Canadians’ level of indebtedness is raising concerns on the basis of several traditional measures, but the most reliable predictor of trouble ahead is the debt-service ratio, says a new report from the C.D. Howe Institute.
In Predicting Financial Crises: The Search for the Most Telling Red Flag in the Economy, authors Jeremy Kronick and Steve Ambler point to debt servicing as an improvement over traditional credit measures in predicting future economic growth and financial crises.
Using a new financial vulnerabilities barometer, the authors show that that inclusion of household debt servicing considerably improves the barometer’s ability to track financial vulnerability, particularly in advance of recessions. In contrast to the Bank of Canada’s financial vulnerability barometer, their index declines sharply after the Great Recession and, while there is some indication that debt servicing is on the rise, financial risks remain low.
“By focusing on debt servicing rather than debt, the barometer appears to yield fewer false positives than the Bank of Canada’s barometer,” write Kronick and Ambler.
The authors suggest that the relationship between debt servicing and both financial crises and economic growth is statistically significant. Increases in new borrowing lead initially to a mild increase in economic activity and a significant reduction in the probability of financial crises, but they subsequently lead to a gradual increase in households’ debt service burden (the sum of principal and interest payments on their outstanding debts), expressed as a ratio of disposable income, which has a significantly negative impact on economic activity and a significantly positive impact on the probability of financial crises.
Kronick and Ambler’s findings have policy implications for both the conduct of monetary policy and financial sector regulators, and they encourage empirical models of financial system vulnerabilities to put more weight on the evolution of debt-service ratios and other indicators related to debt servicing.
“Regulators concerned with the housing market and overall financial stability should look beyond traditional credit-to-GDP measures, which were always going to increase in a low interest rate environment, and closely monitor the behaviour of debt servicing,” conclude Kronick and Ambler. “This will result in a more accurate risk assessment.”
Jeremy Kronick is Associate Director, Research, at the C.D. Howe Institute.
Steve Ambler is Professor of Economics, Université du Québec à Montréal. He is the David Dodge Chair in Monetary Policy at the C.D. Howe Institute.