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Mark Carney is issuing his starkest warning yet about the troubling levels of debt that households have piled up amid near-record-low borrowing costs.

Many Canadians are increasingly vulnerable to shocks such as higher interest rates and job losses, in turn putting the wider financial system and economy at greater risk, the Bank of Canada Governor and his rate-setting panel say in a semi-annual report.

The banking sector remains relatively strong, the central bank said Thursday in its assessment of the financial system, but problems facing some of the most debt-ridden borrowers have deepened while overseas troubles, like Europe's debt crisis, mean overall risks are elevated.

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Mr. Carney and other policy makers have been ringing alarm bells about too many households becoming too stretched for comfort for much of the past year. Thursday's salvo, however, showed they are now more worried about a dynamic that's becoming more complex.

As the recovery slows at home and abroad, Canadian growth will depend on consumer spending while exports languish. At the same time, low borrowing costs are still making big purchases too tempting for people who will have trouble paying off their debts when interest rates start rising again. And those borrowers are on even more fragile footing, now that the economy seems to have less momentum than Mr. Carney once thought and some jobs may be in jeopardy.

"The probability of an adverse labour market shock materializing is judged to have edged higher in recent months," the central bank said. "A shock to economic conditions could be transmitted to the broader financial system through a deterioration in the credit quality of loans to households."

Highlighting the type of ripple effect that helped turn the U.S. subprime mortgage crisis into a financial system meltdown and a global economic slump, the central bank said a decline in borrowers' creditworthiness would "prompt a tightening of credit conditions that could trigger a mutually reinforcing deterioration of [economic] activity and financial stability."

Equally troubling, the central bank said that with housing affordability on the decline and households "increasingly stretched" financially, "the probability of a negative shock to property prices has risen as well."

Consequently, the report again identified Canadians' unprecedented debt-to-income ratio – currently about 146 per cent – as the main domestic risk.

To drive home the point, policy makers conducted a "stress test" to project the effects of a jump in unemployment, a scenario they view as more likely given the bleaker prospects for the Canadian and global economic recoveries. The test found that if the economy were to deteriorate so much that the jobless rate rose to 11 per cent, the share of households devoting at least 40 per cent of their income to servicing debts would climb from 6.5 per cent to 7.8 per cent, and the proportion of household loans that are in arrears for three months or more would more than double, rising from 0.6 per cent to 1.4 per cent.

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``Households cannot continue to borrow at a faster rate than their incomes are growing indefinitely,'' said Sal Guatieri, a senior economist at BMO Nesbitt Burns Inc. in Toronto. "At some point, that ratio has to stabilize, or the economy and financial system would be at risk. That's the problem the Americans, and the British, got into."

Indeed, economists like Mr. Guatieri and consumer advocates marvel that even as the debt-to-income ratio in the United States, while still high, has fallen back to pre-crisis levels, Canada's keeps rising.

"During this recession, it doesn't seem that Canadians changed their habits, which is shocking," Laurie Campbell, executive director of the Toronto-based credit counselling agency Credit Canada, said in an interview. "In the U.S., they certainly did start to put their wallets away, they started to become more cautious and conscious of the financial decisions they've been making. In Canada, we're still going down this very scary path of incurring debt and of not understanding that there is a breaking point."

Nonetheless, Mr. Carney noted in the central bank's report that changes to mortgage rules that Finance Minister Jim Flaherty announced earlier this year, designed to make it tougher for buyers to take on loans they can't afford, are "starting to have an impact." In addition, the Canadian Bankers Association says its members are working to ensure that potential borrowers would be able to make future payments if interest rates rose.

With the benchmark interest rate expected to stay at 1 per cent until well into 2011, though, the central bank's language suggested policy makers are still hoping moral suasion will succeed in cajoling borrowers, and lenders, into more cautious behaviour.

"Households bear ultimate responsibility for ensuring that they will be able to service that debt in the future," the central bank said. "It is also essential that financial institutions actively monitor the risk surrounding households' ability to service their debt over time, taking into account the macroeconomic outlook."

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Thursday's report also said authorities are "co-operating closely and will continue to monitor the financial situation of the household sector," but Mr. Carney and his deputies have suggested on several occasions that they view tightly tailored regulatory changes as more appropriate than monetary policy for addressing the issue.

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Economics/business writer

Jeremy has covered Canadian and international economics at The Globe and Mail since late 2009. More

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