Stephen Poloz sees high home prices as economic risk

Bank of Canada governor Stephen Polozsaysthe Canadian housing sector is vulnerable because of high housing prices and high levels of household debt,but says he continues to believe it is on course for a soft landing.

Speaking in Ottawa Thursday, Poloz said Canadas financial system is vulnerable to a sharp correction in housing prices.

The most important domestic risk is a sharp reduction in house prices, he said at a news conference following the release of the central banks semi-annual review of the financial system.

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If it were to happen, its impact on the economy and financial system would be severe, Poloz said.

His statement comes a day after the Organization for Economic Co-operation and Development told Canada it was concerned that rising home prices were widening inequality and the International Monetary Fund warned that high house prices might be a threat to global growth.

Poloz said the probability of a sharp correction is small and, if it comes, it will be caused by external factors, such as a sudden failure of the economic recovery that seems to be underway in the world economy.

If something else happened outside, the risks inside [Canada] might be magnified by this indebtedness and high housing prices, Poloz said.

He refused to comment on a suggestion by the OECD that the government end its practice of insuring high-risk mortgages through Canada Mortgage and Housing Corp. Poloz said that question would be better answered by the federal government or CMHC.

Low rates were tool in downturn

Poloz said the lower mortgage rates put forward recently by some Canadian banks were an inevitable consequence of the low bank rate currently in effect. The Bank of Canada has not changed its key interest rate since 2010.

Its important to keep the context, which is that we went through a sizeable global downturn. When you put interest rates down as low as you can, you expect to have a reaction somewhere and it wont come from businesses facing less demand, but from the banking sector, he said.

Stronger housing and stronger consumption was exactly what we were hoping to achieve.

Poloz said the central bank is "comfortable" with the current trends in the housing market and believes Canada's house prices will have a soft landing.

Deputy governor Carolyn Wilkins says data backing the soft landing scenario includes a slowdown in housing starts, cooling in the construction of condos and the plateauing of household debt ratios, although at levels near those that existed prior to the U.S. meltdown in 2008.

There had been a "fundamental shift in peoples behaviour" because of rules that require them to qualify for a mortgage at the equivalent of a five-year rate, Polozadded.

"People are choosing a smaller house and less of a mortgage than they would otherwise qualify for, because everyone knows rates might rise," he said.

But the purpose of the bank's financial system review is to pinpoint areas of potential concern to the banking sector and the economy and so housing remains an area of vulnerability.

The central bank worries that house prices continue to rise faster than incomes and that certain hot spots like Toronto's condominium market are over-built.

Particularly vulnerable to a housing correction may be smaller financial entities, such as credit unions, which may not have the resources of big banks to withstand a reversal, the Bank of Canada said in its report.

Risks from Chinese, U.S. economy

"Many smaller entities, including some mortgage investment corporations and smaller credit unions, cater specifically to borrowers who do not qualify for insured mortgages. These may include low-income individuals, recent immigrants, rural residents whose income tends to be more volatile."

The otherkey areas of vulnerability come fromoutside the country, including a sharp increase in long-term interest rates emanating from the U.S., stress from China and other emerging markets, and weakness in Europe.

Poloz said he believes the U.S. is on course for recovery, but its poor first-quarter performance, including housing and investment figures lower than anticipated lead to the U.S. economy being flagged as a risk factor.

The Bank of Canadasees risks from China growing due to concerns about the less regulated shadow banking activities, noting that a hard landing in China would be felt globally and in Canada's resource sector. The risks from the eurozone have lessened, however, it said.

The Bank of Canada has changed framework for the reviewby clearly defining vulnerabilities and risks in its new Enhanced Risk-Assessment Framework. This is the first time it has offered a media lock-up and press conference to discuss the contents of the report.