TORONTO (Reuters) - Canada's economy should grow modestly next year, but problems abroad could threaten its strong banks and the government may need to act if there's a further rise in already record levels of housing prices and household debt, the International Monetary Fund said on Thursday.
In a report that praised Canada's "exemplary" fiscal and monetary policies, the multinational agency said it expects real economic growth to slow to 2.2 percent in 2011 and 1.9 percent in 2012. But the spillover of the European crisis on financial markets and global growth remains a major risk.
"Direct trade linkages with Europe are there. They're not very large so we would not expect a very large impact from a decline in European demand for Canadian product," said Gian Maria Milesi-Ferretti, IMF Mission Chief to Canada.
"More of concern are the potential global financial market repercussions of turmoil in Europe and there is a lot of uncertainty about that."
The IMF approved of the Bank of Canada's current accommodative stance - its key interest rate sits at a below-inflation 1 percent - but noted there is scope for further monetary easing if the economy weakens.
It also applauded the Canadian government's plan to balance its budget in the medium term, but said there was room for further stimulus if the economy ran into trouble. IMF officials noted Canada has the scope to respond flexibly, including allowing the deficit to automatically widen.
Provincial governments, many of which borrowed heavily to cope with the recession, need to move ahead with fiscal consolidation.
The IMF warned that high household debt levels and elevated house prices are the main domestic vulnerability, the same risks it cited a couple months ago.
While noting a stable banking sector that helped Canada survive the global recession better than many of its peers, the IMF called for more oversight of the Canadian Mortgage and Housing Corporation. The government housing agency provides mortgage insurance and mortgage-backed securities.
The IMF also said additional measures to restrain the housing market might be needed if prices and household debt continue to climb. The government tightened mortgage rules earlier this year.
In a separate report on house prices and household wealth, the IMF estimated that Canadian house prices were above levels consistent with fundamentals in some provinces. It projected that a potential 10 percent correction in prices would lead to a 1-1/4 percent drop in private consumption.
The IMF said growth in personal consumption and real estate investment should be subdued, in light of high household debt and the measures taken to cool the housing market.
Like the Bank of Canada, it also warned that businesses will need to step up investment to pick up the slack from weak net exports and fiscal challenges.
It said the Canadian dollar was "on the strong side" of medium-term fundamentals.
Editing by Jeffrey Hodgson and Janet Guttsman