The Canadian Economy does not operate in a vacuum and we are not isolated from global events, as we saw in 2008 and early 2009.

~ David Rosenberg

On Tuesday the Bank of Canada became the first central bank of the G7 countries to raise interest rates. Granted, the BoC's overnight rate now sits at .50%, up from .25% before the announcement. We're still basically offering free money for borrowers to finance and even increase their debts.

Usually, central banks raise rates when the economy is accelerating in an attempt to control inflationary pressures. A rate hike implies that things are improving in the Canadian economy. Indeed, recent manufacturing and GDP stats support that conclusion and lend support to the frequently cited notion that Canada is in a much better position than most other G20 member nations.

The Canadian economy performed better than most during the recent (ongoing?) recession and there are plenty of reasons to bask in the glow of our new golden child status. But there are also a number of latent factors that could cast a shadow on some of the accolades we've been enjoying. There is a possibility that Canada is not leading the global economy, but following it. Today I'm going to look at both sides of the debate and try to figure out which is closer to the truth.

Canada as Economic Golden Child

Canadians have a general reputation for being more cautious than our American cousins. We tend to be slower adopters, less prone to embracing the latest thing until it's been proven. That served us well in the financial arena over the past couple of decades: Canada was slow to adopt the financial innovations that lead to the U.S. housing crash and was quick to reverse some of those harmful practices (40 year amortizations anyone?) when things turned south. Here are a few things Canada has going for it on the global economic stage:

1.  Better Capital Controls for Banks: Canadian banks are not allowed to use as much leverage, although some might argue that even tighter controls are necessary (and others would argue that fewer controls would be better.)

2. Better Mortgage Regulations:

  • In general, Canada did not allow the most egregiously lax lending practices to take hold here as they did in the U.S.. Still, extremely low interest rates and somewhat relaxed lending standards did lead to an increase in housing prices even in the middle of the recession. Yet some reports contend that a foreclosure wave in Canada is unlikely.
  • Recourse Mortgages: You cannot walk away from your mortgage in Canada. If you can't make the payments, the lender will sell the home at whatever price they can get and you will still be responsible for the difference.
  • Mortgages Are Not Tax Deductible: Many Canadians have complained about this practice, but the reality is that it keeps a lid on the buy and flip mentality that causes homes to be treated as investments rather than shelter. That, in turn, can prevent the socialized losses that inevitably ensue when the housing market becomes overheated and then corrects abruptly.


3. Resource Riches: Canada is rich in the resources (oil, gas, base and precious metals, agricultural commodities, and lumber) that China, the U.S. and the rest of the world need.

4.  Lower Stimulus & Bailout Spending: A lot has been made of the fact that Canada did not have to bail out its banks in the way other countries did. Some would argue that Canada did in fact offer monetary support to the big banks, albeit through the back door rather than the front.

5.  Federal Government & Bank Balance Sheets in Better Shape: Canada's federal debt situation is much more favourable than many nations, and our banks reportedly have very little exposure to Greece.

Is the Worst Yet to Come?

Although we have avoided some of the pitfalls of the economic crisis into which other nations have fallen, there is a case to be made for the idea that we are, like a little brother or sister, just trailing behind. We have yet to reach those pitfalls, and as such, cannot be confident that we won't fall into the same traps when we do.

1.  Personal Debt Levels: Tucked away in even the most congratulatory commentary is this potentially huge caveat: Canadians are racking up record piles of debt. The OECD recently urged the Bank of Canada to begin a series of measured rate hikes in view of their optimistic predictions about the Canadian economy. In the same report, they acknowledged that the “high rate of household indebtedness is a source of risk to the outlook.” There is even evidence that the household debt load of Canadians is higher than the PIIGS countries.

2.  Provincial Debt Levels: Canada's “rosy national picture may be masking a different story at the provincial level.” A lot of federal costs have been offloaded to the provinces, leaving many with debt to GDP ratios that are much higher than those of the nation as a whole.

3.  Housing Bubble: While it's great that Canada avoided a U.S. style housing meltdown thanks, in part, to the superior regulations mentioned above, Canadians were not immune to the effects of rock bottom interest rates. Those low rates encouraged many to pile on more debt and drove the price of housing in Canada much higher. Many feel that current conditions reflect a housing bubble and that we are on the cusp of quite a pop. Whether the bust will be as severe as the one in the U.S. remains to be seen. (See CMHC: Fannie Mae Canadian Style? for more on housing.)

4.  Exogenous Influences: That's just a fancy way to state the obvious: What happens in economies outside Canada can and will have a direct effect on our economy. As David Rosenberg points out in the article referenced in today's opening quote, 2008 taught us that our resource economy is far from bullet proof. Rather, it's more like a double-edged sword, exaggerating gains in a strong global economic environment, and losses in a weak one. Here are a few trouble spots to keep your eye on:

  • China: Recent data show that China's manufacturing growth is slowing. If China's growth slows, that will affect commodities markets and therefore Canadian resource companies.
  • Europe: On Monday the ECB (European Central Bank) warned of a second wave of large losses for European banks, still reeling from the credit crisis. With the interconnectedness of today's financial system, that's bound to have an effect on banks and other financial institutions worldwide, including Canada.
  • United States: The debt issues of our neighbours to the south, although well-publicized, have moved to the back burner lately as Europe has become the new black sheep of the global family. But if the sovereign debt issues across the pond begin to spread further, the U.S. will be affected. With the massive bailouts and stimulus programs that have added to their already astronomical debt load, it's hard to see how they could finance yet another round for the already intoxicated debt addicts on Wall Street and Main Street.

At some point, the still runs dry and the bond market rum runners demand more money from imbibers. That will mean higher interest rates at the longer end of the curve, and there's nothing any central bank can do about that, except print more money to buy those bonds. This can only continue until people realize that this virtuous circle is really a vicious cycle.

So Which Is It?

Will Canada's fiscal prudence and abundant resources make it the global golden child, or will our late adopter role only serve to delay the inevitable? I really don't know the answer, but I think that our caution and reluctance to hop on every train that passes by may at least buy us more time than our global brothers and sisters, who seem to have run out of it. The true test will come over the next few months and years as we deal with this debt crisis.

Will Canada follow the same path as our older siblings by printing money and paying for debt with more debt? Or will we take on the role of the precocious younger sibling who demonstrates fiscal restraint, allows bankrupt households and corporations to fail, and emerges from a difficult period stronger than ever?