Rejecting Canada's rates conundrum

Not so fast with the rate cuts, says ex-RBA board member Warwick McKibbin... he's worried if Glenn Stevens and the board cut rates today, Australia won't have enough bullets left in the gun if the economy starts to seriously slide.

If McKibbin wanted an example of a country with few bullets left in its gun, and to bolster his case for keeping a loaded weapon, he could have looked to Canada.

Canada entered the 2008 financial crisis in similar interest rate territory to that which Australia finds itself in at the start of an uncertain 2012. Canada's benchmark interest rate in January 2008 was 4.25 per cent – the same as the RBA's rate (this morning). Within 17 months, the Bank of Canada had carved its rate down to 0.5 per cent.

Though the deep rate cuts were among several key factors that contributed to Canada's stability through the worst of the 2008-2009 financial crisis, the country has paid a steep price. Canadians are staring at the possibility of a renewed crisis with little remaining leverage and a fear of what will happen when rates inevitably creep higher for a population struggling to service existing debts even at bargain interest rates.

Household debt levels in Canada have risen to 152.98 per cent of disposable income, up from 146 per cent in 2010 and up 40 per cent in the past decade. Those debt levels are beyond those in American and British households, and slightly higher than those in Australia.

Canada's central bank chief, Mark Carney, has estimated that roughly one in 10 Canadians are spending more than 40 per cent of income on servicing debt. He has repeatedly warned that Canadians have been over-capitalising on a low-interest rate environment.

The fact that Canadian home buyers are being offered five-year mortgage rates of 2.99 per cent, with only a five per cent down payment, has not exactly discouraged Canadians from taking on debt at unsustainable levels.

Yet Canadians have been comfortable taking on extra debt because – amongst other positive factors – average house prices have risen 85 per cent since 1998. Now, with its ratio of house prices to income at 30 per cent above its historical average, the Canadian housing bubble alarms are increasingly being rung.

BoA Merrill Lynch recently warned that rock-bottom interest rates were the only factor propping up Canada's rising home prices and that under normalised interest rates home prices would by 25 per cent overvalued.

In comforting contrast to Canada, Australia has leverage to lower rates to help the country respond to an economic storm or help prop up the housing market.

On the other hand, Canada has a one per cent benchmark rate, and predictions of rates as low as 0.25 per cent by the end of 2012, leaving its central bank with little room to respond to soaring household debt, an increasingly overinflated housing market and questions about the impact of the eurozone debt crisis.

The case for RBA rate cuts has been made. But the conundrum that has handcuffed Canadian policymakers may give pause to any Australian politician or economist lobbying for a lower interest rate environment, and perhaps bolster Professor McKibbin's calls for caution.

Christopher Mason is a Toronto-based journalist and staff reporter for Business Spectator.