Canada
Selected Issues Paper

Canada has experienced drastic changes in its economy during the global financial crisis. This Selected Issues paper discusses the evolution of equilibrium real home prices in key Canadian provinces in the post-crisis period, Canadian dollar movement during and after the global financial turmoil in line with other world currencies, assessment of impacts on Canada’s potential growth, development of Canadian automotive sector—namely, NAFTA partners during the crisis, and the role of Canada Mortgage and Housing Corporation (CMHC) in Canada’s housing market.

Abstract

Canada has experienced drastic changes in its economy during the global financial crisis. This Selected Issues paper discusses the evolution of equilibrium real home prices in key Canadian provinces in the post-crisis period, Canadian dollar movement during and after the global financial turmoil in line with other world currencies, assessment of impacts on Canada’s potential growth, development of Canadian automotive sector—namely, NAFTA partners during the crisis, and the role of Canada Mortgage and Housing Corporation (CMHC) in Canada’s housing market.

I. The Post-Crisis Canadian Housing Market1

A. Introduction

1. Canadian house prices recovered strongly in the post-crisis era but recently stalled. After falling by over 10 percent from their pre-crisis peak levels, Canadian Real Estate Association (CREA) existing house prices have recovered rapidly following the financial crisis, rising by over 20 percent from their 2008Q4 trough levels.2 However, since end-March 2010, house price increases have come to a halt, with prices stabilizing or falling slightly. Across regions, Quebec essentially experienced no declines in house prices even during the crisis, while western provinces suffered double-digit price losses during the crisis, partly reflecting the downward pressures on commodity prices. Ontario and British Columbia experienced rapid house price increases of around 20 percent on average since their crisis-related trough levels, ahead of the introduction of the harmonized sales tax.

uA01fig01

Canada: Existing Home Prices

(Percentage change)

Citation: IMF Staff Country Reports 2010, 378; 10.5089/9781455213559.002.A001

Sources: Canadian Real Estate Association and author’s calculations.Note: Parentheses below each label indicate the percentage of the total population residing in each province.

2. This chapter estimates the evolution of equilibrium real home prices in the post crisis period in key provinces. Specifically, we look closely at fundamental determinants of house price developments in five large Canadian provinces (Alberta, British Columbia, Ontario, Quebec, and Saskatchewan) to come to an assessment about possible deviations from equilibrium prices. Following Tsounta (2009), we use an econometric model to estimate the equilibrium house prices, as determined by demand (derived on the basis of factors such as disposable income and demographic developments) and supply (derived from factors influencing the available housing stock). The specification of these models is a long-run (cointegration) relationship between house prices and their determinants, which is then embedded in an error-correction mechanism. We examine current valuations against economic fundamentals using quarterly regional data—such as disposable income, demographic developments (which also account for inter-provincial and international migration trends) and mortgage credit for the period 1993Q1–2010Q3.

3. Results suggest that home price developments are largely explained by fundamentals throughout Canada, with the possible exceptions of Ontario and British Columbia. While prior to the crisis the commodity boom had pushed house prices in western provinces above levels explained by economic fundamentals, the latest data suggest that house prices are above model predictions only in British Columbia and Ontario (and to a much lesser extend in Quebec and Alberta), possibly related to sharp activity prior to the introduction of the harmonized sales tax in the two provinces, which raised services costs for buying some houses (discussed in more detail later on). Specifically, we find that house prices in Ontario and British Columbia are around 9–14 percent above levels predicted by our econometric model as of the third quarter of 2010. In contrast, house prices in Quebec and Alberta are only slightly above levels predicted by the model while Saskatchewan appears to have house prices below levels dictated by fundamentals even though both of the resource-rich western provinces of Alberta and Saskatchewan had experienced significant deviations from economic fundamentals during the housing and commodity boom period. Despite the limitations of econometric estimates of house-price dynamics, the measured small degree of house price deviations from model predictions coupled with the recent cooling in the housing market suggest that, on the national level, Canadian prices are trending towards levels dictated by economic fundamentals.

