She said, for example, that annual insurance claims for property and infrastructure damage over the past decade were up nearly tenfold from the 1980s. She added that the transition to a low-carbon economy will also mean a “repricing of carbon-intensive assets” by investors – which may not be a smooth process.

“This is the start of a long journey,” Ms. Wilkins said.