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Feb 26, 2015

Can Canada learn anything from the Eurozone debt crisis?

February 26, 2015

Canadians like to brag about the strength of our country’s public finances.

But a cursory look at government debt reveals that the provinces owe a striking amount of it. This is worrying, as provinces are far more vulnerable to the whims of bond markets than the federal government.

To date, however, it hasn’t impeded the provinces’ ability to borrow. Interest rates are low and the major rating agencies forecast virtually zero probability of a provincial default.

Many warn these conditions will not last: Interest rates will rise and the provinces will be forced to hike taxes and slash spending. In truth, a credit crisis is unlikely in the short term. But who’s to say Ottawa won’t have to come to one of the province’s rescue at some point in time?

Stephen Gordon raised this concern last week in his column on lessons from the Greek debt crisis. Canada is no Greece, but the challenges of managing government debts in a currency union raise uncomfortable parallels between Canada and the beleaguered Eurozone. Gordon urges Canadian governments to get ahead of the curve by establishing ground rules for provinces to follow in the event of a credit crunch.

But what should these rules look like? Experts in this area generally have a couple of scenarios in mind. One idea is that Ottawa could turn provinces over to the bond markets. It would declare a no-bailout policy and signal its willingness to let provinces default. Risk premiums on provincial bonds would rise and provinces — under the pressure of higher rates — would be forced to adjust.

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This strategy isn’t credible. Ottawa might say it’s willing to let a province default, but would it really? Gross provincial debt is roughly 50% of GDP (the highest of any group of sub-national governments in the Organisation for Economic Co-operation and Development). A missed bond payment would send Canadian bond markets into a tailspin.

And we should be thankful that a no-bailout policy isn’t credible. It might limit provincial borrowing, but it would do so at the risk of inviting self-fulfilling defaults. Spain learned this the hard way in 2012 when the biggest threat to national solvency was not excessive debt levels, but exorbitant risk premiums or fear of insolvency itself. The federal government never has to worry about this. It’s assumed the Bank of Canada would print money in the event of a federal repayments crisis. But it’s not clear whether this commitment extends to the provinces. Ottawa’s implicit guarantee is the provinces’ best defence against market hysteria.

Ottawa could, in theory, stake out a middle ground by making the guarantee explicit, but putting strict conditions on any potential bailout. This strategy would limit market panic and if Ottawa’s conditions are sufficiently demanding, it would prevent excessive borrowing as well. But if a bailout does occur, Ottawa would have incentives to soften its terms and provinces would recognize this; incentives to borrow would persist.

Clearly, it’s dangerous to let implicitly guaranteed governments borrow money. The temptation to over borrow and put other governments at risk is too great. This is why most federations restrict sub-national borrowing in one form or another.

Unfortunately, Canada is not likely to adopt such a model. It emerges in states of distress when central governments trade bailouts for fiscal rules. These negotiations aren’t going to happen as long as the provinces borrow at affordable rates.

And it’s not obvious, even if provinces were on the brink, whether centralization would occur. Provinces are protective of their sovereignty and Ottawa lacks the ability to restrict it. This was illustrated in 1935 when Alberta chose to default rather than to accept the supervision of a national loans council.

Granted, times have changed. Incentives to repay bondholders are higher. It’s likely Ottawa and the provinces would strike a deal. But would it involve meaningful borrowing limits?

The Eurozone may be instructive. It has managed to impose harsh conditions on Greece. Why couldn’t Canada, a more centralized currency union, do the same? The answer is surprisingly simple: Europe’s paymasters are sovereign states. While German politicians have no incentive to soften a recipient’s bailout terms, federal politicians in Canada do have one: the support of provincial voters.

This isn’t all bad. Greek austerity is excessive and politically unsustainable. But Ottawa’s inability to impose any meaningful discipline is worrying.

We have to think harder about managing provincial debts. Last week, in our report on the risk of a provincial debt crisis in Canada, the Mowat Centre recommended the adoption of a neutral council for assessing federal-provincial transfers. The proposed council could support provincial finances in several ways, including ensuring that transfers are consistent with principles of fiscal discipline and that Ottawa provides provinces with sufficient countercyclical fiscal support.

Of course, this is only a partial solution. We have a long way to go in our thinking about how to manage our provincial debt problem. And so, while Canada won’t be laying out rules for the provinces any time soon, Stephen Gordon’s call to action is a welcome one.

Kyle Hanniman is a policy associate at the Mowat Centre the author of Mowat’s recent report, Calm counsel: Fiscal federalism and provincial credit risk.

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Release Date

February 24, 2015


The National Post


Kyle Hanniman

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