The financial picture for Canadian households and businesses was showing signs of increased health until the United States started a trade war, the Bank of Canada said on Thursday.
The central bank says in its latest Financial Stability Report that at the start of the year, households had, on average, less debt relative to their income than a year earlier, while insolvency filings by businesses had dropped significantly.
“The country’s financial system has faced unprecedented shocks in recent years, and it has proven resilient,” said governor Tiff Macklem in prepared remarks on the report.
“But proactive steps taken by households and businesses, together with substantially lower interest rates, put the system on a more resilient footing heading into 2025.”
However, the U.S.-instigated trade war has pushed risks higher overall, said Macklem.
“The Canadian economy and financial system face a new threat. U.S. trade policy has taken a dramatic protectionist shift. Tariffs and uncertainty have sharply reduced prospects for global economic growth,” he said.
“A long-lasting trade war poses the greatest threat to the Canadian economy,” he said, warning about both near-term market volatility and more medium-term risks of a prolonged trade war, including reduced growth and increased unemployment.
Mortgage holders could fall further behind if tariffs last
There’s tremendous uncertainty as to the future direction of tariffs, but in a scenario where they remain for some time, the Bank of Canada sees the potential for Canadians to fall behind on mortgage payments at levels not seen in a generation.
In its scenario, which the central bank emphasizes is not a forecast, an extended trade war could cause mortgage arrears to top 0.5 per cent — higher than what happened during the 2008-09 global financial crisis, though still below the more than 0.6 per cent seen in the 1990s.
Government supports could help lessen the impact, but it’s not yet clear how widely or generously those might be.
A stress-test scenario on Canada’s financial system by the International Monetary Fund, included in the bank’s report, uses a more extreme scenario. While the Bank of Canada’s own risk scenario sees a recession lasting four quarters, which is roughly in line with the 2008-09 and the 1990-91 recessions, the IMF scenario tests against seven quarters.
Under its scenario, the IMF saw the potential for GDP to fall 5.1 per cent, unemployment to peak at 9.2 per cent, house prices to drop 26 per cent and equities to fall 36 per cent, peak to trough.
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The potential outcomes are a sharp contrast to how the financial picture was looking at the start of the year.
The Bank of Canada notes that while there has been heightened concern in recent years about the wave of mortgages coming up for renewal at higher rates, the shock is looking smaller than it did at the end of 2023.
A sharp drop in interest rates in 2024 means payments are not expected to rise as much as feared, declining to an average of a roughly eight per cent rise at renewal in 2025 and five per cent in 2026, compared with the more than 14 per cent and 11 per cent, respectively, expected in last year’s Financial Stability Report.
Many homeowners have also seen their incomes rise, and property values increase, leaving the overall Canadian ratio of household debt to disposable income at 173 per cent at the end of 2024, down from 179 per cent at the end of 2023.
Non-financial businesses also remain in good financial health, the bank said, noting a spike in insolvencies following the end of government supports was short-lived.
It says that until the sharp increase in market volatility at the start of April, the issuance of new debt was strong and the cost of financing remained low.
Non-mortgage holders have high credit, auto loan debt
While lower interest rates have helped boost the resilience of businesses and those with mortgages, non-mortgage households still show rising signs of economic stress.
The report shows that for those households, both credit card and auto loans more than 60 days behind in payments have surpassed pre-pandemic levels, and have risen above historical averages.
“The share of households without a mortgage that are behind on credit card or auto loan payments has continued to increase,” said the Bank of Canada’s deputy governor Carolyn Rogers.
That’s in contrast to households with mortgages, where payment arrears on both remain below historical averages.
Canadians overall still have high debt levels compared with historical standards, creating elevated risks if the trade war persists, especially for those more exposed to trade.
The Bank of Canada says loans to households or businesses in trade-sensitive industries or regions represent about 15 per cent of assets of banks in Canada, but that the knock-on effects of an economic slowdown could hit a wider range of industries and workers.
Canadian banks are well-positioned, however, to absorb higher losses, thanks to higher capital buffers and provisions for credit losses, the central bank said.
The Bank of Canada said the financial system as a whole also remains resilient, but vigilance is needed given the risks.
“There are many uncertainties,” said Macklem. “We still do not know what tariffs will remain, whether they’ll be reduced or escalated, or how long all of this will last. That makes it particularly difficult to anticipate the risks to the financial system.”