Credit Canada

By: Eric Beauchesne and Anne Howland

Canadian households are so burdened with debt that any significant rise in interest rates could increase personal bankruptcies at a pace not seen in five to 10 years, according to an economist echoing similar warnings from the Bank of Canada.

CIBC World Markets economist Benjamin Tal, who regularly analyzes consumer investment and spending, warns it would take only a one-percentage-point jump in rates to start exposing cracks in the seemingly solid financial situation many households enjoy.

"The implications of the credit boom of the last five, six or seven years is that we have a generation of borrowers that has never experienced high interest rates and, therefore, people have been borrowing much more.... As a society, we have become more vulnerable to the risk of higher interest rates," Mr. Tal said.

Canadians will likely feel some pain from next week's widely expected quarter-point rate hike by the Bank of Canada, which will trigger increases in variable-rate mortgages, the prime business lending rate and lines of credit, he said.

"So we will see ... probably a very moderate increase in [payment] delinquencies," he said. "If interest rates went up [a full percentage point], it would be a totally different story. That's where we would see much more significant pain, a significant slowing in credit growth and an increase in bankruptcies."

There are few easy answers for Canadians saddled with variable-rate debt products, such as a mortgage, which will be immediately affected by interest rate hikes, said Laurie Campbell, executive director of Credit Canada.

While consumers carrying debt with a fixed interest rate, such as a credit card, will not feel the heat of rising interest rates in the short term, those with variable-rate debt, such as loans pegged at prime-plus, will be the first to feel the pinch, she said.

"The unfortunate reality is that many Canadians are living far beyond their means," she said.

Because many of the variable-rate debt products are already at a low rate, it is difficult for consumers to take steps to lessen the impact of rising rates, Ms. Campbell said.

"There's no easy answer. These are already low-interest products," she said. "There's no lower [rate] vehicle to go to."

A recent CIBC World Markets report noted that household credit is rising by about 10% on a year-over-year basis.

During the first three months of 2007, household debt rose 2.7% while personal disposable income increased 2.0%, it said.

"Even more importantly, the number of proposals for personal bankruptcies -- a possible signal of increased bankruptcies down the road -- is now rising by 14.9% on a year-over-year basis, the fastest pace since the 2001 recession," Mr. Tal wrote in another report, released yesterday.

The combination of higher rates, a softer labour market and a strong dollar mean "the likelihood is that the coming six to 12 months will see a gradual -- albeit modest -- rise in the number of bankruptcies," Mr. Tal wrote.

Quebec and Ontario will be the hardest hit, he added.

The Bank of Canada has already noted the impact of debt on consumers, but households may be even more vulnerable than the central bank suspects, private sector analysts suggest.

"[The bank's] simulation exercise suggests that the household sector is becoming more vulnerable to shocks over time," the Bank of Canada said in its latest financial system review.

"These simulations also suggest that some vulnerabilities could build up in the household sector if interest rates were to rise significantly."

"Significantly" would suggest a sustained increase in the trend-setting overnight target rate to around 6%.

However, Mr. Tal doubts rates will rise that much.

"The Bank of Canada will not take interest rates too high because it knows it would be risking taking the consumer down," he said.

Also, the dollar will probably rise as rates do, acting as a dual-braking system on the economy and inflation, he added.

BMO Capital Markets economist Douglas Porter wrote in a report yesterday: "After a year in neutral, the Bank of Canada appears poised to shift back into tightening gear next week and will likely come back for more in September."

The key overnight rate is widely expected to be raised 25 basis points to 4.5% on Tuesday, the highest in six years and up two percentage points from just two years ago, Mr. Porter noted.

"The bank's expected return to the global tightening parade marks a dramatic about-turn from just four months ago, when speculation was running rampant that the next move would be a cut," he added.

* Material reprinted with the express permision of: "National Post Company", a CanWest Partnership.