Also needing cash: The provinces

Federal deficits will soar as a result of the measures Ottawa has announced to keep the economy on life support as Canada goes to war with COVID-19. But there is overwhelming consensus that the new borrowing is both necessary and, with interest rates as low as they are, feasible. So far, most discussion of borrowing capacity has focused on the federal government. But there are eye-popping deficit forecasts from provincial capitals, too. Can we really expect provinces to borrow all the money this crisis requires? If not, what, if anything, should Ottawa do to keep them afloat?

The provinces entered the crisis with the highest collective debt- to- GDP ratio of any sub- national sector in the world. The Parliamentary Budget Officer has been warning about the unsustainability of provincial budgets for years. For these reasons alone, the federal government ought to issue the brunt of additional debt. But provincial deficits will soar no matter what the federal government does. Such is life in our highly decentralized federation.

Trouble is, provinces can’t borrow at federal interest rates. Right now, they all pay more than a full percentage point more than the federal government on 10- year bonds — significantly higher than just a few weeks ago.

Granted, relative borrowing costs have risen precisely as rates on federal bonds have fallen, so overall provincial borrowing costs haven’t increased that much. Still, they are higher than the rates faced by the central governments of most developed countries, including Italy.

Why do these spreads exist at all? Don’t most investors assume Ottawa implicitly backs provincial debt? My research strongly suggests they do. But there is always a chance the feds won’t rescue a teetering province, which means investors do need to consider provinces’ standalone creditworthiness.

The bigger problem right now is not default, however, but financial markets coming unhinged. As in 2008, investors are desperately seeking liquidity, which leads to a strong preference for federal over provincial debt. Hence the rise in provincial spreads and increasing difficulty of issuing provincial debt. With the market’s desired spread rising and secondary trading of bonds thinning, provinces and their underwriters (who buy the debt and resell it to investors) often struggle to identify a market- clearing price, a problem that is bigger the smaller and less liquid a province’s pool of debt.

In theory, the market is never strictly closed to provinces. They can borrow so long as they pay a premium over unreliable spread indications from secondary markets. Perhaps. But provinces have been known to sit out these periods and rely instead on treasury bills and other short- term borrowing instruments to see them through. This increases their short-term refinancing risk, but it keeps them from overpaying for long- term debt and potentially spooking investors with desperate spread concessions.

These time-outs are usually short. But not always. Newfoundland and Labrador went six months without issuing a bond in 2015-16, despite significant borrowing needs. What about this time around? Several provinces have issued bonds in recent weeks, but most issues have gone to one or a small number of investors and even demand for short- term debt has been choppy. Newfoundland and Labrador came close to running out of cash. So it was no surprise when on March 25 the Bank of Canada started buying up to 40 per cent of provinces’ money market offerings, a move that appears to have shored up demand for both short- term paper and longterm bonds, as well.

Will it be enough? Provinces have weathered substantial volatility over the past 12 years and have always come out the other end borrowing long- term debt. But today’s spreads are high; borrowing needs are soaring; and we are experiencing the fastest economic contraction ever, with untold potential for financial dislocation. The Bank of Canada and federal government may need to do more.

That was Manitoba Premier Brian Pallister’s thinking last week in recommending the creation of a federal credit agency to allow provinces to borrow at federal rates. That’s certainly worth considering. In the meantime, a faster and less controversial solution would be for the Bank of Canada to follow the lead of the Reserve Bank of Australia and European Central Bank and expand its new quantitative easing program to include subnational bonds.

Doing so would raise all the usual concerns about moral hazard. Won’t central bank bond- buying lead to reckless borrowing? But the central threat to provincial finances right now is the pandemic — not the decisions governments have made — and Canada needs to do everything it can to keep cash and credit circulating. With their vital ties to households, businesses, municipalities, non- profits, hospitals and the vulnerable, the provinces are crucial links in this system.

In the current crisis, businesses and households desperately need liquidity. But so do the provinces.