Thursday, 13 May 2010

Canada, a great example of successful structural reforms and efficient banking regulation

When United States economy tanked, everyone was expecting the Canadian economy to follow the same fate given how connected both economies are.

It was not the case.

Jim Flaherty, Canadian's finance minister attributed the resilience of the Canadian economy to its "boring" financial system, rock solid and heavily regulated.
Leverage for banks was capped to around 20 times.

Maybe Canadians are strict followers of Austrian economics and have learnt more about the importance of a sound financial system?

Truth is Canadians are much more conservative than their American neighbors when it comes to lending. But the main difference as well compared to the US is that the government did not interfere in the way the housing market was financed: No Fannie Mae or Freddie Mac (we know the story on how well these two ex "private" companies are doing at the moment, losing billions after billions of dollars but that's another story to come in my blog).

Also Canadian banks have truly been much better than their US counterpats in managing risk and cutting risk when needed.

This is a link to a very good article from the Wall Street Journal regarding the Canadian Banks.

"Start with the housing sector. Canadian banks are not compelled by laws such as our Community Reinvestment Act to lend to less creditworthy borrowers. Nor does Canada have agencies like Fannie Mae and Freddie Mac promoting "affordable housing" through guarantees or purchases of high-risk and securitized loans. With fewer incentives to sell off their mortgage loans, Canadian banks held a larger share of them on their balance sheets. Bank-held mortgages tend to perform more soundly than securitized ones.

In the U.S., Federal Housing Administration programs allowed mortgages with only a 3% down payment, while the Federal Home Loan Bank provided multiple subsidies to finance borrowing. In Canada, if a down payment is less than 20% of the value of a home, the mortgage holder must purchase mortgage insurance. Mortgage interest is not tax deductible.

The differences do not end there. A homeowner in the U.S. can simply walk away from his loan if the balance on his mortgage exceeds the value of his house. The lender has no recourse except to take the house in satisfaction of the debt. Canadian mortgage holders are held strictly responsible for their home loans and banks can launch claims against their other assets.

And yet Canada's homeownership rate equals that in the U.S. (Both fluctuate, in the mid to high 60% range.)"

Yes that's the way it should be done! Banks like individuals have skin in the game, simple as that, and they are accountable for it.

As a fact reminder, in the US, one quarter of US household are in negative equity territory.

Update from Reuters on the trend in the US Housing:

"The percentage of American single-family homes with mortgages in negative equity rose to 23.3 percent in the first quarter from 21.4 percent in the fourth quarter, according to the Zillow Real Estate Market Reports."

It doesn't bode well for the American banks balance sheet...

Although during the recession the Bank of Canada reduced its benchmark interest rate to 0.25% and injected liquidity, given the latest price action in the housing market, the authorities are already moving to prevent the bubble to grow and a rate hike is expected in June.

Furthermore, Canada has been hugely successful in reducing its debt burden since 1995.
Canada's debt-to-GDP ratio is now around 53%.
Canada's debt burden has dropped by more than 50 percentage points from its peak in 1995. At that time it was the second-highest in the G8: from 68% in 1995 to about 29% in 2008.

Canada's debt chart 1979 to 2008:

How was this achieved?

By a radical 20% cut in spending imposed by the federal government in the 1990s which led to a cut of 47,000 civil servants jobs.

Canada was at the time close to the brink.

Here are the details of the cuts they proceeded with and what the government of Prime Minister Jean Chretien targeted, as per the following link from an article of The Times from Alexander Frean, Ottawa :

"There were big cuts in fisheries (22 per cent), defence (more than 15 per cent), transport (50 per cent) and international aid (20 per cent) departments but benefits for the elderly increased by 15 per cent over six years and spending on aboriginal peoples and children rose by around 10 per cent."

"They believe that other countries have something to learn from their country’s experience. One said: “Some nations think you cannot just eliminate the public debt. But we have shown that it is possible.” "

It was brutal but it did put the country back in the right direction.

This is what Europe needs to adress in relation to its public finances issues. They need to follow Canada and cut agressively. Spain and Portugal as well as Greece should apply the Canadian recipe. The UK as well would be wise to follow a similar path and the task is truly daunting for the new coalition government.
Ireland, Spain and Portugal are on the right track, Greece is in a difficult position due to a very lax fiscal system and general widespread corruption.
France has hardly started reducing public spending and it is a concern given the last balanced budget was in 1980 and budget surplus was 1976.

The projections for the Canadian Economy going forward are very good as per below's link:

"In 1994, when Canada's deficit peaked before federal spending cuts, including to provincial transfers, started the road to surplus, the only industrialized nation in the world with a worse fiscal picture than Canada was Italy. Canada's debt-to-GDP ratio was over 70 per cent.

In 2009-10, when the deficit hit a record $53.8 billion, Canada had the best record of any nation in the G7 on most economic indicators, including debt-to-GDP ratio.

In 2008-09, the debt-to-GDP ratio was 29 per cent, the lowest in 29 years. It will peak at 35.4 per cent in 2010-11 and then begin dropping again slowly hitting 31.9 per cent in 2014-15."


  1. A lot of the reason why Canada did not experience the same dramatic effect from the recent financial crisis like the U.S. did was because of high commodity prices. Canada is still a resource-based economy - everyone wants what we have at the current moment. Gold is at record highs and oil is at record highs as well as potash and other commodities. If you look at the post chart (Canada's debt chart 1979 to 2008) you will see a spike in the debt to GDP during the mid 90's. The reason for the spike was record low commodity prices. Canada had to issue more debt during the lean commodity years. It was during the mid 90's that the "Tech Boom" was in full force. Investors were not interested in investing in commodities and those valuations tumbled. As China started to demand infrastructure, the demand for commodities grew along with it - thus higher commodity prices. Canada does have a decent banking system, but there are many dangers on the horizon. The Canada consumer debt rate is a growing concern. If commodity prices start to tumble, Canadians will not be able to service debt ratio. The U.S. is forecasted to be the largest producer of oil by 2015. This increase in American oil production will reduce demand for Alberta oil. Canada did manage to evade an out and out meltdown during the last downturn, but it is not out of the woods yet.

    1. Very interesting comment, thanks for your input. You are indeed raising very valid points.




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