Bank of Canada – FSR Dec 2012
Back in April, I reviewed a document called the “Financial System Review”, published semi-annually by the Bank of Canada. Due to the dire warnings contained therein, I thought it necessary to produce a more user-friendly summary of the information the Bank presented to the public. The information the Bank provided was top-notch, though I disagreed with some of their interpretations.
Since this is a regular publication, I think it will be useful to keep readers abreast of all the developing issues here in the Canadian and global economy. It affects everyone and so it will be important to have an understanding of the crises looming overhead so that you’re able to act effectively to guarantee the financial prosperity of you and your family.
In the new Financial System Review, published December 2012, the Bank revisits many of the same risks they brought up in the December 2011 issue and comments on their relative improvements or deterioration. Overall, the picture is not good and Canadians may soon be facing a crisis similar to that of the United Kingdom, Europe and the United States.
Over the last year there has been a severe deterioration in economic indicators throughout Europe and where last year’s FSR focused on the USA, the Bank’s attention has now shifted to the Eurozone. When I reviewed the 2011 FSR, I concluded that the Bank will continue interpreting crises in their favour, calling for ever more central bank action in the markets. In this issue, the Bank does not disappoint, calling for ever more stimulus and centralization.
…additional monetary policy stimulus announced by several central banks – including the U.S. Federal Reserve, the European Central Bank (ECB), the Bank of Japan and the Bank of England – will help support global economic growth… plans for establishing a single banking supervisor need to be supplemented with other critical elements of a banking union – namely a framework for common deposit insurance and cross-border bank resolution… including a fiscal transfer system and some form of mutualisation of sovereign debt.
Why the Bank believes further monopolization of the financial sector will improve performance is never explored, it is taken as a foregone conclusion that centralization improves the economy. Common deposit insurance and banking regulations did not prevent a crisis from developing in the United States so one must wonder why the Bank proposes such measures in the face of so much evidence that centralization adds nothing to the stability of the global financial system.
Nevertheless, the Bank decides to take the credit for what minor improvements (called “green shoots” by the media) have been found in remote sectors of the economy and praises the actions taken thus far by other central banks, including the recent announcement of QE3 by the Federal Reserve. This is an open-ended program to create $40 billion in new currency every month until they are satisfied with the economy’s performance. Such actions further assault the dollar’s status as the world’s reserve currency by demonstrating to the world that its supply is theoretically unlimited.
The previous FSR discussed five key risks in the global economy. In this edition they have been reduced to four, but this should not be taken as an indication that any dangers have actually subsided.
This is “the principal threat to financial stability in Canada” according to the Bank. Like many commentators in the financial media, the Bank does mention that the ECB’s monetary policies have only bought time (i.e. “kick the can down the road”) and have not addressed the real fundamental problems facing the European economy. This problem lay in the enormous debts incurred by Eurozone members.
The quality of loans on bank’s balance sheets continues to deteriorate, with impairment charges at Spanish banks nearly doubling over the past three years. Further losses are likely, as the number of non-performing loans is highly elevated and increased defaults are likely.
The proposed solution by the Bank is further monopolization of the banking industry in Europe. This is a rather odd suggestion as I previously mentioned. The kind of centralization the Bank recommends was present in the United States and did not seem to be able to deal with the 2008 crisis. However this is quite in line with my prediction that the Bank will interpret facts to favour its own agenda.
Deficient Global Demand
As most institutions are big believers in the school of economic thought known as “Keynesianism”, it is not surprising that this is brought up as a risk. Under Keynesian-style thought, economic crises are a blend of insufficient consumer demand, idle resources and investor irrationality. It never probes deeper in to the “why” of these situations and always comes down in favour of more government and central bank action in the marketplace. In this section, the Bank is true to Keynesian form.
In the first paragraph, the Bank places blame on the savers of the world for not doing their part in helping to boost aggregate demand (a.k.a. consumption spending). They expected the people of other nations to increase their spending in proportion to the decline in western spending. Instead people are doing exactly what they need to be doing when they find themselves overextended; save and pay down debt (“deleveraging”). Keynesian economics expects people to be sacrificial lambs to a statistic known as Gross Domestic Product (GDP), which is regarded as the end-all, be-all statistic for measuring economic growth. For reasons I will not go in to here, it has long been debated whether this particular measure of the economy provides anything useful at all from a policy perspective.
The section goes on to mention the explosion in debt in many advanced economies.
Government indebtedness is high and on an unsustainable upward trajectory in a number of major advanced economies – including the United States and especially Japan.
Of course, this is a direct result of the government’s attempts to replace lost consumer demand by borrowing vast quantities of funds from the central bank and private sector debt markets and spending it in to the economy. Such action boosts GDP, but has limited actual stimulative properties that should be clear to everyone by now. As pointed out in a recent 2010 study, there are diminishing returns to GDP growth as debt-to-GDP ratios increase past the 60% threshold.
