2012: The year of borrowing trouble

For debt-addled Canadians across the country, 2012 will be a crucial test of whether they can rein in their borrowing in another year of super-low interest rates.

After Boxing Week caps off a holiday spending spree that by many measures outstripped the previous year's, households will be back to the unpleasant reality of an uncertain economic climate, stagnant wages and the risk that global threats like the European crisis cause job losses at home.

But experts say spending money helps people calm their nerves, even when they're nervous about their financial burdens, so there's no guarantee Canadians will hunker down, other than those who have literally exhausted their capacity to borrow.

That's why Bank of Canada Governor Mark Carney, who is expected to keep his main interest rate at 1 per cent for at least another year after 15 months at that level, spent this December much as he did in 2009 and 2010: flagging the dangers of taking on debt that will be less manageable when rates rise, and urging households to start living within their means. While he is mainly concerned about the most vulnerable 10 per cent of households, and says debt is not yet a "clear and present danger" to the economy, he still considers it the No. 1 domestic risk.

And no wonder: The debt-to-income ratio rose to a record 153 per cent in the third quarter, according to Statistics Canada. That compares with 146 per cent in 2010 and exceeds the level in the U.S. and the U.K., where families are working to rebuild wealth lost to housing crashes. Canada is inching closer to the 160-plus threshold that got the U.S. and the U.K. into so much trouble four years ago.

A sudden negative event such as a surge in unemployment, a drop in house prices – which many analysts say are roughly 10 per cent higher than they should be – or rising interest rates could land up to two million Canadian households in trouble. And, regardless, the more people spend on interest payments, the less they have to spend on everything else, crimping the consumer spending that accounts for most of the economy at a time when prospects for exports over the next year or two are shaky.

Still, economists point to an encouraging sign: Though debt loads grew in 2011, they did so at the slowest pace in almost a decade.

Mortgage debt, the vast majority of all consumer credit, rose at about a 7-per-cent annual pace, down from 12 per cent two years ago, and credit-card debt growth, aside from the usual holiday-shopping season spike, has also moderated. The debt-to-income ratio has risen largely because incomes are gaining at a slower pace than debt loads are.

Jeffrey Schwartz, executive director of Consolidated Credit Counselling Services of Canada Inc., said that in the past year, more of the most vulnerable Canadians – people devoting at least 40 per cent of their incomes to debt-servicing costs – have started to regain control by coming to groups such as his for help.

The question is whether this vigilance can be sustained, with some economists predicting no change in interest rates until late 2013.

"The test will be the next 12 to 24 months, how we behave in the low interest-rate environment and whether we are able to resist the temptation," said Benjamin Tal, deputy chief economist at CIBC World Markets. "If next year house prices are up 12 per cent, and mortgage activity and credit is up 15 per cent, I will be very concerned. Interest rates will eventually rise, and we would be in a much more vulnerable position than we are now."

Analysts speculate that at some point this year, Finance Minister Jim Flaherty may step into the mortgage market to tighten eligibility requirements for the fourth time in three years. Most, however, see this as unlikely until the European debt crisis stabilizes.

Craig Alexander, chief economist at Toronto-Dominion Bank, said that without the mortgage measures already taken, the debt-to-income ratio would have soared past 160 per cent.

The latest crack was last winter, when Mr. Flaherty announced that Ottawa would no longer insure mortgages with 35-year amortizations, essentially reducing the limit on insured mortgages to 30 years, and cut the maximum amount Canadians can borrow when refinancing their mortgages to 85 per cent of the value of their homes from 90 per cent. Ottawa also pulled government guarantees on lines of credit secured by homes.

Many economists – and Ed Clark, TD's chief executive officer – say further cutting the maximum length on federally insured mortgages to 25 years would be prudent, and that such a move wouldn't necessarily hurt the economy or the housing market.

For now, though, even as Mr. Carney and Mr. Flaherty emphasize they are closely watching debt growth, they continue to rely on moral suasion to cajole consumers, and banks, into showing restraint. In a Dec. 12 speech, Mr. Carney argued Canada has a limited window to cut its reliance on unsustainable, "debt-fuelled" consumer spending. As investors around the world pour capital into Canada, he warned, too much is being used to fund household borrowing instead of building the economy's productive capacity, and he urged businesses to boost investment to fill the "noticeable gap" in the economy as households cut back.

That sort of long-term thinking is music to the ears of economists like Mr. Alexander, who argue Canadians must do more to shift their behaviour while they still can. While most of the attention has been focused on lower-income households, however, Mr. Alexander noted that Canadians near retirement have also piled up debt.

"Whenever interest rates rise, it will be a shock to a lot of people, and I think it's going to be a national shock, because they've been low for so long," he said. "But that might be a 2013 story or, more important, a 2014 story."