Persistent deficits, higher spending could heighten Canada’s ‘vulnerability’

Nation could see ‘faster ... slowdown or sudden shock,’ ratings agency warns

TORONTO The Liberal government’s preference for continued deficits and increasing program spending “could increase the vulnerability of public finances to a faster economic slowdown or sudden shock,” according to Fitch Ratings.

Canada has the second-largest gross government debt of “AAA” rated countries after the U.S., which is “incompatible” with its gold-plated rating, the ratings agency said in its post-budget analysis. While the Toronto-based credit agency concedes that increased spending and projected deficits in Canada’s latest budget remain consistent with a falling federal debt burden, the forecast assumes the economy will avoid a recession.

“Modest fiscal loosening and sustained deficits will increase the economy’s exposure to a downturn,” it said.

While the expanded federal deficits remain relatively modest at less than one per cent of GDP and are sufficiently low to keep debtto-gdp ratio drifting lower over the medium term, the country’s gross general government debt, combining federal and provincial fiscal accounts, is higher than other similarly rated sovereigns, and the ratings agency notes that debt levels are “incompatible with (Canada’s) ‘AAA’ status.”

Fitch had issued a similar warning in 2017.

New spending items in the budget aim to stimulate an economy that’s lost momentum, with some analysts suggesting a recession may be round the corner. Canada’s GDP fell by 0.1 per cent in November and December, but the economy managed a marginal 0.4-percent growth in the fourth quarter.

The Organization for Economic Co-operation and Development said it is now forecasting a 1.5-percent growth this year for Canada, compared to its previous call for GDP growth of 2.2 per cent.

On Wednesday, Finance Minister Bill Morneau disputed the notion that a recession might rear its head. “We’re expecting … that we will have a return to growth at expected levels in the second quarter (of 2019) and our long-term forecasts are positive,” Morneau said.

However, investors are becoming more cautious and more convinced that the next interest-rate move from the country’s previously hawkish central bank will be more dovish.

Local yields have fallen in recent weeks amid weakening economic data, a more downbeat assessment from the Bank of Canada and a global rally in bonds. Wednesday’s dovish shift by the U.S. Federal Reserve and the market’s more gloomy view on prospects for the U.S. buoyed sovereign bonds and supported the view that policy-makers in Ottawa will need to cut rates.

With “the bulk of the curve being below the overnight rate, it really says that the BOC will be reluctantly led to cutting rates,” Ryan Goulding, a fixed-income manager at Vancouver-based Leith Wheeler Investment Counsel Ltd., which manages around $19 billion, told Bloomberg. But it may not happen until “after a long, disappointing wait” for capital spending to pick up, he said.

The annual deficit projections in Tuesday’s budget, which is set to reach as high as $19.8 billion, will be racked up as the government makes several large, one-time investments for 2018-19, including $2.2-billion worth of new infrastructure funding and $1 billion towards improving energy efficiency.

The budget also pledges up to $3.9 billion for supply managed dairy, egg and poultry farmers affected by recent trade deals with the Asia-pacific and Europe. Other big-ticket items include a $300 million zero-emissions car incentive, and a $1.25-billion houses-for-votes program that provides interest-free loans to first-time home buyers through the Canada Mortgage and Housing Corp.

The election year budget was offered under a backdrop of disappointing growth over the last several months, according to CIBC Capital Market analysts Avery Shenfeld and Andrew Grantham. “This was less a rain of largesse and more of a sprinkling of measures, aimed at winning-over targeted groups.”