The rapid rise in household borrowing in recent years, combined with reduced savings, have increased the vulnerability of North American households to an adverse turn in the economy, according to a report released today by Scotiabank.

“The debt-financed consumer spending spree in the United States and Canada is not letting up, pointing to even higher levels of household indebtedness in 2004,” says senior economist Adrienne Warren, co-author of the report with Aron Gamplel “The key factors underpinning borrowing — affordability, rising property values, immigration, dual incomes and asset diversification — are still broadly supportive.”

“Though the current economic and interest rate environment is relatively benign, debt service burdens are highly leveraged to a significant rise in borrowing costs,” added deputy chief economist Gampel. “No less problematic would be the sharp deterioration in underlying economic circumstances, such as job losses, slower income growth or declining home prices.

According to the report, rising home valuations, and more recently higher stock prices, are boosting household net worth, thereby helping to insulate borrowers from the ongoing rise in indebtedness. Nevertheless, alternative measures of savings and liquidity have continued to weaken, suggesting that the financial cushion supporting households is probably inadequate to protect against a sustained rise in interest rates or a severe correction in the housing market.

The economists estimate that in Canada, for example, a one percentage point increase in the average effective interest rate over five years would lift debt servicing costs as a share of after-tax income to almost 9% from the current 7.5% level.

At the same time, the economists note that the immediate impact of rising interest rates will be diffused by the significant amount of refinancing activity that has basically locked in low borrowing costs.

The report also highlights important differences in Canadian and U.S. balance sheet trends. In the U.S., a lack of improvement in debt servicing ratios despite ultra-low borrowing costs as well as rising household leverage in real estate markets are key concerns. In Canada, a growing shift to variable-rate mortgages and lines of credit has increased the speed and degree to which higher interest rates would affect the household sector.

“Despite record household indebtedness, North American finances are reasonably healthy, thanks to low interest rates and continued income gains,” said Warren. “Household net worth is on the rise again, mainly due to appreciating home values, and in Canada has just surpassed its late-1990s peak. Nevertheless, recent balance sheet developments suggest that a sustained rise in interest rates or a decline in housing prices would pose a credible longer-term risk to the overall economy.”