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CURRENT ANALYSIS
July 2012
Canadian household finances: more to it than just debt
Chart 1
Vulnerable households
% of households with total debt service ratio (interest and principal payments) >40%
10
9
8
7
6
5
4
3
2
1
0
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
The rapid and persistent increase in household debt in the past decade has produced considerable concern about the overall vulnerability of Canadian households to adverse economic shocks, such as significant declines in home values,
sharp increases in interest rates, or a jump in unemployment. Elevated debt
loads create risks for the macroeconomy; however, equal focus should be given
to the asset side of the household balance sheet that accounts for a far larger
chunk of household financial position. This note aims to provide a broader approach to analyzing Canadian household balance sheets in an effort to better
understand the overall financial health of Canadian consumers.
Source: Ipsos Reid Canadian Financial Monitor, RBC Economics Research
Household debt is at an all-time high…
Chart 2
Household debt service ratio
Mortgage & nonmortgage interest payments as a % of personal disposable income
11
10
Debt service ratio
9
Long-term average
8
7
6
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
2012
Source: Statistics Canada, RBC Economics Research
Chart 3
Estimated mortgage payments
% of personal disposable income
60
55
50
Estimated mortgage payments
45
Long-term average
40
35
Elevated credit balances have been called the “biggest domestic risk” to the
Canadian economic outlook by the Bank of Canada1. High debt levels increase
households’ vulnerability to adverse macroeconomic shocks, and the central
bank is concerned about the implications for the financial system if such events
materialize. Even if the economy does not encounter another negative shock,
though, there are questions about how much consumers will cut back on spending as interest rates rise or the value of real estate assets stabilize. Such a pullback in household spending has significant implications for the outlook given
that consumer expenditure accounts for roughly 60% of total output in the
economy. The high level of debt that is held has increased the degree of financial stress on households in recent years, thereby making a larger share of them
more vulnerable to adverse economic shocks (Chart 1) and has raised the risks
that some consumers will not be able to meet their financial obligations over
time. Large-scale loan delinquencies, defaults, or related consumer bankruptcies would have significant implications for the financial system and the economy, as was seen in the recent US financial crisis.
…but debt-servicing costs are historically low
30
25
20
1980
1982
1984
1986
1988
1990
1992
1994
1996
Source: Statistics Canada, Bank of Canada, RBC Economics Research
David Onyett-Jeffries
Economist
(416) 974-6525
[email protected]
1998
2000
2002
2004
2006
2008
2010
2012
Despite debt rising to all-time highs, Statistics Canada’s debt-service ratio
(calculated as interest payments on mortgage and non-mortgage debt as a percent
of personal disposable income) was 7.3% in the first quarter of 2012, holding
around the general level that has prevailed since the middle of 2009 and below
the series’ long-run average of 8.1% (Chart 2). While these data incorporate only
interest payments and thus neglect the repayment of principal, broader definitions
of debt-servicing costs show similar trends. Our estimated mortgage-payment
costs (interest and principal) as a percent of personal disposable income (PDI)
indicate that despite the increase in average home prices (therefore, larger mortgage balances), the cost of carrying a mortgage is modestly below the estimated
historical average (Chart 3). Thus, while there are historically elevated levels of
debt in the economy, the benign interest-rate environment and sustained income
growth means that households are not being overwhelmed by required debtservice payments.
CURRENT ANALYSIS | JULY 2012
Asset values provide more than a counterbalance
Chart 4
Household assets & liabilities
$Trillions, end of period
9
8
7
6
Total assets
Total liabilities
5
4
3
2
1
0
1970
1974
1978
1982
1986
1990
1994
1998
2002
2006
2010
Source: Statistics Canada, RBC Economics Research
Chart 5
Household asset composition
% of total household assets
70
65
With so much focus on debt, the asset side of the balance sheet often is overlooked. Household asset values totalled $8.1 trillion in the first quarter of
2012, approximately five times that of total liabilities (Chart 4). Furthermore, while much has been made about debt reaching record-high levels,
assets values too touched all-time highs in the first quarter of 2012 thus more
than fully recovering from the weakness seen in the middle of last year. The
recent winter edition of the quarterly Bank of Canada Review2 noted that
rising asset values, in particular those for real estate, “can facilitate the accumulation of debt.” This asset-supported debt growth occurs through two
main channels: 1) as house prices rise, households take out larger mortgages
in order to finance the purchase of their homes (assuming the down payment
as a percentage of the purchase price remains unchanged), or 2) households
withdraw a portion of the accumulated equity in their real estate assets
through credit facilities that use home equity as collateral (i.e., home equity
lines of credit).
