The Bank of Canada Warns Canadians over the Threat of ‘Euro Crisis’ Spill Over

{This is a guest column by freelance writer Joanna Hayward. It provides a very good concise description of the euro crisis and what it means for Canadians--MC}

Last week, in the run up to G20, the Bank of Canada issued a stark warning concerning the potential impact of the deepening European financial crisis upon the Canadian economy. The bank, which has systematically raised concerns in relation to Canada’s inflated house prices and domestic borrowing rates, stated that:

‘If sovereign debt in Europe continues to intensify, it would further weaken global economic growth and prompt a general retrenchment from risk. In turn, the weaker global outlook would fuel sovereign fiscal strains and impair the credit quality of loan portfolios’.

‘Together these factors would increase the probability of an adverse shock to the income of wealth of Canadian households’.

The Euro Crisis Explained

The ‘Euro crisis’, or European sovereign debt crisis, is a continuing financial crisis whereby certain countries within the Eurozone (e.g. Greece) have been unable to refinance their government debt without support from third parties.

Several complex and combined factors have led to the European debt crisis. Examples include high risk borrowing practices which stemmed from high credit availability from 2002-2008, the globalization of finance against the backdrop of international trade imbalance and artificially high real estate prices. Global recession and fiscal policies for minimising its impact, including policies linked to bank bailouts, have also contributed.

Though each Eurozone member state theoretically retains sovereignty, individual economic outputs are intertwined through monetary and currency union. The interconnection between member states, currency union, the European Union and global financial systems exacerbates financial contagion. This means that, if one nation defaults on its sovereign debt, the creditor nation must face financial losses.

Debt protection can be linked to both the rising Eurozone crisis and the interconnection between its economies and other global economies. In the same way that individuals enter into income or mortgage protection insurance contracts, credit default swap contracts were entered into by institutions. These, contracts, designed to transfer credit exposure, created penalty agreements actionable upon a default of payment on certain debt instruments (including government bonds).

Understanding the Risk to Canadians

Pivotal to the bank’s concerns are Canada’s inflated house prices and high levels household debt, which, they believe, leave the Canadian economy vulnerable should there be a catastrophic financial shock in Europe. The bank’s report suggests that this vulnerability would prevent the Canadian markets from fully absorbing any further deterioration in global financial conditions within its trade, confidence and financial channels.

Further, the bank suggests that the impact of further deterioration in global financial conditions may have greater implications for Canadian households than the recession of 2008. As many households have since taken on further debt, house prices have continued to rise and oversupply of certain housing stock has increased, the bank warns of an increased risk of house price correction.

A hypothetical stress test used by the bank suggests a 3% rise in unemployment could result from further economic strain. This figure, which mirrors that of the last recession, would nearly triple the number of indebted households which would go into arrears.

Additionally, the bank has indicated that a European financial shock would likely bear upon the net worth of Canadians. Currently approximately 40% of Canadian household worth is directly linked to real estate values. Ten years ago, this figure was only 34%.

Individual Member States – What went wrong

With much public attention focused on European bailout decisions, the preceding economic behavioural patterns of individual member states often remains unexplained.  Each member country has contributed, in some way to the current Eurozone status quo, either through its inability to refinance its government debt, or through its approach to monetary bailout.

Last week’s report by the Bank of Canada preceded a Greek election, the outcome of which was likely to determine whether or not Greece remained in the Euro. This election, leading into G20, raised significant economic concerns, both in Europe and beyond.

The Greek Example

The Greek economy, which had grown rapidly during the early 2000’s, was hit especially hard during the global financial crisis of 2008 as a result of its economic reliance upon shipping and tourism. During the recession, the Greek government spent heavily in a bid to support its economy but, in so doing, increased the country’s debt levels.

In 2010, the Greek government borrowed heavily from the EU and, consequently, its sovereign debt rating was slashed. Subsequent austerity measures caused anger amongst the Greek population, due in part to a sharp rise in unemployment rates. With the help of bank designed derivatives, Greece disguised its growing debt, deceiving EU officials.

Concern over the Greeks' ability or motivation to meet bailout terms has dominated discussions over the viability of the Euro. Following last week’s elections, Greek Conservative Antonis Samaras was sworn in as Prime Minister. He will lead a three party coalition, which aims to uphold the Country’s third-party bail out commitments.

This news has been cautiously welcomed by Canadian Officials, who left the G20 with an invite to join Pacific Trade Talks. Canadian Prime Minister Stephen Harper stated:

‘I am convinced that European Leaders fully understand what needs to be done’ he said. ‘The issue is now acting quickly and dramatically to actually take those steps’.

--------- Joanna Hayward is a 29 year old London-based business writer who covers executive ins and outs in the top companies around the world. As she regularly travels around performing interviews, Joanna loves nothing more than to tend to her garden during her spare time, her yearly crop of strawberries are her proudest achievement.