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Analysis: Canada's star fades as economy faces tough 2012

By Louise Egan

OTTAWA (Reuters) - Canada's moment in the sun as the fastest-growing economy in the G7 club of rich countries is set to end this year, when it will likely underperform the United States for the first time in seven years and struggle with a mounting household debt problem.

A potential housing market downturn has emerged as the top threat to the economy from within, along with the grim realization that a bad ending to the European debt crisis could set back growth in Canada, the world's 10th largest economy.

Even some perennially optimistic Canadians say the economy has lost its shine, pointing to late 2011 as the turning point.

In an opinion piece in the Financial Post newspaper this month, the usually upbeat economist Finn Poschmann explained how he had crossed over "growling and snarling, into the bearish camp."

"People spend a lot of time making fun of me and offer rose- colored glasses," chuckled Poschmann, vice president of research at the C.D. Howe Institute, a think tank, in an interview with Reuters.

"It was over the course of the fall as the housing prices just continued to march upwards and debt was growing ... It's not sustainable. It won't be sustained. Let's take a breath here," he said.

In the best case scenario, the housing situation will dampen growth as house prices grow faster than people's incomes and demand slows. In the worst case scenario, a crash could force many Canadians to default on their mortgages and really hurt the economy, although nobody expects a downturn as dramatic as the U.S. housing price collapse.

Canada had a remarkably swift recovery from the 2008-09 economic recession and leapt ahead of the U.S. in job growth, recovering the jobs lost in the recession by January 2011.

Prime Minister Stephen Harper and his finance minister, Jim Flaherty, often boasted of a track record that stood out in the industrialized world: solid growth, an unemployment rate well below that of the United States, a sound banking system that never needed bailouts and a relatively small fiscal deficit that it would eliminate within five years.

Canada is also one of the shrinking number of countries that still has an AAA debt rating. Foreign investors felt so confident in its safe-haven status that they bought a record amount of the country's bonds and stocks in 2010. Inflows have remained heavy since then, boosting the Canadian dollar and driving down bond and mortgage rates.

But as Harper's cabinet ministers fan out across the country this month to consult with business executives and others about the federal budget, they are likely to hear a different story of uncertainty and delayed decisions on hiring and investment.

Harper told his caucus this week that the priority for 2012 is preserving growth and creating jobs. The Conservative government aims to balance the budget in the medium term.

But Canada's job-creation machine has ground to a halt and for the first time in five year it no longer leads the U.S. in employment creation, although its jobless rate is still lower, said Doug Porter, deputy chief economist at BMO Capital Markets.

The Bank of Canada has held its key interest rate frozen at an ultra-low 1 percent for a record 16 months in a sign it too fears more turbulence ahead.

A Reuters poll released on Thursday showed analysts predict Canada will break with a six-year trend and grow 2.1 percent this year, below the U.S. forecast of 2.2 percent.

DOMINO EFFECTS

More dramatic is the shift in business sentiment. Net optimism among money managers at some of Canada's largest companies fell sharply in the fourth quarter to four percentage points from 22 points in the previous quarter, according to a survey by Deloitte.

Some 28 percent of Canadian chief financial officers expect the economy to worsen in the next six months compared to just 12 percent of American CFOs who hold that view.

"The messaging we're getting is consistent in terms of everyone is really worried about the economy and possible domino effects," said Eddie Leschiutta, a lead partner at Deloitte Canada and regional leader of the survey.

Canadian executives remain more upbeat generally than their U.S. competitors because the economy has a stronger starting point. But their mood has soured more dramatically and their forecasts of earnings growth are far more conservative.

Europe's problems, previously brushed off as having little direct impact on Canada, now loom large.

"The sense that we have is that it's really in the third quarter and through the fourth quarter that Canada starts saying 'wait a minute, this is big enough that it's going to affect us as well,' said Leschiutta.

Canada has little direct exposure to European debt but the impact on the global economy of a full-blown European banking crisis could squeeze its exports, hurt confidence and make borrowing harder.

Central bank chief Mark Carney on Wednesday said the European crisis was the biggest threat to Canada by far. He also predicted the household debt to income ratio would rise further from an already alarming 153 percent record reached last year.

But he assured business leaders that no matter how tough the times get, the banks are healthy and willing to lend.

And can Canada regain its status as the G7's star performer?

"That ship has sailed," said BMO's Porter.

"That doesn't take away from the fact that we've had a very good run over the last five or six years versus everyone else, and we're still left in a much better position ... but the gap is starting to close."

(Editing by Jeffrey Hodgson and Janet Guttsman)

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