Debt-fuelled economy unsustainable, Carney says

Canada's relatively healthy economy has been largely based on borrowed money but the situation cannot go on indefinitely, Bank of Canada governor Mark Carney warned Thursday.

The central bank governor's stern words to a business audience in Halifax came just hours after federal Finance Minister Jim Flaherty moved toclamp down on household lendingby reducing the amortization period on mortgages to 25 years from 30, and by limiting home equity loans.

Carney made clear that he endorses the moves, calling them "prudent" and "timely" to support the long-term stability of the housing market and guard against financial excesses.

"These measures are to ensure the sustainable evolution of the Canadian housing market and, importantly, the finances of Canadian households," Carney told a press conference following his remarks.

Carney suggested he has no patience for the view that instead of raising interest rates his next move will be to cut the trendsetting overnight rate from the current one per cent, where it's been since September 2010.

"Our economy cannot ... depend indefinitely on debt-fuelled household expenditures, particularly in an environment of modest income growth," he said.

"Notably, housing investment rose further relative to GDP in the first quarter, and accounts for an unusually elevated share of the overall Canadian economy."

Earlier this month, Statistics Canada reported that household debt in relation to disposable income had reached a new record at 152 per cent, but much of that was due to falling incomes rather than increased borrowing.

Still, there's evidence of consumer fatigue already. In a report issued Thursday, Statistics Canada saidretail salesfell an above-consensus 0.5 per cent in April.

Raising rates may become appropriate

Carney said that if the current economic expansion in Canada continues, "some modest withdrawal" of monetary stimulus interest rate hikes may become appropriate.

The governor has used similar language on interest rates before, most notably the last two policy setting dates, but markets are largely ignoring his warning given the darkening storm clouds gathering outside Canada's borders.

On Thursday, the CIBC suggested that Carney may have little choice but to keep interest rates where they are until 2014, assuming that's the time the U.S. economy shows some signs of life.

Carney gave every indication in his speech that he is worried about the global recovery, particularly the growing risk that Europe's debt crisis will expand and set off a chain of events that lead to slower global growth, and possibly even a double-dip recession.

Some of the risks around the European crisis are materializing, he said, and now the outlook is "skewed to the downside," which means it is more likely the situation will get worse than improve.

This is already impacting the global economy. Slow growth in advanced nations has slowed expansion in China and other emerging markets, which have supported what little global growth there is. For Canada, this has meantthe price of commodities like oil that it sells to the world have fallen, although they remain elevated.

European debt crisis the real danger

But the real danger is of European contagion, which given the inter-dependent global financial markets, will hit Canada as well.

Even Canada's strong fundamentals won't save us, Carney said.

"Given the reality of global finance, it's not enough to have our house in order unless we seal ourselves off from the world," he said. "And, of course, if we seal ourselves off from the world, we would end up much poorer."

Carney's words echoed those of Flaherty early in the day when he warned that unless Europe acts quickly to contain the damage, Canadians will be in for a difficult summer.

The government made clear the solutions will not be easy, nor will they be instant. Carney said policy-makers must work to get the structure of the global economy right, fix the European monetary union, move to resolve global imbalances between borrowing nations like the U.S. and creditor nations like China, and continue with financial reforms that will end "too-big-to-fail" banks and build resilient institutions..