OTTAWA - The risks of another global financial and economic shock is rising, says the Bank of Canada, and Canadians may be in poor shape to deal with the fallout.
In a decidedly gloomy report of global developments since the summer, the central bank said Thursday in its December issue of the Financial System Review that both the global and Canadian economic recoveries are slowing.
But the main risk to the recovery is the growing seriousness of Europe's government debt crisis, along with the inability of countries to confront the hard choices needed to scale back global trade imbalances that were a key contributor to the crisis.
Canadians won't be spared another shock, the bank said, because rather than consolidate their finances during the current tough economic times, they have continued to take on debt and stretch their finances.
Household debt has risen to 145 per cent of disposable income as Canadians have taken advantage of super-low interest rates to purchase homes and other consumer items on credit. But if interest rates rise, or employment falls, many Canadians could find themselves in over their heads, the bank said.
"Developments since (June) suggest that the vulnerability of the Canadian household sector has increased," the bank said in the semi-annual financial systems review.
"The probability of an adverse labour market shock materializing is judged to have edged higher in recent months, owing to the downward revision ... to the outlook for the global and Canadian economies."
A shock could also impact Canada's financial institutions as households lose their ability to make debt payments.
Nothing in the bank's latest analysis is new, except that it is more pessimistic across the board.
"The Bank of Canada has become increasingly worried about the global macro environment, which explains why it suspended its tightening cycle in October, and suggests it will stand pat until the global economy picks up and Europe's credit crisis ebbs," said economist Sal Guatieri of BMO Capital Markets.
But there is a risk to the bank staying at one per cent in its policy rate for a lengthy period because it tends to encourage the kind of behaviour it warns against. Guatieri says governor Mark Carney will take the earliest opportunity to start hiking rates again.
When that is, remains a question mark, however. BMO believes it could come as early as May, but others say it could be as late as the end of next year.
The latest review locates all the potential problems for Canada as emanating from abroad, since the bank still judges the domestic financial system as relatively sound. However, the problems are considerable and they have grown since the last time the bank reported on financial systems in June.
The bank said there are three key sources of risk -- Europe's sovereign debt woes, financial weakness due to the slow recovery, and global imbalances.
"There remains an elevated risk that global financial stability could be undermined by an adverse feedback loop between weak economic activity, fiscal strains, and the financial system," it said.
The bank said world governments have made all the right noises about solving the structural problems facing the world, but have done very little toward putting those words into action.
In particular, it says, trade imbalances between consumer countries like the United States and producing states like China narrowed during the recession but now have resumed widening again. And the main problem is that China and other emerging countries continue to fix their currencies at depressed values to encourage exports and discourage consumption of foreign goods.
If the situation continues, the bank said a global trade war cannot be ruled out.
"The risk of real and financial protectionism has increased," it said. "Overall, the bank judges that the risk of market turmoil resulting from global imbalances is high and has risen since June."
Governments can act to reduce risks, the bank says, by putting into action plans to rein in deficits and moving to floating currency exchange rates determined by markets rather than government fiat. In Canada, it said, authorities should monitor closely the debt being taken on by Canadians.
