No way to sugar-coat this. This is going to hurt.
This week's decision by the Office of the Superintendent of Financial Institutions (OSFI) to increase the domestic stability buffer to 3.5 per cent, on the heels of the Bank of Canada’s decision to increase its interest rate to 4.75 per cent – the highest level in over 20 years – are almost certain to lead to a recession and make Canada's lagging productivity issue even worse.
The intention behind these decisions is to dissuade homebuyers from paying high prices, persuade employers not to hire, cause unemployment to deter unions from demanding wage increases and punish consumers with balances on their credit cards.
The result will also be to reduce business investment that has been declining since the middle of the pandemic to even lower levels, putting the country’s economic future even more at risk.
According to all the economists from the big banks, this is the recession we need and even more interest rate increases are likely.
Canada, according to the Organization for Economic Cooperation and Development based in Paris, has been at the back of the pack in terms of productivity growth and financing conditions for small and medium sized enterprises, or “SMEs,” for many years.
Better access to financing is desperately needed to reverse a decades-long slide. Instead of getting better, it is getting worse.
BoC and OSFI manage conditions for households and banks but not for SMEs
The Bank of Canada gets reliable statistics on household debt and housing prices. It and OSFI get regular advice from the banks and get real time insight into what’s happening on their balance sheets.
In a two-pronged approach, the BoC is hammering demand for debt by increasing rates while OSFI is choking off the banks ability to supply debt by increasing the domestic stability buffer – additional equity banks must retain – for the second time in less than a year.
Interest rates and stability buffers are blunt policy instruments. While the intention may be just to slow the rate of increase in consumer spending and real estate buying, they will stop much of the lending needed to fund investments in productivity and growth by SMEs.
Few economists, apart from the notable exceptions who appear in Business in Vancouver, focus on SMEs and how they are key to Canada’s economic future.
Jock Finlayson, Ken Peacock and David Williams, in many articles in past issues of BIV, have described the serious, persistent and deeply structural problem that is Canada’s lagging productivity and GDP growth, and the consequences for the future of the Canadian and B.C. economies.
They have explained how GDP growth depends on increases in efficiency, expansion of capacity and growth to scale primarily by SMEs – all of which is mainly funded by debt.
This is not just growth for its own sake. This is change and adaptation that businesses need in order not to fall further behind. It is growth that makes taxation possible and supports the Canadian dollar at a level where we can afford the imports we rely on.
The above-mentioned and others at the C.D. Howe Institute – the only public economic commentator that did not think hiking rates in early June was a good idea – have been sounding the alarm about declining productivity and appallingly low business investment for years as the Bank of Canada’s own data shows capital stock per Canadian worker has been declining since 2015.
The hidden cost of highly regulated and protected banks
SMEs in Canada do not have the same access to financing comparable in terms of volume and cost as peers and competitors in other OECD countries. It is a well-documented structural issue that has existed for over a decade.
Commentators, mainly from governments and banks, insist SMEs in Canada are not at a disadvantage. They base this on opinion surveys, not statistics, and point to a lack of equity capital or even a lack of ambition and risk-taking ability among Canadian entrepreneurs as the culprit.
This is victim blaming, and a bit rich coming from bureaucrats and bank executives.
The brute fact is that the availability and cost of debt is materially less favourable for SMEs in Canada than in almost every other comparable OECD country. The fact that in surveys organized by the federal government of SME owners and managers, financing is not at the top of the list of challenges likely indicates how low their expectations are for getting it than anything else.
In the U.S., where Canadian governments are working hard to increase economic integration, SMEs are much better off in terms of access to financing.
Improving access to debt capital in Canada is the only practical route into this problem. Every financing discussion starts with it. "How much?" is followed by "What is the risk" and then "What return is needed to compensate for the risk?" When the return is too high to be a cash obligation of the venture, that’s when the subject of equity will naturally come up.
These discussions are unlikely to take place with large banks, where commercial lending is no longer a favoured line of business and where AI is being implemented for all but the largest lending transactions. Inside the big banks, lending to SMEs has to compete for attention with other business lines: Capital markets, wealth management, retail banking and mortgage lending, all of which generate more reliable returns with less risk.
Business-focused banks – like recently shuttered Silicon Valley Bank – are more liable to fail, but that would be worth the risk if it there could be a SME sector in Canada as robust and creative as that which exists in the U.S.
Credit unions could step up. They have been gradually increasing their share of SME business and have always been preferred as counterparties in surveys done by the Canadian Federation of Independent Business. However, they are far behind the major banks in terms of capability and capacity.
Artificial intelligence, fintechs, changes in the wholesale funding market, the possibility that regulators and governments will take the time to dig more deeply into this issue, can also give us hope.
We know Canada’s lagging productivity is a result of alarmingly weak business investment by SMEs. We know access to financing for Canadian SMEs has to be better than it is now.
It was a problem before the pandemic and before the interest rate shocks the Bank of Canada decided to inflict on the economy. The future is at risk. What are we going to do about it?
Guy Heywood, a former banker and CPA, is principal of Corporate Banking Advisory. He advises companies on financing strategies and technology.
