Debt binge a very real risk

Push to cushion blow could long reverberate

Extreme diseases require extreme remedies, but the debts racked up by Canadian governments to respond to COVID-19 run the very real risk of ruining the next generation.

National Bank Financial warned this week that Canada’s triple-A credit rating could come under review because combined federal and provincial deficits this year could add up to $350 billion, or 20 per cent of GDP.

The bank said a “non-trivial and quasi-permanent step-up in indebtedness is the stuff downside credit rating pressure is made of."

Two of the big four credit rating agencies, Moody’s and DBRS Morningstar, have already reaffirmed Canada’s rating and stability, deeming that the federal government’s emergency measures are temporary and manageable.

But the other two big agencies, Standard & Poor’s and Fitch Ratings, have still to pronounce. It is perhaps just as well that more goes into a rating than a glance at budgetary balance.

If it did, Canada’s gold standard ranking could be lost already.

The Parliamentary Budget Officer, Yves Giroux, spoke to the federal finance committee on Tuesday and suggested that his $252 billion budget deficit scenario, released on April 30, is likely to prove “very optimistic” given the measures the Liberal government has announced since then.

Former prime minister Stephen Harper reminisced about his time in office during the Great Recession in an op-ed for the Wall Street Journal this week.

He said he learned that governing in the midst of a crisis is the easy part.

I THINK THERE IS AN INCREASING WORRY THESE AID PACKAGES MAY BE MORE PERMANENT THAN PREVIOUSLY THOUGHT.

“In the short term, spending initiatives or tax breaks are always popular, especially when the public wants to see action,” he said. “The inevitable spending cuts and tax hikes later — even those that end temporary measures — will encounter serious resistance.”

Justin Trudeau is certainly making the government’s response look easy, disbursing billions of dollars hither and thither. This is a government that relishes spending, after all.

Even people supportive of his efforts to help two million low-income seniors raised their eyebrows when he extended the largesse to all seven million over65-year-olds, many of whom protested on social media that they didn’t need the money. Seniors are already subject to a means-test: the Guaranteed Income Supplement is given to those with income of less than $18,600. A more prudent government would have directed the $2.5-billion package their way.

The apparently limitless nature of federal spending was on display again on Wednesday, with another $962 million in relief to be dispensed by regional development agencies to companies that have “fallen through the cracks” of other programs.

Debt-to-GDP levels could crack 50 per cent this year, a level not seen since the 1990s, when it peaked at 68 per cent.

Giroux was surely correct in his analysis when he said the cost of the government doing nothing when COVID hit would probably have been higher than the current $150 billion (and rising) price tag.

But emerging from this crisis is going to require a delicate touch, if the consequences are to be anything but epochal.

Already, the government has extended the life of the emergency wage subsidy because so few companies have applied for it thus far (only 1.69 million workers are covered, compared to 7.8 million applicants who receive the emergency response benefit that runs out early next month).

“I think there is an increasing worry these aid packages may be more permanent than previously thought,” said Warren Lovely, chief rate strategist, at National Bank Financial.

If they do not end on schedule, it may attract the attention of the rating agencies.

This is not just about bragging rights. In his mandate letter from the prime minister, Finance Minister Bill Morneau was instructed to preserve the triple-A credit rating — in large measure because it is the foundation of confidence in Canada’s economy, indicating to investors the level of risk they can expect to incur.

A downgrade would not only increase the cost of borrowing for the federal government but it would impact the benchmark interest rate. Costs could rise for banks and corporations, with implications for stock markets and wider lending.

In an extreme case, the negative feedback loop would lead to banking and corporate failures, which would in turn put more pressure on government finances and further downgrades. Higher borrowing costs for banks would be passed on to households in the form of higher mortgage rates or a cutback in lending.

Thomas Torgerson, managing director of sovereign rating at DBRS Morningstar, said a single downgrade is unlikely to have a material impact on interest rates. For a politically stable country like Canada, a sudden change in risk profile is unlikely.

But there is a very real prospect that the kind of massive debt Ottawa is incurring stores up a debt crisis for the next generation.

Incredibly, the carrying cost of the debt has barely increased in past couple of years. The federal debt has risen from $685 billion in 2018 to an estimated $962 billion this year, according to the PBO, though Giroux suggested breaking through the $1-trillion barrier is eminently possible. Yet public debt charges have hovered around $23 billion, thanks to interest rates at historically low levels (the yield on a 10-year benchmark bond is just 0.59 per cent).

We are fortunate that this is not 1995, when the yield on the 10-year bond was nearer 10 per cent; 36 cents of every dollar went toward public debt charges; and there was widespread speculation that Canada would have to call the International Monetary Fund for a bailout.

“The debt looks highly affordable at current interest rates. For the time being, the central bank is absorbing a lot of bond issues the government of Canada is bringing to market,” said Lovely.

Yet nobody knows if the deficits currently being amassed will be always be financed at these low rates.

As Paul Boothe, a former senior bureaucrat at Finance Canada, explained, in normal circumstances around one-third of government of Canada debt is held by foreigners. Nobody knows who might buy that debt, or at what rate, once the pandemic has passed.

“This is not to say governments shouldn’t be spending and running big deficits now. It does mean that growing deficits and debt are a worrisome side-effect of the virus,” he said. “We need to spend responsibly because it’s likely our children will bear the cost of debt we incur today.”