This paper assesses the impact of high household debt on economic volatility in Canada. The debt per se may not necessarily be a risk for economic activity; it can amplify other shocks as well. A few studies have emphasized the link between the growth of household debt before 2007 and the severity of the Great Recession. Economies with debt tend to experience more severe housing busts and recessions. If household debt ratios are not stabilized, the vulnerability of the Canadian economy is likely to be high.

Abstract

This paper assesses the impact of high household debt on economic volatility in Canada. The debt per se may not necessarily be a risk for economic activity; it can amplify other shocks as well. A few studies have emphasized the link between the growth of household debt before 2007 and the severity of the Great Recession. Economies with debt tend to experience more severe housing busts and recessions. If household debt ratios are not stabilized, the vulnerability of the Canadian economy is likely to be high.

II. Is There an Excess Supply of Housing in Canada?1

A. Introduction

1. Residential investment in Canada recovered quickly from the 2008–09 recession and, at about 7 percent of GDP as of Q3:2012, is well above its historical average. Thanks to strong monetary and fiscal stimulus measures, it took only a year and a half for Canadian residential investment to return to its pre-recession level, against the average 3 to 4 years in previous cycles (chart, left). After recovering from the recession, residential investment as a share of GDP continued to increase and reached a two-decade high in 2012 (chart, right).

uA02fig01

Residential investment during cycles

(Residential inv. as a share of GDP, index 100=peak)

Citation: IMF Staff Country Reports 2013, 041; 10.5089/9781475587050.002.A002

Sources: Haver, Fund Staff calculations
uA02fig02

Residential Investment

(Percent of GDP)

Citation: IMF Staff Country Reports 2013, 041; 10.5089/9781475587050.002.A002

2. The strength of construction activity has raised concerns of possible overbuilding and excess supply.2 According to CMHC, the construction sector added 175 thousand new housing units per year on average over the last three decades in Canada, while household formation grew at an average annual estimated rate of 165 thousands, as derived from CENSUS data (chart). Over the last decade, however, housing completions averaged 200 thousands units per year while household formation averaged at around 175 thousands, raising concerns of a possible overbuilding.

uA02fig03

Household Formation and Housing Completions

(average annual growth in thousands of units and persons)

Citation: IMF Staff Country Reports 2013, 041; 10.5089/9781475587050.002.A002

Sources: CMHC, Census, Fund Staff estimates.

3. This chapter estimates Canada’s housing stock to determine whether there is an excess supply of housing. To do so, we proceed as follows: first, we construct time series of Canada’s housing stock and household formation. This allows us to estimate the vacancy ratio, a commonly used measure of excess housing supply. Second, we estimate an empirical model where the change in housing stock is a function of a set of underlying fundamentals (including household formation, household disposable income, construction costs, mortgage rates, and house prices growth). Overbuilding is thus derived by comparing actual data with the predicted values of the model. The results reveal some overbuilding, particularly during 2004–2008 and since mid-2011. As of Q3:2012, Canada’s housing stock is found to be at 1½ percent above the level consistent with fundamentals.3

B. Estimating Canada’s Housing Stock

4. In order to assess the current level of housing supply, we reconstructed a time series of housing stock in Canada. Statistics Canada provides data on the total net stock owned and rented, total vacant dwellings for rent or for sale, and occupied stock owned and rented, at both national and provincial level, until 2000 only. We extrapolated the series to the years that follow and up to Q3:2012, adopting the same methodology (see the Appendix I for details). In particular, the housing stock in period t is defined as the stock in period t-1, plus newly added units (completions) and conversions (or additions), and minus demolitions.4 The behavior of both conversion and demolition vary over time and with the housing cycles (chart). During the housing boom in the late 1980, conversions were large contributors to the change in net housing stock, while demolitions rose to historic highs during the pre-crisis period (2002–2008).

uA02fig04

Conversion and demolition

(units)

Citation: IMF Staff Country Reports 2013, 041; 10.5089/9781475587050.002.A002

Sources: StatCan, CMHC, Fund

5. The results show that Canada’s housing stock more than doubled since the 1970s, with Alberta and British Columbia posting the largest gains. Between 1971 and 2011, Canada’s housing stock grew at a yearly average rate of 2 percent. The largest provinces posted the most dynamics trends, with Alberta and British Columbia growing at an average yearly 3 and 2.6 percent respectively (chart). This strong growth was at the expense of smaller provinces whose share in the total net stock diminished over the period. Ontario and Quebec shares of the national stock stagnated over this period, at around ⅓ and ¼ respectively.

uA02fig05

Canada’s Housing Stock and Provincial Distribution

(units)