60
The high level of assets insulates households from negative shocks because
it is possible that when individuals face an adverse economic shock, such as
job loss, they could meet their financial obligations through the liquidation
of their assets. Thus, assets can serve to improve consumers’ solvency and
warrant consideration in assessing the risks arising from household debt.
55
50
45
40
35
Nonfinancial assets
Long-term average
Financial assets
Long-term average
30
1970
1974
1978
1982
1986
1990
1994
1998
2002
2006
2010
Changing attitudes toward risk
Source: Statistics Canada, RBC Economics Research
Chart 6
Household asset returns
% change, quarter-over-quarter
8
6
4
2
0
-2
-4
-6
Financial assets
Nonfinancial assets
-8
1990
1992
1994
1996
1998
2000
2002
Source: Statistics Canada, RBC Economics Research
2004
2006
2008
2010
2012
The appreciation of home prices in the last decade combined with increasing
rates of homeownership have placed added weight to real estate3 holdings
within household-asset portfolios and has resulted in a rising share of total
household assets comprised of non-financial assets (of which real estate
dominates). The current portfolio allocations of 55% financial assets and
45% non-financial assets are in line with those seen in the late 1980s and
early 1990s, and are better balanced than was seen at the beginning of the
2000s (Chart 5). This diversification mitigates the effect of an isolated shock
to either housing or financial markets. The rebalancing of portfolios during
the last decade reflects the combination of the prolonged upswing in the
housing markets fuelled by falling costs of borrowing with the steep correction in equity markets following the bursting of the technology bubble in the
early 2000s. This rebalancing has helped to bring household portfolio allocations back in line with longer-term trends.
The diversification of household assets is important in managing household
portfolio risk. Historically, the relationship between the return4 on household
financial and non-financial assets has been fairly weak, with the correlation
between quarterly returns of each asset class since 1990 only 0.14 (Chart 6).
Furthermore, as evidenced by Chart 6, returns on non-financial assets historically exhibit far less volatility than those on financial assets, thereby suggesting that increasing holdings of real estate assets lower the overall volatility of household-asset portfolios.
Another recent trend within aggregate-portfolio allocations has been to shift
away from low-yield, though relatively safe, financial asset classes. In par-
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CURRENT ANALYSIS | JULY 2012
ticular, relative holdings of cash and deposits, and fixed-income assets have
declined fairly steadily (down to 25% and 2% of financial assets, respectively, from 35% and 15%, respectively, in the early 1980s—Chart 7). While
this likely reflects the generally declining interest-rate environment for the
last two decades (and thus lower interest earned on deposits and fixedincome securities) that in turn reflects a lowering of underlying inflation, the
decreased allocation to safe and liquid cash holdings means that households
have a smaller buffer of readily available funds to lean on in the event of
adverse economic shocks that require fast access to funds.
Chart 7
Household financial asset composition
% of total household assets
80
70
60
50
40
30
20
10
0
The offset to this decline in historically less-risky asset balances has been an
increase in more volatile financial assets. Equities (direct holdings of shares)
and life insurance and pension assets (which largely represent indirect holdings of securities via investment funds5) account for approximately 75% of
total financial assets compared to just over 50% in the early 1980s. The increased (direct and indirect) share of assets invested in equity markets and
the corresponding decreased holdings of cash and fixed-income assets are
raising household exposure to financial market risk, thereby boosting overall
volatility of portfolios. As a result, while the portfolio diversification between financial and non-financial assets reduces portfolio volatility, the increased exposure to risky financial assets has resulted in asset portfolios becoming more vulnerable on net to adverse market movements (Chart 8).
