The International Monetary Fund, in its annual report on Canada, also said Canadian dollar was between 5 and 15 percent higher than warranted by long-term economic fundamentals.
Although government measures since 2008 to cool overheated mortgage borrowing and house prices have helped prevent a US-style housing bubble, residential prices and construction are both still excessive, the IMF said, based on its meetings with Canadian officials from Dec. 3-18.
"The jury is still out on whether this is going to take care of the problem," Roberto Cardarelli, IMF mission chief for Canada, told reporters in Ottawa after releasing the report.
Since the IMF conducted its study, there have been more signs of moderation in the housing market. Home prices grew at the slowest pace in three years in December year-on-year, and housing starts fell more steeply than expected in January.
The high indebtedness increases Canada's vulnerability to an external shock because people cannot borrow their way out of a crisis if they are already maxed out, Cardarelli said.
In the IMF's soft landing scenario, a housing slowdown, including a cumulative 11.5 percent drop in prices over the next five years, would subtract 0.4 percentage point from gross domestic product yearly.
It urged Ottawa to be ready to intervene again if there is a sustained increase in the household debt-to-income ratio from the record high 164.4 percent in the third quarter of 2012.
"These measures could include higher down-payment requirements, lower caps on debt service-to-income ratios, and tighter loan-to-value ratios on refinancing," the IMF said.
It said the Bank of Canada should not use interest rate hikes to curb household borrowing except as a last resort, and it urged the central bank to keep its benchmark rate on hold at 1.0 percent until growth regains momentum, which it expects in late 2013.
The IMF forecast 1.8 percent economic growth in 2013 following a sluggish spell late last year, broadly in line with that of the government and central bank. It sees growth picking up in the second half of this year as the United States, Canada's top trade partner, recovers.
Growth could be weaker if there is a downturn in the United States or Europe, or if commodity prices slide further.
STRONG CURRENCY HURTS MANUFACTURING
Wading into a controversial domestic debate, the report said the sharp appreciation of the Canadian dollar and increased competition from China "contributed to the decline of Canada's manufacturing market share in the United States over the last decade."
It noted that the Canadian authorities "only partially agreed" with this view, saying the decline of manufacturing was a trend among all advanced economies. The main opposition party, the New Democrats, has clashed with the ruling Conservatives on this issue, arguing that the strong currency has hammered manufacturing jobs.
The IMF said the federal government is on track to balance its budget by 2015-16, but the fiscal outlook for some of the largest provinces such as Ontario and Quebec is less certain. A priority in the medium term will be to contain healthcare costs, a provincial responsibility, it said.
The IMF urged the federal government to consider two new approaches to fiscal planning, but policy makers appeared reluctant to agree, the report said.
It suggested Ottawa publish a "fiscal sustainability report" every three to five years that would review progress by each level of government - federal, provincial, territorial and municipal on managing debt and deficits.
And a variety of measures could be adopted to soften the impact of volatile prices for oil and other commodities on the economy and on government budgets. For example, the government could put aside savings during commodity booms for use in leaner times, and exclude commodities from some of its fiscal indicators to produce more accurate projections.
Copyright Reuters, 2013