Citation: IMF Staff Country Reports 2013, 041; 10.5089/9781475587050.002.A002

Sources: StatCan, CMHC, Fund Staff estimates

6. The growth of Canada’s housing stock has outpaced household formation over the last decade (chart). We interpolated 5-years CENSUS household series to compare yearly household formation with the yearly change in the housing stock. Over the last decade, the cumulative supply of new housing units outpaced the (demographic-related) demand for housing by about 10 percent.

uA02fig06

Household Formation and Change in Housing Stock

(persons, units)

Citation: IMF Staff Country Reports 2013, 041; 10.5089/9781475587050.002.A002

Sources: Fund Staff estimates

7. As a result, vacant housing units are currently at historically high levels (chart). With estimates for household formation and the stock of housing, we can derive the vacancy ratio, that is, the number of unoccupied units as a share of the housing stock. The lack of reliable data on second homes (whether they are occupied or not) makes it difficult to get an estimate of the “natural” number of unoccupied houses in Canada (that is, the share of units that remain unoccupied due to frictions in the housing market when the latter is at equilibrium). Yet, assuming this share is relatively small and constant over time (in line with what can be deduced from the occasional Survey of Financial Security from Statistics Canada), we can take the difference between the vacancy ratio and its historical average as a measure of the degree of disequilibrium in the housing stock. Doing so suggest an excess supply of housing of about 1½–2 percent (of the total housing stock) as of end 2011. While informative, these findings are based solely on demographics and thus fail to capture the influence of other determinants of construction activity. In the next section we turn to a model-based analysis of housing stock, taking into account a few factors that are commonly believed to influence the supply and demand for housing.

uA02fig07

Vacancy Rate

(percent, vacant housing units as a share of total housingstock)

Citation: IMF Staff Country Reports 2013, 041; 10.5089/9781475587050.002.A002

Sources: StatCan, Fund Staff estimates

C. A Model of Canada’s Housing Stock

8. We estimate an empirical model of the housing stock. In line with the literature (Egebo et al., 1990, Demers, 2005, Dupuis and Zheng, 2010, and Dagher and Reynaud, 2012), we estimate a model where the change in housing stock is a function of a set of economic fundamentals that include household formation, real construction costs, real household disposable income, the real mortgage rate, and real house price growth. We use quarterly data over the Q2:1984–Q3:2012 period, based on data availability, and estimated the model using OLS. All variables are in logarithmic form, except the real disposable income (an index) and both the mortgage rate and real house price growth (percentages) (see the Appendix for data sources).5 They all enter the regression lagged by 4 quarters, to limit potential endogeneity issues and seasonal effects. Real house prices growth is calculated as a 2-year moving average. The construction cost series is proxied by the quarterly rate of increase of unionized workers in the construction sector, since wages represent the largest share of construction cost. The estimation results show that the demand component, i.e. household formation, is the main determinant of the change in the stock of housing (Model A, table). As expected, construction costs and the mortgage rate are negatively related to changes in the housing stock as they decrease the profitability of residential investment. In Model B, we introduce the change in real house prices. As expected, they influence positively the changes in housing stock as expectations about the profitability of residential investment are positively correlated with expectation of price increase.

Dependent variable: Δ housing stock

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Standard deviations in brackets.

9. Construction activity has been significantly above the level predicted by our model since 2002. Model B captures well past episode of boom-bust cycle, such as the one at the end of the 1980s, while over-predicts the housing stock at the end of the 1990s, possibly as Canada’s housing sector was still adjusting from previous excesses. On average over the sample period, the model suggests an excess-supply of around 200 thousands units—slightly more than a full year of construction at current levels. When focusing on the 2002–2012 period, this number rises to almost 400 thousands, representing about 20 percent of the change in housing stock over this period. As of Q3:2012, the model suggests that the housing stock is about 1½ percent above the level consistent with fundamental, down from its peak of 3 percent at the end of 2008.6

10. Overbuilding has been concentrated in Ontario and Quebec, and to a lesser extent in British Columbia. Lack of data, in particular on construction costs, limits the scope for estimating our model at the provincial level. However, using yearly frequency, we can estimate Model B over the 1992–2011 period for each Canadian province. The estimated (aggregated across provinces) degree of overbuilding is in line with the national estimate.

D. Conclusions

11. The last time residential investment-to-GDP ratio reached 7 percent, the Canadian housing sector went through a long period of stagnation. With current house prices and construction activity at historical highs, an adjustment is likely to take place in the coming years. This chapter analyzes the dynamics of the housing stock in Canada and found that Canada experienced some overbuilding when house prices and construction were booming, between 2002 and 2008. While there was an excess supply of housing of about 3 percent of the total stock at the end 2008, that excess has fallen to about 1½ percent as of Q3:2012.

