PACKING ON DEBT ONLY WAY OUT OF CRISIS

COVID-19 Canada has borrowed itself into a corner

Murdoch Alexander MacPherson had come to Toronto bearing feel-good stories about debt. “I want to read another letter that has to do with a case,” the Saskatchewan lawyer and politician told his audience, “a report from the manager to one of those so-called soulless corporations in the City of Toronto.”

The story of a debtor coming away from a meeting with his creditors “entirely satisfied” was one of several yarns MacPherson would spin that day in November 1934 (another involved a $125 debt and a mare), as he flogged the Farmers’ Creditors Arrangement Act as part of his administrator duties. The legislation was Prime Minister R.B. Bennett’s answer to resolving the impasse between farmers who owed money and those who had lent to them.

Part of the solution was softening society’s attitude about debt; rather than punish debtors for succumbing to forces beyond their control, MacPherson urged creditors to share some of the pain for the sake of the greater good.

“It is based on the belief which Parliament has that people of this country, whether they owe or are owed money, will be reasonable and fair and that they all recognize, whether owing or owed, that some sacrifice must be made by everyone before normalcy can begin to obtain,” he told the Canadian Club of Toronto.

An almost 86-year-old speech may seem like a strange thing to bring up, but there aren’t many precedents for the world to draw upon when it comes to the economic fallout effects of the coronavirus pandemic. The recent Great Recession could make a logical reference point for the current crisis, but the Great Depression might be more relevant when it comes to understanding what we’re about to confront, especially when it comes to amassing debt.

During the Depression, drought and low commodity prices crushed farm incomes and left people struggling to pay back loans. The federal government of the day was finally jolted enough to set aside its laissez-faire ideology and take action.

Yet even after MacPherson’s speech and actions, a return to economic stability was still years away.

The economy only truly turned around when the government of William Lyon Mackenzie King (who ousted Bennett) initiated a massive spending program to help win the Second World War.

King’s current heir, Justin Trudeau, also plans to spend heavily to avoid economic disaster, albeit to eradicate a different existential threat. But there are echoes of Bennett, too. Canada once again will be asking for reasonableness and fairness when it comes to debt. And, like the Depression, the coronavirus pandemic has paralyzed everyday life, only it has happened in weeks, not years.

The virus has sent the economy off a cliff. Canadians made approximately 929,000 new employment insurance claims in just one week in March, more than 20 times the usual weekly total and equal to almost five per cent of the country’s workforce, according to DBRS Morningstar.

“The severity of the downturn intensifies our concerns about the creditworthiness of some Canadian households and firms, especially since many were highly leveraged going into the crisis,” the debt-rating agency said in a recent report.

Economic output has taken a big hit as well. A recent note by Capital Economics predicted Canada’s gross domestic product would contract by an annualized 35 per cent in the second quarter.

The downturn has left plenty of people and companies suddenly facing the possibility that their income and cash flows, used to pay bills and pay down debts, will quickly dry up.

If consumers and companies don’t have cash, it apparently falls to the government to get some to them before they begin defaulting on their loans. And the way governments will have to get that money during the current crisis is to borrow.

In other words, Canada’s problem and solution are one and the same: debt put us into a tough spot, debt must now get us out.

“The federal government is going to have to take on an enormous amount of debt in the short term, and then turn around and give a lot of that debt back to firms and households,” said Philip Cross, a fellow at the Macdonald-Laurier Institute and former chief economic analyst at Statistics Canada. “Because there’s no way the private sector can increase its debt load that quickly in the short term, markets would only trust the federal government and its endless power of the printing press to make good on all that debt.”

A misstep could leave many companies and consumers on the brink of bankruptcy. French economist and University of California, Berkeley professor Pierre-Olivier Gourinchas believes that a sudden economic stop “can easily trigger a cascading chain of events,” since modern commerce is made up of a number of connections between consumers, companies and lenders.

If people are at home and avoiding each other, they may not be able to work and may not be able to buy certain things — they may not want to anyway if they are worried about job security. If people can’t or don’t buy things, businesses make less money and may need to lay people off, which leaves even more people with less money. Banks could end up with loans that their customers (either corporate or consumer) cannot pay back, and may shy away from further lending.

“Panic or loss of confidence adds another layer,” Gourinchas said in a policy brief for Economics for Inclusive Prosperity, a network of academic economists. “The result would be cascading business failures, with an associated surge in layoffs and a buildup in financial fragilities.”