4. Analyzing house-price valuations is important for various reasons:3

  • Households’ behavior. As housing represents the largest single asset for most households, changes in its valuation would have important consequences for their balance sheets and thus spending behavior.

  • Financial soundness. Mortgages and other real-estate related assets also represent an important component of financial institutions’ balance sheet (almost a third of chartered banks’ assets, with mortgage credit rising by an average of 7.7 percent per year during 2000–08, then contracting by 4 percent in 2009), implying that housing market developments could have important implications for the health of the financial system, including profitability and soundness.4

  • Policy Implications. House prices also affect the consumer price index, and thus inflationary trends and expectations. As a result, understanding housing price dynamics has important implications for monetary policy in its role to preserve price stability as well as financial stability. Last but not least, revenues from real estate transactions (including construction-related income and excise taxes) have an important impact on a country’s fiscal position. More generally, the construction sector could have important implications in the overall performance of the economy; it employed 6½ percent of the Canadian workforce (over 1 million) in 2009 and deducted over ½ percentage point from growth (versus a positive average annual contribution of 0.3 percentage points between1997–2007).

5. The paper is structured as follows. The next section analyzes recent housing market developments in Canada. Section III describes the results of our analysis and Section IV concludes.

B. The Ups and Downs Following the Crisis

6. Similar to most OECD countries, Canadian housing activity and prices were hit hard by the financial crisis. In particular,

  • New house prices experienced a moderate retrieval at the national level (falling by 3 percent in 2009). However, after rising impressively in the west during the commodity boom years, they have plummeted amid the financial crisis and the retrenchment in commodity prices, falling by around 6.5 percent in British Columbia and 10 percent in Alberta in 2009 alone.5

  • Teranet-National Bank’s existing home price index also shows significant declines amid the financial crisis, especially in the resource-rich western provinces and the financial hub of Toronto (the index records house prices in Canada’s six metropolitan areas of Ottawa, Toronto, Calgary, Vancouver, Montreal, and Halifax).

uA01fig02

New House Price Index

(Y/Y, percentage change)

Citation: IMF Staff Country Reports 2010, 378; 10.5089/9781455213559.002.A001

Source: Statistics Canada; Haver Analytics.

Cumulative Nominal Changes in House Prices

(Percentage change)

article image
Source: Teranet-National Bank and author’s calculations.

7. The retrenchment in house prices during the financial crisis also coincided with declining construction and sales activity. In April 2009, housing starts reached a low not seen since 1996 while building permits were 40 percent down from their all time peak (recorded in December 2005). In regional terms, the west experienced remarkable decreases in housing starts and building permits; for example, in early 2009, housing starts and building permits were around one-fifth the levels recorded in the commodity boom years, while CREA’s existing home sales declined by over 35 percent peak-to-trough, with the largest declines experienced in the resource rich provinces of British Columbia and Alberta.

uA01fig03

Canada: Existing Home Sales

(Percentage change)

Citation: IMF Staff Country Reports 2010, 378; 10.5089/9781455213559.002.A001

Sources: Canadian Real Estate Association and author’s calculations.
uA01fig04

Building Permits and Housing Starts

(Annual rate; in thousands)

Citation: IMF Staff Country Reports 2010, 378; 10.5089/9781455213559.002.A001

Source: Haver Analytics.

8. The Canadian housing market recovered strongly following the crisis. Existing house prices have rebounded in 2010, with British Columbia’s Teranet-National Bank existing home price index rising by over 11 percent (year on year) in August 2010 and Ontario house prices rising by around 12 percent (both quality adjusted); smaller increases were recorded in the rest of Canada. Traditional valuation measures (house price-to-income and house price-to-rent) had reached historic highs during that period (Figure 1). Similarly, housing activity was on the rise with building permits and housing starts almost doubling between February 2009 and March 2010, with particularly large increases recorded in British Columbia. CREA’s existing home sales have also more than recovered their crisis-related losses, reaching an all-time high in 2009Q4, with particularly strong sales recorded in Ontario and British Columbia (up 62 and 135 percent, respectively since crisis trough).

