Provinces too big to fail but need help
Provinces are too big to fail, but too small to weather COVID-19 on their own
Heading into 1993, Saskatchewan was a leading candidate for a dubious honour: provincial bankruptcy.
No province had defaulted on its debts since Alberta during the Great Depression, but Saskatchewan’s borrowing had soared throughout the 1980s and its credit rating had been downgraded, making it harder to sell its bonds to investors.
Compounding the problem were the after-effects of the recession that gripped Canada in early 1990 and refused to let go until the spring of 1992. A province going bust was no longer some abstract possibility; it was very real.
Enter Roy Romanow, a New Democrat elected premier in 1991, who, along with finance minister Janice Mackinnon, began trying to get Saskatchewan’s fiscal house in order. Along the way there were some heated exchanges between Romanow and Brian Mulroney, then prime minister, who was facing a difficult fiscal situation himself.
But Saskatchewan’s fiscal salvation ultimately came from two sources: austerity and the federal government.
“You can’t say as prime minister, ‘Well, tough luck,’ ” Romanow told the Post in an interview. “That damages the entire body politic called Canada.”
The Saskatchewan experience is informative because the COVID-19 pandemic is poised to bring about a similar sort of situation, but for all of the provinces and territories and all at once.
Canada has already plunged into one of the most severe recessions in its history. The unprecedented government response to the coronavirus crisis is cushioning the blow, but at the cost of increasing provincial debt burdens that were already heavy.
Given the federal government’s lower debt costs and relatively vast amounts of borrowing room, provincial eyes have again turned toward the feds for some kind of additional help, highlighting one of Canada’s unspoken truths: The provinces are too big to fail.
This has probably been the case since Canada became a country; a foundering Prince Edward Island was even lured into joining Confederation by the national government’s offer of assuming railway debt. The question that government officials could, or should, be asking now is whether the time has come for a better or more formal way to solve debt crises, because the current problem could be too big and too broad for another quick political fix.
Former prime minister Stephen Harper, who led Canada during the global financial crisis, recently wrote in the Wall Street Journal that “unless we experience a period of astronomical global growth, simple arithmetic dictates that many governments, both national and subnational, will experience debt crises or at least severe pressures, in the years to come.”
In 1993, Romanow and Mackinnon enacted, in the ex-premier’s words, a “pretty draconian” budget of spending cuts and tax increases. Rural hospitals were closed and a children’s dental plan was scrapped, among other things. Protests ensued.
Meanwhile, Mulroney and the federal government tinkered with federal-provincial financial arrangements, giving Saskatchewan the breathing room it required.
Despite their butting of heads at the time, Romanow said he did, and still does, respect Mulroney.
As a result of their tinkering, though, a long-standing Canadian riddle of provincial bankruptcy did not get solved, nor has it since then.
“Roy Romanow did all the eggheads of fiscal policy a huge disfavour, because we were about to get an answer to that question,” said Don Drummond, who was an assistant deputy minister of fiscal policy and economic analysis in the Department of Finance at the time of Saskatchewan’s near-default experience. “And then damn it if he didn’t fix his own problem.”
The stakes, however, are still high.
Drummond, who went on to become the chief economist of Toronto-dominion Bank and is now an adjunct professor of public policy at Queen’s University in Kingston, Ont., drew a comparison to the 2008 collapse of investment bank Lehman Brothers Holdings Inc. The U.S. government at the time declined to rescue Lehman, kicking the global financial crisis into overdrive.
“I’m not saying that would happen with a province,” he said.
“But there’s no way that everybody else, including the national economy, comes away unscathed if a province defaults.”
Provincial governments had $853 billion of debt securities outstanding before the COVID -19 crisis, more than that of the federal government, according to Bloomberg. The pandemic will require them to sell even more debt, despite Canada’s Parliamentary Budget Officer warning in February that the spending plans of most provinces were already unsustainable.
Lost tax revenue will help cause record budget deficits this year in every province except Saskatchewan and Nova Scotia, according to a recent report by the Bank of Nova Scotia. The report also predicted weaker economic growth and increased spending will add around $64 billion to provincial borrowing requirements.
For example, the Financial Accountability Office of Ontario this week estimated that the province’s real GDP will decline by nine per cent in 2020, the biggest annual drop on record, and that the deficit will nearly quadruple to $41 billion, also a record. The province’s net debt-to-gdp ratio will likewise increase to an unprecedented 49.7 per cent.
“COVID-19 will leave a lasting mark on provincial finances, which will put credit ratings at risk,” Royal Bank of Canada economists Robert Hogue and Ramya Muthukumaran said in a recent note.
British Columbia has been one of Canada’s stronger provinces, economically and fiscally, but S&P Global Ratings on Thursday revised its outlook for the province to negative from stable.
The debt-ratings agency maintained its triple-a rating, but said the pandemic would turn B.C.’S GDP and revenue growth rates negative and create deficits and greater levels of debt.
