Are Canadians ready for higher rates?

Policy makers are right to fret about overbuilding in the Toronto and Vancouver condo markets, but it's worth remembering that unless those bubble-like markets burst, the less-than-ideal mix of high household debt and overpriced housing may be more manageable than it looks.

Concerns about housing have been in sharp relief for weeks now, long before Tuesday's report from Canada Mortgage and Housing Corp. showed a surge in condominium construction, which helped push overall construction starts up 14 per cent last month to the fastest annual rate since September, 2007. That's because Bank of Canada Governor Mark Carney started hinting in mid-April that he is looking for an opportunity to start lifting his key interest rate from the current 1 per cent. He also reiterated his concerns about too many people failing to resist the lure of cheap debt that won't be as affordable when rates are higher.

Francis Fong, an economist with Toronto-Dominion Bank, says in a study released Tuesday that while most Canadians look "well-positioned" to absorb an interest-rate increase of around 2 percentage points, "there is a substantial minority that cannot."

Specifically, Mr. Fong points to analysis from the Bank of Canada itself, which warns that 7.5 per cent of Canadian households could be in some financial trouble once borrowing costs "normalize." He also points to a projection by the Canadian Association of Accredited Mortgage Professionals that a benchmark rate of 3 per cent would put 21 per cent of all mortgage holders in hot water.

But here's the thing: nobody believes Mr. Carney has any intention (or capacity) to bring interest rates to that level anytime soon. Even TD, which predicts the first rate hike will come before the end of 2012, sees Mr. Carney moving very gradually to 2 per cent – by the end of 2013. The central banker will be able to move more aggressively once the European crisis seems more stable again, and once the U.S. economy is stronger and the Federal Reserve is closer to hiking, too. So, Mr. Fong warns, barring another "major shock" to the global economy, Mr. Carney's rate (which directly influences variable-rate mortgages and other floating loans) will rise by at least 2 percentage points before 2015.

Mr. Fong's main point is that while higher rates are hardly a boon for consumer spending, rates will go up so slowly that there "will likely be enough lead time" for many households to "adjust their spending habits" to account for higher payments.

Moreover, he points to signs that Canadians are already accumulating debt at a slower rate, as does Benjamin Tal of CIBC World Markets in a separate report. Even in an environment of historically low interest rates, Mr. Tal says, overall household credit is rising at the slowest pace since 2002.

"The pace of growth in household credit is no longer a reason for the Bank of Canada to move from the sidelines any time soon," he argues, suggesting Mr. Carney's warnings are being heeded after all.

No need to worry, then? Afraid not.

TD's Mr. Fong notes that annual mortgage credit growth, while down from its pre-recession peak, has held steady at an almost 8-per-cent pace for three years. This suggests borrowers are using their credit cards and lines of credit less, but taking out mortgages at roughly the same clip.

And Mr. Tal notes in his report that the real-estate market is "overshooting," even as signals suggest – in most markets, anyway – that activity is slowing down.

Which brings us back to overbuilding in Toronto and Vancouver. The same day that CMHC published its eye-popping housing starts numbers, the Crown corporation said in its annual report that it sees no "clear evidence" of a bubble. Mr. Carney, meanwhile, will probably never utter the B-word, but has been hinting for several months that he sees at least the makings of one in some cities.

This below is in his semi-annual assessment of the financial system, from December: "Certain areas of the national housing market may be more vulnerable to price declines," he said, adding, "the supply of completed but unoccupied condominiums is elevated, which suggests a heightened risk of correction in this market."

Over and over again since then, Mr. Carney has said authorities are watching closely, and will act to cool the market if necessary, while stressing that interest-rate hikes are too blunt an instrument to deal with this issue, other than in "exceptional circumstances." With Greece and Spain roiling global markets again, and lukewarm economic news south of the border, it's harder to imagine Mr. Carney raising rates this year than it was a few weeks ago. Still, the excess supply of condos in Canada's biggest cities suggests we may have reached "exceptional circumstances."

That leaves CMHC and, by extension, Finance Minister Jim Flaherty, who is in the process of beefing up oversight of the often clueless-sounding agency.

Mr. Flaherty warned recently that condo developers seem willing to build new units until sales dry up. This could lead to a crash, and the last buyers in could get burned, he warned in a meeting with The Globe and Mail's editorial board last month.

Some of this frenzied building and buying is linked to foreign investment, the actual amount of which is hard to know since even the government says it doesn't know. So there may be little the government can do, other than hope the market lands softly.

However, if Ottawa is so worried about the last buyers in, there is one thing it could do to ensure that those people are not the Canadians who can least afford to get burned. The last of three times that Mr. Flaherty has ordered CMHC to tighten its eligibility requirements, in January, 2011, he opted against raising the minimum down payment from the current 5 per cent. (Mr. Flaherty had been warned by the Canadian Real Estate Association and Canadian Association of Accredited Mortgage Professionals that raising the current 5-per-cent minimum down payment would shut too many first-time buyers out of the market and cost jobs.) Raising the minimum to, say, 7 per cent, would seem to be a measured, prudent way for Ottawa to limit the number of naive new borrowers who could be left holding the bag for a lifetime because greedy condo builders couldn't rein themselves in.