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Risks Rising, Bank of Canada Warns

Risks to the economy and financial system have edged higher over the past six months, the Bank of Canada warned Wednesday, citing the European debt crisis, the uneven global recovery, and vulnerable consumers who are not doing enough to cut their debts.

In their latest semi-annual assessment of the financial system, central bank policy makers said Canada’s banking sector remains relatively sound.

Still, they reiterated that Canadian banks and markets could be affected significantly should the European debt crisis spread to the continent’s bigger countries or beyond, noting that there has been “persistent skepticism” among investors about whether Europe’s lead policy makers will be able to stop the bleeding.

Similarly, policy makers are worried that many Canadian households won’t be able to manage their debt loads when interest rates rise or if there’s another downturn in the jobs market.

“The Canadian financial system is not immune to the tensions that are currently affecting European markets,” Governor Mark Carney and his rate-setting panel said in the report.

“Even though the direct exposure of the Canadian banking sector to credit claims on entities from the most vulnerable countries is low, domestic banks could face losses on loans to other countries whose banks are more exposed.’’

On Canadian household debt, Mr. Carney and his deputies said the risks posed to the wider financial system and the economy remain “elevated,” and once again urged borrowers and banks to be careful about taking on or dishing out loans.

While policy makers view the probability of a “labour market shock” as lower than six months ago, they said further slowing in the growth of credit is essential.

This is especially so because the central bank has issued several stern warnings, including last week in Vancouver – the country’s hottest real-estate market by far – but has been reluctant to raise interest rates because of the extremely uncertain global picture, leaving the policy response to the Finance Department. The government has tightened mortgage rules through measures that are helping to slow the pace of debt accumulation, but “it will take some time for their full effect to be felt.”

“The growing vulnerability of this sector increases the risk that a shock to economic conditions would be transmitted to the broader financial system via a deterioration in the credit quality of household loans,” the central bank said.

“The resulting increase in loan-loss provisions and the reduced quality of the remaining loans could lead to tighter credit conditions and, in turn, to mutually reinforcing declines in real activity and in the overall health of the financial sector.’’

Ever mindful of how Canada’s export-heavy economy could suffer disproportionately if other countries fail to do their part in fostering a smoother global recovery, Mr. Carney warned that in addition to the “acute fiscal strains” in Europe that threaten to lead to a Greek default, which could have severe ramifications throughout the global banking system, countries like the United States and Japan must come up with credible debt-reduction plans. Furthermore, efforts to beef up international banking standards must continue apace, he said.

“The most pressing issue internationally is to take up additional steps to consolidate public finances and to shore up the balance sheets of banks that are undercapitalized and burdened with underperforming assets,” policy makers said. “If the significant fragilities that still burden the financial system are not addressed in a timely manner, the progress achieved to date could be derailed.’’

Aside from encouraging consumer borrowing and bringing Canada’s household debt to record levels, the central bank said low interest rates in advanced economies are also fuelling riskier behaviour in financial markets both at home and abroad, as investors search for better returns. That dynamic could lead to an “under-pricing” of risk, the bank said, and in turn, “excessive” risk-taking.

While the threat to Canada’s financial stability is low, the central bank said it has gone up since December, a reflection of the weaker end of the “two-speed” global recovery as advanced economies struggle to keep their economies growing at a decent clip.

In another and perhaps more ominous illustration of the world’s uneven rebound from the worst recession since the Great Depression, Mr. Carney and his team expanded on their previously somewhat vague warnings about mounting evidence that China’s economy is overheating.

Strong credit growth, rapid development and surging home prices all suggest the world’s fastest-growing economy “may be at risk of a boom-bust cycle,” the bank said.

Using a simulated model, the central bank showed that if Chinese central bankers raised interest rates sharply to fight inflation, causing domestic growth and demand for commodities to slow, global economic activity could slow by a full percentage point next year.

Such a scenario would undoubtedly impact Canada, as a commodity producer that also depends on the rest of the world to buy its manufactured exports.

“This shock would be transmitted internationally through direct trade links, lower investor confidence, and falling prices for financial assets which, taken together, could result in financial contagion,” the Bank of Canada report said.

“This exercise serves to emphasize the importance of a timely and sustainable rotation of the global sources of demand,” the bank said – something that is being held back by the fact that many developing countries aren’t letting their currencies appreciate quickly enough, foregoing a vital inflation-fighting tool.

OTTAWA— Globe and Mail Update