Household debt levels in Canada are the highest in the world, making the country more vulnerable to an economic shock, according to a new report.

The warning from the OECD came in a report on economic growth which highlighted concerns over the levels of household debt in both advanced and emerging economies.

Consumer debt tops 100% of GDP in Canada, while the level of debt expressed as a percentage of GDP stands at above 80% in both South Korea and the UK.

High levels of household debt prolonged the 2008 financial crisis, while the house-price bubble was a major contributing factor in the destabilization of the banking sector.

Image: OECD

The high and increasing levels of debt amongst Canadians is due to high house prices.

Although strong house prices benefit homeowners or sellers, the OECD flags up the correlation between higher than normal house prices and a downturn. Excessive house price developments are predictive signals of future recessions, the OECD notes.

Housing debt becomes a real problem should interest rates rise, because they make mortgage repayments more expensive, and can sometimes even tie the hands of central bankers who may need to raise interest rates to curb inflation. Real economic growth comes from productive investment rather than borrowing to buy houses.

Although Canada has seen strong and steady growth in house prices over the last 10 years, the outlook is starting to soften. Last month, the index experienced a 0.8% drop when compared to the month before, the largest drop since September 2010.

Canadian house price rises in 11 key cities.

The OECD is not alone in its warning. In its annual report on the global financial system, the International Monetary Fund (IMF) has also issued a warning to governments not to rely on debt-fuelled consumer spending to create growth.

The IMF said consumer spending and levels of household debt benefit the economy for the first two to three years, but then risks begin to mount.

At first, households take on more debt to buy things like new homes and cars, giving the economy a short-term boost.

But later, highly indebted households are likely to prioritize repaying their debts rather than spending more money. And that’s a drag on economic growth. If a sudden economic shock – or a sharp decline in house prices – is added into the mix, the results can be very challenging.

Vancouver in British Columbia is home to Canada’s most expensive real estate.
Image: REUTERS/Chris Helgren

Time to build?

“Debt greases the wheels of the economy. It allows individuals to make big investments today – like buying a house or going to college – by pledging some of their future earnings. That’s all fine in theory. But as the global financial crisis showed, rapid growth in household debt – especially mortgages – can be dangerous,” IMF senior economist Nico Valckx warned in a blog.

The OECD recommends that both policies and the underlying structural features of the economy are addressed in order to stop households taking on too much debt.

For housing markets, it recommends removing implicit home-ownership subsidies, such as tax deductions on mortgage interest payments. It also recommends trying to keep house prices in check by increasing the supply of new homes.