The Bank of Canada is warning that certain overheated segments of the housing market could put Canada's economy at risk and has again singled out Toronto's condominium market as an area of particular concern.

In its latest assessment of Canada's financial system, the central bank said that imbalances in the housing market and high levels of household debt still pose an "elevated" risk to the stability of the Canadian economy and are the two biggest risk factors on the domestic front — with the eurozone crisis presenting the biggest threat internationally.

It said that while house prices have stopped rising in most major urban areas and housing starts, resales and overall housing demand have slowed, there are still signs of overbuilding and overvaluation in some parts of Canada's housing market.

"House prices are high relative to income … and the total number of housing units under construction remains significantly above its historical average relative to the population," the bank's report says.

Almost all of that construction activity is in the area of multiple-unit dwellings of the condominium variety.

The bank's assessment of the housing market echoes that of the Organization for Economic Co-operation and Development (OECD), which last week issued a report that identified Canada's housing market as one of the three most overvalued among advanced economies.

Condo market dip could have ripple effect

The bank said Canada's housing problem is particularly acute in Toronto, with a large number of unsold highrise units that are under construction or in the pre-construction phase. If these units are not sold over the next 12 to 30 months as they are completed, it could cause prices to fall and bring residential construction to a halt, the bank warned.

If investor demand has boosted condominium construction beyond demographic needs, this could make the market more susceptible to shifts in buyer sentiment, the bank said.

That, in turn, could blow back on other parts of the economy.

"Any correction in condominium prices could spread to other segments of the housing market as buyers and sellers adjust their expectations," the bank said in its analysis. "Such a correction would reduce household net worth, confidence and consumption spending, with negative spillovers to income and employment."

If the correction to the imbalances in the condo market is sudden rather than gradual, it could provide an unwelcome jolt that has the potential to reverberate not just in other segments of the housing sector but across the economy.

While borrowing costs remain low now, the spillover effects from a sudden dip in the condo market could "weaken the credit quality of banks' loan portfolios" and result in tighter lending conditions for households and businesses, the bank said.

"This chain of events could then feed back into the housing market, causing the drop in house prices to overshoot," the report said.

Sharp deterioration 'unlikely'

The housing market could be thrown off by any number of factors, such as an increase in interest rates, an economic downturn or a deepening of the eurozone crisis.

RBC assistant chief economist Dawn Desjardins agrees that a sharp decline in the condo market could have a ripple effect.

"People see that market deteriorating — do they suddenly feel very concerned about whether it is going to bleed through the country? [Do they ask,] 'Should I be selling or perhaps not buying as opposed to moving on with a purchase?'

"That's the kind of trickle-through that we see in terms of a possible scenario, but I think it would have to be quite a pronounced deterioration in that one particular market for that result to actually occur."

The bank's scenarios, she says, are just that — and are different from its "base case" outlooks, which are much more about what the bank thinks will happen rather than what could happen.

"It's just kind of food for thought and to direct people's attention to areas where there's possible trouble down the road, but in no way is it imminent — and, quite likely, won't happen at all," Desjardins said. 

Outlook more positive than 6 months ago

Desjardins says the bank's June assessment is not that different from its earlier report in December and is overall more positive in tone, painting a picture of a less-threatening environment than six months ago.  

Indeed, the bank said in its analysis that "recent developments in the housing market have been encouraging" and that it expects the housing market to correct itself gradually.

The household debt picture is also improving, with the pace of debt accumulation now "broadly in line with the growth rate of disposable income," although a rise in interest rates could still leave some households vulnerable, the bank said.

The risk to Canada's economy from a eurozone still in recession remains "very high," with economic activity in the region "constrained by fiscal austerity, low confidence and tight credit conditions," the bank said. 

Weak economic activity, a fragile banking sector and vast differences in competitiveness between the countries that make up the currency union are a drag on the eurozone's recovery efforts and pose a risk to the stability of an interconnected global financial system, of which Canada is an important part.

Economic growth in Canada picked up in the first quarter of 2013 after a weak last quarter of 2012 but is still being dragged down by "deficient demand" in the global economy, the report said. The economy also faces some risk from the prolonged period of low interest rates, which has led to increased risk taking.