Hidden Risks Behind Growth: Why the Bank of Canada Needs a More Substantial Interest Rate Cut

Interest rate cut

Last week, Statistics Canada reported an annualized growth rate of 2.1% in the second quarter of this year. At first glance, this seems encouraging. However, a deeper look reveals structural issues within the Canadian economy, and the challenges facing the banking sector further highlight the potential risks.

Firstly, while a 2.1% growth rate appears promising, this growth has been primarily driven by government spending, with public expenditures accounting for approximately 80% of the economic expansion this quarter. it raises concerns about the sustainability of Canada's economic growth, particularly as Canada’s public debt continues to rise.

Moreover, despite overall economic growth, per capita GDP in Canada has declined for the fifth consecutive quarter. This indicates that the growth is more reliant on population increases rather than the labor productivity. For business consultants and companies looking to understand economic trends, this decline in per capita GDP underscores the need for more robust and sustainable growth strategies.

Consumer spending trends also highlight the underlying weaknesses in the economy. Although consumer spending increased by 0.6% in the second quarter, this growth was largely driven by passive spending on essentials such as mortgage payments, rent, and utility bills. These are expenses that consumers cannot easily control, reflecting the rising cost of living in Canada. In contrast, discretionary spending on durable goods has contracted, signaling a decline in consumer confidence and a cautious outlook on the future economy.

Meanwhile, Canada’s banking sector is facing significant challenges. Their Q3 2024 financial reporting reveal that the six major Canadian banks wrote off a staggering CAD 3.5 billion in bad debt in the third quarter. To put this in perspective, during the worst period of the 2008 financial crisis, banks wrote off only CAD 1.5 billion, and during the third quarter of 2020, at the height of the pandemic, the figure was CAD 2.6 billion. The Canadian banking sector’s struggle, particularly with rising bad debt provisions, is a clear indicator of the economic risks businesses may face.

For businesses and investors, understanding the impact of the Bank of Canada’s interest rate decisions is crucial. Although the Bank of Canada has begun cutting rates and plans to continue, it remains uncertain whether this will alleviate the banking sector's difficulties. The health of the banking sector is closely tied to broader economic stability. If the housing market in Canada fails to recover, the bad debt problem could worsen, posing greater risks to the entire economy.

In summary, while Canada’s economic growth may appear strong on the surface, the underlying risks are significant. The banking sector's struggles serve as a warning for businesses. If effective measures are not taken to promote a healthier growth model, Canada’s future economic outlook could be bleak. This makes the Bank of Canada’s upcoming interest rate decision after the Labor Day long weekend particularly important. A more substantial interest rate cut, beyond a mere reduction of 25 basis points, is necessary to address these challenges and support sustainable economic growth.