One of the longest-running financial weaknesses in Canada has been our high levels of debt.

The non-financial sector’s total credit as a percentage of Canada’s gross domestic product was more than 300 per cent (or over US$5.2 trillion) in the third quarter of 2019, the most recent period for which the Bank for International Settlements, a bank for central banks, has data. That’s one of the highest levels in the world. Among advanced economies, the average was about 270 per cent.

Unless payments are deferred, all this debt must be “serviced,” or paid back, even if incomes and revenues are being wiped out. Otherwise, people and businesses will become insolvent, which was already becoming a concern back when things were normal.

Month-over-month total insolvencies were up 8.7 per cent in January and 10.4 per cent year-over-year, according to the Office of the Superintendent of Bankruptcy.

Bank of Canada senior deputy governor Carolyn Wilkins in November said the bank’s research had found Canada “would be hit particularly hard” by a scenario where rising uncertainty worsens a global economic slowdown, which is quite similar to the situation we’re experiencing now. Canada is extra-sensitive to collapsing commodity prices and diminished demand for exports, but the concern at that time was trade wars, not a global pandemic.

“The fact that household debt is higher than it was in 2008 would make things worse, too,” Wilkins said. “That’s because indebted households facing a deteriorating financial situation would have to adjust their consumption spending more than they would have had to in the past.”

More recently, the vulnerability that Wilkins flagged has become more apparent. For example, a survey by the insolvency division of accounting firm MNP LLP found that 25 per cent of respondents were already unable to meet all their monthly debt obligations.

Canada’s housing sector, a prime driver of economic growth for the past decade, is not immune either.

For years, rising prices and high levels of debt led to skepticism about the real estate market’s soundness. When pressed, though, lenders would point to Canada’s low jobless rate. Rising home prices also meant households’ overall wealth was increasing, a development some economists said mitigated the debt threat.

But both the employment and wealth arguments might now be tested. Recent reports by the Royal Bank of Canada’s economics unit have predicted unemployment could rise past 11 per cent (or about double where it was in February) and that property values could fall for a short period if “tightsqueezed sellers” are forced to make concessions.

“An increase in defaults from highly leveraged households could be seen in the medium term,” noted another recent report by DBRS Morningstar.

The Canadian Federation of Independent Business also recently surveyed its members and found approximately a quarter of small businesses were not able to pay April’s commercial lease or mortgage payment due to COVID-19-related problems.

Canadian government officials are likely aware of all that data. The federal government has to step in, and is stepping in, to try to “buffer as much of this pain as possible,” said Kevin Page, chief executive of the Institute of Fiscal Studies and Democracy at the University of Ottawa.

So far, the federal government has announced more than $250-billion worth of measures, such as wage subsidies and speedier access to employment insurance sickness benefits, to try to help consumers and companies. Ottawa has also pushed banks to better accommodate their customers during the crisis, and the lenders have responded by offering deferred mortgage payments for up to six months, among other things.

INTENSIFIES OUR CONCERNS ABOUT CREDIT-WORTHINESS

OF SOME HOUSEHOLDS.

In addition, the Bank of Canada has slashed interest rates to historic lows, vowed to buy tens of billions of dollars’ worth of bonds and provided a “Standing Term Liquidity Facility” to lend to commercial banks at favourable terms, which nine banks, including the country’s biggest, have already taken advantage of.

The federal banking regulator also lowered the amount of capital the country’s biggest banks must carry, freeing up $300 billion in lending room, and is allowing loans on which payments are deferred to be accounted for as debts that are still being paid back.

Yet to ensure everyone is paying their bills and that the economy comes out of the crisis on solid footing, federal and provincial governments must ultimately pack on more debt.

Governments “are the only game in town” for now, Cross said.

Ottawa’s game plan is to get its borrowed money to consumers and companies sooner to keep them solvent, thus improving the odds that the federal government will get the money back by way of faster economic growth and stronger tax receipts later on.

But even before all the government’s measures had been outlined, Canada’s Parliamentary Budget Officer had projected the federal deficit could explode to more than $112 billion in 2020-21, or approximately 5.2 per cent of GDP, from around $26.7 billion in 2019-20. The feds are currently carrying more than $700 billion in debt, which amounts to over 30 per cent of GDP, but the debt-to-GDP ratio could top 38 per cent in 2020-21, according to the PBO’s scenario.

