Bank of Canada warns of dangerous euro zone 'ripple effect'

The minimal damage from Europe's sovereign-debt woes on Canada's domestic economy and financial system could increase dramatically if euro-zone policy makers fail to contain the crisis, the Bank of Canada warns.

Canadian banks have little direct exposure to struggling European governments or financial institutions, the central bank said Thursday in a semi-annual assessment of the financial system. Nonetheless, trading partners like the United States have greater links, it said, and if the crisis gets much worse, the worldwide pullback from risk-taking and added pressure on global credit markets that would follow would sap wealth and confidence at home, too.

Risks to the financial system have "increased markedly" since June, Bank of Canada Governor Mark Carney and his policy team said, as Europe's escalating drama – flagged as the No. 1 risk to Canada – threatens to set back the global recovery and infect healthier regions.

"The global retrenchment of risk associated with the European crisis has indeed resulted in a significant correction in the prices of equities and other risky assets, as well as a widening of credit spreads in Canada," the central bankers said. "Should the crisis deepen and spread further to the larger European economies, transmission to Canada could become more severe."

To be sure, The central bank noted Canada's financial system and economy are relatively strong and the country does little direct trade with euro-zone nations, so "spillovers" from the turmoil have been limited. But the longer it drags on and the worse it gets, Canadian banks' indirect exposure to some of the most vulnerable nations could become a bigger issue.

For instance, the report showed Canadian banks' total claims on Italian entities are just 3.4 per cent of their top-quality capital. For German banks, however, that number is 154 per cent; for French banks, it is 193 per cent. U.S. banks have tight links with the banking sectors in both countries, as well as with banks in the United Kingdom.

"We're exposed to U.S. banks, and U.S. banks are exposed to French and German banks and the U.K., and they're exposed to the PIIGS (Portugal, Ireland, Italy, Greece and Spain)," said Benjamin Reitzes, a senior economist with BMO Capital Markets. "So it's a ripple effect."

The Bank of Canada report came two days after Mr. Carney kept his main interest rate at 1 per cent for a 10th straight decision, citing extreme uncertainty about Europe and the global outlook. On Thursday, Mr. Carney and his team urged European policy makers – who are meeting in Brussels Friday in another attempt to put a floor under the crisis – to "address the situation in a forceful manner," saying "measures taken to date have repeatedly fallen short."

Policy makers also highlighted a conundrum for the U.S. and its debt problems. The bank said there is a "small but significant risk" that repeated failure to take steps to tame the massive U.S. budget deficit could cause investors to lose faith in Washington's resolve and demand more of a premium to hold U.S. debt. For now, though, if U.S. governments and households tighten their belts too aggressively, the American economy could backslide into a new recession.

On Canadian household debt, the bank said credit growth has started to slow but is still outpacing income growth, so the debt-to-income ratio – already at a record 149 per cent – is likely to rise further, putting more families at risk if deteriorating conditions cause more job losses or a big drop in real-estate prices. Moreover, the bank said the supply of finished but unoccupied condominiums in some cities "suggests a heightened risk of a correction."

Policy makers stopped short of explicitly urging the federal government to tighten mortgage rules for a fourth time in three years. Still, economists said the message was clear enough, as is Mr. Carney's discomfort with one of the effects of keeping borrowing costs so low.

"He's sort of stuck in the middle," said Diana Petramala, an economist with Toronto-Dominion Bank. "You've got what's going on internationally, which could create a huge shock to the Canadian economy, and households have become more vulnerable to such shocks since the last financial crisis. At the same time, keeping rates lower for longer could create more risk-taking."