Many investors and credit-ratings agencies have long assumed that a province would never be allowed to fail, even though there is not a statutory process in place for saving one, said Kevin Page, Canada’s first parliamentary budget officer and now the founding chief executive of the University of Ottawa’s Institute of Fiscal Studies and Democracy.
Provincial borrowing costs would likely rise without the assumption of federal support, and interest costs could crowd out spending on schools and hospitals and other areas under provincial jurisdiction.
Moody’s Investors Service, one of the Big Three credit agencies, in April changed its outlook for Newfoundland and Labrador’s debt to negative from stable after Premier Dwight Ball in March warned the federal government that his province was running out of cash.
Still, Moody’s affirmed Newfoundland and Labrador’s rating at a decent A1, even though the math put the province’s baseline credit assessment at A3, two notches lower. The agency went with the more favourable rating because of “an assumption of a high level of extraordinary support from the Government of Canada,” which has a triple-a rating, Moody’s said.
But if one province were to go under, that assumption would be gone, Drummond said. “Then they’re all in deep trouble.”
If the federal government stepped in to play hero, it would mean acknowledging that unspoken truth and reinforcing the assumption that provinces are simply too big to fail.
Big banks have also been deemed too big to fail, but at the time that was agreed to, reforms followed to both prevent failure and ensure there was a systemic response when bankruptcies happened.
For example, Canada now has a “bail-in” regime, under which certain big-bank debt could be converted into common shares to recapitalize a struggling lender.
There is the possibility that the fiscal straits caused by COVID-19 could inspire reform as well.
After the Great Depression, when Alberta and other provinces struggled, the feds took responsibility for employment insurance to ease their burdens.
“Pressure will increase on the federal government by premiers, territorial leaders, First Nations leaders and mayors for a review of fiscal arrangements,” Page said in an email.
Even prior to the pandemic, there had been pressure on the federal government to overhaul the Fiscal Stabilization Program, which allows the feds to lend financial help to any province dealing with a year-over-year decline of more than five per cent in non-resource revenues.
Collapsing crude prices had made this a priority for oil-producing Alberta, since payments from the stabilization program are capped at $60 per person.
Another proposal floated recently by Manitoba Premier Brian Pallister is that the feds could set up an emergency credit agency to borrow on behalf of the provinces.
The federal government borrows at a lower rate than the provinces, which could save them money that could be funnelled back into health care or other areas of need.
But in the past, the federal government and the provinces have relied on ad hoc fixes.
Alberta’s defaults ended about 75 years ago with a federal bailout.
Drummond noted that, among other things, Saskatchewan in 1993 benefited by approximately $17 million when the feds tweaked the equalization formula and then made a $125-million payment tied to loan guarantees for an oil upgrader.
A $30-million stabilization payment to the Prairie province was made in 1993, but it had to be returned when it was later determined Saskatchewan didn’t qualify for the assistance.
There also was the $2.5-billion resource-sharing agreement with Newfoundland and Labrador in April 2019, and the Bank of Canada’s provincial bond-buying today, which reduced some of the fiscal pressure on the Atlantic province.
These fixes feed the too-big-tofail narrative, and make the expectation of bailouts a reasonable one, said Trevor Tombe, an associate professor of economics at the University of Calgary.
“We’re not going to have a province go bankrupt,” he said.
Rather, there could be a situation where the federal government, similar to the way the International Monetary Fund acts, provides support in exchange for the provinces making certain changes.
Tombe said the crisis could prompt changes in the way health transfers are structured, particularly when it comes to federal payments that are explicitly marked for specific initiatives, such as long-term care.
He also noted another tool available to the federal government that could assist the provinces: Disaster Financial Assistance Arrangements, which could be tweaked to allow funding related to pandemics.
Romanow’s budget was unpopular, but it kept the federal government away and Saskatchewan from defaulting. Similar hard choices could become necessary in the years ahead as provinces claw their way out of the red.
“In the not too distant future, governments are going to have to phase out emergency assistance programs, assess their financial circumstances and begin the difficult process of reducing spending,” Mackinnon said in an email.
Taboos are being challenged everywhere. U.S. Senate Majority Leader Mitch Mcconnell recently caused a flap by suggesting cashstrapped states should declare bankruptcy, which is something state governments can’t do.
In Canada, a province can’t seek shelter under something like the Companies’ Creditors Arrangement Act, which allows corporations to restructure. This leaves them with choices similar to those Saskatchewan faced in 1991: a mix of austerity and help from the feds.
Drummond said that if Saskatchewan had not made its fiscal adjustments in the 1990s, the feds would likely have come through with more assistance, perhaps something similar to the Bank of Canada’s current policy of buying provincial bonds, which puts downward pressure on interest rates.
Whatever the measure, Romanow suggested that any prime minister would do whatever it takes to avoid a financial calamity caused by a provincial bankruptcy.
“You can’t allow that,” he said. “Because the entire country gets blackened by that.”
Pressure will increase on the federal government by premiers, territorial leaders, First Nations leaders and mayors ...