Figure 1.
Figure 1.

G-7: Price-to-income and price-to-rent ratios, 1970-2010

Citation: IMF Staff Country Reports 2010, 378; 10.5089/9781455213559.002.A001

Sources: OECD and author’s calculations.

9. There was a large increase in construction and sales activity in British Columbia and Ontario the last year partly due to the sales tax harmonization.6 Existing home sales reached a historic peak at end-2009 with Ontario and British Columbia accounting for three-fourths of this impressive performance. The large concentration of activity in Ontario and British Columbia could partly reflect pent up activity prior to the introduction of a harmonized sales tax on July 1, 2010. In particular, starting in July an additional tax of 8 percent in Ontario and 7 percent in British Columbia is levied on the purchase of new homes, the renovation of existing homes, and the closing costs for home sales.7 While tax rebates would offset the majority of the additional tax on new housing for moderate priced houses (under C$400,000 in Ontario and under $525,000 in British Columbia),8 costs of services related to the purchase of houses would rise by around 0.6 percent of the selling price.9

uA01fig05

Canada: Existing Home Sales

(Percentage change)

Citation: IMF Staff Country Reports 2010, 378; 10.5089/9781455213559.002.A001

Sources: Canadian Real Estate Association and author’s calculations.
uA01fig06

Contribution to Canada-wide Growth in Existing Home Sales Between Trough and Peak, Post Crisis

(Percent)

Citation: IMF Staff Country Reports 2010, 378; 10.5089/9781455213559.002.A001

Sources: Canadian Real Estate Association and author’s calculation.

10. The very strong housing economic activity had prompted policy action by the authorities. In February 2010, Finance Canada (2010) announced a number of steps to support the long-term stability of Canada’s housing market and help prevent negative trends from developing. Specifically, effective April 19, 2010, the rules for government-backed insured mortgages were amended as follows:

  • Require that all borrowers meet the standards for a five-year fixed rate mortgage even if they choose a mortgage with a lower interest rate and shorter term. This initiative was meant to help Canadians prepare for higher future interest rates.

  • Lower the maximum amount Canadians can withdraw in refinancing their mortgages to 90 per cent from 95 percent of the value of their homes.

  • Require a minimum down payment of 20 percent for government-backed mortgage insurance on non-owner-occupied properties purchased for speculation.

11. Since spring 2010, the housing market has cooled. Specifically, CREA’s existing home prices have stabilized while home sales in the third quarter of 2010 are down 27 percent from their all-time peak in 2009Q4, with British Columbia’s sales plummeting by 44 percent since the recent peak. Similarly, overall building permits are down 10 percent since March 2010 at the national level (down 20 percent in Ontario) while housing starts are down over 18 percent since April 2010 (down over 30 percent in Ontario).

C. Estimation

12. The analysis is based on an error-correction model examining current valuations against economic fundamentals; described in detail in Tsounta (2009). In summary, the price measure used is the existing home price from the Canadian Real Estate Association’s Multiple Listing Service (MLS) database, and is deflated by each province’s CPI for the period 1993Q1–2010Q3. We examine current valuations against economic fundamentals using quarterly regional data—such as disposable income, demographic developments, and mortgage credit. Disposable income and mortgage credit exhibited cyclical movements during the downturn. The analysis is based on an error-correction model, which combines the long-run, cointegrating relationship among the variables in levels and the short-run relationships among the first differences of the variables, separately for each of the five provinces considered, namely Alberta, British Columbia, Quebec, Ontario, and Saskatchewan.

