Wednesday, February 09, 2011

Roubini Global Economics - Will New Regulations Bring Continued Rebalancing for Canadian Housing?

RGE's Wednesday Note - Will New Regulations Bring Continued Rebalancing for Canadian Housing? - February 9, 2011
By Tetiana Sears and Rachel Ziemba

Though Canada managed to avoid a U.S.-style housing crash, the Great White North may face its own set of difficulties, as the same ample credit extension, low interest rates and government incentives that helped the housing market rapidly recover the losses incurred during the 2008-09 downturn are contributing to increased household indebtedness, which we note in our latest North America Focus. The ratio of debt to disposable income reached a record high of 148% in Q3 2010. As underlying macroeconomic trends (e.g., the open output gap and weak core inflation) warrant an extended pause in the Bank of Canada’s tightening cycle, Canadian authorities have turned to regulatory means to dampen excessive credit practices and ultimately decrease households' vulnerability to rising debt service payments.

To this end, in January the Canadian Department of Finance announced new regulations for mortgages, including a reduction in the maximum amortization period to 30 from 35 years for government-insured mortgages with a loan-to-value ratio greater than 80% and a reduction in the maximum size of a home equity loan to 85% from 90% of the property value. The government also restricted its support for home equity lines of credit (HELOCs) to safeguard its balance sheet from any future problems with structured products. This course of action, which follows similar measures in early 2010, was taken to encourage Canadians to maintain equity in their homes and limit the creation of debt-backed products by keeping them off of the public balance sheet.

The shortening of the amortization will raise the qualifying income of those seeking mortgages approved by the Canada Mortgage and Housing Corporation (CMHC), and some homebuyers (mostly first-time) will be priced out of the market or will choose a more affordable house. The reduction in the HELOC should temper renovation activity and spending on durable goods, dampening consumption. Although the total impact of the new regulation will only be marginal, it will contribute to a decrease in housing demand through this year, along with slower job growth and higher debt-servicing costs. All in all, the softening of the housing market could be a drag on economic growth.

The most recent Canadian housing data (housing starts for January and building permits for December) suggest that Canadian homebuilding activity is stabilizing at the levels of late 2010 as domestic, U.S. and global momentum combine to help bring the market in for a soft landing. This week’s data on new-home construction continued to build on our base case scenario, given stricter lending standards and mortgage origination rules in Canada. Although we don’t see any evidence of a sharp correction, there are risks of some volatility in the housing market in coming months as new mortgage regulations are implemented in March. Despite this likely transitory increase in mortgage applications, the broader trend of cooling housing market activity appears to be well entrenched. Although both new and existing home sales picked up in Q4 2010, the overall pace has notably moderated from late 2009-early 2010. Higher prices, rising debt and slow growth in wages will keep trends modest.

Canada’s growth momentum picked up in late 2010, along with growth south of the border, as exports and mining demand and services picked up. Labor market data, a lagging indicator, suggest that this stronger momentum could carry into Q1, posing upside risks to RGE’s current forecast of 2.3% growth for 2011. Should economic growth surprise on the upside, housing market activity could be more resilient.

Stronger growth would remove support for the central bank’s dovish bias and suggests that the gradual increase in benchmark and long-term interest rates would boost debt service costs. On balance, rising debt payments will be only partly offset by income growth as debt is outpacing wage growth, and we expect that January’s job gains are not sustainable. As the Canadian economy faces these opposing forces, housing market activity should continue to rebalance and is likely to stabilize in the latter part of 2011 at a pace of growth lower than that of 2010. Regulators have to hope the pace remains gradual.

Canadian policy makers are by no means the only ones struggling with the dilemma of whether to worry about frothy asset markets. Capital flows into many emerging market economies, particularly in Asia, have stoked domestic housing markets—with dollar-pegged and RMB offshoring epicenter Hong Kong particularly affected. Other advanced economies, like the Nordics and Switzerland (which have stronger balance sheets than the eurozone periphery) have also experienced strong housing price appreciation, as RGE noted in a recent Europe Focus. They have attracted significant capital inflows during the economic recovery, and the well-capitalized banks took advantage of low interest rates to increase lending, supporting the recovery of the housing market and domestic demand.

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