November 24, 2012 - MLI research co-ordinator Philip Cross and author Marc Joffe write about Ontario's looming default crisis in today's Ottawa Citizen. Read the full op-ed below.
The op-ed is based on MLI's recent study, Provincial Solvency and Federal Obligations by Marc Joffe, published on October 18, 2012.
By Philip Cross and Marc Joffe, Ottawa Citizen, November 24, 2012
The recent announcement that the federal government has delayed balancing its books by a year due to the slowdown in global growth has focused the debate on public finances on the federal deficit. But this is the wrong focus. By international standards, Canada's federal government remains a beacon of fiscal probity.
Despite a run-up in the federal deficit to over $50 billion during the recent recession, it has shrunk quickly. Even allowing for the slower global growth that will delay by a year its balancing the books, there are few signs of a return to structural deficits, as the government has capped the future growth of health spending and raised the eligibility age for OAS.
Instead, the focus of attention should be on the provinces. In the most recent quarter, their collective deficit was $42 billion (at annual rates), over twice as large as the federal deficit. While the federal deficit has been cut by more than half during the recovery from recession, the provincial deficits collectively have barely shrunk from their high of $52 billion in mid-2009.
The outlook for provincial debt is increasingly worrisome. Taking the current fiscal spending and taxation patterns by province, and projecting what will happen to provincial finances as the population ages and as interest rates trend to more normal levels, shows that eight of the 10 provinces have a more than 50-per-cent likelihood of default 30 years from now.
Provincial government defaults on debt have been more common than many think. Half the provinces needed federal bailouts during the 1930s.
As recently as 1993, the Saskatchewan cabinet openly debated default as an option during its fiscal crisis. A recent study by the Macdonald-Laurier Institute finds that the key determinant of default is not when debt hits a certain level of GDP, but when interest charges eat up 25 per cent of all tax revenues.
A default by a provincial government would affect all Canadians. Provincial bond rates do not reflect provincial default risks, a sign that markets assume that the provinces will be bailed out by the federal government, as they have in the past. This implicit subsidy lowers the cost of financing provincial debt.
The rankings of the risk of provincial default may surprise many people, partly because the stock of debt today is not the key determinant of future solvency problems. Alberta has the most risk 30 years out, the byproduct of today's youthful population growing old later and its volatile energy resource revenues. Conversely, despite having the highest debt-to-GDP ratio of any province today, Quebec has the lowest risk 30 years out, as its population aging occurs earlier than in other provinces and as it has recently taken steps to rein in its deficit.
Ontario has the highest risk of insolvency over the next 15 to 20 years and the second highest over 30 years (at 79 per cent). This is the result of both its high level of debt today and the large deficits it is currently running. Ontario has the second-highest ratio of debt to GDP of any province of 39 per cent in 2012, behind only Quebec, while its annual deficit is $13 billion.
All this assumes that governments continue with their current spending and taxing policies. In practice, we know that some governments are capable of radical change when faced with a fiscal crisis.
Alberta in the mid-1990s, for example, closed three of the eight hospitals in Calgary, resulting in the memorable video of one being blown up. After its futile experiment of fighting a recession with large deficits, Ontario cut spending sharply in the mid-1990s to avoid falling over its fiscal cliff. Future fiscal austerity will be more challenging, however, because it is rooted in structural changes as the population ages and economic growth slows. As spelled out in Don Drummond's report on Ontario's finances, this will require a fundamental re-think of how the government delivers services.
So, if bondholders are convinced they are not going to get stuck holding the short end of the stick, who is?
Here is a hint about the answer to that question: look in a mirror. The public will bear the burden of the spending cuts and tax increases that inevitably accompany the onset of every fiscal crisis, and there is no reason to think that will change anytime in the coming decades.
Philip Cross is research co-ordinator at the Macdonald-Laurier Institute in Ottawa. Marc Joffe is principal consultant at Public Sector Credit Solutions in San Francisco.