13. Estimation results reveal that prices in Ontario and British Columbia are somewhat above the levels implied by the model, in Alberta and Quebec, house prices are essentially at equilibrium, while house prices in Saskatchewan appear to be somewhat lower that levels predicted by fundamentals, in sharp contrast with the experience during the commodity boom years (Figures 24). Home prices as measured by the CREA index were found to be around 9–14 percent above model predictions in British Columbia and Ontario at the end of the third quarter of 2010, with the recent cooling in the housing market mitigating some of the earlier larger deviations from model predictions. We find that Ontario’s house prices have been above model estimates since mid-2009, while Quebec appeared to have weathered the housing boom and crisis with somewhat moderate deviations from model estimates. British Columbia experienced higher house prices than dictated by the model during the commodity boom, with a temporary correction during the crisis; however, recent estimates suggest that house prices are above levels dictated by the model, though declining. Given that most house price developments are explained by our model predictions and the degree of uncertainty surrounding such kind of estimations, the Canadian housing market, on the aggregate, does not seem to deviate significantly from levels dictated by economic fundamentals. For reference, according to Klyuev (2008) at the peak of the U.S. housing bubble, price-to-fundamentals deviations using a similar model were of the order of 30–40 percent (the smallest deviation was in the Midwest, at 18 percent).

Figure 2.
Figure 2.

Select Eastern Canadian Provinces: House Price Deviations from Model Predictions,1993Q1-2010Q3

(In percent)

Citation: IMF Staff Country Reports 2010, 378; 10.5089/9781455213559.002.A001

Source: Author’s calculations.
Figure 3.
Figure 3.

Select Western Canadian Provinces: House Price Deviations from Model Predictions, 1993Q1-2010Q3

(In percent)

Citation: IMF Staff Country Reports 2010, 378; 10.5089/9781455213559.002.A001

Source: Author’s calculations.
Figure 4a.
Figure 4a.

House Price Dynamics

(In Canadian dollars)

Citation: IMF Staff Country Reports 2010, 378; 10.5089/9781455213559.002.A001

Sources: Canadian Real Estate Association and author’s calculations.
Figure 4b.
Figure 4b.

House Price Dynamics, continued

(In Canadian dollars)

Citation: IMF Staff Country Reports 2010, 378; 10.5089/9781455213559.002.A001

Sources: Canadian Real Estate Association and author’s calculations.

House Price Deviation from Model Predictions, 2010Q3

(In percent)

article image
Source: Author’s Estimates.

D. Conclusions

14. House prices declined markedly in Canada with the financial crisis but then recovered strongly. This paper uses an error-correction model to assess the current extent of overvaluation in provincial house prices as measured by the CREA index. Our work generally confirms previous work (e.g., Tsounta (2009), and IMF (2004, 2008, 2009)), which find that while house prices might be a bit on the high side compared to model estimates in some regions, overall they are close to equilibrium. The results—which given the approximations implicit in the model and the difficulties of taking into account all possible factors in analyzing house price dynamics have to be taken with due caution—suggest that the marked increases in house prices, especially in Ontario and British Columbia following the crisis trough, led real house prices to rise somewhat above levels implied by our econometric model. In these two key provinces, the current deviations average at around 9–14 percent. In contrast, Alberta and Saskatchewan house prices are now closer to levels predicted by the model, in contrast to their performance during the commodity boom years.

15. The authorities’ proactive response in addressing possible housing market concerns in recent years, has been important in explaining Canada’s healthy housing market performance thus far. Prior to the crisis, in order to protect the Canadian housing market from bubbles, the authorities had lowered the maximum amortization period for new government-backed mortgages to 35 years, required a minimum down-payment of five per cent for new government-backed mortgages, established a consistent minimum credit score requirement, and introduced new loan documentation standards. These rules, set by the Canadian Mortgage Housing Corporation, limited the risk of relaxation of lending standards, and as such limited Canada’s exposure to the subprime market. On the onset of the crisis, the authorities took steps to bolster the housing market by purchasing mortgage-backed securities, expanding the Canada Mortgage Bond program to 10-year (from five-year) maturity, enhancing liquidity, lowering policy and thus mortgage rates, and announcing a temporary home-renovation tax credit as well as a first-time homebuyers tax credit. As noted earlier, in April 2010, amid concerns for an overheating Canadian housing market, the government tightened mortgage rules for obtaining government-insured mortgages.

