The extraordinary surge in short-term business lending at the end of last year clearly demonstrates how businesses managed to cope with tumultuous finan¬cial markets. The credit crisis dried up liquidity on credit markets, spreads rose through the roof while volatility was surging on stock exchanges, all making for extremely unfavourable conditions for the issuance of debt and equities.

Yet, while long-term financing was severely hit, short-term lending boomed in both Canada and the United States to levels not seen since the 1970s. Equally impres¬sive was the way this boom defied any sort of economic fundamentals at the time that would have called for such a ramp-up.

As asset-backed commercial paper (ABCP) was severely disrupted, companies turned to banks for financing. However, this alone cannot explain the massive acceleration. Another part of the explanation lies in the move away from capital market financing to short-term bank financing despite potential asset-liability mismatch issues. Another reason was a strong incentive to build up liquidity reserves against future possible shortfalls similar to the experience of the 1980s and 1990s recessions. However, economic fundamentals are now taking the lead again, and these recent trends are already reversing.

Canadian business markets: Short-term lending to slow
Through the end of 2007 and the beginning of 2008, Canadian-dollar denominat¬ed loans at banks surged to reach the highest rate of growth since 1982 . Part of this reflected the collapse of the ABCP market as some liquidity back-up lines of credit were used. Still, the decline in commercial paper outstanding (C$ 1.4 billion between June and October 2007) was small compared to the in¬crease in bank loans (C$6.6 billion during the same period), meaning that this was not the only driver of Canada's lending boom. The traditional close link between short-term business financing and inventory investment appears to have broken down. The last two times that short-term financing over¬shot inventory investment in similar fashion (1979-1981 and 1988-1990), the economy went into a recession and lending tanked.

Past experience suggests that firms have a strong incentive to take on short-term debt before downturns to protect their liquidity levels against an anticipat¬ed deterioration in their working capital (e.g., write-offs of accounts receivable). We believe that the Canadian economy is still safe from a recession but that there is a high probability that lending growth will falter in the months ahead as the economy grows at a subdued pace. Already, growth in Canadian short-term financing is off the 22% peak recorded in January on a year-over-year basis, having declined steadily to 14.6% as of April.

This deceleration is in line with our forecast so far, but the big decline in Cana¬da's inventory investment in the first quarter of 2008 would have normally meant a more substantial decline in short-term lending growth. These two variables are usually well correlated, but the link has faded recently. Even though liquidity levels and leverage measures of non-financial businesses appear healthy, the market drivers that call for more conservatism on lenders' part remain powerful, meaning that this recent episode may well be offset by a period of much softer growth in future short-term financing as short-term credit expan¬sion falls back in line with inventory investment.

Based on such a scenario for the latter part of the year, our forecast of 8% growth for short-term credit in 2008 for Canada is on track, although the record spikes earlier in the year convey upward risks.

On the long-term side, financing was affected by market turmoil at the beginning of the year (chart 3); however, some conditions have improved in the second quarter. The commodity-driven TSX broke another record in May, risk appetite has been rising gradually and credit spreads have stabilized as investor sentiment turned less negative. While these conditions have been positive for long-term market-based issuance, downward risks are still alive for the near-term as the North American economy and financial markets prove fragile as evi¬denced by the latest eruption of market anxiety in June.

As such, the slowdown in stock issuance in Canada tracks our 3% projection, but retreating commodities later this year could mitigate the effect of strong stock markets so far. The late recovery in the Canadian bond market makes our 4.6% year-end forecast very achievable, especially if our expectation of Canadi¬an capital spending to remain healthy proves correct. Overall, our long-term forecast of 3.7% for long-term financing growth in Canada appears sound.

United States: Financial and economic challenges weigh on long-term business financing
In the United States, growth in commercial and industrial (C&I) loans jumped 49.6% in the month of September 2007 alone on an annualized basis but has retreated significantly since then. As of May, C&I loan growth was down to only 3.3% annualized. Constrained credit on capital markets, which has caused businesses to turn to banks and liquidity back-up lines attached to asset-backed commercial paper to access financing, has contributed to C&I loan growth lev¬els unseen in 28 years, heightening the risk of short-term lending overshooting our forecast of 7%.

These factors are already proving short-lived and we expect further cooling going forward, especially as inventory accumulation is likely to remain on the soft side.

Long-term financing decelerated sharply in the early stages of the crisis, with stock issuances taking most of the hit while, on bond markets, specula¬tive-grade issuance bore the burden of the jump in risk aversion. Investment-grade issuance was left relatively intact. Our forecast is still tracking well so far for bonds and commercial mortgages while equity financing will most definitely fall out of the forecast range given recent market developments.

