Is Canada at risk of a major housing correction in 2012?

The Canadian housing market is at risk of a price correction and remains the chief domestic vulnerability to the country’s economy in the new year, according to two new reports.

They warn of an overvaluation of Canadian housing by 10% to 15%, aggravated by rising levels of household debt.
Entering a year laden with potential global economic shocks, Canadian authorities need to beware of housing risk as the chief domestic risk, the International Monetary Fund warned.

“Adverse macroeconomic shocks, such as a faltering global environment and declining commodity prices, could result in significant job losses, tighter lending standards, and declines in house prices, triggering a protracted period of weak private consumption as households reduce their debt,” the IMF said in its annual report on the Canadian economy.

Should the European sovereign debt crisis destabilize the global economy, triggering in Canada a 15% decline in house prices, combined with a severe downturn in construction activity “could result in a GDP decline of some 2.5% over a period of two years relative to the baseline,” the report said.

TD Economics also warns of a possible housing correction bringing prices more in line with fundamentals next year and into 2013.

Deciding the fate of the housing market will be the opposing forces of rock-bottom interest rates and economic weakness, TD economist Sonya Gulati said in a report.

“Looking ahead, we anticipate a tug-of-war action to take hold in the Canadian real estate market. At one end of the rope is the magnetism of low interest rates; at the other are subdued prospects for economic, income and employment growth.

“Ultimately, we expect the economic side of the equation to win out over the near-term,” she said.

That would mean a soft first half of the year largely as a result of external economic tensions. Even if those headwinds subside in the latter half of 2012, rising interest rates will restore the pressure on housing prices.

On average, and with great regional variation, Canadian housing prices could fall by 1.9% next year and 3.6% in 2013, Ms. Gulati said. Home sales could suffer comparable declines, while average starts should fall to 170,000 to 180,000 annually over the next two years.

“Collectively, these adjustments will gradually erase the over-valuation in the marketplace,” Ms. Gulati said.

The pace of adjustment could become decidedly less gradual if Europe fails to contain financial contagion. And if households continue to take on debt, the eventual deleveraging effect could be more pronounced.

With income growth lagging borrowing, household debt has risen to a record 150% of disposable income, a burden the Bank of Canada said represents the greatest domestic threat to economic stability.

While low interest rates continue to encourage borrowing growth, the IMF lent its support to the central bank’s accommodative rate policy.

“Should the recovery be accompanied by further sustained increases in mortgage debt as a share of disposable income spurred by low interest rates, a tightening of macroprudential policies by the government may be needed,” it said.

Source: Tim Shufelt, Financial Post

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