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Latest interest rate hike exposes hard truth in mortgage market

You don't have to be an economist to know rising interest rates will hurt a lot of Canadians, says strategist Robert McGarvey

Over the past few months, the Bank of Canada has faced a terrible dilemma: keep interest rates low or raise them to combat potential inflation.

It seems the decision has been made: on July 12, the bank raised interest rates for the first time since the 2008 financial crisis, from 0.50 per cent to 0.75 per cent. On Sept. 6, the federal bank announced it would increase the overnight rate once again, to 1 per cent. 

If this is the start of a trend and not a temporary aberration, then Canadians can expect considerably higher borrowing costs in future.

You don’t have to be an economist to know that rising interest rates will hurt a lot of Canadians. And you don’t have to be a sociologist to know that, demographically, young families are going to be hurt the most.

Many economists believe the bank created the debt problem. Canadians have been on a debt binge since interest rates dropped to near zero after the financial crisis of 2008. The total debt-to-gross-domestic-product (GDP) ratio in Canada has increased to more than 350 per cent. In other words, Canadians are up to their eyeballs in debt.

There’s also been a considerable rise in government-related debt.

And a lot of debt is being used for consumption. Canadians keep spending whether or not they have income to support their lifestyles.

However, the largest part of the debt is the result of the out-of-control housing market.

According to Deutsche Bank, the Canadian housing market is wildly out of sync with Canadians’ ability to pay. It put the housing market overvaluation at 63 per cent. The Economist has similar fears about Canada’s housing market, which it estimates is 75 per cent overvalued when compared with rents.

There are two main causes of this distortion in the housing market. Yes, ultra-low interest rates contribute to the problem. But foreign buyers (mostly Asian) are driving up prices in key urban centres. Foreign buyers have been particularly active in the Vancouver and Toronto real estate markets.

Foreign cash flows

Why are foreign buyers buying property in Canada?

Consider China. Many Chinese families have accumulated considerable wealth through the economic revolution that Chinese authorities call “market socialism.”

But China’s government remains stridently communist and authoritarian. Whatever the internal virtues of this one-party state, China is seen by many of its own citizens as a dangerous place to keep their money.

So sensible Chinese families are getting their money out by any means possible and investing in more stable economies like Canada’s.

What was a trickle of foreign investment a decade ago has become a flood. By some estimates, China will export more than $1 trillion of real-estate-bound investment in the next decade. Roughly 10 per cent or $100 billion of this is earmarked for Canada.

Massive foreign investment distorts the domestic housing market, imposing double-digit inflation on housing in largely stagnant economies. And this forces buyers (young first-time buyers in particular) to assume vastly greater debt than they otherwise would have to.

Up to 25 per cent of present mortgage holders would lose their homes if interest rates returned to historical norms. A majority of young first-time homebuyers would be severely compromised by rate rises. And unlike in U.S. property markets, a mortgage in Canada is recourse, which has to do with which assets a lender can go after if a borrower fails to repay a loan; in other words, you can’t just walk away from an underwater mortgage.

How did such a dangerous situation come to pass?

There are some fundamental flaws in our economic thinking. Apart from seriously unbalanced international trade deals, the Bank of Canada is accepting the false logic that raising interest rates is the best way to head off inflation.

This mistake could trigger a recessionary spiral that rapidly gets out of control.

Many young Canadians have bought into the homily that if they get a university education, they’ll be on their way to middle-class respectability.

They’re about to discover that that respectability comes with massive student debts and, presuming they want to buy a house, an enormous (and potentially fatal) home mortgage.

The cycles of crisis in modern capitalism are as regular as clockwork. It’s a myth that we’ve solved them.

Regrettably, thanks to the Bank of Canada, the most highly educated generation of young people in our history is about to discover that truth the hard way.


- Robert McGarvey is chief strategist for Troy Media Digital Solutions Ltd., an economic historian and former managing director of Merlin Consulting, a London, U.K.-based consulting firm.