1970
1974
The increased volatility in household-asset values consequently raises the
volatility of household net worth6. This fact was highly evident in the recent
economic downturn when Canadian households lost $535 billion (9.0%) of
aggregate net worth as falling financial and real estate markets ate away at
household balance sheets. When adjusting the impact of inflation and population growth, this decline was even more pronounced, with per capita real
net worth falling 10.2%. In comparison, the fallout from the technology bubble in the early 2000s produced a smaller peak-to-trough decline in real per
capita net worth of 9.2%.
1982
1986
1990
1994
1998
Long-term average
Equities, life insurance & pensions, other investments
Fixed-income assets
Long-term average
Long-term average
2002
2006
2010
Source: Statistics Canada, RBC Economics Research
Chart 8
Household asset return volatility
Rolling 10-year standard deviation, %
5.0
4.5
4.0
3.5
Trend volatility
3.0
2.5
2.0
1.5
1.0
0.5
0.0
1980
The effect on wealth
1978
Cash & deposits
1983
1986
1989
1992
1995
1998
2001
2004
2007
2010
Source: Statistics Canada, RBC Economics Research
Chart 9
Real household net worth per capita
Thousands of 2002$ per person aged 15+, end of period
200
180
160
140
120
100
80
60
40
20
0
1980
While the recent decline represented a significant deterioration of household
finances, the silver lining is that this loss occurred from an all-time peak level
of household net worth, which stood 75% higher than levels seen at the beginning of the 1990’s when adjusted for both population growth and inflation
(Chart 9). Further, the increased exposure to equity markets helped households
recoup the lost net worth in its entirety by the first quarter of 2010 and moved
to a high watermark in the first quarter of 2011 as equity markets bounced
back. After financial market weakness weighed on aggregate net worth in the
middle of 2011, it recovered over the subsequent two quarters and sat at a record high of $6.5 trillion in the first quarter of 2012. On a real per capita basis
net worth in early 2012 remained modestly below its all-time peak but was
7.3% above the recessionary trough seen at the beginning of 2009.
1984
1988
1992
1996
2000
2004
2008
Q1-2012
Source: Statistics Canada, RBC Economics Research
Chart 10
Household investment
Net investment in financial & nonfinancial assets as a % of personal disposable income
30
25
20
15
10
5
0
1970-1979
1980-1989
1990-1999
2000-2011
Source: Statistics Canada, RBC Economics Research
Changing approach to building wealth
Another factor that is influencing household net worth dynamics relates to
how households are accumulating their wealth. Net worth can increase either
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CURRENT ANALYSIS | JULY 2012
through saving and investing in assets, or via an appreciation in the value of the assets already held by households. Chart 10 indicates
that the net investment7 in financial and non-financial assets relative to PDI has steadily declined in the last four decades. This trend
indicates that households are allocating smaller proportions of income toward saving, thereby suggesting that investment has been
playing a generally diminishing role in household net worth accumulation. This in turn suggests that Canadian households are increasingly relying on capital gains (both realized and not) accruing from financial and non-financial asset holdings instead of ongoing purchases of assets. While this approach to building wealth is successful in an environment of sustained asset-price appreciation,
it raises some concerns about the overall sustainability of household net worth growth going forward. In particular, we are entering a
period in which real estate markets are broadly expected to cool following almost a decade of price escalation. If household real estate values are little changed while mortgage debt outstanding continues to expand8 (as is our base forecast for the next two years),
then this would necessarily imply a decline in homeowners’ equity9 and a negative hit to overall net worth. Furthermore, in the event
that real estate values were to decline, the presence of debt amplifies the overall effect: a 10% decline in home values would translate
into a 15% decline in homeowners’ equity (assuming mortgage growth is flat) and a 5% decline in overall household net worth before even considering any effect from the likely adverse price movements in financial markets.
A broader approach to the outlook for household finances
Household debt is historically elevated, and while we anticipate that the pace of debt accumulation will continue its recent moderating trend in the near term, these balances are expected to continue to expand, though growth in incomes will see the debt-to-personal
disposable income ratio stabilize. The cost of servicing the debt, however, remains manageable currently, and even when we incorporate our forecast that the Bank of Canada will raise the overnight rate by 100 basis points by the end of 2013, debt-service costs
will remain historically low. As well, to this point, household-asset balances have increased at a greater rate than that of liabilities
outstanding, thereby supporting growth in net worth and greatly enhancing the solvency position of households by establishing a
sizeable financial cushion. These factors serve to mitigate greatly the risks arising from debt and support the view that households
are in better financial shape than the debt alone would suggest.