Borrowing even more also sets up questions about debt that no one has much time to think about right now.

“How does it impact the recovery on the other side of this, once we get most of this public health-care crisis behind us?” asked Page, who was also Canada’s first Parliamentary Budget Officer.

The level of borrowing would be sustainable if the economy has a rapid recovery, Cross said. But Canada was already in a period of slower growth and the prospects for a lot of companies, particularly in the energy sector, look pretty bleak at the moment.

“It’s hard to imagine that we’re going to have a rip-roaring recovery,” he said. “You would think that in the recovery, firms and households, especially, are going to be looking to pay down debt, not to spend more, and that’s going to structurally limit the speed of the recovery and that’s going to make servicing debt difficult.”

As a result, ratings agencies could downgrade their opinions of Canada’s creditworthiness, which would probably cause borrowing costs to rise. The mandate letter Finance Minister Bill Morneau received from Trudeau included orders to protect Canada’s triple-A rating, the highest it can be, but keeping that rating could be a challenge unless the agencies make some COVID-19 concessions.

There are also concerns about provincial debt. Newfoundland and Labrador Premier Dwight Ball recently wrote to Trudeau warning that his province had “run out of time,” as it has been trying and failing to borrow the money needed to deal with the current crisis.

The call for help was ultimately answered by a provincial bond-buying program by the Bank of Canada.

The federal government still has plenty of fiscal room, at least for now.

“Given credit market access at historically low rates, and looking to historical experience, suggests that the government could undertake additional significant borrowing if required,” the current PBO said in its scenario analysis of COVID-19 and the oil shock.

As an example, the watchdog pointed to the measures the Canadian government used during the height of the

Second World War, which “resulted in massive deficits” that averaged 21 per cent of the gross national product from 1942 to 1945.

Those deficits, however, were not permanent. In 1947, the federal government recorded its biggest-ever budget surplus relative to the economy, which was five per cent of GDP.

Keep in mind, too, that there will be a lag in getting money to consumers and businesses, some of which are already struggling. For example, funds from the government’s $71-billion emergency wage subsidy aren’t expected to flow for around six weeks.

The subsidies won’t help everyone. The Canadian Centre for Policy Alternatives estimated approximately 862,000 unemployed workers will not receive any support from either employment insurance or the Canada Emergency Response Benefit.

Scott Hannah, chief executive of the Credit Counselling

Society, an accredited non-profit charity that helps consumers with their debts, said less than 10 per cent of the firm’s clients have so far asked for short-term relief. Despite the big headline numbers about layoffs, a lot of people are still working, he said.

“There’s the initial fear of, ‘I need to make sure that we’ve got enough food and supplies in the house for the next two or three weeks,’” he said. “We’re now seeing consumers contacting us who are saying, ‘I have been impacted by this, I’m not sure what to do, or what my creditors are going to do.’ ”

Understandably, banks and other creditors don’t want to incur big losses, Hannah said, so they have to work with their customers to pre-empt defaults by deferring payments and other strategies. Some consumers have been frustrated trying to get relief from their bank, but the lenders have been dealing with thousands of calls and say they are prepared to help.

Case-by-case compromises by lenders may have to tide over a number of borrowers and creditors until the coronavirus crisis passes or government assistance arrives.

Such compromise is something M.A. MacPherson, the administrator of a forgotten piece of legislation, suggested in 1934 in the Great Depression. Those who owe and those who borrow should find common cause, he said.

“In the final analysis everyone — almost everyone — in this country, be he debtor or creditor, is anxious to help the other fellow out if the other fellow is in distress,” he told the Canadian Club back then.

The longer the current crisis lasts, the more MacPherson’s analysis will be put to the test.

WE’RE NOW SEEING CONSUMERS CONTACTING US WHO ARE SAYING, ‘I HAVE BEEN IMPACTED BY THIS, I’M NOT SURE WHAT TO DO, OR WHAT MY CREDITORS ARE GOING TO DO.’ — SCOTT HANNAH, CEO OF THE CREDIT COUNSELLING SOCIETY

NATIONAL ARCHIVES OF CANADA The Farmers’ Creditors Arrangement Act was Prime Minister R.B. Bennett’s answer to resolving the impasse between farmers who owed money and those who had lent to them. Bennett is surrounded by members of his cabinet above.