Is Canada Heading For A Deflationary World?

As we enter 2013, we’ll be hearing a plethora of prognostications about the Canadian economy. From what I can sense, most of it looks concerning. With the exception of unemployment, which posted a staggering 50+ thousand job number in December, things seem pretty murky. GDP is flat. Commodity prices which have been the cornerstone or buffer against much of the global volatility have flattened as a result of waning demand from core customers in Europe, China, and the US, who’ve got even bigger issues to deal with.

These are the normal starting points in assessing Canada’s prospects going forward, however, I’m seeing another element that is acting like the elephant in the room and has a greater potential to create severe disruption. That elephant is our debt. Recently it was reported that Canadian family debt levels are at record high levels. The average household is carrying a debt/disposable income ratio in the 160% range which is extremely high. Let’s be clear on what this means. It means that for every dollar of disposable income created, $1.60 is borrowed in the form of a mortgage, student loan, line of credit, and/or credit cards. The US didn’t even reach these levels and they imploded and are still in the early stages of recovery. Our politicians and banking leaders have raised consistent concerns about this but it appears it is falling on deaf ears. So I’m wondering what could happen if this continues. There’s a lot of talk and chatter that inflation could return as a result of increased money that is being printed by central banks around the world, led by the Federal Reserve in the US. The thinking is that increasing the money supply would stimulate the economy. The product of this hopefully rising economic activity is some form of inflation as commodity prices and inputs would rise. The driver of these outcomes is a devaluing of paper money, which makes exports cheaper and more competitive.

That’s the conventional thinking, but I’m wondering if we’re looking at it all wrong, especially here in Canada? What if instead we are heading toward a deflationary world instead of an inflationary world? Just looking purely at numbers, the Consumer Price Index in Canada ended 2012 at 1.5 percent and for November posted a 0.8 percent number. Both trended much lower than other Western developed economies, which were tracking in the 2 percent range. It’s not deflation yet, but it seems we’re having a look at it. There are some precedents to why deflation could be in the offing. The one that I stumbled upon in my mind-mapping that lines up to the Canadian experience is what Sweden is going through.

The Swedish Experience
Sweden, like Canada has seen its debt ratios swell even higher. It is also trending at 173% of disposable income range. It has also seen its currency rise as a result of the Euro debt crisis. Investors have been parking money in Swedish Krona’s. In addition, property prices have been rising beyond historical trends just like in Canada. About half of all mortgages in Sweden now fall into the floating-rate category while estimates have put the average amortization period at more than 70 years. Those conditions leave Swedes particularly vulnerable to sudden changes in interest rates and external shocks. Finally, the Swedish central bank has been also reluctant to print money. This is not the first time the fundamentals in Sweden have lined up in this manner. In the 90’s, Sweden saw it’s private debt levels swell to untenable levels. The result was a painful deleveraging cycle that negatively impacted economic growth and spawned deflation. The US is also undergoing a similar debt deflation deleveraging process that left unemployment high and economic growth tepid.

In a nutshell, both Canada and Sweden have been on a borrowing spree and at some point rates will pop back up and a lot of people will get caught holding mortgages or debts they can’t afford. What will happen? They’ll either sell property or go bankrupt. In other words, cut back on spending to reduce their debt load. This would lead to stagnant economic growth or even recession. Either way prices for property will fall and consumption will also fall causing prices for goods and services to fall. What’s the incentive to make a big ticket purchase if the price is going to go down tomorrow? Not much. The deleveraging process becomes a vicious circle that generates deflation.

Canada could argue that because it is a commodity producing nation with an abundance of minerals, lumber and oil that it can withstand these deflationary forces mainly through demand by the US for oil and other commodities. Factor in China’s insatiable appetite for commodities and it should be happy days for Canada. That historically would be true, but recently a new paradigm has presented itself. It was announced by the International Energy Association that the US would be a net exporter of oil by 2020 and by 2025-2035 be the largest producer of oil, even overtaking Saudi Arabia. This would be a huge game changer because if this goes down, then the US will no longer be dependent on Middle East oil. It would be self-sufficient, requiring less Canadian oil sands bitumen. Oil prices would fall. Canadian economic growth would slow, unemployment increases, people can no longer afford carrying high debt levels and so it goes. Canada would be forced to seek other markets which could offset, however Corporate Canada has shown reluctance or even worse an apathy to pursuing other global prospects. Canadian business has become too complacent and has become too comfy catering to south of the 49th parallel. The recent trepidations in allowing approval of major investments by CNOOC and Petronas into the Canadian oil sands highlights this unease in Canada for doing business globally.

Innovation Lagging
Growing sustainable economies need new ideas and must innovate. This requires heavy investments in education as well as research and development. In Canada, the latter has been lagging significantly in recent years. You could say that Canada maybe in the early years of a lost decade in R&D investment. According to the OECD, R&D spending declined an average of 1.2 per cent between 2005 and 2010, with sharp drops in 2008 and 2010. Total spending now sits at $24-billion. Contrast this to China, where spending on R&D doubled between 2005 and 2010 to $179-billion (U.S.), ranking it second only to the United States. China is now spending more than Canada on R&D relative to the size of its economy (1.77 per cent of GDP versus 1.74 per cent). The report warned that falling investment in R&D could have a lasting impact on “innovation and long-term growth.”. The OECD scorecard of 22 measures of innovation capacity shows Canada generally above the OECD median, including government spending on R&D, quality of its universities, trademarks, published scientific work, patents and college graduates, and science scores by 15 year-olds. Unfortunately it lags other wealthy countries is several key areas, such as business spending on R&D, leading corporate spenders, venture capital, and patents by start-ups and wireless broadband subscribers. Innovation allows you some element of pricing power as you are first to market your product. If you are piggy-backing other established products and services you are more susceptible to pricing pressures.

Canada has been fortunate to get away with flesh wounds from the financial and economic pain that has been inflicted worldwide. It’s been stable to withstand the front side of the hurricane but if the elements of high leverage and lack of internal investment remain, Canada could get hit on the backside with deflation as we’ve seen in countries like Japan, it could be a hangover that will be difficult to shake.