Canadian Household Finances and the Housing Market
Last year’s report focused heavily on this subject and they continue the discussion here. The section leads by stating what we should all know at this point.
The most important domestic risk to financial stability in Canada continues to stem from the elevated level of household indebtedness and stretched valuation in some segments of the housing market.
The beginnings of a correction in the housing market are already starting to show, with sales of existing homes declining due to changes in the mortgage lending rules undertaken over the past year. In my report on the 2011 CMHC financial statements, I predicted that these changes would accelerate the arrival of a correction in the housing market and evidence of this is already starting to come in.
Household debt figures are still in the stratosphere and with the growth of credit beginning to moderate, it appears that Canadians may be tapping out.
Such extreme amounts of leverage make private homeowners particularly susceptible to increases in the interest rate or changes to their income. Nevertheless, Canadians are managing to hold on at the moment with loans in arrears improving slightly over last year.
The Bank points out that the share of new mortgages in 2012 with fixed interest rates has been close to 90%, which is significantly higher than the 55% average it was during the 2010-11 period. This will provide some measure of protection against interest rate volatility, but not much since the typical fixed rate mortgage is only fixed for 5 years. Nearly a third of all outstanding mortgages are at variable rates and thus those borrowers are fully exposed to interest rate risk.
In attempting to explain why housing activity was so elevated, the Bank makes a particularly confused statement:
Housing activity has been elevated relative to historical norms for close to a decade, supported in particular by strong resale and renovation activity.
This is completely circular; they may as well say that housing activity is elevated because housing activity is elevated. It does absolutely nothing to explain what was driving this change in behaviours. Of course, if they really did explore the driving forces behind this, they would necessarily wind up pointing the finger at themselves and this would not fit will with their projected image as economic saviours.
Despite the moderations in resale activity, new housing starts continue to rise along with prices, which are now 16% above their previous peak in August 2008.
It’s rather amazing to see television commentators deny the existence of any kind of distortions in the housing market when the price/income ratio is 25% higher than it was during the peak of the 1980’s housing bubble.
Another item of significance is the huge supply overhang of multi-unit dwellings (townhomes and condominiums), making this sector of the industry particularly prone to sudden downwards movements in price.
In fact, the correction in this segment may already have begun.
As in the previous FSR, the Bank performed a stress test based on a 3% rise in the unemployment rate and a six-week increase in the average duration of unemployment. The results were no different, with loans in arrears rising to 1.2%, enough to wipe out all the Canadian Mortgage & Housing Corporation’s capital if those loans transition to default.
Low Interest Rate Environment in Major Advanced Economies
The most interesting part of this risk is that the Bank can talk at length about it and never once implicate itself or other central banks. The Bank is the one entity most responsible for creating such conditions and the numerous stimulus programs (a sample of which are outlined below) are directly responsible for creating this risk.
European Central Bank (ECB)
- Outright Monetary Transactions (OMT: No limit)
- European Financial Stability Facility (EFSF: €440 billion)
- European Financial Stability Mechanism (EFSM: €60 billion)
- European Stability Mechanism (ESM: €500 billion)
- Lowered main refinancing rate of 0.75%
Bank of England (BoE)
- Asset Purchase Facility (APF: £375 billion)
- Main interest rate of 0.5%
Bank of Japan (BoJ)
- Asset Purchase Program (APP: ¥91 trillion)
- Benchmark rate of 0% – 0.1%
Bank of Canada (BoC)
- Benchmark rate of 1%
United States Federal Reserve (FED)
- Troubled Asset Relief Program (TARP: $700 billion)
- Term Asset-Backed Securities Loan Facility (TALF: $1 trillion)
- Quantitative Easing (QE3: $40 billion per month)
- Federal funds rate target of 0% – 0.25%
Despite completely ignoring their own hand in creating this environment, the Bank does go on to make an astute prediction.
Significant volatility and losses may result if investors try to exit from some asset classes en masse in response to a change in perception regarding the interest rate environment.
Indeed, if people begin to perceive that a rapid increase in interest rates is on the horizon, then the currency and bond markets will experience a massive sell-off causing chaos that could easily metastasize into severe devaluations in a number of key currencies such as the US dollar, Euro, Pound and Yen.
The 2012 FSR is not so different from the 2011 FSR I previously reviewed. The identified risks are substantially the same and I did not expect them to change either. The updated statistics provide a useful picture of the Canadian and global economy and the Bank does a relatively good job at pointing out all of the pertinent data. Unfortunately, the Bank continues to ignore its own role in creating these conditions and proposes that an even stronger banking monopoly be established in order to better control the decline of western economies. Their final suggestion is that the new BASEL III rules be implemented globally. What they should have realized is that a highly integrated, centrally controlled financial system cannot help but create distortions in the marketplace due to the calculation problem, first theorized by the famous economist Ludwig von Mises.