There are, however, concerns regarding the asset side of the balance sheet. The increasing exposure of households to riskier financial
assets has increased overall portfolio volatility and made net worth more susceptible to swings in financial markets. Given the current heightened level of uncertainty surrounding the global economic outlook, this suggests that households may be in for a fairly
bumpy ride in the near term. As well, while we do not expect any significant declines in home prices in Canada, the generally flat
values mean that the non-financial components of the balance sheets are not likely to do much heavy lifting in supporting net worth
growth in the near term. Furthermore, continued volatility of net worth growth will likely serve as a factor somewhat limiting the
pace of personal expenditure growth during our forecast horizon as households weigh the potential need to rebuild savings. Gradually improving labour market conditions and an attendant decline in the unemployment rate are expected to keep incomes growing at
a sufficient pace that even as interest rates gradually increase, consumer spending will post a solid, if unspectacular rise, for the remainder of this year and into 2013.
Notes:
1.
http://www.bankofcanada.ca/wp-content/uploads/2012/06/fsr-0612.pdf
2.
http://www.bankofcanada.ca/wp-content/uploads/2012/02/review_winter11-12.pdf
3.
Real estate includes residential structures, non-residential structures and land, and accounts for the bulk of non-financial asset holdings.
4.
The return of household assets is estimated using the asset values from the National Balance Sheet Accounts and the Financial Flow Accounts data. The appendix to this note provides an explanation of the calculations.
5.
National Balance Sheet Account data indicate that fixed-income assets currently represent 40% of total assets of insurance and pension
funds (CANSIM table 378-0096), which is down from 67% in 1990. Despite the high allocation to fixed-income assets, the quarterly change
in the market value of life insurance and pension assets on household balance sheets has a correlation coefficient of 0.89 with equity market
returns, thereby leading to their inclusion in the “more volatile” financial asset class.
6.
Net worth is defined as the difference between household assets and liabilities. The value of liabilities outstanding is not affected by market
movements, instead only changing when liabilities are incurred or repaid.
7.
Net investment is the difference between asset purchases and asset sales.
8.
Such an environment could occur when mortgage-financed investment in real estate offsets depreciation and prices hold steady.
9.
Homeowners’ equity is the difference between the value of household residential real estate assets and mortgage debt secured against
those assets.
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CURRENT ANALYSIS | JULY 2012
Appendix
Statistics Canada’s National Balance Sheet Accounts (NBSA) provide a breakdown of the aggregate values of asset balances and
liabilities outstanding for households and the unincorporated businesses on which they hold residual claims. The NBSA represent a
snapshot of financial position at a point of time (specifically the end of a calendar quarter or year). These data, however, do not, in
themselves, provide a sense as to how the stocks of assets and liabilities evolve over time; they merely indicate aggregated net changes.
In order to get a better sense of the flows to and from Canadian household balance sheets, the NBSA can be integrated with Statistics
Canada’s Financial Flow Accounts (FFA). The FFA include estimates of net investment in financial and non-financial assets
(purchases less dispositions), asset depreciation, and transaction in financial liabilities. Using the following accounting identity:
End of period assets = start of period assets + net investment – depreciation + valuation change
these data can be combined to provide an estimate of the effect that the change in the value of the assets on the balance sheet and thus
allow for an indication of the financial returns earned on asset holdings as follows:
Valuation change = end of period assets – (start of period assets + net investment – depreciation)
Chart A.1 shows the estimated annual breakdown of the dollar change in total household assets by component.
Chart A.1
Household asset balance changes
$billions
800
600
400
200
-200
Valuation change
-400
Net investment
Depreciation
-600
1971
1975
1979
1983
1987
1991
1995
1999
2003
2007
2011
Source: Statistics Canada, RBC Economics Research
The “valuation change” component is used to calculate the returns and volatility of returns in the discussion in this note. Given that the
timing of the investment inflows are not known specifically, the simplifying assumption is made that the net investment occurs at the
beginning of the period while the depreciation occurs at the end. The percentage return, therefore, is calculated as follows:
Asset % return = (valuation change) / (start of period assets + net investment) x 100%
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