“The most important domestic financial system risk is the inability of highly indebted households to service their debt in the face of a sharp decline in their incomes, leading to a large and widespread correction in house prices,” the central bank wrote in its Financial System Review, released Wednesday. “This risk continues to be rated as ‘elevated.’”
While the probability of the risk occurring, the results would be severe for the economy, according to the BoC.
“The most likely trigger for this risk is a negative foreign demand shock, or a combination of shocks, that leads to a severe recession in Canada and a sharp rise in the unemployment rate,” the bank wrote. “While the recent fall in commodity prices has had a negative effect on the Canadian economy, it is likely that a larger shock would be needed to trigger this risk. Alternatively, the risk could be triggered by a rise in unemployment that is caused by a surge in global long-term interest rates.”
A drastic increase to long-term interest rates was also discussed as a potential threat to the Canadian economy.
“This could then lead to higher risk premiums and decreases in asset prices that could be exacerbated by liquidity constraints,” the BoC wrote. “The effects of these international developments would be rapidly transmitted to Canada through its strong links to global financial markets, as well as through trade and confidence channels.”
One of the biggest risks to Canada’s economy is household financial stress and the possibility of a sharp housing price correction, according to the Bank of Canada.