In addition,expected soft capital spending will likely emphasize downside risks for issuance in the bond and commercial mortgage segments as well. As a result, it now appears very probable that overall long-term business lending growth will end the year in negative territory.

Business credit quality: Controlled deterioration ahead
Deterioration of credit quality was already under way in the earlier stages of the credit crisis and the current backdrop featuring higher financing costs, surging commodity prices and subdued demand means squeezed corporate profits and cash flows. In Canada, manufacturers will once again be the big losers, while wholesale and retail trade still benefit from strong spending momentum. In the United States, business exposure to diversified global markets will be a critical factor in preserving credit quality. Despite these challenges, North-American businesses are still much less levered than at the beginning of the decade and high liquidity levels on balance sheets should provide enough ammuni¬tion to businesses to get through the soft patch without too much damage.

Diverging consumer credit markets
The gap between Canadian and U.S. household debt markets keeps widening as the U.S. housing market pays dearly for past financial innovation excesses, while Canada's market stays on firmer footing, with only the most conservative of innovative products being offered. While there is still room for more innova¬tion in Canada, the effects have been positive so far and have contributed to one of the longest housing cycles in Canadian history, with the number of units started exceeding the 200,000-mark for the past six years.

While these levels will likely not be sustained significantly longer because eroding affordability has started to cool the hotter markets, we still don't foresee any danger of a U.S.- style collapse. Canada's lateness in liberalizing its mortgage (and mortgage in¬surance) market compared to other countries (e.g., Spain, the United States, the United Kingdom) may have helped it to avoid the pitfalls of some of the riskier practices and products. Still, the home ownership rate in Canada is among the highest in the world and, although they have appreciated, house prices have not been inflated to bubble levels on a widespread basis.

Canadian household credit still buoyant
As a result of recent developments, mortgage credit growth in Canada exceeds our expectations, running at 13.5% on a year-over-year basis as of March. This is the fastest pace in nearly 18 years, even as housing activity in some of the hottest markets is waning. Mortgage growth is, nevertheless, expected to decel¬erate given the effects of a mildly slowing economy that should cool demand and housing starts.

Our 9.2% projection for mortgage growth is in line with this scenario. In addition to a healthy housing market, robust consumer spending in Canada is fuelling double-digit increases in non-mortgage consumer loans, with very high activity in the personal lines of credit segment, which jumped nearly 17% in April on a year-over-year basis. Here, also, some moderate expected deterioration in Canada's job market will likely curb spending and bring overall consumer loan growth closer to our year-end forecast of 8.5%.

U.S. mortgage financing decelerating markedly
The U.S. case contrasts sharply. Even if the housing market has shown some very tentative signs of bottoming out, talk of a recovery is premature. The culprit remains the increasing number of foreclosures. Attempts at providing loan modification options to troubled borrowers have been modest so far, despite the "Hope Now" initiative.

A recent study from the Office of the Comp¬troller of the Currency (OCC) found that in national U.S. banks, payment plans outnumber loan modifications by a ratio of four-to-one. Loan modifications allow for interest rates and maturity date alterations, whereas payment plans merely help borrowers become current without much change to the loan con¬tract.

Meanwhile, the 10.8 months of supply in inventory as of May, declining home values, surging delinquencies and faltering consumer confi¬dence make clear that the road to normalcy will be long and arduous.

Growth in mortgages outstanding is still in positive territory as of the first quarter, at 5.6% from a year ago, but the small 3% increase from the previous quarter maintains a decelerating trend that should continue as prospective buyers stay on the sidelines and foreclosures continue to mount.

Outstanding mortgages are on track to grow by only 3%-4% during the year, well below our initial forecast of 9% growth. The more widespread effects of the credit crunch have also emphasized the downside risks to our non-mortgage consumer lend¬ing forecast, which is now on track to end the year with below 5% gains, somewhat lower than our 8.2% projection.

Credit quality deterioration a bigger threat in the United States
Credit quality is much less at risk in Canada than in the United States. This is confirmed by trends in charge-off rates, which decreased again in Canada in 2007 while jumping significantly in the United States. In both cases, bankrupt¬cy rates had been kept in check despite the rising debt-service burden, likely due to the effects of strong non-employment income gains and elevated con¬sumer liquidity providing a thick buffer.

The first quarter of 2008 showed a significant increase in U.S. charge-off rates (chart 13), most likely the spillover effects from mortgage foreclosures.

In this context, with the slow speed of implementation of mortgage modification meas¬ures, combined with high energy and food prices that make matters worse, the risks of further and faster deterioration in U.S. household credit quality have been heightened. Deteriorating credit quality also holds true for the Canadian consumer, but bankruptcies are still under control given a stronger job market and still lower levels of indebtedness.