October 26, 2012 - MLI's Philip Cross writes about the outlook for provincial debt in today's Financial Post. He says, "Taking the current pattern of spending and taxation by province, and projecting what will happen to provincial finances as the populations ages and as interest rates trend to more normal levels, shows that eight of the 10 provinces have a more than 50% likelihood of default 30 years from now."
According to Cross, "A default by a provincial government would affect all Canadians. Not only would federal taxpayers have to pick up the tab for a bailout but interest rates across the country could go up if our current status as a safe haven in a world of financial uncertainty is tarnished." He adds that the only way to avoid this is to adopt policies that begin to address a province's fiscal follies. "Past fiscal crises show that the longer action is delayed, the more severe and less politically appealing it will be."
In his column, he also refers to MLI's recently released study by Marc Joffe on the same subject, Provincial Solvency and Federal Obligations.
Read his full column below:
By Philip Cross, Financial Post, October 26, 2012
Outlook for provincial debt is increasingly worrisome
Is there a provincial default crisis in Canada's future? With the best fiscal record in the G7 over the last two decades and having weathered the economic storm of the late unlamented recession better than any other G7 country, Canadians have earned some bragging rights. Unknown to most Canadians, however, major problems of public debt at the provincial level are being stored up for the future, problems that could ultimately tarnish Canada's reputation and darken our economic future if we do not change course, and soon.
The problem is not in Ottawa. 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 to less than $20-billion and shows no signs of returning to structural deficits.
Unfortunately, this does not apply to most provinces. Their collective deficit was $42-billion (at annual rates) in the second quarter of 2012, over twice as large as the federal deficit and not far from their high of $52-billion in mid-2009.
The outlook for provincial debt is increasingly worrisome. Taking the current pattern of spending and taxation 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% likelihood of default 30 years from now.
Just mentioning the words "government" and "default" in the same sentence in Canada causes conniptions in some quarters. You might well ask why after recent events in Europe. Professors Carmen M. Reinhart and Kenneth S. Rogoff documented in their perfectly timed 2009 book, This Time Is Different, that government defaults over the centuries happen so often, the wonder is not that they occur but why anyone lends to some governments in the first place.
Provincial government defaults on debt have been more common than many people 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 Marc Joffe for 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% of all tax revenues.
A major finding of the study is that provincial bond yields are remarkably close to federal yields despite differences in their default risk, as measured either in the short-term by the ratings agencies or in the long-term using a model developed by Joffe. The explanation appears to be that markets assume a repeat of the federal bailout of the provinces in the 1930s. Some commentators have suggested markets expect the provinces to react appropriately before going over their own fiscal cliff, but this should vary more from province to province than we see reflected in actual bond yields.
A default by a provincial government would affect all Canadians. Not only would federal taxpayers have to pick up the tab for a bailout but interest rates across the country could go up if our current status as a safe haven in a world of financial uncertainty is tarnished. And while every debt crisis is different, Europe shows how contagion can easily spread from one jurisdiction to another.
We know that some provinces are capable of radical change when faced with a fiscal crisis. Each province has its own preference for the mix of spending cuts and tax hikes needed to balance their books. Alberta in the mid-1990s, for example, closed three of the eight hospitals in Calgary, resulting in a memorable video of one being blown up. At the other end of the spectrum, Saskatchewan and Quebec have resorted more to tax increases than other provinces.
However, if the federal government is ever forced to bail out a province, it will be in a position to insist on changes to provincial policies that may conflict with that province's preferences. This reflects the reality that we are seeing in Europe today, where the countries paying for the bailout of other members of the eurozone are extracting a price in terms of structural reforms to improve productivity and fiscal responsibility.
The only sure way to avoid a loss of any province's sovereignty over its areas of jurisdiction, like spending on health care and education or the taxation of natural resources, is to adopt policies that begin to address its fiscal follies. Past fiscal crises show that the longer action is delayed, the more severe and less politically appealing it will be. Otherwise, some provinces risk becoming an ignominious entry in a future edition of Rogoff and Reinhart.