Canadian economy braces for impact as banking sector stress intensifies

FOMC statement raises concerns for Canada's 2023 economic outlook

Canadian economy braces for impact as banking sector stress intensifies

The Canadian economy is bracing for impact as recent developments in the banking sector are expected to have a significant impact on credit conditions for households and businesses, according to new analysis from the Bank of Montreal (BMO).

Bank economists Doug Porter and Sal Guatieri noted that the Federal Open Market Committee's (FOMC) recent statement regarding the uncertainty of the impact on economic activity, hiring, and inflation, has raised concerns about the Canadian economy's outlook for 2023,

On balance, it is expected that the turmoil will tighten lending conditions notably in the US and Europe, cutting into already-softer capital spending trends and denting what had been a resilient consumer. However, the impact on Canada and Australia is expected to be less severe.

Experts have been in the mild recession camp for the past six months on the North American economy for 2023, but the combination of the near-record rate hikes of the past 12 months and a moderately tighter credit backdrop points to a contraction in the economy in the coming quarters, Porter and Guatieri said. The ultimate depth and duration will revolve around how long the current turmoil persists.

As the Canadian economy braces for the impact, policymakers are expected to take necessary steps to support the economy and businesses amid uncertain economic conditions.

Assessing Canada's financial sector

According to recent reports, Canada's financial sector has managed to stay relatively strong amidst the current global economic downturn. However, this does not mean that the country's domestic economy will emerge completely unscathed.

Lessons from the 2008 financial crisis show that even with the healthiest banking system in the world, credit conditions can still tighten significantly during periods of uncertainty, leading to a deep downturn in capital spending and the broader economy. This was evident in Canada's experience after the collapse of Lehman Bros, where real GDP dropped by 4% year over year in the four quarters after the event.

Recent surveys by the Bank of Canada suggest that business lending conditions have been slightly on the tighter side of normal, with most of the tightening occurring on the pricey side. Capital spending had already begun to lose momentum towards the end of last year, leading to a soft 5.5% drop in business investment in Q4. The BoC's Business Outlook Survey also reported a tightening of conditions, although not nearly as severe as in 2008.

The survey also showed that business plans to boost capital spending have decreased significantly from very strong levels. With the events of the past two weeks, the situation is likely to worsen, leading to further economic impact.

Recent reports suggest that lending to households and consumer spending, in general, tend to be less susceptible to shifts in credit conditions and more dictated by moves in interest rates and employment. However, financial market turmoil and spillover effects can still undermine confidence and spending, leading to a potential impact on Canadian consumers.

In 2008, consumer spending turned sharply for two quarters due to the financial crisis. While the Bank of Canada's loan officer survey only began tracking household lending conditions in 2017, we know that conditions tightened sharply at the start of the pandemic, especially for non-mortgage consumer loans, but then quickly backed off. However, recent events have led to businesses reporting further tightening of credit conditions, with preliminary signs that households are also facing a stricter backdrop.

Any further tightening of credit conditions would reinforce the policy rate increases over the past year and raise the odds of an outright downturn in the broader economy in the coming quarters. This would also bring forward the point at which the Bank of Canada could begin to take its foot off the brakes, especially with inflation beginning to relent.

While Canada's relatively strong and stable banking sector may provide some cushion, the country is not immune to the turmoil in other economies. Canadian consumers should prepare for potential challenges in the months ahead, and businesses should monitor credit conditions closely to ensure continued access to credit.