References

  • Finance Canada (2010), “Government of Canada Takes Action to Strengthen Housing Financing,” Ottawa, February 16.

  • IMF (2009), World Economic Outlook: Crisis and Recovery, April, Washington, DC: International Monetary Fund.

  • IMF (2008), World Economic Outlook: Housing and the Business Cycle, April, Washington, DC: International Monetary Fund.

  • IMF (2004), World Economic Outlook: The Global Demographic Transition, September, International Monetary Fund.

  • Klyuev, V. (2008), “What Goes Up Must Come Down? House Price Dynamics in the United States,” IMF Working Paper 08/187, Washington, DC: International Monetary Fund, July.

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  • TD Economics (2010), “The Economic Impact of HST Reform,” Special Report, July 6.

  • Tsounta (2009), “Is the Canadian Housing Market Overvalued? A Post-Crisis Assessment,” IMF Working Paper 09/235, Washington, DC: International Monetary Fund, October.

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1

Prepared by Evridiki Tsounta.

2

There are numerous measures of house prices available in Canada, including new house price index provided by Statistics Canada, existing home prices provided by the Canadian Real Estate Association (CREA) and the Teranet-National Bank existing home price index. While the latter is similar to the Case-Shiller index, CREA’s sales weighted index remains the most widely used given its larger sample size (all provinces, more years, all multiple listing sales by realtors). This measure exhibits the largest volatility, including large upswings, does not take into account compositional effects, and in that respect it should represent an upper limit in terms of any deviations from economic fundamentals. Our analysis is based on the CREA index unless otherwise noted.

3

Tsounta (2009) provides a more detailed discussion of the macro-financial linkages surrounding the housing sector and the vulnerabilities amid highly indebted Canadian households.

4

Chapter 5 provides a more detailed discussion of the Canadian mortgage market.

5

For example, in late 2006, new house prices in Alberta were 50 percent higher than a year ago (up 97 percent from end-2002 to their peak in late-2007) with more sustained increases in Saskatchewan (up over 120 percent between end-2002 and their peak in mid-2008). In contrast, prices in the rest of Canada exhibited more moderate increases, rising at most by around 13 percent (in Fall 2006) on an annual basis (up 41 percent between end-2002 and their peak in early 2008).

6

The two provinces comprise 50 percent of Canadian economic activity and host over half the Canadian population.

7

For more details on the harmonized sales taxes in Ontario and British Columbia, please refer to TD Economics (2010).

8

Higher priced new houses would be directly impacted by the harmonization; TD Economics (2010) estimates than a C$650,000 new house would cost C$4,500 more in Ontario and C$2,000 more in British Columbia.

9

TD Economics (2010) estimates that 75 percent of all new homes in Ontario are priced at below C$400,000.

Canada: Selected Issues Paper
Author: International Monetary Fund
  • View in gallery

    Canada: Existing Home Prices

    (Percentage change)

  • View in gallery

    New House Price Index

    (Y/Y, percentage change)

  • View in gallery

    Canada: Existing Home Sales

    (Percentage change)

  • View in gallery

    Building Permits and Housing Starts

    (Annual rate; in thousands)

  • View in gallery

    G-7: Price-to-income and price-to-rent ratios, 1970-2010

  • View in gallery

    Canada: Existing Home Sales

    (Percentage change)

  • View in gallery

    Contribution to Canada-wide Growth in Existing Home Sales Between Trough and Peak, Post Crisis

    (Percent)

  • View in gallery

    Select Eastern Canadian Provinces: House Price Deviations from Model Predictions,1993Q1-2010Q3

    (In percent)

  • View in gallery

    Select Western Canadian Provinces: House Price Deviations from Model Predictions, 1993Q1-2010Q3

    (In percent)

  • View in gallery

    House Price Dynamics

    (In Canadian dollars)

  • View in gallery

    House Price Dynamics, continued

    (In Canadian dollars)