Appendix I. Housing Model, Data Definition, and Data Sources

The stock of existing housing (Ht) is the sum of occupied units Ot, or equivalently the number of households, and vacant units Vt:

Ht = Ot + Vt

Occupancy in period t is defined as the occupancy in period t-1 plus net household formation (HFtn):

Ot=Ot1+HFtnHFtn=INtOUTt

where INt is the number of newly occupied units, or gross household formation, and OUTt the newly vacated units.

Vacancy in period t is defined as the vacancy in period t-1 minus net household formation (HFtn) and demolition (DEMt) plus newly built units NEWt and newly added units, or additions, ADDt:

Vt=Vt1HFtnDEMt+NEWt+ADDt

Excess supply is defined as:

HtHt*=(OtOt*)+(VtVt*)

where (VtVt*) is the excess vacancy, i.e. the difference between the current level of vacant units and its normal or equilibrium level, a measure commonly used to gauge the potential for construction activity. (OtOt*) is the excess occupancy that occurs when household formation is above equilibrium.

Overbuilding is defined as the difference between the net change in the stock and net household formation. As the addition of new housing units is feeding the vacant housing segment in the first place, overbuilding appears when (NEWt + ADDtDEMt) > HFtn. This translates into Vt > Vt-1, which should ultimately increase the housing stock above the level determined by household formation when (Ot=Ot*).

Surprisingly, there is a relative lack of publicly-available data of housing indicators in Canada, particularly on the housing stock, vacancy and occupancy ratios, and household formation. Series on the housing stock in Canada have been discontinued in 2000 and the only measure of the vacancy ratio, i.e. the ratio of non-occupied units to the total stock of houses, is for apartments in metropolitan areas. CENSUS Canada provides household formation estimates only every five years.

Starting from the latest available data of the housing stock in 2000, we follow StatCan definitions and estimate the series up to 2012. The equation below describes the estimate of the stock for 2001:

H2001e=H2000+NEW2001+ADD2001DEM2001

where the (NEWt) is defined as completions, (ADDt) as conversion, and (DEMt) as demolitions in the table below:

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Sources of the data used for the regression model:

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References

  • Dagher, Jihad, and Julien Reynaud, 2012. “The Residential Construction Sector: When Will It Emerge From Its Rubble?”. IMF United States Selected Issues, IMF Country Report No. 12/214.

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  • Demers, Frederick, 2005. “Modelling and Forecasting Housing Investment: The Case of Canada”. Bank of Canada, Working Paper No. 2005–41.

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  • Dupuis, David, and Yi Zheng, 2010. “A Model of Housing Stock for Canada”. Bank of Canada, Working Paper No. 2010–19.

  • Egebo, Thomas, Pete Richardson and Ian Lienert, 1990. “A model of housing investment for the major OECD economies”. OECD, Economic Studies No. 14 (Spring 1990).

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1

Prepared by J. Reynaud, with research assistance from T. Mahedy (all WHD).

2

In this chapter, “overbuilding” is a flow measure, describing the excess of housing units added to the market relative to the level consistent with the demand for new units. “Excess supply” is a stock measure, defined as the number of housing units in excess of the overall demand for houses. See the Appendix for details.

3

Box 1 in the Staff Report discusses how we expect this gap to close over the next few years, given staff projections of the key variables in the model.

4

Because of the lack of information on the timing of conversions, we assumed all conversions occur within one year. In reality, some of them can take up to 3 years, depending on the size of the building. Our assumption, however, is unlikely to have a large impact on the housing stock and on our yearly estimates of overbuilding, as conversions represent a relative small share of the overall number of new housing units added per year.

5

The real disposable income per capita enters the regression as an index to avoid collinearity with the mortgage rate variable.

6

Dupuis and Zheng (2010) found that the Canadian housing stock was in excess supply by about 2 percent as of 2008.

Canada: Selected Issues
Author: International Monetary Fund. Western Hemisphere Dept.
  • View in gallery

    Residential investment during cycles

    (Residential inv. as a share of GDP, index 100=peak)

  • View in gallery

    Residential Investment

    (Percent of GDP)

  • View in gallery

    Household Formation and Housing Completions

    (average annual growth in thousands of units and persons)

  • View in gallery

    Conversion and demolition

    (units)

  • View in gallery

    Canada’s Housing Stock and Provincial Distribution

    (units)

  • View in gallery

    Household Formation and Change in Housing Stock

    (persons, units)

  • View in gallery

    Vacancy Rate

    (percent, vacant housing units as a share of total housingstock)