Canadian financial system stable, but trade war poses big risks, says central bank

By Promit Mukherjee and David Ljunggren

OTTAWA, May 8 (Reuters) - A prolonged trade war could increase the risks to Canadian financial stability by hurting banks and other institutions and by making it harder for households and businesses to pay down debt, the Bank of Canada said on Thursday.

In its annual Financial Stability Report, the central bank said the financial system was resilient.

But the impacts of tariffs slapped by U.S. President Donald Trump on Canada and Ottawa's subsequent counter-tariffs could hurt financial stability, especially if they continue for a long period of time.

"A long-lasting trade war poses the greatest threat to the Canadian economy. It also increases risks to financial stability," the bank said, referring to the outcome of the two scenarios of economic growth the BoC had offered in April.

The first of the two scenarios envisaged a relatively quick end to the tariffs. The second assumed a global trade war.

Governor Tiff Macklem said there had been some positive developments since April but cautioned that it was still early.

Prime Minister Mark Carney sat down with Trump this week for meetings which both sides described as positive.

"I think it's important that they understand each other's positions, and it's important that the lines of communication were open," Macklem told a press conference. "There's clearly a long way to go."

The BoC said in the near term, the unpredictability of U.S. trade policy could cause further market volatility and strains on liquidity. In an extreme case, market volatility could turn into market dysfunction.

In the medium to long term, a prolonged global trade war would have severe economic consequences, it added.

If the trade war continues, some households, especially those carrying higher levels of debt, might default on their payments, the bank said, adding that currently, stress was concentrated mainly among households without a mortgage.

This could hurt a strong banking system which has built a robust liquidity base and access to funds, the BoC said.

"If credit losses occur on a large enough scale, banks could cut back on lending in response. Struggling households and businesses would have less access to credit to get through tough times. This cycle could exacerbate the economic downturn," it said.

The BoC also highlighted a heightened risk from hedge funds which have been taking increasing exposure to Government of Canada bonds. In some cases they have bought almost half of all the auctions of government bonds.

But a bulk of their purchases is supported by debt, making them more likely to pull back from the market in periods of stress, threatening the bond market.

As interest rates started coming down in Canada last year, overall level of household debt dropped and insolvencies among businesses fell.

Those households with a mortgage that will be renewing this year or next are generally in a more resilient position to make payments due to lower rates, but if impacted by job loss or loss of income, some households might be hit.

Businesses with existing vulnerabilities such as high leverage, weak profitability and low cash reserves are also at risk of falling behind on debt payments.