Canada losing its ‘wiggle room’ if U.S. economy goes sour again

As worries about another U.S. recession mount, Canada's economy is highly exposed to any downturn and is less equipped to fight a slump than it was three years ago.

Heavy government and consumer debt, along with reduced flexibility for stimulus spending and monetary policy mean Canada today has less resilience to a crumbling U.S. economy compared with the global financial crisis of 2008.

"Policy makers in Canada have less wiggle room on the fiscal and monetary fronts and households face larger debt burdens," Toronto-Dominion Bank deputy chief economist Derek Burleton said in a report. "By virtue of its fundamental strengths, many believe that the downturn would be less severe and the economy would recover more quickly than would be the case south of the border. Given Canada's increased domestic vulnerability, such an outcome would not be guaranteed."

TD pegged the odds of another U.S. recession at 40 per cent. Should another U.S. downturn occur, Canadian businesses would be in better position this time around because most have less debt and more liquid assets, and because it is "highly unlikely" that a double-dip south of the border would be as deep as the last recession, TD said in its report.

But with governments and households less able to spend, Canada's economy is more vulnerable to shocks, TD said. That view is at odds with the message Finance Minister Jim Flaherty and Bank of Canada Governor Mark Carney gave last week at a parliamentary panel, when they said Canada and its trading partners would sidestep any recession, and that they have the tools to blunt the impact if they are wrong.

Among the key differences between the current touch-and-go global economic climate and the eve of the last U.S. recession, which started in late 2007, is the level of interest rates. The Bank of Canada's benchmark interest rate is at just 1 per cent, compared with 4.25 per cent before the recession. That gave the central bank plenty of room to bring the rate down to spur borrowing and spending without resorting to unconventional methods such as quantitative easing – or buying government securities to push longer-term interest rates down. This time, its flexibility is more limited.

And while governments in Canada are, for the most part, in much better fiscal shape than in other advanced economies, they are nonetheless grappling with the spending hangover from the buckets of stimulus spending put in place to combat the last downturn. According to TD's calculations, total federal-provincial debt as a share of gross domestic product has climbed from 54 per cent in 2007 to 62 per cent now, as governments added $166-billion to their debt loads.

Meanwhile, low interest rates have pushed the share of income that Canadian households must devote to debt-servicing costs down from 8.3 per cent to 7.6 per cent.

But the gap between average home prices and average incomes has widened, and TD says home prices are currently overvalued by 10 to 15 per cent. With the jobless rate more than a full percentage point above its pre-recession trough of 6 per cent, it's little wonder why economists say the household sector is on shaky ground and that Canadians' sense of financial well-being could take a huge hit if home prices tumble.

Although Canada's economy was pulled under in late 2008 as exports to the United States plunged, it emerged strongly from the recession in part thanks to a housing boom that was fuelled by ultra-low interest rates. Also, Canadian banks were far less exposed to the U.S. financial crisis than many others around the world, allowing them to keep credit flowing more smoothly through the downturn. And while the Harper government clocked record deficits to fight the recession, Canada's total debt is more manageable than levels in the United States or in many European nations, and foreign demand for Canadian bonds and other assets has helped keep Ottawa's borrowing costs low.

Of course, another recession in the United States is not a foregone conclusion.

U.S. stocks rebounded Monday after the Standard & Poor's 500 Index had its steepest four-week decline since 2009, as speculation grew among investors that U.S. Federal Reserve Board chairman Ben Bernanke will use a speech in Jackson Hole, Wyo. on Friday to lay out plans to give the world's biggest and most important economy a fresh jolt. The Dow Jones Industrial Average, which has lost more than 400 points on four separate days this month, also gained.

To an extent, whether or not the U.S. economy slips into a technical recession, America's recovery is much less robust than after previous downturns. And the longer Canada's No. 1 export market hovers around zero growth, the more growth on this side of border will be restrained.

Don Drummond, the former chief economist at TD who is leading a spending review for the Ontario government, said household debt puts Canada in a precarious position, especially considering the country followed the U.S. into recession in 2008-09, a time when the economy was more solid and debt was less of an issue.

"Having great and differentiated fundamentals has never really protected us from very much," Mr. Drummond said. "Our household debt numbers are pretty similar to the United States, so we can argue we've got these great and better fundamentals, but not much better on that side. And while it's hard for the U.S. housing sector to go down too much further, certainly Canada's could slip down."